General

Islamic vs Conventional Banking Products

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.

Importance of Understanding the Differences

Understanding the differences between Islamic banking and conventional banking is essential for the following reasons:

  1. Religious and Moral Considerations: For individuals who want to adhere to Islamic principles and avoid interest-based transactions, Islamic banking provides an alternative that aligns with their values.
  2. Ethical Considerations: Islamic banking promotes ethical conduct and transparency in financial transactions, which can appeal to individuals and businesses prioritizing social responsibility.
  3. Investment Opportunities: Islamic banking products offer unique investment opportunities not available through conventional banking products, such as profit-and-loss sharing arrangements.
  4. Financial Management: Understanding the differences between Islamic and conventional banking can help individuals and businesses make informed decisions about their financial management strategies.
  5. Global Business: As Islamic banking gains popularity worldwide, understanding the differences between it and conventional banking can help businesses expand their reach and tap into new markets.

Key Differences Between Islamic and Conventional Banking Products

The following are the differences between Islamic and Conventional banking products.

Conventional Banking Islamic Banking
In conventional banking, one financing mode is interest-based lending or loan. In this, the borrower must pay back the original loan amount plus interest.  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. In contrast to Conventional, Islamic banking comes with three modes of finance: partnerships, rental arrangements, and trade/ sale basics.  Partnerships   1. Mudarabah   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.   2. Musharakah   A partnership agreement where both parties provide capital and expertise, and profits and losses are shared based on a pre-agreed ratio.   3. Wakalah   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.   Profits are shared based on a pre-agreed ratio, while the investor bears losses.   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   Trade/sale basis   1. Murabaha   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.   2. Musawamah   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.   3. Salam   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.   4. Istisna   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.   5. Tijarah   Tijarah is a mode of finance in Islamic banking that involves trading goods and commodities between the buyer and the seller.

Current A/C – All types & variants for Businesses/ Individuals

Conventional banking Islamic banking
Loan-based Qard-based (Loan based)
In conventional banking, the deposited funds of the customers are used for interest-based money lending and investments that generate profit through interest-earning businesses, such as loans and mortgages. Islamic Current Account operates on a Qard (loan) basis. The funds deposited by the account holder are not used for any interest-based investments.  Instead, they are invested in shariah-compliant avenues such as trade, real estate, and other permissible businesses.

 Savings A/C & Term Deposits – Businesses/Individuals

Conventional banking Islamic banking
Interest-based Mudarabah-based
The savings accounts in typical or conventional banking are based on load, where the bank pays a fixed interest back to the depositors. In Islamic saving accounts, the bank returns a variable amount of profit with you as a depositor, which is not fixed or earned from interest as in conventional banking.
For your information, the bank earned interest on the loan it gave to another person or company and shared a part with the depositors. As the return is based on the Mudarabah, there may be some losses, but these are shared with you and the bank. Although the chances for losses are very low, it’s worth telling.

Interest Rate/ Profit Rate

Conventional banking Islamic banking
The depositor is paid a fixed return rate over the amount they deposited. The depositor is paid a proportion of the actual profit earned according to the profit-sharing ratio set between the bank and you as a depositor.
Fixed returns Varying returns

Running Finance/Working Capital Limits

Conventional banking Islamic banking
Loan/ revolving credit facility Many modes/facilities are available depending upon the bank, including Musharakah, Salam, Istisna, Tijarah, Finance, or Murabaha Finance.
The only risk with conventional banking is that the client/ loanee may default, not paying back the loan and interest. The risk for Islamic banking varies according to the financing type and the customer’s business.

 LCs/ Contracts/ Guarantees

Conventional banking Islamic banking
Mark-up on credit advanced and credit warranty against a fee. Multiple modes are in Islamic banking, including Trade based modes ( Murabaha/Musawamah) and Service based modes (Wakala/ Kafalah).
The customer is charged for non-funded facilities. Customers are also charged in Islamic banking for non-funded facilities.
Banks charge interest on delayed payments.  Islamic banks cannot charge interest, but they charge profit on credit sales.

Long-Term Finance

Conventional banking Islamic banking
Loan facilities for the years of the tenor. Different financing modes are used, e.g., Diminishing Musharakah, Ijarah, etc.
Conventional banks provide loans to their customers and charge markup (interest) on the outstanding principal amount. In Diminishing Musharakah, Islamic banks form joint ownership in a new asset and rent out their share to the customer. The bank’s ownership share in the asset decreases over time while the customer’s share increases.  In Ijarah, Islamic banks buy an asset on behalf of the customer and lease its usufruct to the customer for a specific tenor.
Conventional banks do not involve asset ownership arrangements while providing customer loans. The bank remains the asset owner throughout the tenor and receives monthly instalments from the customer.  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.
Compounding of interest also takes place annually. The bank’s ownership share in the asset decreases over time while the customer’s share increases.  Islamic banks sell their ownership share in the asset to the customer periodically.

Lending & Borrowing Mechanism

Conventional banking Islamic banking
Banks take money from depositors as a loan and lend it to customers at a higher interest rate, allowing them to profit by keeping the difference between the interest rates. Savings accounts are based on the Mudarabah-based model.  A current account is deposited on qard bases.
Conventional banks take money from depositors on a debt basis and lend it out on a debt basis, charging interest to customers as their profit.  They also offer interest to depositors, which is considered Riba in Islam. On the other hand, Islamic banks collect funds either on qard basis (as a loan) or on a Mudarabah basis (as an investment partnership).  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.

Treating Money/Currency as Commodity

Conventional banking Islamic banking
Money is like a commodity. Money isn’t recognized as a commodity; instead, it’s taken as a ‘mode of exchange’.
The banks can rent or trade the money or currency and make profits from it. The bank that follows Islamic banking can’t rent or trade the money to make profits.

Risk Sharing

Conventional banking Islamic banking
Conventional banks only provide loans to their customers, and the only risk involved for the lender is the possibility of the borrower defaulting on the loan Islamic banks have different modes, e.g., Mudarabah and Musharakah.
The bank does not share any other risks with its customers. These modes operate based on a partnership, meaning the profit or loss is shared between the bank and the customer according to the agreed ratio.  This way, Islamic banks share risk with their customers, unlike conventional banking.
All the financial risk involved in the transaction is borne solely by the borrower, and the bank does not have any stake in the success or failure of the venture for which the loan was taken. All three parties are involved in the risk-sharing mechanism, depositors, the financed, and bank. The risk is divided among all partners according to the agreed proportion.

Late Payment Charges

Conventional banking Islamic banking
Charges late payment fees as a source of income, which contributes significantly to their profitability Charges charity for late payments as a way to discipline clients and encourage timely payments.
Charges interest on outstanding debt, which compounds the total amount owed by the borrower. Shariah prohibits Islamic banks from re-pricing the outstanding amount, which becomes a debt.
Does not waive off late payment charges in the course of business, as it adds to their profitability. Does not charge interest on outstanding debt, eliminating the compounding effect.
The income generated from late payment charges contributes to the bank’s overall profits and is not directed towards social welfare. Charity income generated from late payments is not added to the bank’s profitability but is only collected and used for social welfare in the health and education sectors.

Islamic banking pros and Cons

Islamic Banking Pros and Cons

Pros

  • Offer ethical and shariah-compliant financial products and services.
  • Encourages risk-sharing between the bank and customers.
  • Focuses on real asset-based financing.
  • Helps promote social justice and fairness in financial dealings.
  • Provides an alternative banking system for people who want to avoid interest-based transactions.

Cons

  • Limited availability of Islamic banking products and services.
  • Higher fees and charges compared to conventional banking.
  • Less established regulatory framework in some countries.
  • Lack of standardization of shariah interpretations and practices.
  • Limited access to certain financial products, such as insurance.

Conventional banking pros and cons

Conventional Banking Pros and Cons

Pros

  • Availability of a wide range of products and services.
  • Easy access to credit and loans for consumers and businesses.
  • High liquidity of funds due to the use of interest-bearing deposits and loans.
  • Greater stability and predictability in terms of returns for depositors.

Cons

  • Higher risk for borrowers due to compounding interest rates and potential for default.
  • Limited investment opportunities for those seeking Shariah-compliant options.