Four Ways Conventional and Islamic Commercial Banks Differ - dummies

Four Ways Conventional and Islamic Commercial Banks Differ

By Faleel Jamaldeen

Although Islamic commercial banks have many products similar to those offered by conventional banks, the two entities differ conceptually. One key difference is that conventional banks earn their money by charging interest and fees for services, whereas Islamic banks earn their money by profit and loss sharing, trading, leasing, charging fees for services rendered, and using other sharia contracts of exchange.

Following are four key ways that conventional and Islamic commercial banks differ.

The oversight of a sharia board

A sharia board consists of Islamic scholars who are qualified to give opinions on Islamic business contracts. In a commercial bank, the board is also involved in supervising bank operations to make sure they comply with sharia principles.

You may wonder why a bank needs a sharia board to ensure its compliance with sharia principles. If the basic distinction between conventional and Islamic banking hinges on interest, can’t Islamic banks satisfy the requirement by just making sure none of their transactions involves charging interest?

Islamic banks and other financial institutions must comply with a variety of principles besides avoiding interest. Islamic finance is based on four core principles:

  • Prohibiting usury

  • Avoiding speculation

  • Avoiding gambling

  • Investing ethically

Interpreting each principle is more difficult than you may think. Scholars spend their lifetimes learning all they can about the intent and past interpretation of sharia law, and they still often have differing opinions about it.

Making sure that Islamic banks comply with sharia isn’t easy — hence the necessity of the sharia supervisory board. This board is the backbone of an Islamic bank; it plays a vital role in establishing and operating the bank.

Concepts of money and the basis of transactions

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-umuamalat) 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).

Relationships with clients or customers

When you deposit your paycheck in a conventional bank, your relationship with that bank is one of creditor to debtor; the bank has a responsibility to pay back your money with or without interest according to your account contract. Similarly, the roles reverse when the bank provides you with a loan.

The relationship between a customer and an Islamic bank is completely different; the debtor and creditor relationship does exist at times in Islamic banking. To understand the relationship between the customer and Islamic bank, you must know what contract that relationship is based on.

Investments in the bank

Investments in conventional commercial banks are based on guaranteed principal and earning a fixed amount of income.

For example, say that a customer in a conventional bank deposits $10,000 in a six-month term deposit. After six months, the bank has a liability to pay back the customer the principal plus the interest rate charged for six months. Even if the bank lost the money in an investment, the bank is still liable to pay back all the money due.

In Islamic banking, the concept of investment is different. Although the customer deposits the money in order to earn extra income for her savings, her principal and returns aren’t guaranteed. Suppose the Islamic bank loses money because of an unexpected business failure. In this case, the bank isn’t liable to pay the money to its customer.

(Note: The failure of an investment isn’t very common in Islamic banks because the banks are very concerned about their customers and make their investment choices very wisely. If they didn’t, they soon would have no customers at all!)