Islamic banking refers to a banking system that operates following Islamic principles, which prohibit interest-based transactions and encourage profit-and-loss sharing arrangements. The products of Islamic banking are designed to adhere to fairness, transparency, and ethical conduct.
Conventional banking, on the other hand, operates based on the principle of interest, which is charged on loans and other financial products. The products of conventional banking are typically designed to generate profit for the bank by charging interest and other fees.
Understanding the differences between Islamic banking and conventional banking is essential for the following reasons:
The following are the differences between Islamic and Conventional banking products.
Conventional banking products such as personal loans, credit cards, mortgages, and business loans are based on interest-based lending.
The interest charged on loans is a key source of revenue for conventional banks and is used to cover operational costs and generate profits.
A partnership agreement where one party (the investor) provides the capital, and the other party (the entrepreneur) provides the expertise and manages the business.
Profits are shared based on a pre-agreed ratio, while the investor bears losses.
A partnership agreement where both parties provide capital and expertise, and profits and losses are shared based on a pre-agreed ratio.
An agency agreement where one party (the investor) provides the capital, and the other party (the bank) manages the investment on behalf of the investor.
Rental arrangement (Ijarah)
The rental arrangement or Ijarah is a mode of finance in Islamic banking similar to leasing in conventional banking.
It involves a contract between the owner of an asset (lessor) and the user (lessee), where the lessor leases the asset to the lessee for a specified period in exchange for periodic rental payments.
The rental payments made by the lessee to the lessor are considered rent for the use of the asset and not interest-based debt.
Ijarah promotes risk-sharing and transparency, as the lessor retains ownership of the asset and bears the risk of any losses or damages to the asset during the lease period
Murabaha is a mode of finance based on the concept of cost-plus financing. It is a contract between a buyer and a seller.
The seller purchases an asset on behalf of the buyer and then sells the asset to the buyer at a higher price that includes a profit margin.
In a musawamah contract, the price of the good or commodity is not disclosed to the buyer, and the negotiation is based on mutual agreement between the two parties.
The seller is not required to disclose the cost of the goods or commodity, and the profit margin is determined through negotiation between the buyer and the seller.
Salam is a mode of finance in Islamic banking where the buyer pays all the payments in advance for goods to be delivered at a future date.
Istisna is a mode of finance in Islamic banking where a manufacturer is contracted to produce a specific asset for a buyer who agrees to purchase the asset once it is completed.
Tijarah is a mode of finance in Islamic banking that involves trading goods and commodities between the buyer and the seller.
Instead, they are invested in shariah-compliant avenues such as trade, real estate, and other permissible businesses.
In Ijarah, Islamic banks buy an asset on behalf of the customer and lease its usufruct to the customer for a specific tenor.
At the end of the tenor, the asset transfer is done either by gifting the asset to the customer or by recognizing the customer’s last instalment or security deposit as consideration for the asset’s sale to the customer.
Islamic banks sell their ownership share in the asset to the customer periodically.
A current account is deposited on qard bases.
They also offer interest to depositors, which is considered Riba in Islam.
They only offer profits to customers on their Mudarabah-based accounts, as earning interest on qard (debt) is strictly prohibited in Islam. This ensures that Islamic banking practices align with Islamic finance principles, prohibiting interest-based transactions.
This way, Islamic banks share risk with their customers, unlike conventional banking.