Essay: 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

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