What is the difference in transactions between Islamic Banks and Conventional Banks?

• The basic difference between Islamic banking  and conventional banking is the absence of interest. Islamic banking does not levy interest in any forms. It involves sharing of risks over any asset or business with the person or the firm using the funds but conventional banking levy interest and has no concern with profit or loss of  the organisation

To say that Islamic banks are different from conventional banks because the former don’t charge interest is accurate, but it’s only the tip of the iceberg. That difference is just one of many ways that the fundamentals of Islamic banking differ from those of conventional commercial banking.

The basic purpose for establishing an Islamic bank is to promote and encourage Islamic principles. Conventional banks are profit-making organizations that generally aren’t based on religious principles. That said, earning money is also a primary function of an Islamic commercial bank. Although the bank has a specific religious purpose, it can’t serve that purpose unless it also meets the objective of earning money.

A bank serves no purpose at all if it can’t stay in business!

Islamic banks operate based on Islamic business law (called fiqh-u-muamalat) for their basic transactions, and they also follow the financial laws and regulations of the countries in which they operate. Conventional banks likewise operate based on a country’s financial laws and regulations, but they don’t have contact with any religious body.

Islamic scholars recognize that money has value, but with limitations. For example, money can’t become more valuable simply because time is passing. However, the value of money can increase if it’s invested in a project that itself is increasing (in size, in success, and so on).

The most basic difference between the two systems is the recognition of Interest as unlawful by Islamic Banks.  In simpler terms following grid can give you a clearer idea:

1.

Islamic Banks do not just  lend money but become P&L partners with the client in the relevant transaction. (Mudarba, Musharka , Murabaha etc)

Conventional banks lend money and expect return without regard for profit and loss. (Interest)

2.

Islamic Bank adhere to both shariah requirements and local prudential regulations

Conventional Banks only comply with prudential regulations 

3.

As per Islamic banking concept, money is not a commodity although it carries value and is a medium of exchange but cannot be sold at a price higher than face value.

For Convetional Banks, Money is a commodity, carries value and medium of exchange.  It can be sold for a premium to face value

3.

Islamic banks do not engage with clients involved in prohibited nature of business such as Breweries, Casinos etc

Conventional Banks will lend to fit clients regardless of nature of business

4.

Islamic Banking Transactions are asset based.

Conventional Banks lend money in lieu of interest as compensation which at times leads to inflation

Islamic banks are distinct from conventional banks. They disagree on certain aspects. Principal area of disagreement between Islamic banks and conventional banks are described herewith.

Ownership Risks

     The fundamental difference between an Islamic bank and a conventional bank is the way they finance a project. It takes us to the argument of Risk Capital and Loan Capital.

Risk Capital is the capital that is rewarded for its participation in a productive process to the extent of the value that its participation creates, whether positive or negative, and which was unknown at the time of deployment of capital. 

To the contrary, the Loan Capital dictates its price of participation in the shape of a pre-determined rate and irrespective of the outcome of its application, whether positive or negative.

Thus under an Islamic financing environment, risk participation by the financiers is encouraged by way of becoming an owner of all or part of the assets. Naturally it entails ownership risks and responsibilities.

Such risks and responsibilities are non-existent when a conventional bank simply lends money on the basis of conducting its due diligence but without assuring the ownership rights in the financed assets.

Being the owner of an asset under an Ijara (Leasing) financing makes the Islamic bank responsible for keeping the asset in good working order so that the client can have quiet enjoyment over its usufruct for which he is required to pay the least rent. Then there is the responsibility of bearing taxes relating to the ownership of the asset as well as on the income generated from the asset.

What if the asset has a major breakdown depriving the lessee of the usufruct? With immediate effect the lease rent ceases to accrue till such time that the asset brought back to normal working condition by the Islamic bank as the owner of the asset. 

A conventional banker who is not familiar with taking aforesaid risks will naturally be reluctant to walk hand in hand with its Islamic counterpart. As such he would endeavor his best to cover the “shortcomings” which may seen weird to an Islamic banker to whom risk taking comes naturally. 

Risk and reward

     Another point where a conventional bank has difference of opinion is the level of return it receives compared to the risk it takes in an Islamic transaction.

     Whilst a conventional bank may traditionally be content whit a set return level on its lending, it is averse to the idea of getting exposed to a greater risk in an Islamic transaction by way of becoming part of owner in the asset, unless there is a convincing increase in its return.

     On the other hand, an Islamic bank remains at a dilemma due to its inability to obtain higher return owing to market forces working against such increase.

Jurisdiction

     Conventional banks draw the facility agreements based on civil code and are comfortable with it. However, when it comes to participating in an Islamic facility, they have to reply on Shari'ah, which is not their domain.

Although many Muslim countries do recognise Shari'ah to be the supreme sourse of jurisprudence, they also have parallel and highly active legal systems based on civil code. As such, when an Islamic bank declares Shari'ah as the governing law, naturally the conventional banks do get worried.

At time the task of convincing a conventional banker to accept Shari'ah as jurisdiction becomes monumental and there have been instances where the issue turned out to be the deal breaker.

Potential of increase in the cost of asset being leased

     In conventional leasing agreement of large value, it is common to find a clause relating to the potential of increse in the cost of the asset being leased.

The clause stipulate that if later on the lessor (lead bank) determines that any of the banks forming part of the lessor group has incurred any increased cost as a result of the introduction of any new tax in its area of operation making the financing expensive, or any new tax on the asset with retrospective effect or enhanced capital adequacy ratio leading to making the lending less attractive or for any other reaon, then the lessor bank(s) will have the right to add such increased amount to the lease rent.

Moreover, the lessor bank(s) shall not be obliged to disclose any calculation to the lessee while claiming the increased costs.

A conventional bank would like to see this point in the lease agreement while participating in an Islamic financing transaction. However, from a Shari'ah scholor's perspective, the point falls under the category of Gharar or element of uncertainly which makes an agreement null and void.

It may not be correct to assume that Shari'ah is rigid to accommodate subsequent increase in the cost of financing an asset. Following are the Shari'ah parameters to address such situation:

The lessee must undertake in the lease agreement that it will be willing to pay higher lease rent to allow the lessor to be able to bear the increased cost related to the financed asset in future, if any,

The Undertaking should include, inter-alia, the foreseeable elements of increased cost such as insurance expense, major repair and maintenance, ownership and income taxes, etc. All this may have been paid by the lessor or the lessee in the capacity of lessor's service agent.

Lessee will not be obligeed to pay for the increased costs to lessor if it is uncertain and cannot be arrived at with the help of a formula or if the lessor declines to provide the details of such increased costs, claiming it to be confidential.

In short, any element of uncertainty in a financing agreement is knocked down by the Shari'ah Supervision Board of an Islamic bank and which act is not looked with favour by a conventional bank.

Penalty for late payment

    It is a practice unanimously adopted by the conventional banks to charge penalty on the amounts delayed for payment by the client. The insist to include this clause in an Islamic facility agreement since they always have it in their own documentation and hence find it difficult to live without it.

Whilst Islamic banks are not allowed by Shari'ah to charge any such penalty since it will be tantamount to Riba (Interest), they usually accommodate this demand from conventional banks but add the phrase that such penalty amount will not be taken by them to their profit and will be donated to charity arganisations of non-religious nature.

    Why emphasis on non-religious charity? Because penalty amount being usurious in nature cannot be compared to Zakat money which is spent on supporting widows, orphans, religious students, Islamic schools, marriages and the likes. This less contentious issue works in favour of Islamic banks as it discourages the customer from intentionally delaying the payment.

Events of Default

     In conventional financing scenario, a long list of the events of default is provided which includes several events outside the borrower's control, such as, force majeure, nationalisation, requisition, etc.

To the contrary, in an Islamic financing transaction, imposing something on the customer over which he has little or no control is disallowed by Shari'ah.

    Shari'ah accepts those events as default which are caused by the customer are redefined as 'events of mandatory prepayment' and are covered under a separate document, rather than in the main facility agreements. This is to comply with Shari'ah requirement that events of default should only consist of the ones controlled by the customer.

Interestingly, upon the occurrence of an events of mandatory prepayment, the customer will technically not be in default from Shari'ah point of view. however, he will be reqired to purchase the asset and upon his failure, the financier banks will have the right to auction the asset in order to recover their dues. financiers can also waive the occurrence of such an event; however, this will require their unanimous decision.