Islamic and Conventional

Banking
 Learning outcomes
After todays lecture you will be able to understand
The governing principles of Islamic banking based on the
literature mostly discussed in the 2nd and 3rd lecture.

Major difference between the Islamic and conventional

banking system.

Modes of financing or products offered by the Islamic

banks.
 Basics of Islamic Banking
Islamic Banking is based on Shariah Laws.

Shariah covers every aspect of our life, it provides

principles how to live at individual level, in the society,
legal and economic system, etc. or simply it is a
complete code of life.
Governing principles of Islamic Banking

1. The prohibition of interest or riba based transactions

2. Avoidance of speculations (gharar)

3. Avoidance of oppression (zulm)

4. Introduction of Islamic tax (zakat)

5. Financing of Sharia Approved activities and

discouraging the production of goods and services
which are not allowed in Islamic values (haram).
1. The prohibition of interest based
transactions
Those who charge usury (riba/interest) are in the same
position as those controlled by the devils influence. This is
because they claim that usury is the same as commerce.
However, God permits commerce and prohibits usury.
Thus, whoever heeds this commandment from his Lord and
refrains from usury, he may keep his past earnings and his
judgment rests with God. As for those who persist in usury,
they will incur Hell, wherein they abide forever. (2:274)
 1. The prohibition of interest based
transactions
Riba literally means increase or excess. An increase
in a loan transaction or exchange of commodity accrues
to the owner without giving an equivalent compensation
in return. For example

Exchanging 1kg of grapes with 1.5kg of grapes that are

of the same type, quality and value.

Exchanging Rs.1000 for Rs.1100.

For the same items any difference in their exchange value

is interest whereas pricing of different items while
exchanging is allowed.
1. The prohibition of interest based
transactions
Prohibition of Riba will promote an economic behavior
which is

economically just (value addition)

socially fair and ethically correct (equal opportunities).

Inequality is definite in the situation where the lender is

guaranteed a positive return without assuming any share of
the borrowers risk whereas the borrower takes upon
himself all sorts of risks in addition to his skills and labor.
1. The prohibition of interest based
transactions
Riba violates the principle of property rights

Money lent on interest is used either productively that it

creates additional wealth or otherwise. When money used
(together with labor and entrepreneurial skills) to produce
additional wealth, such money lent cannot have any
property rights claim to the incremental wealth because
there was no prior bargain over it. Instead interest,
demanded a guaranteed return regardless of the enterprise.
1. The prohibition of interest based
transactions
Promotion of profit-and-risk-sharing

The sharing of risks and uncertainties of the enterprise is

fundamental to Shariah contracts. Shariah condemns the
act of guaranteeing (even by the entrepreneur) to restore
the invested funds intact.
1. The prohibition of interest based
transactions
Lending is a virtuous act

Lending should be a generous act. If money is needed

other than for commercial purposes (thus, risksharing),
such need should not be exploited where the borrower is
put under undue burden.

Allah says in Quran

Who is he that will lend unto Allah a goodly loan, that He

may double it for him or his may be a rich reward(57:11)
 2. Avoidance of speculations (Gharar)

Definition of Gharar

An Islamic finance term describing a risky or

hazardous sale, where details concerning the
sale item are unknown or uncertain. Gharar is
generally prohibited under Islam, which explicitly
forbids trades that are considered to have
excessive risk due to uncertainty.
 2. Avoidance of speculations (Gharar)
Most of the Islamic scholars view Gharar as both
ignorance of the material attributes of the subject
matter of a sale and also uncertainty regarding its
availability and existence.
Majority of derivative contracts are forbidden and
considered invalid because of the uncertainty involved
in the future delivery of the underlying asset such as
forwards, futures and options, short selling, and
speculation.
 2. Avoidance of speculations (Gharar)

Gharar is prevented when transactions are

transparent with:

all details agreed in advance; and

ownership undisputed.

However, Gharar may be tolerated if there is an

important Maslahah or public benefit.
2. Avoidance of speculations (Gharar)
Preventable uncertainty is present in any contract
subject to risks in the ordinary course of business
Istisna or salam contracts.

Prohibition of Gharar is indirectly a risk management

technique in Islam therefore encouraging the exercise of
due diligence and avoidance of contracts with high
degree of information inconsistency with high turnover.

Treating Gharar as risk has its penalties i.e. trading of

risks therefore is prohibited where the traded risks may
have been transferable in derivative format.
 3. Avoidance of oppression (zulm)
Zulm refers to all form of inequity, injustice, exploitation,
oppression and wrong doing.

A person either deprives others of their rights or does not

fulfill his obligations towards them.

Zulm also refers to trading in matters which are prohibited

(haram) under Shariah such as:-

a. alcoholic drinks/beverages; and

b. non halal poultry/meat, pork.

An extension of the social justice and fair economics.

 Comparison of Islamic with
Conventional Banks
Islamic banks Conventional banks
The functions and operating The functions and operating
modes of Islamic banks are modes of conventional
based on the principles of banks are based on fully
Islamic Shariah. manmade principles
(capitalism theory).
 Comparison of Islamic with
Conventional Banks
Islamic banks Conventional banks

It promotes risk sharing The investor/lender is

between provider of capital guaranteed of a
(investor) and the user of predetermined rate of
funds (entrepreneur). interest or returns.
 Comparison of Islamic with
Conventional Banks
Islamic banks Conventional banks

It also aims at maximizing Unrestricted profit

profit but subject to Shariah maximization illustrated by
restrictions. derivatives trading, deposit
multiplication, etc.
 Comparison of Islamic with
Conventional Banks
Islamic banks
In the modern Islamic
banking system, it has
become one of the service-
oriented functions of the
Islamic banks to be a Zakat
collection centre and they
also pay out their Zakat.
Conventional banks
Conventional banks do offer
the service of Zakat
deduction but the depositors
are reluctant to pay Zakat
from their accounts in
conventional banks.
 Comparison of Islamic with
Conventional Banks
Islamic banks
Participation in partnership
business is the fundamental
function of the Islamic
banks.
Conventional banks
Lending money and getting
it back with compounding
interest is the fundamental
function of the conventional
banks. Money is a
commodity and the
motivation.
 Comparison of Islamic with
Conventional Banks
Islamic banks Conventional banks
Islamic banks have no It can charge additional
provision to charge any money (penalty and
extra money from the compounded interest) in
defaulters except for case of defaults.
compensation and is used
for charitable purposes.
 Comparison of Islamic with
Conventional Banks
Islamic banks Conventional banks

Importance is given to the Banks interest is the main

public interest or maslahah. objective. It makes no effort
Its ultimate aim is to ensure to ensure growth with equity.
growth with fairness.
 Comparison of Islamic with
Conventional Banks
Islamic banks Conventional banks

For the Islamic banks, it Interest-based commercial

must be based on a Shariah banks dont care about the
approved underlying activities being performed
transaction. with their financing.
 Comparison of Islamic with
Conventional Banks
Islamic banks Conventional banks
Since income from the

Since it shares profit and advances/loans is fixed, it

loss, the Islamic banks pay gives little importance to

greater attention to developing expertise in

developing project appraisal project appraisal and

and evaluations. evaluations. Risks are

transferable at a price
(insurance).
 Comparison of Islamic with
Conventional Banks
Islamic banks Conventional banks

Greater emphasis on the The conventional banks give

viability of the projects. greater emphasis on
creditworthiness of the
clients.
 Comparison of Islamic with
Conventional Banks
Islamic banks Conventional banks
Islamic bank can only A conventional bank has to
guarantee deposits for
deposit account, which is guarantee all its deposits.
based on the principle of al-
wadiah, thus the depositors
are guaranteed repayment of
their funds, however if the
account is based on the
Mudarabah concept, client
have to share in a loss
position.
4. Introduction of Islamic tax (zakat)
Islamic banks perform as their obligatory duty to take
care of the whole system of Zakat as its principal
religious liability, and they pay Zakat themselves as well.

Naturally Islamic banks will be trusted more than the

conventional banks to perform this job.
 5. Financing of Sharia Approved
activities

Islamic banks will make sure that funds are used

only in Sharia approved economic activities, e.g.
businesses of alcoholic goods, narcotics, haram
meat, pork, casinos, and prostitutions, etc.
 Islamic Modes of Financing
Participatory Modes
1. Mudarabah
2. Musharakah
Sale Modes
1. Murabaha
2. Salam and parallel salam
3. Istisna and parallel Istisna
Rent based Modes
1. Ijarah
2. Ijarah wa Iqtina
 Summary of the Lecture
In this lecture we covered the following topics;
Governing principles of Islamic banking.

Comparison of Islamic and conventional banking

practices.
A brief introduction of Islamic modes of financing