Differences Between Islamic and Conventional Bank

By : Ust Hj Zaharuddin Hj Abd Rahman
(Senior Shariah Compliance Manager, Product Development Division, RHB Islamic Bank Berhad)

One must refrain from making a direct comparison between Islamic banking and conventional banking (apple to apple comparison). This is because they are extremely different in many ways. The key difference is that Islamic Banking is based on Shariah foundation. Thus, all dealing, transaction, business approach, product feature, investment focus, responsibility are derived from the Shariah law, which lead to the significant difference in many part of the operations with as of the conventional.

Another key differentiating factor is the fact that Islamic banking embraces the concept of partnership, profit and risk sharing and value adding between banker (in this case financiers) and client. These elements, when artfully blended and applied will certainly result in a win-win situation in any business.

The foundation of Islamic bank is based on the Islamic faith and must stay within the limits of Islamic Law or the Shariah in all of its actions and deeds. The original meaning of the Arabic word Shariah is 'the way to the source of life' and is now used to refer to legal system in keeping with the code of behaviour called for by the Holly Qur'an (Koran). Amongst the governing principles of an Islamic bank are :

1. The absence of interest-based (riba) transactions;

2. The avoidance of economic activities involving oppression (zulm)

3. The avoidance of economic activities involving speculation (gharar);

4. The introduction of an Islamic tax, zakat;

5. The discouragement of the production of goods and services which contradict the Islamic value (haram)

On the other hand, conventional banking is essentially based on the debtor-creditor relationship between the depositors and the bank on one hand, and between the borrowers and the bank on the other. Interest is considered to be the price of credit, reflecting the opportunity cost of money.

Islamic law considers a loan to be given or taken, free of charge, to meet any contingency. Thus in Islamic Banking, the creditor should not take advantage of the borrower. When money is lent out on the basis of interest, more often that it leads to some kind of injustice. The first Islamic principle underlying for such kind of transactions is “deal not unjustly, and ye shall not be dealt with unjustly” [2:279] which explain why commercial banking in an Islamic framework is not based on the debtor-creditor relationship.

The other principle pertaining to financial transactions in Islam is that there should not be any reward without taking a risk. This principle is applicable to both labor and capital. As no payment is allowed for labor, unless it is applied to work, there is no reward for capital unless it is exposed to business risk.

Thus, financial intermediation in an Islamic framework has been developed on the basis of the above-mentioned principles. Consequently financial relationships in Islam have been participatory in nature.

Lastly, for the interest of the readers, the unique features of the conventional banking and Islamic banking are shown in terms of a box diagram as shown below:-

Conventional Banks	Islamic Banks
1. The functions and operating modes of conventional banks are based on fully manmade principles.	1. The functions and operating modes of Islamic banks are based on the principles of Islamic Shariah.
2. The investor is assured of a predetermined rate of interest.	2. In contrast, it promotes risk sharing between provider of capital (investor) and the user of funds (entrepreneur).
3. It aims at maximizing profit without any restriction.	3. It also aims at maximizing profit but subject to Shariah restrictions.
4. It does not deal with Zakat.	4. 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.
5. Lending money and getting it back with compounding interest is the fundamental function of the conventional banks.	5. Participation in partnership business is the fundamental function of the Islamic banks. So we have to understand our customer’s business very well.
6. It can charge additional money (penalty and compounded interest) in case of defaulters.	6. The Islamic banks have no provision to charge any extra money from the defaulters. Only small amount of compensation and these proceeds is given to charity. Rebates are give for early settlement at the Bank’s discretion.
7. Very often it results in the bank’s own interest becoming prominent. It makes no effort to ensure growth with equity.	7. It gives due importance to the public interest. Its ultimate aim is to ensure growth with equity.
8. For interest-based commercial banks, borrowing from the money market is relatively easier.	8. For the Islamic banks, it must be based on a Shariah approved underlying transaction.
9. Since income from the advances is fixed, it gives little importance to developing expertise in project appraisal and evaluations.	9. Since it shares profit and loss, the Islamic banks pay greater attention to developing project appraisal and evaluations.
10. The conventional banks give greater emphasis on credit-worthiness of the clients.	10. The Islamic banks, on the other hand, give greater emphasis on the viability of the projects.
11. The status of a conventional bank, in relation to its clients, is that of creditor and debtors.	11. The status of Islamic bank in relation to its clients is that of partners, investors and trader, buyer and seller.
12. A conventional bank has to guarantee all its deposits.	12. Islamic bank can only guarantee deposits for deposit account, which is 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..