Islamic banking and Conventional bank Example

Essays on Islamic banking and Conventional bank Essay Difference between conventional banking and Islamic banking of Table of Contents Introduction 3 Aim of the study 3 Importance of the study 3 Difference between Islamic banks and Conventional banks 4 Difference between the two types of banks: practical approach 4 Difference between the two types of banks: theoretical approach 6 Conclusion 7 References 8 Introduction The global financial crisis of 2008 changed the banking system all over the world. At one hand, it highlighted and questioned the functioning of conventional banks while one the hand, it increased attention on functioning of Islamic banks. The law that rules conventional banks is rule of debit and credit while Islamic banking system is governed by Shariah laws. Academicians have observed that advantages of shariah-compliant financial services such as long term uncertain loans and mismatched short term deposits are mitigated with equity elements. Further, shariah compliant products are popular with those individuals who seek to avail those financial services that are consistent with Islamic religious views. Prior to the crisis, these banks were infamous and operative within their respective countries. However, crashing of major financial banks attracted attention of investors and financial intermediates towards these banks (Lewis Algaoud, 2001). The paper intends to discuss different Islamic banking services and products and distinguish them from conventional banking services. In addition, the paper will also explain elaborately different laws that govern Islamic banking sector and separate its operations from conventional banking. Aim of the study The paper aims at having a clear view and deep understanding of the elements of financial services that differentiate Islamic banks from conventional banks. Importance of the study During 2007-08, every conventional bank across the globe faced the heat of financial crisis. Many investment banks were bankrupt and debt ridden. However, during this period the Islamic banks existing in MENA (Middle East and North Africa) countries such as UAE, and Qatar performed unexpectedly well (Lewis Algaoud, 2001). It was observed that their bonds suffered a little but otherwise, they managed well. Furthermore, when the global banks were hesitant towards lending, these banks granted new loans during liquidity crisis. The comparative study will serve as an answer to various unasked questions regarding effectiveness of Islamic banks, which can be adopted by conventional banks to prevent future disasters. Difference between Islamic banks and Conventional banks Difference between the two types of banks: practical approach Islamic finance and banking facilities are a rising sector whose functions are based on Shariah (Islamic Law) principles. The main governing principles of Shariah are: Absence of interest-based transactions (Riba) Avoidance of speculation (Gharar) Avoidance of oppression (Zulm) Introduction of Islamic taxation (Zakat) Discouragement to activities that disagree with Islamic values (Haram) (Lewis Algaoud, 2001) A very distinctive aspect of Islamic finance is that it does not allow direct lending and borrowing in terms of money and other financial assets in order to create debt. In Shariah rule, the debt can only be created through lease based financial schemes or by selling or leasing real assets such as buildings, property and other physical infrastructure. Moreover, under this law, the debt of one person cannot be transferred or sold to someone. In other words, Islamic banking opposes the very reason of financial crisis, which was selling of subprime mortgages in the form of collateral bonds by investments banks to investors. The principle of Shariah insists on involvement of productive economic development in any kind of financial transaction. Scientifically, this factor eliminates the potential scope of excessive risk exposure related to leverage (IMF, 2014). In many countries such as Pakistan and Iran, Islamic banks are only source of mainstream financing while in countries such as Malaysia, United Kingdom, Indonesia and Bangladesh, Shariah compliant financing exists along with conventional banking. Unlike conventional banks, the essence of Islamic bank lies in risk and profit sharing so that profit is directly proportional to the risk. For instance, the risk associated with an investment activity is always integrated in respective financial transaction. Such a technique ensures stability and soundness in Islamic finance. Another important aspect of Islamic financing is that it prohibits trading of unregulated financial services such as derivatives and discounted debt sale whereas investors are allowed to invest in fixed return instruments (Ryu, Piao Nam, 2012). A survey by World Bank exhibited quantitative analysis of performance of Islamic banks and conventional banks all over the world. The data gathered through the survey was useful in preparing comparative study between both banks. The survey included 2956 banks across 141 countries and around 100 banks out of the same were Islamic banks. It was observed that between 1995 and 2007, an increasing number of Islamic banks have reported their financial information compared to conventional banks. It was further observed that Islamic banks enjoy higher share of fee income over conventional banks, by relying more on non-deposit funding. The loan-deposit ratio of conventional banks was comparatively high suggesting heavy dependence on interest-income generated through loans and deposits. Furthermore, asset quality of these banks was compared on the basis of loss reserves, loan loss provisions and non-performing assets. Even in this criterion, Islamic banks outperformed conventional banks by having significantly low loan loss reserve and non-performing assets. The last indicator that was employed was determination of bank stability based on solvency, profitability, leverage and volatility along with return on assets and capital asset ratio. It was observed that Islamic banks are better capitalized and more profitable compared to conventional banks. Alongside, Islamic banks were found to be less liquid than conventional banks (Beck, Demirgà ¼Ãƒ §-Kunt Merrouche, 2013). The following graph presents growth of assets in Islamic and conventional banks from 2006 to 2010- Figure 1 (Source: World Bank, 2014) Figure 2 (Source: IMF, 2014) Difference between the two types of banks: theoretical approach In modern Islamic banking services it is important to incorporate Zakat (Islamic tax) in all the activities while no such law is there in conventional banking. The conventional banks are formed for the purpose of earning profit through lending money and earning it back along with compounded interest. For these banks money is treated as a commodity and a source of motivation. On the other hand, Islamic banks believe in participative banking with know-your-customer orientation. Unlike conventional banks, Islamic banks do not follow principles of capitalism theory and profit maximization is subject to Shariah restrictions. In conventional banks earning profit is the main motive and risks can be transferred at a given cost. However, Shariah approved banks all financial transactions aim at greater good through economic development. These banks put great emphasis on the viability of the projects they approve. On the contrary, conventional banks ensure that the client is credit-worthy where credit is equivalent to ‘commodity pricing’. The Islamic bank plays a number of roles such as investor, partner, trader, seller and buyer with respect to relationship with clients, whereas that of conventional bank is to maintain creditor-debtor relationship (Lewis Algaoud, 2001). Conclusion The paper has emphasized on discussing the differences between conventional banks and Islamic banks. Comparison has been made between these two types of banks to understand the rationale behind success of Islamic banks during financial crisis of 2008. It was observed the Islamic finance and banking is an emerging sector yes it has greater extent of stability than conventional banks. The code of governance for Islamic banks is defined by Shariah (Islamic law) while conventional banks function on the basis of debit-credit rule. The paper has highlighted theoretical as well as practical approach to comparison and determination of differences. In theoretical approach it was found that Islamic banks not only provide fund to their client but they participate in their decision making as well. Whereas, the conventional banks are highly profit oriented. Statistics from World Bank supported the fact that Islamic banks are less risky and more profitable. As a result, it is expected that the conventional banking system will adopt the working structure of Islamic banks to prevent future financial disasters. References Beck, T., Demirgà ¼Ãƒ §-Kunt, A. Merrouche, O. (2013). Islamic vs. conventional banking: Business model, efficiency and stability. Retrieved from: http://elibrary.worldbank.org/doi/pdf/10.1596/1813-9450-5446. IMF. (2014). Islamic Banks: More Resilient to Crisis? Retrieved from: https://www.imf.org/external/pubs/ft/survey/so/2010/RES100410A.htm. Lewis, M. Algaoud, L. M. (2001).  Islamic banking. Cheltenham: Edward Elgar. Ryu, K.P., Piao, S.Z. Nam, D. (2012). A Comparative Study between the Islamic and Conventional Banking Systems and Its Implications. Scholarly Journal of Business Administration, 2(5), 48-54. World Bank. (2014). Can Socially Responsible Investing bridge the Gap between Islamic and Conventional Financial Markets? Retrieved from: http://blogs.worldbank.org/psd/can-socially-responsible-investing-bridge-the-gap-between-islamic-and-conventional-financial-markets.