The difference between the two banking systems also lies in terms of governance structure, Islamic banks must comply with the rules posed by the Holy Quran and meet the expectations of Muslim community by providing acceptable financing modes of Islam
Islamic finance is a financial system that operates according to “Sharia” principles. Sharia, which is an Arabic term, means, “The way to the source of life” It has all the features of a conventional financial system such as capital markets, fund managers, investment firms and insurance companies. However, these systems are governed by Islamic laws. A core concept of Islam is that Allah is the owner of all wealth in the world, and humans are only the trustees of the wealth. Therefore, humans need to manage wealth according to Allah’s commands, which promote justice and prohibit certain activities. The law does not forbid Muslims from enjoying wealth, they have the right to enjoy whatever wealth they acquire and spend in sharia-compliant ways. They need not feel reprehensible about being wealthy as long as their behaviour aligns with Islam. Islamic banking and conventional banking differs in certain aspects, while the conventional banking follows the interest based principle, Islamic banking is based on interest free principle and principle of profit and loss sharing and in performing their businesses as intermediaries. An Islamic bank is essentially a partner with its depositors and also a partner with its entrepreneurs this agreement is done to avoid the payment of interest. The difference between the two banking systems also lies in terms of governance structure, Islamic banks must comply with the rules posed by the Holy Quran and meet the expectations of Muslim community by providing acceptable financing modes of Islam.
Conventional banking on the other hand is based on debtor-creditor relationship between the bank and the customer, interest is the consideration between the borrower and the banker reflecting the opportunity cost of money.
Differences Between Islamic Banking and Conventional Banking:
|Business Framework||Islamic Banking System||Conventional Banking System|
|Banking Practice||Based on Sharia Laws, Sharia scholars ensure adherence to Islamic laws and provide guidance||Based on secular banking laws and financial practices of respective countries|
|Equity Financing with Capital risk||Islamic banks provide equity capital to a project or venture. Losses are shared on equity participation while profits are shared on a pre-agreed ratio. Management of the enterprise depends upon the type of financing provided. Example: Mudarabah, Musharkah etc||Although Venture Capital companies and investment banks take equity stakes and management control of an enterprise for providing start-up finance, commercial banks who are the primary lenders, do not have this facility|
|Prohibition of Gharar||Transactions deemed Gharar are prohibited, it denotes varying degree of deception on the price and quality of goods. E.g. Derivatives, which are prohibited in Islamic Finance||Trading of all financial instruments including derivatives are allowed in conventional banking|
|Profit and Loss Sharing||All transactions are based on this principle, returns are variable depending on bank performance, and consumers can participate in the profit upside in a more equitable way than receiving a predetermined return.||Returns to customers are irrespective of bank performance and profitability. Customer is treated only as a depositor and does get any other compensation other than interest.|
Islamic Finance does not restrict economic activity but instead directs it towards responsible activities that benefits other people, and honours Allah. It allows for a free market economy where supply and demand are decided in the market and not as per the government rules and regulations.