What’s the difference between Islamic and conventional banking?
At first glance, it may seem there is little difference between Islamic and conventional banking. Both systems accept deposits from consumers and commercial entities and offer financing solutions to them. However, specific considerations have been taken to separate the two and ensure Islamic banking meets Shariah principles.
| Point of difference |
Conventional |
Islamic |
| Origination |
Man-Made |
Divine Source of Legislation |
| Objective |
An Individual tendency towards profiteering. |
Advancement of the society to achieve the social solidarity. |
| Business line |
Interest based borrowing and lending, and offering banking services. No right to invest or trade. |
Offers banking services and has the right to invest & trade within Sharia parameters. |
| Money |
Money is treated as commodity, and the profit is achieved from the difference between the borrowing and lending interest-rates. |
Money is not considered as commodity but as medium of exchanging commodities, goods, assets and services. |
| Capital Investment |
Grants loans against collaterals to ensure the repayment of the principal plus interest, regardless of whether the project is Sharia compliant or not. |
Invests the money through various Islamic modes in Sharia compliant projects and according to feasibility study |
| Interest |
Interest-based banking which is prohibited by Sharia, since it is considered to be Riba. |
Interest free banking allowed by Sharia. |
| Profit |
Is achieved from the difference between the borrowing and lending interest-rate, regardless of the project, for which the loan is taken, having generated any profit or not. Hence, profit is guaranteed and not associated with risk. |
Investment activities: based on profit-sharing principle. Financing activities: generating the profit from its trading activities. Hence, profit is associated with risk, and not guaranteed. |
| Loss |
Is borne by the borrower alone, regardless whether the loss incurred is due to his fault or not |
Investment activities: if the loss incurred is due to intervening contingencies (“force-majeure”) the bank bears it alone, whereas the customer loses its efforts. Financing activities: the customer is a debtor and has to pay off his debt. If he is unable to pay for genuine circumstances, he is granted some more time until he is able to pay. |
| Deposits and Savings account |
Loan with guaranteed & pre-agreed (fixed) interest |
Invests on basis of profit-sharing |
| Contracts |
Contracts are not bound to follow Sharia principles |
Sharia compliant contracts |
What is Islamic Banking?
Islamic Banking is based on an interest-free financial system that reflects the principles of Shariah. This banking system adheres to Islam's high ethos and moral values, and is governed by the principles laid down by Shariah.
Shariah scholars have approved specific financial contracts, conforming to Shariah principles, to be used in financial transactions. Every transaction Islamic bank and window engage in is based on one or more of these contracts. This system discourages all unethical practices and plays a crucial role in establishing a transparent economic system. The prohibition of risk-free return and the permission of trading are the foremost ideas behind Islamic banking and finance.
Who oversees Shariah standards and principles?
Islamic banks and windows are overseen by an Internal Shariah Supervisory Committee (ISSC). This Committee comprises Shariah scholars responsible for ensuring all operations of that bank comply with Shariah standards and principles. The ISSC is also supported by the Sharia Control Department who can be reached by writing to Sharia.Control@uab.ae.
Riba: Riba in all its forms is prohibited in Islam. It usually refers to usury or interest, although the legal notion extends beyond mere interest. Riba includes an increase, addition, unjust return or advantage obtained by the lender as a condition of a loan. Any risk-free or guaranteed rate of return on a loan or investment is also considered as Riba.
Gharar: An element of deception either through ignorance of an essential element of the goods, the price, or through faulty description of the goods, in which one or both parties stand to be deceived.
A sale where the cost and the profit (mark-up) are known.Therefore, the Murabaha Transaction in Banking is practised whereby the Bank buys the commodity from the market based on the customer’s request. After owning the commodity, it will be sold to the customer on a deferred payment basis, where the cost, the mark-up profit and tenor are known and agreed between both parties (Bank & customer).
Tawarruq: Purchasing a commodity from the market on a deferred payment basis and selling it to a third party (other than the first seller) on the spot in order to get cash. Tawarruq in Banking is practised whereby the Bank buying a commodity from the market and then selling it to the customer for a deferred payment. Once the ownership of the commodity is transferred to the customer, the latter appoints the Bank as the customer’s agent to sell the purchased commodity to a third party on the spot and then depositing the sale proceeds in the customer’s account. There are several conditions for the validity of Tawarruq contract, the most important is not to sell the commodity to the first seller otherwise it will become “Bai’ Al `Inah”, which is prohibited. Also, the sell and buy of the commodity should be real and the subject commodity should be an acceptable commodity from Sharia perspective.
Istisna’: Is a contract between the Bank (Sane’) and its client (Al Mustasni’) to construct, manufacture or create specified and described assets or goods with a specified and agreed cost including all associated costs mentioned in the quotation with an agreed delivery date. However, since the bank’s nature of business is not as a developer or a manufacturer, the bank will sign “Parallel Istisna’” with an expertise with the same T&Cs of the original Istisna’ agreement signed between the bank and its client.
Ijarah (leasing): A contract between the bank (Lessee) and its client (Lessor), where the bank buys a commodity, then leases the same to the client for an agreed tenor and payment plan. The payment under Ijarah can be either fixed payment or variable. The bank shall issue a separate promise “Wa’ad” to sell the leased property to the lessor at the Ijarah maturity date at a nominal price or as a free gift.
Bai’ Al Salam: A deferred selling contract of a commodity described to be delivered in future but the price is paid on the spot.
Bai Al Salam in banking is practised whereby the Bank will enter into Salam contract either as a buyer or as a seller for a commodity that is known and prescribed for future delivery with spot payment.
Bai’ Al Taqsit (Sales on Installments): In this sale contract, the commodity is sold and delivered on the spot against a deferred payment. The future payment date(s) must be known, whether the payment of the price is for the whole or a part of it. Usually the deferred payment price is paid in installments.
Musharakah: In this contract, the bank will finance the client in the form of an investment partnership in which all partners are entitled to a share in the profits of a project in a mutually agreed ratio. Losses are shared in proportion to the amount invested.
Qard Hasan (Interest-free loan): A contract of a loan between two parties on the basis of fulfilling a financial need of the borrower. The amount of repayment must be equivalent to the amount borrowed. It is however legitimate for a borrower to pay more than the amount borrowed as long as it is not stated or agreed at the point of contract.
Amanah (Safekeeping): A custody or safekeeping arrangement whereby the customer will deposit cash or other assets in a bank for safekeeping. The bank guarantees the safety of the assets kept by it for an agreed fee.
Wakala: An agency contract in which an authorization given by the principal to its agent to act on its behalf either in a unrestricted or restricted form.
Mudaraba: A trust-based contract where capital is provided, in cash or assets by a capital provider (Rab Al Mal) to an entrepreneur (Mudarib). The profit split has to be agreed between the parties; however the capital provider shall bear all the loss if no misconduct, negligence or violation occurs to the terms and conditions.
