Islamic and Conventional

Banking

Summary of the Previous Lecture

We studied the concept of time value of money
In the conventional economic system and its
basis on interest at a fixed rate.
Under Islamic economic system it is based on
price for a commodity with a difference for cash
and credit sale.

Learning outcomes
After todays lecture you will be able to understand
The governing principles of Islamic banking based on the
literature mostly discussed in the 2nd and 3rd lecture.
Major difference between the Islamic and conventional
banking system.
Modes of financing or products offered by the Islamic
banks.

Basics of Islamic Banking

Islamic Banking is based on Shariah Laws.
Shariah covers every aspect of our life, it provides
principles how to live at individual level, in the society,
legal and economic system, etc. or simply it is a
complete code of life.

Governing principles of Islamic Banking

1. The prohibition of interest or riba based transactions
2. Avoidance of speculations (gharar)
3. Avoidance of oppression (zulm)
4. Introduction of Islamic tax (zakat)
5. Financing of Sharia Approved activities and
discouraging the production of goods and services
which are not allowed in Islamic values (haram).

1. The prohibition of interest based

transactions
Those who charge usury (riba/interest) are in the same
position as those controlled by the devils influence. This is
because they claim that usury is the same as commerce.
However, God permits commerce and prohibits usury.
Thus, whoever heeds this commandment from his Lord and
refrains from usury, he may keep his past earnings and his
judgment rests with God. As for those who persist in usury,
they will incur Hell, wherein they abide forever. (2:274)

1. The prohibition of interest based

transactions
Riba literally means increase or excess. An increase
in a loan transaction or exchange of commodity accrues
to the owner without giving an equivalent compensation
in return. For example
Exchanging 1kg of grapes with 1.5kg of grapes that are
of the same type, quality and value.
Exchanging Rs.1000 for Rs.1100.
For the same items any difference in their exchange value
is interest whereas pricing of different items while
exchanging is allowed.

1. The prohibition of interest based

transactions
Prohibition of Riba will promote an economic behavior
which is
economically just (value addition)
socially fair and ethically correct (equal opportunities).
Inequality is definite in the situation where the lender is
guaranteed a positive return without assuming any share of
the borrowers risk whereas the borrower takes upon
himself all sorts of risks in addition to his skills and labor.

1. The prohibition of interest based

transactions
Riba violates the principle of property rights
Money lent on interest is used either productively that it
creates additional wealth or otherwise. When money used
(together with labor and entrepreneurial skills) to produce
additional wealth, such money lent cannot have any
property rights claim to the incremental wealth because
there was no prior bargain over it. Instead interest,
demanded a guaranteed return regardless of the enterprise.

1. The prohibition of interest based

transactions
Promotion of profit-and-risk-sharing
The sharing of risks and uncertainties of the enterprise is
fundamental to Shariah contracts. Shariah condemns the
act of guaranteeing (even by the entrepreneur) to restore
the invested funds intact.

1. The prohibition of interest based

transactions
Lending is a virtuous act
Lending should be a generous act. If money is needed
other than for commercial purposes (thus, risksharing),
such need should not be exploited where the borrower is
put under undue burden.
Allah says in Quran
Who is he that will lend unto Allah a goodly loan, that He
may double it for him or his may be a rich reward(57:11)

2. Avoidance of speculations (Gharar)

Definition of Gharar
An Islamic finance term describing a risky or
hazardous sale, where details concerning the
sale item are unknown or uncertain. Gharar is
generally prohibited under Islam, which explicitly
forbids trades that are considered to have
excessive risk due to uncertainty.

2. Avoidance of speculations (Gharar)

Most of the Islamic scholars view Gharar as both

ignorance of the material attributes of the subject

matter of a sale and also uncertainty regarding its
availability and existence.
Majority of derivative contracts are forbidden and

considered invalid because of the uncertainty involved

in the future delivery of the underlying asset such as
forwards, futures and options, short selling, and
speculation.

2. Avoidance of speculations (Gharar)

Gharar is prevented when transactions are
transparent with:
all details agreed in advance; and
ownership undisputed.
However, Gharar may be tolerated if there is an
important Maslahah or public benefit.

2. Avoidance of speculations (Gharar)

Preventable uncertainty is present in any contract
subject to risks in the ordinary course of business
Istisna or salam contracts.
Prohibition of Gharar is indirectly a risk management
technique in Islam therefore encouraging the exercise of
due diligence and avoidance of contracts with high
degree of information inconsistency with high turnover.
Treating Gharar as risk has its penalties i.e. trading of
risks therefore is prohibited where the traded risks may
have been transferable in derivative format.

3. Avoidance of oppression (zulm)

Zulm refers to all form of inequity, injustice, exploitation,
oppression and wrong doing.

A person either deprives others of their rights or does not

fulfill his obligations towards them.

Zulm also refers to trading in matters which are prohibited

(haram) under Shariah such as:-

a. alcoholic drinks/beverages; and

b. non halal poultry/meat, pork.

An extension of the social justice and fair economics.

Comparison of Islamic with

Conventional Banks
Islamic banks

Conventional banks

The functions and operating

The functions and operating

modes of Islamic banks are

modes of conventional

based on the principles of

banks are based on fully

Islamic Shariah.

manmade principles
(capitalism theory).

Comparison of Islamic with

Conventional Banks
Islamic banks

Conventional banks

It promotes risk sharing

The investor/lender is

between provider of capital

guaranteed of a

(investor) and the user of

predetermined rate of

funds (entrepreneur).

interest or returns.

Comparison of Islamic with

Conventional Banks
Islamic banks

Conventional banks

It also aims at maximizing

Unrestricted profit

profit but subject to Shariah

maximization illustrated by

restrictions.

derivatives trading, deposit

multiplication, etc.

Comparison of Islamic with

Conventional Banks
Islamic banks

Conventional banks

In the modern Islamic

Conventional banks do offer

banking system, it has

the service of Zakat

become one of the service-

deduction but the depositors

oriented functions of the

are reluctant to pay Zakat

Islamic banks to be a Zakat

from their accounts in

collection centre and they

conventional banks.

also pay out their Zakat.

Comparison of Islamic with

Conventional Banks
Islamic banks

Conventional banks

Participation in partnership

Lending money and getting

business is the fundamental

it back with compounding

function of the Islamic

interest is the fundamental

banks.

function of the conventional

banks. Money is a
commodity and the
motivation.

Comparison of Islamic with

Conventional Banks
Islamic banks

Conventional banks

Islamic banks have no

It can charge additional

provision to charge any

money (penalty and

extra money from the

compounded interest) in

defaulters except for

case of defaults.

compensation and is used

for charitable purposes.

Comparison of Islamic with

Conventional Banks
Islamic banks

Conventional banks

Importance is given to the

Banks interest is the main

public interest or maslahah.

objective. It makes no effort

Its ultimate aim is to ensure

to ensure growth with equity.

growth with fairness.

Comparison of Islamic with

Conventional Banks
Islamic banks

Conventional banks

For the Islamic banks, it

Interest-based commercial

must be based on a Shariah

banks dont care about the

approved underlying

activities being performed

transaction.

with their financing.

Comparison of Islamic with

Conventional Banks
Islamic banks

Conventional banks
Since income from the

Since it shares profit and

advances/loans is fixed, it

loss, the Islamic banks pay

gives little importance to

greater attention to

developing expertise in

developing project appraisal

project appraisal and

and evaluations.

evaluations. Risks are

transferable at a price
(insurance).

Comparison of Islamic with

Conventional Banks
Islamic banks

Conventional banks

Greater emphasis on the

The conventional banks give

viability of the projects.

greater emphasis on
creditworthiness of the
clients.

Comparison of Islamic with

Conventional Banks
Islamic banks
Islamic bank can only
guarantee deposits for
deposit account, which is
based on the principle of alwadiah, thus the depositors
are guaranteed repayment of
their funds, however if the
account is based on the
Mudarabah concept, client
have to share in a loss
position.

Conventional banks
A conventional bank has to
guarantee all its deposits.

4. Introduction of Islamic tax (zakat)

Islamic banks perform as their obligatory duty to take
care of the whole system of Zakat as its principal
religious liability, and they pay Zakat themselves as well.
Naturally Islamic banks will be trusted more than the
conventional banks to perform this job.

5. Financing of Sharia Approved

activities
Islamic banks will make sure that funds are used
only in Sharia approved economic activities, e.g.
businesses of alcoholic goods, narcotics, haram
meat, pork, casinos, and prostitutions, etc.

Islamic Modes of Financing

Participatory Modes
1. Mudarabah
2. Musharakah

Sale Modes
1. Murabaha
2. Salam and parallel salam
3. Istisna and parallel Istisna

Rent based Modes

1. Ijarah
2. Ijarah wa Iqtina

Summary of the Lecture

In this lecture we covered the following topics;
Governing principles of Islamic banking.
Comparison of Islamic and conventional banking
practices.
A brief introduction of Islamic modes of financing