Islamic banking is a banking system that is based on the principles of Islamic law, also referred to as Shariah law, and guided by Islamic economics. The two basic principles behind Islamic banks are to share profits and losses, notably to ban lenders and investors from charging and paying interest. Shariah represents the idea that all human beings and governments are subject to justice under the law, it is common to use the term “Shariah-compliant” to describe anything that is permissible under Islamic law.
Therefore, a commercial bank is a kind of financial institution that gives administrations such as accepting deposits, make business, individual and home loans, offers checking account services, and offering basic investment products and savings accounts to individuals and small businesses. A commercial bank is where most people do their banking, rather than an investment bank. Commercial bank can also refer to a division of a large bank, which more specifically deals with deposit and loan services provided to large, middle sized business.
Furthermore, Islamic finance is unlike conventional finance, which is familiar to most of us, Islamic finance has one overarching requirement which is every transaction must be Shariah-compliant. First, Islamic finance is belief in divine guidance. Islamic said the universe was creating by Allah (swt) and He created man on earth to fulfil certain objectives through obeying His commands. These commands are not restricted to worship and religious rituals but cover a substantial area of almost every aspect of life, including economic and financial transactions. In a conventional financial system, religion and government are kept separate and independent each other. This is to uphold religious freedom and secularity in government such that is not overly influence by any particular religion.
In addition, there are no interest such thing in the Islamic finance. This mean Islamic bank cannot earn interest on a loan, or be required to pay interest on a loan. Compared with conventional financing, this is like borrowing money from the bank and not having to pay a cent of interest. By the way Islamic banks of course do not loan the money for free. If the lender were to obtain an Islamic loan for a project, instead of being charged interest for the loan, lender could be paying fees or sharing a portion of the profits from the project with the bank. conventional banking uses interest charged to lenders along with other investments to turn over an income. Islamic banking on the other hand uses Islamic teachings and Syariah laws in their banking products, which levy profit rates instead of interest rates. Many have come in contact with all types of banking products, conventional and Islamic, on a daily basis but may not be aware of how they operate and more importantly.
However, Islamic finance is no haram investment. Islamic finance is that they require transactions to be ‘halal’ in nature. This means that you are not allowed to purchase alcohol, gambling, or any type of ‘non-halal’ products and services using an Islamic credit card. Not all will see this as a disadvantage, as it could help curb perpetual bad habits. Likewise, if you apply for an Islamic housing loan, hire purchase, credit card or any other product, banks would reject the application if your income is not deemed ‘halal’ by Syariah concepts and laws. This does not necessary apply to only perceived illicit businesses but those that profit from non-Halal goods like alcoholic beverages. There are restrictions to Islamic financing when it comes to the ‘halal’ source of income. As an advantage, it does not apply to conventional banking products. If you happen to own a string of legal gambling lottery ticket businesses, you would be allowed to apply for conventional banking products as long as you are able to provide the necessary income documents.
Moreover, Islamic finance is encouraged risk sharing, the idea of risk sharing is conscientiously business partners, such as between a customer and a financial institution. For an Islamic institution, risk sharing is favored in business dealings with the customers. This fosters the equitable distribution of risk, profits and losses. It also means that the due diligence an Islamic bank performs covers not only the creditworthiness of the customer but also the financial viability of the project. All in all, risk sharing is meant to enhance transparency and very importantly, it is to promote mutual trust and fairness in dealings among business partners, institutions and consumers.
Besides, financing is based on real assets. Financing extended through Islamic products can only expand in step with the rise of the real economy, thereby helping to curb excessive speculation and credit expansion. In contrast, conventional financing is typically based on the promise to pay where real assets are not tied to the transaction. This means that conventional financing activity can grow several steps ahead of the real economy, thereby causing speculation and unjustifiable asset price inflation. Islamic finance offers similar services as does conventional finance. This include taking deposits, giving loans, providing trade finance, investing in financial assets and distributing insurance.
There are some advantages for the Islamic banking. For example, when BBA (Sale and Buy Back Agreement) House Financing was first introduced, total cost of the property purchased was determined at the point of the contract, also known as aqad. If an individual wished to purchase a house for RM500,000, the bank would buy a property at RM500,000 and sell it back to the customer at RM850,000, which gives the bank a profit of RM350,000. The total of RM850,000 would be paid over the duration of an agreed number of years stated in the contract. There were no fluctuations experienced on monthly commitments as how conventional mortgages endure (vary according to interest rate shift in Base Rates).
Over time, financial institutions realized that it worked as a disadvantage to customers who were locked in with a very high profit rate or vice versa, where the bank could be facing very low profit rates. To counter that effect, they introduced a variable rate financing as how conventional interest rates fluctuate, except this has a maximum capacity. This works well in safeguarding investment and to ensure commitments do not exceed a certain monthly amount.
Another advantage appears clearly in Islamic hire purchase products and concerns late penalties. According to the Bank Negara website, Islamic hire purchase imposes a late payment fee of 1.00% per annum of the due instalment whilst most conventional hire purchase charge a fee of 8.00% per annum but there is a down side.
Also with conventional mortgages, if an individual wish to increase the loan amount on a property, there would only be an additional stamping fee levied, without having to draw up a new agreement. On the other hand, if you used Islamic based mortgage to finance your property, increasing the loan amount would require you to make a new buy-and-sell agreement. In a conventional mortgage, this could lead to more savings if such a situation where to arise.
Moreover, the disadvantages of the Islamic banking are Bank Negara goes on to mention that some, if not all financial institutions, impose administrative fees and other types of fees to regulate the account. These add-on charges would vary across banks but are likely equal the conventional product charges to maintain competitiveness of conventional banking.
The example for the disadvantages if the conventional bank which is if you were to option for a conventional banking product such as mortgage, the interest rates being adjusted on the loan does not have a maximum. Of course interest rates have to be justified when the bank adjusts its base rates but in all technicality, it could potentially increase to an alarming rate without having a capacity. This would in turn cost the home owner to have very high monthly commitments and make it difficult to draw up a long term budget. However, Bank Negara Malaysia has regulations in place to manage the fluctuations of market rates to safeguard consumer interests.
Conclusion, the biggest difference between Islamic bank and conventional bank is the Islamic financial transactions must be Shariah-compliant. There is no interest and no haram investment in the Islamic bank. Risk sharing and profit sharing is encouraged in the Islamic finance and the financing is based in real assets.