GOLLIS UNIVERSITY OF BERBERA

FACULTY OF MS - IT
ISLAMIC BANKING
SEMESTER FIVE: ASSIGNMENT

BY: ABDIQANI ID NO: 101 SH MAHAMED HASSAN

Submitted to Lecturer: Khadar Hassan

Monday, May 21, 2012

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Introduction Islamic banking refers to a system of banking or banking activity that is consistent with Islamic law (Shariah) 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 haraam. The main aim of Conventional Banking is to earn profit by borrowing and lending money in exchange of interest. As a result there is an unfair competition among the bankers and among the customers. Under conventional framework a bank borrows to lend and it mobilizes savings/deposits by borrowing from savers and lends those deposits to productive interest on deposits and advances respectively. The banks generally maintain a difference which is known as interest-spread which is the main income of an interest-based bank.

Islamic Banking vs. Conventional Banking: Similarities and Differences

Islamic banking and Conventional Banking perform all those functions which are expected from a financial institution like collecting deposits from savers and providing financing and investments to Businesses. 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 is shared between the person providing the capital and the person providing the expertise.

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Islamic banking and Conventional Banking are both financial intermediations. A financial intermediary is the institution that acts as a middleman between cash surplus units (savers) and deficit spending units (users of fund). It is quite obvious that the main function of conventional banks is financial intermediation. However, there are those who would like to think that there is no such thing in the Islamic economic system as financial intermediation and that an Islamic bank can only be sufficiently Islamic if it can operate like a trader, one who buys and sells goods and commodities. The financial intermediary in conventional banking is a borrower-lender institution. Since such institution will not survive unless it at least covers expenses, then an income must be generated from such arrangement. This is where interest appears. An Islamic bank, on the other hand, is based on a multi-tier Mudarabah. A Mudarabah is a partnership in profit where capital and management may joint together to create value. The income accruing to the Islamic financial intermediary is coming out of profit not from interest. The root of such a conception is the fact that Shari'ah doesnt distinguish between sellers being a trader or a final intermediary. In Shari'ah all people stand against one legal code. 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 functions 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, Istisnaa, and 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. A conventional banker is a risk manager. 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 inobservance risk. Risk analysis refers 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 undesired, and it may cause the value of his investment to be reduced.

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Contrary to popular opinion, being concerned about time value of money is a similarity not a difference between Islamic and conventional banking. There is no basis for the current thinking that Shari'ah doesnt allow the attachment of monetary value to time in the contracts exchange. The contract of Salam and differed-payment sales flies in the face of this argument. It is only in loans that Shari'ah requires that no time value of money is considered (but replaced by great rewards in the hereafter). A major difference, however, remains in the handling of delinquency and default. In Conventional Banking, when a borrower delays payment of debt, interest will accrue on his delayed portion. Unless, such borrower defaults and become incapable of paying back his debt, such interest will compensate the conventional bank for lost business. This cant be done in Islamic banking as this is considered usurious. To make it clearer, lets compare the two systems in the following Table:

Conventional Banking System Money is a medium of exchange. Money is a product and store of value interest on capital.

Islamic Banking System Money is just a medium of exchange. Real Asset is a product not Money are the basis for earning profit.

Time value is the basis for charging Profit on exchange of goods & services

Interest is charged even in case, the Loss is shared when the organization organization suffers losses. Thus no suffers loss. concept of sharing loss. The status of a conventional bank, in The status of Islamic bank in relation to relations to its clients, is that of creditors its clients is that of Partners, Investors, and debtors. and Trader, Buyer and Seller

While disbursing cash finance, running The execution of agreements for the finance or working capital finance, no exchange of goods & services is must, agreement for exchange of goods & while disbursing funds under Murabaha, services is made. Salam & Istisnaa contracts.

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Due to non-existence of goods & services Due to existence of goods & services no behind the money while disbursing funds, expansion of money takes place and thus the expansion of money takes place, which no inflation is created. creates inflation. Due to inflation the entrepreneur increases Due to control over inflation, no extra prices of his goods & services, due to price is charged by the entrepreneur. incorporating inflationary effect into cost of product. Lending money and getting it back with Compounding functions of the conventional banks. Conventional banks invest their deposit in Islamic interest based modes. banking only deals in Halal products and services, all transactions must be in Shariah Compliance It can charge additional money in case of The Islamic banks have no provision to defaulters charge any extra money from the defaulters. calculation is strictly compounding interest is the fundamental prohibited under Islamic banking system.

CONCLUSION An Islamic bank is a deposit-taking banking institution whose scope of activities includes all currently known banking activities, excluding borrowing and lending on the basis of interest. On the liabilities side, it mobilizes funds on the basis of a Mudarabah or Wakalah (agent) contract. It can also accept demand deposits which are treated as interest-free loans from the clients to the bank. And which are guaranteed. On the assets side, it advances funds on a profit-andloss sharing or a debt-creating basis, in accordance with the principles of the Shariah. Islamic banking is not as foreign to

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business world as it is perceived by certain quarters. It is a business very much like conventional banking within certain restrictions imposed by Islamic law. All business needs are being fulfilled by Islamic Banks in efficient ways through Murabaha, Ijara, Salam, Istisnaa, Musharaka and Mudaraba. Two features of Islamic financial system are worth mentioning. First is linkage between financial and real sector as Islamic Banks cannot extend credit facility without having support from real sector. Financing is either made through sharing risk and reward or must be asset backed. Second a unique feature of Islamic financial system is in the form of Mudaraba which can play role of catalyst for transforming society into prosperity by extending capital facility to skillful persons lacking capital. Islamic banking is not a mere copy of conventional practices rather major differences exist in the operations of Islamic Financial Institutions (IFIs) in comparison with conventional banking. Islamic Banks 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.