islamic and conventional banking. summary of the previous lecture we studied the concept of time...

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 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.

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 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)


• 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.


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.


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.


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.


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.


• 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.


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.


• 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

The functions and operating

modes of Islamic banks are

based on the principles of

Islamic Shariah.

Conventional banks

The functions and operating

modes of conventional

banks are based on fully

manmade principles

(capitalism theory).


Islamic banks

It promotes risk sharing

between provider of capital

(investor) and the user of

funds (entrepreneur).

Conventional banks

The investor/lender is

guaranteed of a

predetermined rate of

interest or returns.


Islamic banks

It also aims at maximizing

profit but subject to Shariah

restrictions.

Conventional banks

Unrestricted profit

maximization illustrated by

derivatives trading, deposit

multiplication, etc.


Islamic 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.

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.


Islamic banks

Participation in partnership

business is the fundamental

function of the 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.


Islamic banks

Islamic banks have no

provision to charge any

extra money from the

defaulters except for

compensation and is used

for charitable purposes.

Conventional banks

It can charge additional

money (penalty and

compounded interest) in

case of defaults.


Islamic banks

Importance is given to the

public interest or maslahah.

Its ultimate aim is to ensure

growth with fairness.

Conventional banks

Banks interest is the main

objective. It makes no effort

to ensure growth with

equity.


Islamic banks

For the Islamic banks, it

must be based on a Shariah

approved underlying

transaction.

Conventional banks

Interest-based commercial

banks don’t care about the

activities being performed

with their financing.


Islamic banks

Since it shares profit and

loss, the Islamic banks pay

greater attention to

developing project appraisal

and evaluations.

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).


Islamic banks

Greater emphasis on the

viability of the projects.

Conventional banks

The conventional banks give

greater emphasis on

creditworthiness of the

clients.


Islamic banks

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.

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.

• 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.

5. Financing of Sharia Approved activities

Islamic Modes of Financing

Participatory Modes1. Mudarabah

2. Musharakah

Sale Modes1. Murabaha

2. Salam and parallel salam

3. Istisna and parallel Istisna

Rent based Modes1. 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

islamic and conventional banking. summary of the previous lecture we studied the concept of time...

Documents

conventional banking

islamic economic system

islamic banks

transactions riba

conventional banking

islamic values haram

conventional economic

value addition