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History of bank is as old as human society. Forever since man came to realize the
importance of money as medium of exchange, the necessity of a controlling or
regulating agency or institution was naturally felt. The work „BANK‟ is derived from
the word „BANCUS‟ or „BANQUE‟ which means a bench. Other authorities hold the
opinion the work „BANK‟ is derived from the German word „BACK‟ which means
„joint stock fund‟. Later on, when the Germans occupied major part od Italy, the work
„BACK‟ was Italianized into „BANK‟.
WHAT IS BANK
Primarily the banking is business of dealing in money and instruments of credit. Banks
were traditionally differentiated from other financial institutions by their principal
functions of accepting deposits–subject to withdrawal or transfer by check–and of
making loans.
ISLAMIC BANKING
Islamic banking refers to a system of banking or banking activity that is
consistent with Islamic law (Sharia’h) principles and guided by Islamic economics. In
particular, Islamic law prohibits usury, the collection and payment of interest, also
commonly called riba.
Generally, Islamic law also prohibits trading in financial risk (which is seen as a form of
gambling). In addition, Islamic law prohibits investing in businesses that are considered
unlawful, or haram. Islamic finance has been gaining momentum on a global scale for
the last 30 years.
Many Islamic Banks have sprung up over the last few years. These changes are
occurring both in Muslim and in western countries, and are driven by a global trend
amongst Muslims to become more observant of their faith. It might have been the
reason why Islamic Banking emerged, however, today Islamic Banking is sought by
Muslims and non-Muslims due to the benefits it offers. Industry size is currently
estimated at more than $400 billion, with projected growth of 15% per annum. Financial
institutions around the globe are trying to keep pace with the growing demand for
Sharia’h compliant products and services.
CONVENTIONAL BANKING
Conventional banking is based on the principle that the more you have, the more
you can get. In other words, if you have little or nothing, you get nothing. As a result,
more than half the population of the world is deprived of the financial services of the
conventional banks. Conventional banking is based on collateral. Conventional banks
look at what has already been acquired by a person Conventional banks go into
‘punishment’ mode when a borrower is taking more time in repaying the loan than it
was agreed upon. They call these borrowers “defaulters”. When a client gets into
difficulty, conventional banks get worried about their money, and make all efforts to
recover the money, including taking over the collateral. In conventional banks charging
interest does not stop unless specific exception is made to a particular defaulted loan.
Interest charged on a loan can be multiple of the principal, depending on the length of
the loan period.
Riba
Perhaps the most far-reaching and controversial aspect of Islamic economics, in terms of
its implications from a Western perspective, is the prohibition of interest (riba). The
payment of riba and the taking of interest as occurs in a conventional banking system is
explicitly prohibited by the Holy Qur’an, and thus investors must be compensated by
other means. It is further stated in the Holy Qur’an that those who disregard the
prohibition of interest are at war with God and His Prophet Muhammad.
Haram/halal
A strict code of ‘ethical investments’ operates for Islamic financial activities. Hence
Islamic banks cannot finance activities or items forbidden (that is, haram) in Islam, such
as trade of alcoholic beverages and pork meat. Furthermore, as the fulfilment of
material needs assures a religious freedom for Muslims, Islamic banks are encouraged
to give priority to the production of essential goods which satisfy the needs of the
majority of the Muslim community. As a guide, participation in the production and
marketing of luxury activities, israf wa traf, is considered as unacceptable from a
religious viewpoint when Muslim societies suffer from a lack of essential goods and
services such as food, clothing, shelter, health and education.
Gharar/maysir
Prohibition of games of chance is explicit in the Holy Qur’an (S5: 90–91). It uses the
word maysir for games of hazard, derived from usr (ease and convenience), implying
that the gambler strives to amass wealth without effort, and the term is now applied
generally to all gambling activities. Gambling in all its forms is forbidden in Islamic
jurisprudence. Along with explicit forms of gambling, Islamic law also forbids any
business activities which contain any element of gambling (Siddiqi, 1985). The shari’a
determined that, in the interests of fair, ethical dealing in commutative contracts,
unjustified enrichment through games of pure chance should be prohibited.
Zakat
According to the Holy Qur’an, God owns all wealth, and private property is seen as a
trust from God. Property has a social function in Islam, and must be used for the benefit
of society. Moreover, there is a divine duty to work. Social justice is the result of
organizing society on Islamic social and legal precepts, including employment of
productive labour and equal opportunities, such that everyone can use all of their
abilities in work and gain just rewards from that work effort. Justice and equality in
Islam means that people should have equal opportunity and does not imply that they
should be equal either in poverty or in riches (Chapra, 1985). However, it is incumbent
on the Islamic state to guarantee a subsistence level to its citizens, in the form of a
minimum level of food, clothing, shelter, medical care and education.The major
purpose here is to moderate social variances in Islamic society, and to enable the poor to
lead a normal, spiritual and material life in dignity and contentment.
Shari’a board
In order to ensure that the practices and activities of Islamic banks do not contradict the
Islamic ethics, Islamic banks are expected to establish a Religious Supervisory Board.
This board consists of Muslim jurists, who act as independent Shari’a auditors and
advisers to the banks, and are involved in vetting all new contracts, auditing existing
contracts, and approving new product developments. Also the Shari’a Board oversees
the collection and distribution of zakat. This additional layer of governance is quite
different from that for a conventional bank (Algaoud and Lewis, 1999).
1. Musharakah
2. Mudarabah
3. Murabaha
4. Salam
5. Istisna
6. Ijaraha
Musharakah
Musharakah means a relationship established under a contract by the mutual consent of
the parties for sharing of profits and losses in the joint business. It is an agreement
under which the Islamic bank provides funds, which are mixed with the funds of the
business enterprise and others. All providers of capital are entitled to participate in
management, but not necessarily required to do so. The profit is distributed among the
partners in pre-agreed ratios, while the loss is borne by each partner strictly in
proportion to respective capital contributions.
Mudarabah
A form of partnership where one party provid es the funds while the other provides
expertise and management. The latter is referred to as the Mudarib. Any profits accrued
are shared between the two parties on a pre-agreed basis, while loss is borne by the
provider of the capital.
Murabaha
Literally it means a sale on mutually agreed profit. Technically, it is a contract of sale in
which the seller declares his cost and profit. Islamic banks have adopted this as a mode
of financing. As a financing technique, it involves a request by the client to the bank to
purchase a certain item for him. The bank does that for a definite profit over the cost,
which is settled in advance.
Salam
Salam means a contract in which advance payment is made for goods to be delivered
later on. The seller undertakes to supply some specific goods to the buyer at a future
date in exchange of an advance price fully paid at the time of contract. It is necessary
that the quality of the commodity intended to be purchased is fully specified leaving no
ambiguity leading to dispute. The objects of this sale are goods and cannot be gold,
silver or currencies. Barring this, ′Salam covers almost everything, which is capable of
being definitely described as to quantity, quality and workmanship.
Istisna
It is a contractual agreement for manufacturing goods and commodities, allowing cash
payment in advance and future delivery or a future payment and future delivery.
Istisna can be used for providing the facility of financing the manufacture or
construction of houses, plants, projects, building of bridges, roads and highways.
Ijaraha
A contract under which an Islamic bank finances equipment, building or other facilities
for the client against an agreed rental together with a unilateral undertaking by the
bank or the client that at the end of the lease period, the ownership in the asset would
be transferred to the lessee. The undertaking or the promise does not become an
integral part of the lease contract to make it conditional. The rental as well as the
purchase price are fixed in such manner that the bank gets back its principal sum along
with profit, which is usually determined in advance.
DIFFERENCE BETWEEN ISLAMIC BANKING AND
CONVENTIONAL
BANKING:-
The Shari‟ah essentially means a way of doing things. This ought to reflect in the
working of Islamic banks at all levels: from doing transactions to record-keeping and
the skill-profile of the manpower. The conventional banks may not move into the turf of
the Islamic banks if there are fundamental differences between the requirements of
interest-based banking and Islamic banking. Otherwise, chances are that interest based
banks may give Islamic banks a run for their money through “Islamic windows”.
Islamic Banks
The features of Islamic Banking Operations under Shariah percept are enumerated
below to identify the basic differences between Conventional and Islamic Banks.
The fundamental difference between Islamic banks and the existing commercial
banks is the avoidance of riba in Islamic banking. Islamic banks are also universal or
multipurpose banks and not purely commercial banks - a cross-breed between
commercial banks and investment banks, investment trusts and investment-
management institutions.
Since the Islamic bank would share in the risks of the consignment, venture,
business or indemnity, it would need to be more careful in the evaluation of
applications. The activities of the bank will be based on the commercial transactions
allowed in Islam, including mudarabah, ijara, bai bi-thamin ajil and murabahah.
The objectives of these Islamic banks in general have been to promote, foster and
develop the application of Islamic principles, law and tradition to the transaction of
financial, banking and related business affairs. The main principles followed by the
Islamic banks are:
Moreover Islamic banks receive two types of deposits: (a) deposits not committed for
investment which take the form of current accounts or savings accounts; and (b)
deposits committed for investment which are called investment accounts. The current
account is operated in the same way as it is operated in the conventional banking
system, but the saving accounts and investment accounts are operated differently.
1. Savings account
This is an account where customers can deposit their savings. Though the depositors
allow the bank to use their money, they get a guarantee of getting the full amount from
the bank. The bank guarantees their savings but is not obliged to pay any rewards to the
savers. Some banks, however, may pay cash rewards from their profits at the end of the
financial year or give some privilege to the holders of these accounts as for example
providing financial assistance for small projects.
2. Investments accounts
The account holder authorises the bank to invest the money in any of its projects
and after the expiry of the specified period the account holder will get an agreed share
of the profits. The facilities that are provided by the Islamic bank will in general be
similar to those provided by other commercial banks. Its customers can maintain
current accounts and deposit accounts, however no interest is payable. In addition, the
customers can deposit their moneys in the investment accounts in which the profits and
h will be shared with the bank.
The Islamic bank can also provide services for the transmission and transfer of
money, the purchase and sale of currency and the financing of trade documents, for all
of which the Islamic bank can charge commissions. In addition, the Islamic banking
business provided by the bank includes the methods of mudarabah, musyahrakah, bai
bi-thamin ajil, murabahab, wadiah and ijara.
a) Relationship:-
Basically the relationship between Islamic Bank and its customers is not of debtor
and creditor, but it is something of sharing risk and rewards. So the relationship
emerges as Mudarib and Rabbul Maal. This basic assumption leads to the following two
things.
No predetermined fixed return on customer‟s deposits.No liability on the part of
Islamic Bank being Mudarib to owners of deposits (Rabbul Maal) to return their funds
in full on demand except the deposits in current account and provided the Bank has not
been negligent in investing the funds to earn profit.
No predetermined fixed return on customer‟s deposits.No liability on the part of
Islamic Bank being Mudarib to owners of deposits (Rabbul Maal) to return their funds
in full on demand except the deposits in current account and provided the Bank has not
been negligent in investing the funds to earn profit.
b)Sharing Profit/Loss:-
Islamic Bank share profit in pre-determined and declared ratio and the capacity of
Mudarib and in case of loss they sacrifice the management services rendered for
operational activity. Islamic Bank, however, shares the loss on investment of its equity.
This ensures justification equity and equality for correct payment of profit or sharing
loss.
c) Finances to customer :-
Unlike conventional bank, Islamic Bank does not allow cash loans. Islamic Bank invests
funds either through participation (Musharka / Mudarbah) or in the form of Islamic
Instrument like Murabaha and Ijarah Funds and other Islamic compliant mode of
financing.
d) Multi-purpose bank:-
Islamic Bank deals in short term, medium term and long-term investment in various
modes of financing including equity participation. So it is a multi-purpose Bank,
functions as commercial as well as investment bank and plays the role of Non-Banking
Financial Institution (NBFI).
Islamic principles simply require that performance of capital should also be considered
while rewarding the capital. Profit has been recognized as „reward‟ for (use of) capital
and Islam permits gainful deployment of surplus resources for enhancement of their
value. However, along with the entitlement of profit, the liability of risk of loss rests
with the capital itself. No other factor can be made to bear the burden of the risk of loss.
Financial transactions, in order to be permissible, should be associated with tangible
real assets. At macro level, this feature of Islamic finance can be helpful in creating
better discipline in conduct of fiscal and monetary policies.
The main difference between Islamic and conventional banking is that Islamic teaching
says that money itself has no intrinsic value, and forbids people from profiting by
lending it, without accepting a level of risk – in other words, interest (known as "riba")
cannot be charged.
To make money from money is prohibited – wealth can only be generated through
legitimate trade and investment. Any gain relating to this trading are shared between
the person providing the capital and the person providing the expertise. At Islamic
Bank of Britain, we generate all our profit through sharia’a compliant trading and
investment activities. We then share the profits with our customers at a pre-agreed
ratio. In order to share profits you must hold one of our savings or investment accounts
There are two major difference between Islamic Banking and Conventional Banking:
2. When Conventional banks involve in transaction with consumer they do not take
the liability only get the benefit from consumer in form of interest whereas
Islamic banks bear all the liability when involve in transaction with consumer.
Getting out any benefit without bearing its liability is declared Haram in Islam.
While the basics of what the business is are the same, the term refers to operating the
business within Islamic law. The main thing that effects this business under that law is
that Islam prohibits the charging of interest. Certainly a problem in modern banking!
However, what is considered to be interest has different definitions by different Islamic
scholars...some say it can only be considered on gold
and silver...but paying back the same weight as you borrowed (the same weight of
paper money for example), is not interest. Like in all religious things, there would seem
to be some conflict and differences between followers that may seem strange to
outsiders. So basically, modern Islamic banking may take many forms, each of which
strives to adhere to it's understanding of Islamic law.
society
4 Prepare and implement investment plans Increase the gap
to reduce the income inequality and
wealth
Islamic banking is unique, but by no means anomalous. It is neither at odds with nor
incomparable to conventional banking. Is it possible to contrast the two models?
II-A case in mind is Murabaha. There are those who say if an Islamic bank does
Murabaha any other form but the traders way of doing things it will not be permissible
from Shari'ah point of view, and an Islamic bank would be in their view a “dubious”
conventional bank. They say: since it is never the intention of the bank, to own there
assets and hold on to them then, such bank is not sufficiently Islamic.
According to this viewpoint, an Islamic bank must have huge warehouses and
elegant stores full of goodies for sale. This is not valid and those who think so miss two
important points:
Intention is of no consequence on the permissibility or otherwise of any exchange
contract in Shari'ah. In an authentic Hadith, the Prophet (PBUH) showed one
companion how to substitute a usurious transaction by another non usurious to reach
the same purpose, He (PBUH) didn’t object to the intention nor that he nullified the
contract on the basis of intention. Rather he corrected the form of contract. If the
anatomy of the contract is in line with Shari'ah requirements, then the transaction is
acceptable. Hence, if bank actually buys and then sells, with ownership passing from
seller to buyer and that the subject of contract is a good or commodity then the
transaction is correct. In conventional banking the subject of contract is money hence
any increase is usurious.
III-The way conventional banks render financial intermediation is very simple. They
borrow money and lend money. Both assets and liabilities are one form of lending.
Islamic banking function in a rather “elaborate” (not perplexing) way. They have to
continuously innovate to satisfy the needs of their clients. It is because of this we see
Murabaha, Musharakah, Mudarabah, Istisna’a, Salam to name just a few Islamic modes
of finance. This makes the job of an Islamic banker “not all roses”, but certainly a more
interesting one.
IV-A conventional banker is a risk manger. He is concerned with all kind of credit,
market, interest rate, legal and other risk factors. An Islamic banker should be just as
concerned. However, there is one added risk for the Islamic banker, this is what we may
call “Shari'ah disobservance risk”. Risk analysis refer to the forces that may cause the
outcome of investment to be sub optimal. Certainly an Islamic investor earning non-
permissible income is an outcome that is most undesireous, and it may cause the value
of his investment to be reduced.
Clearly, this is a disadvantage from two aspects: Firstly, an Islamic bank will not have
the opportunity in a Murabaha transaction for example, to be compensated for lost
profit. But more importantly, it increases significantly, the Murabaha risks. Since bank
clients are rational people who will seize an opportunity when they see one, they will
always delay payment. One major Ijtihad of contemporary
Motivation and renewed interest in Islamic finance industry stems from its strong
economic, financial and social considerations, backed by its unique features. Most
significant is its appeal to add to financial diversity and innovation being skewed
towards:
(i) Asset backed and equity based transactions, which promote entrepreneur
friendliness and consideration of project viability
(iii) inculcating market discipline and higher ethical standards given its emphasis on
non-exploitation and social welfare.
In the wake of high Asian domestic savings rates and build up of the region’s foreign
exchange reserves as well as oil surpluses of Middle East in the last few years, Islamic
finance is now also emerging as a way to wealth management, both of richer nations
and high net worth individuals.
Impressive as the growth record of individual Islamic banks may be, the fact is that at
present, those banks have mostly served as intermediaries between the financial
resources of Muslims and major commercial banks in the West. In this context, this has
been a one-way relationship, so far. There is still no major Islamic bank that has been
able to develop ways and means of intermediating between Western financial resources
and the demand for them in Muslim countries.
It also appears that individual Islamic banks face difficulties in fund placement because
they have had a major bias towards short-term, secured, low-return but liquid
investments. The challenge for these institutions stems from motivational and technical
factors.
Motivationally, their basic aim appears to have been that of demonstrating the viability
of Islamic banking without taking too many risks. Admittedly, this is a noble and a very
important objective, While there is considerable room for competition and expansion in
this field, the long-term survivability of individual Islamic banks will depend on how
rapidly, aggressively, and effectively they can develop techniques and instruments that
would allow them to carry on a two-way intermediation function. They need to find
ways and means of developing marketable Shari‘ah-based instruments by which asset
portfolios generated in Muslim countries can be marketed in the West as well as
marketing Shari’ah-based Western portfolios in Muslim communities.
While Muslim countries may, for legitimate reasons, opt for an Islamic financial system,
for the economy as a whole to benefit fully from the operations of such a system, it is
necessary that (a) government expenditures are fully rationalized, (b) revenues from
taxation, and those derived from property legitimately placed within the government
domain by the Shari’ah, are raised to meet the expenditure needs the government, (c)
the financial sector is liberalized so that returns to this sector reflect returns to the real
economy, (d) equity markets are developed to allow financing of investment projects
outside banking institutions, and, finally, (e) the structure of the banking system should
be such as to allow strong banking supervision and prudential regulation
commensurate with the risks involved in various transactions.* To accomplish the last
objective, the banking structure can be tiered in accordance with principal Islamic
financial transactions. It is reasonable to assume that risks involved in Musharakah or
Mudarabah financing, are different from those involved in trade-type financing. It
follows, therefore, that prudential regulations of these transactions should be different.