Essay: Similarities and differences in Islamic and conventional banking

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  • Similarities and differences in Islamic and conventional banking
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This study seeks to address the similarities and differences in Islamic and conventional banking

1.0 Introduction

This study seeks to address the similarities and differences in Islamic and conventional banking while attempting to prove that Islamic banking offers greater promise as a tool for economic upliftment and prevention of financial crises.

A report by KPMG (2011) Islamic banking is a discipline which has its roots in the holy Quran, the sacred scripture of the religion of Islam as well as the Hadith which represents the teachings of the holy Prophet Mohammed (PBBUH). The discipline is also sometimes referred to as Sharia compliant finance.

1.1 Background of Islamic Banking

Islamic Banking is not very different from conventional banking subject to certain restrictions imposed by Islamic law (Sharia) and addresses the needs of a large number of business requirements. Islamic banking is not a mere replication of conventional practices. There are significant differences in what Islamic Financial Institutions (IFIs) do compared to conventional banking. IFIs have succeeded in creating trust in the eyes of depositors and receive deposits on profit and loss sharing basis. However investment and financing options available to Islamic banks are limited in comparison with conventional banks due to the restrictions against unethical investments such as speculation, gambling, alcohol, arms industry, pornography and all interest-based transactions. The difference between the systems are fundamental and at the very root of the operation of Islamic banking activities.

This difference nevertheless has immense implications for the future of banking. As the Vatican’s official organ, L’Osservatore Romano (2009), stated matter of fact a few years ago: “The ethical principles on which Islamic finance is based may bring banks closer to their clients and to the true spirit which should mark every financial service”.

1.2 Current Situation

Today Islamic banks are operating in nearly all Muslim countries and many non-Muslim countries. This has been so ever since the 1970s when Islamic banks first emerged in the Middle East. Unlike conventional banking industry, the Islamic banking industry provides only the Islamically compatible financial services for their customers. Therefore, governance according to Islamic requirements is essential to the system. A well-known saying in the industry goes “An Islamic Bank is as good as its Sharia Board”. The Sharia board determines what products such a bank may or may not offer. This is a key feature of Islamic banking industry which distinguishes it from the conventional financial system.

Conventional banks on the other hand have been established on unbridled capitalistic principles based on interest which is unacceptable in Islam (Quran 2:275). Thus Muslims have had little choice but to establish their own financial institutions under Islamic principles and not because of any desire to be exclusive in any sense. In fact Islamic banks promote their products and services to all, irrespective of their religious affiliation while leading conventional players have also set up Islamic windows to fulfil the religious requirements of their Muslim customers.

Given the competition with the conventional finance industry, Islamic financial Institutions (IFIs) offer competitive prices of their services including financing, globally based on the premise that customers should come to them based not on religious compulsion but genuine conviction. Thus return to depositors and/or charge to users of funds is almost equal in both streams of banking. Hence if we compare Islamic finance with conventional finance based upon the outcome [returns] of the transaction, we can reasonably conclude that there is no substantial difference between Islamic and conventional finance. This is the reason for widespread misperceptions about Islamic finance even in Muslim societies.

1.3 Aims and Objectives

According to Sharia, fair play is required and no specific rate of profit is settled. It is the process of transactions through financial contracts which differentiate Islamic finance from conventional finance. Hence this study is an attempt to understand the mechanism of the Islamic financial system and document the similarities and differences with the conventional financial system. This study documents the products (modes) used by Islamic Financial Institutions (IFIs) and conventional banks in their operations including deposit collection, servicing and provision of financing facilities, investments etc.

Therefore, the objectives of this study will be as follows:

• To analyse the different behaviours towards Islamic banks over conventional banks.

• To give people the awareness that will make them choose the best banking system to fulfil their needs.

• Discuss the possibility of potential expansion for Islamic banking services in Sri Lanka.

1.4 Chapter Outline

Having discussed about the aims of the study, the study continues with Introduction to Islamic banking, conventional banking and followed by reviews of some of the comparative studies on Islamic banks as well as on conventional banking is covered in literature review in chapter 2. Data and Methodology used for the study are discussed in detail in chapter 3 while empirical finding/analysis and conclusion constitute chapter 4 and 5 respectively.

 

2.0 Literature Review

2.1 Introduction

Islamic banking is a growing sector with its diversity in different segments and spectrum. It caters for Muslim’s dominated communities as well as in countries where Muslims are in minority. In addition, it is a broad standard, individuals and communities that seek ethical financial solutions have been attracted to Islamic banking. It is clear from banking practice that Islamic banking is equally popular in most communities.

It is clear from above statements that Islamic banking is not only Islamic or specific banking but a system which provides more ethical and moral concept of financial solutions.

As stated by Muhammad (2013, pp.14) Islamic banking is a financial institution whose statutes, rules and procedures expressly state its commitment to the Principles of Islamic Sharia and to the banning of the receipt and payment of interest on any of its operations.

Further in a report by the International Federation of Accountants (2015) Islamic finance—or perhaps more accurately, Sharia-compliant finance is a form of finance in which the financing activity is in accordance with the principles of Sharia law, the moral and ethical code of the Islamic religion. Unlike conventional finance, Islamic finance prohibits all forms of interest for lending money (that is, usury), investments in businesses that provide goods or services considered contrary to Islamic principles, and selling things that one does not own (that is, short-selling). While these prohibitions are tied to the basic beliefs of Islam, and so have been applied for hundreds of years by Muslims, Islamic finance has only more recently manifested itself in financial products, services, and institutions. In the broadest sense, Islamic finance principles are intended to place some consideration on society as a whole – the impact that all financial activity has on the welfare of people and their community. Today there are a number of banks and other financial institutions, as well as units within conventional banks and financial institutions, that apply these principles.

According to KPMG (2011) report, the Sri Lankan Banking Act No.30 of 1988 was amended in 2005 to permit licensed commercial banks and licensed specialized banks to offer selected Islamic finance instruments. In Sri Lanka there is a fully fledged Islamic bank and few licensed banks operate Islamic windows.

2.2 Islamic Banking

As per Venardos (2012, pp.44) the first Islamic bank was started in Myt.Ghamar savings bank in Egypt in 1963. The study of Ahmad (2010, pp.99) reveals that Islamic banking movement achieved steady progress and assumed significant dimension through the establishment of the Nasser social bank in 1972, Dubai Islamic bank in 1975, and Faisal Islamic bank in Egypt and Sudan in 1977. Since then there has been a steady expansion all over the world with Islamic banking establishing itself even in western countries with many conventional banks also creating Islamic financial instruments.

According to the UK Islamic Finance Secretariat, the global market for Islamic finance at the end of 2011 was worth around $1.3 trillion and, despite the Global Financial Crisis, Sharia-compliant assets have grown significantly over the past ten years. According to the same Economist article, globally banks hold over 90% of Islamic assets and, together with funds, are big investors in Sharia-compliant bonds known as Sukuk (The Economist online, 2012).

2.3 Conventional Banking

Conventional banking system refers to all banks that do not operate on Islamic principles. Conventional banks employ interest as their central tool for profit making. The owners of conventional banks therefore make profit purely on interest and which is the only source of profit. Conventional banks provide the full range of financial services, covering every need in every sector, with interest being central in all their activities.

2.4 Differences between Islamic Banking and Conventional Banking

As per Schaik (2001, p.46) Islamic banking differs from conventional banking in 3 ways, First of all, in its mission and objectives, because Islam is the backbone of Islamic banking, moral principles and objectives play a more important role in the operations of an Islamic bank than in a non-Islamic bank. Second, in its products: an Islamic bank offers no interest-bearing products or services, for example, and is more oriented towards risk-sharing products. Third, in its organisational structure and corporate governance: Islamic banks have an Islamic (religious) board, to ensure that the bank’s practices are in line with the Sharia, and a strong social solidarity division. Because of these elements, Islamic banks have the characteristics of investment banks, commercial banks and development banks.

An article (Awan, 2009) states that, Conventional banking favours the rich, and those who are already in business, and is only marginally concerned with the success of ventures it finances. In contrast, under profit-and-loss sharing (PLS) system Islamic institutions as well as their depositors link their own fate to the success of the projects they finance.

These differences make the two institutions totally different from each other. The two institutions operate in the same environment but with different modes of operation and opposite objectives

2.5 Methods of Financing

Islamic commercial law is in fact supported on four elementary principles. The fundamental of primary Islamic business principle is profit and loss sharing and the next is based on fixed service fees and charges and third is based on free of cost and no charges. The other principles are changing with the circumstances of the business and its operation. There are fundamental financing contracts which are Sharia compliant and have been developed for the practice of Islamic banks. The Islamic modes of financing are split up into two groups, which involve both the assets and liabilities sides of the bank’s balance sheets.

Fundamental modes which are based on the profit-and-loss-sharing (PLS) principle and comprise: Mudaraba (trustee finance), Musharaka (equity participation). Marginal modes which are based on mark-up principle and are non-PLS based, for instance, Qard-Al-Hasanah (beneficence loans), Bai’ Mua’jjal (credit sales or deferred payments sales), Bai’ Salam or Bai’ Salaf (purchase with deferred delivery), Ijara and Ijara-wa-iqtina’ (leasing and lease-purchase), Murabaha (mark-up), Istisna’a (forward contract), and Jo’alah (service charge).

2.5.1 Mudarabah

The analysis made by Zubair and Abbas (1987, pp.16-17) Mudaraba is an agreement between the bank and the customer. Here, the bank is recognized as the financing partner and the customer is known as the managing partner. This is a formation of equity contribution. Here, the bank and the client talk about the business plan, and afterward the bank gives the finance to the client. The customer then set up and supervises the business. Besides, guarantee is not necessary because the recovery of the capital depends on the achievement of the business financed. If the business makes profit, the profit must be distributed between the two parties as per their pre-agreed ratio. The agreed profit can either be a proportion of the realized profit or at a fixed/predetermined rate. In case if the business makes a loss, it is the bank which takes up all losses unless the finance user is found in a breach of trust. Mudaraba works also in such a way where the bank is the managing partner and the client is the financing partner. In this case, it is known as investment deposit.

2.5.2 Musharaka

Zubair and Abbas (1987, pp.16) states, Musharaka is considered as a form of equity participation contract where is usually employed to finance long-term investment projects. It is a joint venture between the financial Institution and the enterprise. This mode of financing gives the bank the chance of participating in fund management. The bank puts emphasis on the productivity and viability of the project rather than their credit worthiness. So, it is a great advantage for the fund seekers. Hence, partners contribute both capital and effort and the returns are distributed according to their capital contribution.

2.5.3 Murabaha

As per Mahmour (2000, pp.10), In Murabaha (Cost-plus sales), the buyer knows the price at which the seller obtained the object to be financed, and agrees to pay a premium over that initial price. Murabaha is one of the most common modes of financing in Islamic banking. Here the transaction involves two parties that are the bank and the customer. The customer approaches the bank and the bank identifies the commodity, collect the relevant information. The information includes the price and mark-up. Then the bank purchases the commodity as per requisition of the client and sells him on cost-plus profit. Under this arrangement, the bank discloses the cost and profit margin to the client. The Islamic Bank, has full control over the fund compared to PLS mode of financing.

2.5.4 Ijarah (Leasing)

According to the study of Mahmour (2000, pp.13) legally, the lease contract is not a sale of the object, but rather a sale of the usufruct (the right to use the object) for a specified period of time. The sale of usufruct is permissible in Islam (Quran 65:6). The most important financial difference between Islamically permitted leasing and conventional finnancial leasing is that the leasing agency must own the leased object for the duration of the lease.

2.6 Risk faced by Islamic Banks

Conventional banks face risks and Islamic banks are no exception. The environment of universal bank protects Islamic banks from asymmetric information and adverse selection in contrast with commercial counterpart. The fact that borrowers are in a position to hold back information from banks, allows them to use the loans obtained for purposes other than specified in the contract agreement. By doing so, banks are exposed to unknown risks. Since universal banks are allowed to hold equity and carry out operations like trading and insurance, they are better equipped to deal with asymmetric information. They can finance their business customers through a combination of shareholding and lending. Hence, this permits universal bank to monitor their customer while sitting on a board of directors, Iqbal and AL-Jarhi (2001).

On the other hand, Islamic Banks encounter other risks. Using the PLS modes in Islamic Banks changes the nature of the risks of these institutions face. Depositors share the business risk of banking operations with the bank. Khan and Ahmed (2001) demonstrated various risk faced by Islamic Banks as being credit risk, benchmark risk, liquidity risk, operational risk, legal risk, withdrawal risk, fiduciary risk and displaced commercial risk. They also give risk associated with different modes of financing.

In a survey carried out by Khan and Ahmed (2001) on the perception of risk faced by the Islamic Banking Institution, mark-up risk appeared as the lending and the most critical one followed by the operational and liquidity risk. While credit risk is the risk that most financial institutions deal with, they argued that Islamic Banks were able to establish better risk management, policies and procedures than measuring, mitigating and monitoring risks, with internal control somewhere in the middle. The results also showed that there was a lack of financial instrument like short term financing assets and derivatives. This risk was evoked many times by several authors in the literature. However, we must note that there is a lack of research on default risk: a situation faced by the bank when a company defaults. Special attention is brought here due to the fact that the loan granted is in the form of equity participation, thus the need to know if the bank will bear the same risk as shareholders in the case of an Islamic Bank operating as universal bank.

Banks working on Islamic principles and techniques suppress the interest rate to zero for savers but alternatively give returns on investments. Khan (1991) argued that portfolio diversification was an important factor to reduce the overall risk on its investment to a negligible amount.

 

3. RESEARCH METHODOLOGY

3.1 Introduction

Ethridge (2004) defined research methodology as specific techniques, tools or procedures applied to achieve a given objective and added that it is a way to systematically solve the research problems. The purpose of this chapter is to describe the process of how research is planned and carried out in order to obtain the necessary information related to the study objectives. It also contains a description of the research methodologies including the core research instrument used which is the questionnaire and highlights its different sections.

3.2 Research Plan

For the purpose of this study, descriptive research design was adopted. The plan consists of making decision on the sources of data, targeted population, sampling, research instrument, and contact methods and data collection.

3.3 Data Collection Method

3.3.1 Primary Data

According to Kumar (2008, pp.57), primary data is any data which the author has obtained ‘first-hand’ from its original source as part of the ‘applied’ aspect of the research. It therefore, does not include any data previously gathered by anyone else. Hence, primary data sources include: individual enquiry in the form of observation, conversations, questionnaires, interviews etc.

As mentioned by Dawson (2002, pp.31) there are three basic types of questionnaire – closed ended, open-ended or a combination of both. Closed-ended questionnaires are used most commonly. This type of questionnaire is used to generate statistics in quantitative research. These questionnaires follow a set format. Open-ended questionnaires are used in qualitative research. The questionnaire does not contain boxes to tick, but instead leaves a blank section for the respondent to write in an answer. open-ended questionnaires can be used to find out what people think about a service. Many researchers tend to use a combination of both open and closed questions. That way, it is possible to find out how many people use a service and what they think about that service on the same form.

For this study, questionnaires have been used among staff members of a fully-fledged Islamic bank in Sri Lanka. This method was used to obtain first-hand information where Islamic banking is already being practiced.

Interviewing is another method of collecting qualitative information, whereby the interviewer will be able to gather additional information through the body language of the respondents. Dawson (2002, pp.27) states, in social research there are many types of interview. The most common of these are unstructured, semi-structured and structured interviews. Unstructured or in-depth interviews are sometimes called life history interviews. This is because they are the favoured approach for life history research. In Semi-structured interview the researcher wants to know specific information which can be compared and contrasted with information gained in other interviews. . Structured interviews are used in quantitative research and can be conducted face-to-face or over the telephone, sometimes with the aid of lap-top computers.

For the purpose of this research, two interviews were carried out; one being the editor of ‘Islamic Finance Today’ magazine of Sri Lanka, and the other being a senior executive in a leading Islamic bank in Sri Lanka.

According to Kothari (2004, pp.95) the observation method is the most commonly used method especially in studies relating to behavioural sciences. In a way we all observe things around us, but this sort of observation is not scientific observation. Observation becomes a scientific tool and the method of data collection for the researcher, when it serves a formulated research purpose, is systematically planned and recorded and is subjected to checks and controls on validity and reliability. Under the observation method, the information is sought by way of investigator’s own direct observation without asking from the respondent. Therefore information was gathered through direct observations at the author’s place of work which is a bank where the day-to-day transaction, behaviours were observed.

3.3.2 Secondary Data

According to Kumar (2008, pp.57), secondary data is that which the author has not been responsible for gathering ‘first-hand’. It therefore includes all the data gathered by someone else and presented in a variety of forms, such as journal articles, reports, archive materials, companies annual reports, newspapers and magazines, conference papers, internet and books etc.

For this research, the secondary data collection related to Islamic banking and the objectives of this research mainly come from books, magazines, journal articles and internet search.

As per Singh (2006, pp.271) statistics refers to numerical facts. State as well as Central, Statistical department and various other agencies can be seen engaged in collecting valuable statistics. The laws regarding banking in Sri Lanka has been obtained from materials of Central Bank of Sri Lanka. This was done to analyse the application of Islamic Banking systems against conventional banking to arrive at a comparison purely from the Sri Lankan perspective. This reveals how the two systems are performing with their differing processes and the advantages and disadvantages of the two competing systems.

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