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CONVENTIONAL DIFFERENCE? Introduction

BANKING

VS

ISLAMIC

BANKING,

IS

THERE

There has been considerable debate on the issue of Islamic banking and whether it is just another way to gain competitive advantage and a niche in the banking market or whether it is a genuine Islamic concern that has motivated the developers of Islamic banking to focus on providing the Muslims with the right Islamic services. Studying in depth, Islamic Banking seems to be somewhat identical to conventional banking but then the issue of intentions and fatwas, which is of significant importance in the context of Islam comes into focus. This essay nonetheless will be presenting the issue of Islamic banking and conventional banking and will be analyzing whether there is actually any difference between the two. The purpose of this essay is to present a document that will allow a better understanding of this dilemma that faces the Islamic world today. The method used for this research will be secondary and qualitative. Academic sources will be used to reach to a conclusion regarding the topic at hand. Islamic Banking Practices: Rammal and Zurbruegg (2007) note that even though Islamic banking practices have been going on throughout the course of Islamic history at different degrees however it was not before the late 20th century that formal Islamic banks were formed on fully private to semi private commercial institutions. Basically, as the name implies, Islamic Banking is the type of banking that is consistent with the rules and regulations and principles of the Islamic Law which in the Muslim world is better known as Sharia. The basic premise is that Islamic strictly forbids the use of fixed interest rates or the fees of borrowing money. Known as riba or usury, this principle says that it leads to a lot of stress on the borrower and allows for the capitalist or the lender to further grown in power. The balance of power then is one of the core concept and teachings of Islam which the conventional banking through its inherent system does not follow. Overtime, Islamic Banking has grown to include almost all the characteristics and banking elements of a fully functional banking system. Islamic banking allows for the

use and benefit of banking services by assuring the avoidance of what is haraam or sinful. The following are important areas of Islamic banking: Savings: As mentioned earlier as well Islamic prohibits the use of riba (defined or fixed interest rate). Instead of fixed interest rate, Islamic banking believes in profit and loss sharing between the borrower and the lender of money so that even if the borrower faces a loss, he or she is not the only one suffering double from the transaction. Now Islamic banking tries to avoid interest by using specific products that differ from the conventional banking. One of these financial products is known as mudarabah ((Beck, Demirgun-Kunt, Merrouche, 2012) which applies the principle of profit and loss sharing such that a predetermined ratio of profits is shared with the person saving however the losses are only borne by the bank. The question however is, is this concept and practice really different from that of conventional banking because technically speaking, this is exactly what happens in conventional banking. A fixed or predetermined ratio of profit is distributed to the savers or the lenders of money and the loss is not shared. How then, does Islamic banking in practice adopts profit and loss sharing is something that needs to be pondered over. Investment: Apart from prohibiting riba, Islamic law also prohibits gharar or uncertainty which is generally associated with speculation or investment in prohibited sectors of the economy for example, in drugs, pork, alcohol (Beck, Demirgun-Kunt, Merrouche, 2012). El Hawary et al (2004) in regards to gharar says that one of the four basic principles of Islamic banking is materiality, a principle which is defied by the use of speculation. Basically materiality means that all financial transactions must have a material finality, that is, they must be directly linked to a real underlying economic transaction. As far as investments are concerned, it has been noted that Islamic banking explicitly bans the use of options, forwards, swaps and futures. On the other hand, the inestemtn option or product available in Islamic Banking is Musharaka where a partnership is made which comes on the balance sheet of the partners of the investors. In easy terms, this can be noted to be a joint venture. A key point to be noted here is that in Islamic

transactions, the bank cannot make the profits explicit because technically the profit and loss has to be shared. The implication in this case is that if the borrower is unable to pay the installment on time, additional penalties cannot be enforced on the borrower. In real practice however, this is not the case. There are penalties enforced on late payments to incentivize the borrowers to actually pay on time. Again, the difference between Islamic banking and conventional banking is questionable. Another type of investment offered by Islamic banks according to Ariss (2010) is takaful which is similar to insurance. Business: In supporting the business community, the product that Islamic banking offers is Musharaka al Mutaniqsa. This is basically a form of rent which the lender is able to receive on the capital that he or she provides. This takes places in case when businesses require working capital or investment capital. The banks then give off these capitals on rent to the organizations. As rent then, the businesses pay the installments. Again, it is technically just a change in name and not a great difference in the essence of how Islamic law is enforced. Competitive Advantage of Islamic Banking: Ariss (2010) says that banking industry has undergone a significant degree of competition intensification. Naturally, this has forced the banking institutions to enter new areas of products and services as well as markets to increase the size of the pie that all banks have to share. Ariss (2010) notes that the development of separate Islamic banks and the offering of Islamic banking made by the existing banks is actually a move to increase the competitive advantage that is gained through this niche offering. However Islamic banking is not all rainbows and butterflies. In most countries where Islamic banking and conventional banking exist side by side, for example like that in Pakistan, separate banking requirements are promulgated. For Islamic banking, because the inherent risk is considered to be higher, the capital requirements for setting up an Islamic banking are higher than that of setting up of a conventional bank. Islamic banking in recent economic and financial crisis: In regards to the recent economic and financial recession, and the tragic destruction of the westernized banking system, doubts have increased as to whether westernized banking systems are effective and efficient and whether they are sustainable or not. As

has already been noted, Islamic banking has been considered to be significantly more efficient than the conventional system of banking by the proponents of the system. This implies the fact that in the midst of increased competitive crisis and uncertainty, Islamic option is actually a good option for investors and businessmen and also for the existing banks (so as to offer Islamic banking services). It is also very interesting to note that Islamic banks through the research of Beck, Demirgun-Kunt, Merrouche, 2012 have shown to have greater stability during the periods of economic and financial crisis. Conclusion: Khan (2010) notes that Islamic bank hold a considerable amount over 700 billion US dollar and that they are growing at a rate of over 15 percent annually. One of the reasons for this growth as noted by Khan (2010) is that Islamic banking is claimed to be more economically efficient than just being ethical and moral. Beck, Demirgun-Kunt, Merrouche, 2012 study whether Islamic banking is different from conventional banking in terms of asset quality, business model efficiency and stability and comes to the conclusion that in substance, there isnt much difference between the Islamic banks and conventional banks however in terms of cost effectiveness, Islamic banks are definitely less effective than conventional banking but, at the same time have been found to have a higher intermediation ratio. Along with this, Islamic banks are found to be better capitalized, mostly because of the concept of materiality and have a better asset quality which again is mostly because Islamic banking does not allow for the use of speculative investment tools which significantly brings down the level of risk in the assets thus improving its quality. However as far as the issue of morality is concerned, Al-Ajmi, Al-Saleh and Hussain (2011) find that Islamic financial institutions have been found to have been adopting traditional financial and banking techniques which are in fact inconsistent with the Islamic or Sharia law. The conclusion then is that even though Islamic banking may differ from conventional banking in terms of greater efficiency, asset quality and business model and in terms of having greater resistance to external changes, as far as Islamic spirit is concerned, there is little difference.

References Al-Ajmi, J., Al-Saleh, N. and Hussain, H. (2011). Investment appraisal practices: A comparative study of conventional and Islamic financial institutions, Advances in Accounting, Vol. 27 (1), pp. 111 124. Ariss, R. (2010). Competitive conditions in Islamic and conventional banking: A global perspective, Review of Financial Economics, vol. 19 (3), pp. 101 108. Beck, T., Demirguc-Kunt, A. and Merrouche, O. (2012). Islamic vs. conventional banking: Business model, efficiency and stability Journal of banking & finance, In Press. Khan, F. (2010). How Islamic is Islamic banking, Journal of Economic Behavior and Organization, Vol. 76 (3), pp. 805 820. Rammal, G. and Zurbruegg, R. (2007). Awareness of Islamic Products among muslims, Journal of Financial Service marketing, Vol. 12 (1), pp. 65 74.