islamic and conventional banks

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Comparison between islamic and conventional banks

Islamic banking :

What is Islamic banking ?

The origin and bases of Islamic banking banking is governed by the sharia Islamic law sometimes referred to as Islamic jurisprudence, Islamic sharia law provides rules that encompass the allocation of resources capital market activities and the distribution of income and wealth.

Islamic not just a religion it's a way of life, the Qur'an and the life of the prophet and his companions have give muslims a detailed manual by which to live every aspect of our lives, from how we greet each other to the way we pray and even the food we eat. Therefore it makes sense that our monetary dealings are also governed by this all-encompassing religion this is called Islamic banking.

Islamic banking refers to a system of banking which is consistent with Islamic law also called shari'a and guided by Islamic economics, in particular Islamic lawprohibits the payment and collection of interest also commonly called Riba (usury) , the main argument against interest is that money is not used as a commodity with which to make a profit but that it should be earned on goods and services only not on control of money itself .

Features of Islamic banking

Islamic economy is based on specific features, the most important of which are as follows :

Its creed -based : Islamic shari'a allows all economics activities in the framework of protecting public interest and safe guarding it.

Its realistic : Islamic rules fulfill all the needs of real life. That is why we find that Islamic shari'a dose not prohibit transactions except those involving injustice, unless there is an express provision prohibiting it and as long as it serves the interest of people and fulfills the realistic needs of life every transaction is lawful.

In the ethic-based : man may make profit from doing business however when this runs against Islamic ethics and morality, it is outlawed. In addition for investment to be legitimate one of the most important requirements is that is outcome must fulfil the reality of investment transaction and that it enables the Islamic financial institution to state what it expects to make in profits whatever this cannot be determined as a certainty or can one commit one's self to it or bear any loss sustained.

If an Islamic financial institution (ifi) gives such a guarantee the investment becomes unlawful and the gain made from it becomes ill-gotten and unlawful because guaranteeing the principle of the investment of specifying it profit as a certainty make the IFI's activity similar to the interest based activities undertaken by conventional banks and this is declared unlawful in verses of the Qur'an and hadiths which deal with Riba (usury).

Main conditions governing Islamic investment :

Money does not generate or beget money in itself but it becomes productive if its involving an activity or work

Investment is subject to the rule of profit and loss sharing.

Investment in business activities is lawful, but prohibitions should be avoided.

Contracts must be free of gharar ( uncertainty, ignorance and the conditions which lead to disputes)

The two main types of usury to be avoided are as follows :

Riba al-nasiah or differed usury, is related to extension of the repayment period for additional payment of money its also called riba al jahiliyah which was a pre-islam from of usury and the worst of its kind.

Riba al-fadl means the excess which is taken in exchange of specific homogenous commodities such as selling gold with another gold.

Modes of financing

As with conventional banking Islamic finance requires tools or instruments through which to operate below is a brief explanation of each of the most commonly used modes of Islamic financing.

Murabaha

Murabaha is a sale whereby the bank purchases a commodity on the order of a client and then sells it to the client on a cost plus profit basis the cost incurred by the bank for the commodity and the intended profit rate is pre-agreed by client murabaha is no considered as a personal loan but commercial transaction based on following two fundamental principles :

The bank buys the goods and commodities from its owner and possesses them either actually or constructively and the sells the goods or commodities to the buyer at a profit margin a greed on buy the two parties.

The price of the sale is fixed and must not increase in case of delay in payment its also not obligation for the bank to give rebate if payment is made prior to the maturity date.

Mudharaba : is a partnership where one partner gives money to another for investing in a commercial enterprise while the other utilizes his or her business skills. The profits generated are shared in a ratio by mutual agreement bur loss if any is borne only by the owner of the capital in which case the entrepreneur gets nothing for his labour

Musharaka : literally means sharing in Islamic finance musharaka means a joint enterprise ( partnership) in which all partners share the profit according to a specific ratio loss is shared according to the ratio of the capital contribution each partner invested.

Ijara and ijara wa lqtina : ijara simply means a leasing or employment contract. There are two types of ijara the first being the contract of renting hiring or leasing the second is ijara wa laqtina which is also called ijara muntahiya bitamleek which is leasing with an undertaking from the leasor to sell the equipment or the facility at the end of the rental term or to provide the leased property as a gift to the lessee provided the lessee pays the entire required rental within a specified period.

Istisna'a : is a sales transaction where a commodity is sold before it come into existence for example this mode of financing may be used for home financing where the client owns land and seeks financing for the construction of a house the financier can provide him with a constructed house on a specified piece of land the price must be fixed with the consent of all parties involved all other necessary specifications of the commodity must also be fully settled the payment of an istisna'a may be made in advance or instalments or in a lump sum at the end of the period.

Salam : is a sales transaction where a commodity usually horticultural or agricultural goods is sold before it comes into existence the price of the commodity must be paid in advance to make the transaction valid.

Types of accounts in an Islamic financial institution (IFI)

In islamic banking each customer is a partner with the Islamic financial institution (IFI) this relationship is classified as a mudarib partnership profit resulting from the account are divided between the parties an IFI receives a certain percentage of the net profits as a return for the amount deposited in different investment accounts as its share being a mudarib as a greed between customer who is the investment account holder and the IFI.

Current accounts : are an interest -free loan by the account holder to the Islamic bank which maintains these funds and pays them to the customer on demand these accounts are similar to a loan in guarantee and the payment of the same amount.

An IFI has the right to invest the funds its holding in current accounts without the customer bearing any loss for this reason the customer does not get any profit on this type of account but he also does not bear any loss.

Investment savings accounts : many Islamic banks offer savings accounts to their customers this account allows the account holder to place funds in a safe environment till such time when they may wish to withdraw them profits and losses under investment savings accounts accrue on the minimum monthly balance profits are paid or losses are deducted after the expiry of the financial year and the net profits are determined and the balances under investment saving accounts are invested on the basis of unrestricted mudharaba an Islamic bank has the right to do everything necessary to realize common interest. An account holder authorizes the Islamic bank to invest the profits made from the moment they are registered in his own account with the Islamic bank.

-Differences between Islamic and conventional banks

There are a number of key differences between the products and serviced offered by a conventional bank in a comparison to an Islamic financial institution ( IFI ) islamic transactions are created in view of the juristic rules of Islamic shria'a and the differences can be highlighted as follow

In conventional bank

Transactions

Funds generate funds and the spread between the loan and borrowing is used by the bank

Current account

A debit account that accrues interest

Financing

Consider loan requests for businesses and provide loans with interest payments to be paid back to the bank in installments in the transaction of exchanging loans among banks these are subject to interest both giving and receiving

Property

A loan is extended and an increase is charged on the loan by subjecting it to interest and compound interest in case of delayed repayment.

Investment of funds

Conventional banks pool funds through deposits and extend loans benefiting from the spreads without being directly involved in risks associated with the projects

Cheques

A differed cheque is bought at a lower value which is a form of interest based transaction and not allowed in Islamic banking

Credit

The amount paid is an interest-based loan , because its an overdraft in Islamic banks what the bank pays on the overdraft customer's behalf is an interest free loan in conventional banks interest is paid on the amount due to the customer - In Islamic banks

Transactions

Based on the principle that funds don't generate funds unless they are coupled with an activity or work .

Current account

A guaranteed loan that's paid on demand without increase or decrease

Financing

Actively encourage entrepreneurs by funding small enterprises by way of partnerships that end with ownership Islamic banks loans are extended to other banks without taking or giving interest

Property

Qur'anic rule if the debtor is in a difficulty grant him time till it is easy for him to repay however if he is procrastinating the bank applies shari'a compliant rules to guarantee its right but without resorting to interest

Investment of funds

Funds must be invested in lawful areas that achieve social and economic development areas outlawed by shari'a must be avoided, the capital is invested on a partnership basis between the bank or entrepreneur and the capital provider.

Cheques

A differed cheque is en cashed against its value on encashment date and it may not be bought before its due date at a discount.

Credit

Murabaha is used whereby a murabaha-based credit is opened with the bank. The bank owns the commodity and then sells it to the customer by way of murabaha.

Finally, in most countries Islamic of the muslim world. The public's acceptance of Islamic finance has been quicker and much greater than is appreciated by must outside observers. Islamic finance is indeed perceived by many of its users as an improved system in many respect. In addition many of the smaller banks and financial institution in the GCC may discover that Islamic finance represents a unique differentiation strategy because of its focus on a niche market segment. For instance there are currently 17 commercial Islamic banks in the GCC , yet a recent report by standard & poor's suggests that the sector is not yet crowded and there is a room for some of the small bank to transfer themselves into Islamic banks .( Islamic retail banking and finance by Sohail Jaffer )

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