When most people hear about banks, all they can think about is the interest rates that come with loans. It gets more confusing when the same people hear about Islamic Banking. Most people tend to think that an Islamic bank is a financial institution that serves Muslims alone. However, Islamic banks are open to all.
The big question is, ‘why then call it Islamic Banking when it is open to all’? The only approach you can use to arrive at the answer is through comparing an Islamic Bank and conventional banks. The following are some of the major differences between the two.
Islamic banking basis its operations on the Sharia Laws. It thus means that goods that are prohibited within the Muslim community will not be traded through these banks. For instance, an Islamic bank cannot advance you a loan to start a wine shop. Most commercial banks that have Islamic windows have a Sharia advisory board that comprises of scholars who provide direction on how the financial institution should operate.
Conventional banks, on the other hand, operate on man-made laws. Their main motivation is business, and sometimes it has taken the intervention of governments to regulate unethical trading. These banks have lobby groups that represent their interest when they want to change laws on how they operate. Some of the laws are based on supply and demand forces while others are simply through consensus.
Concept of money
When you ask many people the main difference between an Islamic bank and a conventional bank, the most probable answer is that the former does not charge interest. It is true, but there is more to it. Money is a medium of exchange, and one can use it to acquire assets and any other commodity allowed by Sharia Laws. Islamic Banks also view money as a store of value and can thus be used to value an asset.
Conventional banks approach money in three dimensions. It is a commodity, medium of exchange and store of value. Viewing money as a commodity makes it possible for these banks to trade money at higher prices than its face value. These banks also rent out money and receive interest when the borrower pays back.
Profit and loss sharing
There are two sides of profit and loss sharing concept. The first one is when a customer trusts a bank for safe keeping of his or her valuables. This can be money or other possessions such as precious metals or a title deed. The second scenario is when a financial institution advances a loan to a client.
Islamic banks will verify and access the risks involved before advancing a loan. There are several arrangements, and Murahaba is among the most common. Take for instance when you want to buy a house. The bank will buy the property and then sell it to you. The agreement will appear like a co-ownership, and you will pay installments until you get all the shares. If a natural calamity occurs, you will share the loss with the bank based on the shares you own.
Conventional banks are profit oriented. If a catastrophe hits your investment, you still have to clear the premiums because they are just after the interest. The only advice they can offer you is to take an insurance policy to cover unforeseen catastrophes. When you deposit money for safekeeping, they can rent it out to other people without your knowledge. These banks will not share the profit they get from the transaction with you.
Relationship with the financial institution
Every time you deposit money in a conventional bank, you institute a creditor-debtor relationship. The same also applies when you borrow money from these banks. The financial institution has a role to pay you back the deposit you made plus interest according to your contract. You also must pay back the money when you borrow.
Conventional banks do not operate on debtor-creditor basis but more like a partnership. That is why in some cases you can share profits and losses depending on the outcomes. Islamic banks carry out risk analysis to ensure that the investment is safe and allowed by Islamic laws.
Even though the two accept deposits and advance loans to their customers, they are very different operation wise. The penetration of Islamic Finance is still low but has a promising future as more and more people learn of its features.