Islamic and Conventional Banking

1. Islamic and Conventional Banking

2. 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.

4. Learning outcomes After today’s 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.

5. 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.

6. Governing principles of Islamic Banking • The prohibition of interest or riba based transactions • Avoidance of speculations (gharar) • Avoidance of oppression (zulm) • Introduction of Islamic tax (zakat) • Financing of Sharia Approved activities and discouraging the production of goods and services which are not allowed in Islamic values (haram).

7. 1. The prohibition of interest based transactions Those who charge usury (riba’/interest) are in the same position as those controlled by the devil’s 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)

8. 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.

9. 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 borrower’s risk whereas the borrower takes upon himself all sorts of risks in addition to his skills and labor.

10. 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.

11. 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.

12. 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)

13. 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.

14. 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.

15. 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.

16. 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.

17. 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:- • alcoholic drinks/beverages; and • non halal poultry/meat, pork. • An extension of the social justice and fair economics.

18. Comparison of Islamic with Conventional Banks Islamic banks Conventional banks The functions and operating modes of conventional banks are based on fully manmade principles (capitalism theory). The functions and operating modes of Islamic banks are based on the principles of Islamic Shariah.

19. Comparison of Islamic with Conventional Banks Islamic banks Conventional banks The investor/lender is guaranteed of a predetermined rate of interest or returns. It promotes risk sharing between provider of capital (investor) and the user of funds (entrepreneur).

20. Comparison of Islamic with Conventional Banks Islamic banks Conventional banks Unrestricted profit maximization illustrated by derivatives trading, deposit multiplication, etc. It also aims at maximizing profit but subject to Shariah restrictions.

21. Comparison of Islamic with Conventional Banks Islamic banks Conventional banks Conventional banks do offer the service of Zakat deduction but the depositors are reluctant to pay Zakat from their accounts in conventional banks. In the modern Islamic banking system, it has become one of the service-oriented functions of the Islamic banks to be a Zakat collection centre and they also pay out their Zakat.

22. Comparison of Islamic with Conventional Banks Islamic banks Conventional banks Lending money and getting it back with compounding interest is the fundamental function of the conventional banks. Money is a commodity and the motivation. Participation in partnership business is the fundamental function of the Islamic banks.

23. Comparison of Islamic with Conventional Banks Islamic banks Conventional banks It can charge additional money (penalty and compounded interest) in case of defaults. Islamic banks have no provision to charge any extra money from the defaulters except for compensation and is used for charitable purposes.

24. Comparison of Islamic with Conventional Banks Islamic banks Conventional banks Banks interest is the main objective. It makes no effort to ensure growth with equity. Importance is given to the public interest or maslahah. Its ultimate aim is to ensure growth with fairness.

25. Comparison of Islamic with Conventional Banks Islamic banks Conventional banks Interest-based commercial banks don’t care about the activities being performed with their financing. For the Islamic banks, it must be based on a Shariah approved underlying transaction.

26. Comparison of Islamic with Conventional Banks Islamic banks Conventional banks Since income from the advances/loans is fixed, it gives little importance to developing expertise in project appraisal and evaluations. Risks are transferable at a price (insurance). Since it shares profit and loss, the Islamic banks pay greater attention to developing project appraisal and evaluations.

27. Comparison of Islamic with Conventional Banks Islamic banks Conventional banks The conventional banks give greater emphasis on creditworthiness of the clients. Greater emphasis on the viability of the projects.

28. Comparison of Islamic with Conventional Banks Islamic banks Conventional banks A conventional bank has to guarantee all its deposits. Islamic bank can only guarantee deposits for deposit account, which is based on the principle of al-wadiah, 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.

29. 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.

30. 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.

31. Islamic Modes of Financing Participatory Modes • Mudarabah • Musharakah Sale Modes • Murabaha • Salam and parallel salam • Istisna and parallel Istisna Rent based Modes • Ijarah • IjarahwaIqtina

32. 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