When it comes to banking in Islam, there’s more to it than meets the eye. Many people are of the view that conventional banking is the only means of banking, but that’s not the case. There are banking options for almost everyone, catering to almost all of the market types and consumers. Even if you’ve got no clue how the world of banking works in today’s financial markets. Still, you can rest assured that there is a solution/product that would be suitable for your unique needs. From conventional to Islamic banking, there are plenty of options you can look forward to. If you are from a background where banking in Islam has some relevance. Be it for your religious belief or the culture you have been grown up in or the geographic area you are from. It is important to have an idea about the intricacies between the conventional banking system and the Islamic banking system. Whichever form of banking you choose to go ahead with, it is always beneficial for you to have knowledge of both options. If you have been looking for such information, but having a hard time finding so. The objective of this article is to provide you with the important information you require. This article will look to provide, in a very condensed form, the similarities and the significant differences between Islamic and conventional banking methods. Before we delve deeper into the differences between the two, it is also important to note that our objective of this article isn’t about highlighting the best possible option, rather it is only to ensure you make an informed decision based on the updated and valuable information you may have at your disposal. Hence, the differences between Islamic and conventional banking you will come across below should help you make decisions about investments in the financial sector. So, when you decide to make your feet wet, these differences between Islamic and conventional banking are likely to help you reach a prudent decision.
Misconceptions with regards to making profits
To start with, it must be noted that the motive of a financial institution is to generate profits. It is not a charitable institution, hence, profit-making is one of the primary goals a financial institute looks into. However, the mode and methodologies of earning profits are what make Islamic and conventional banking different from each other. It is a misconception that Islamic banks cannot make profits. And how the profits are earned using Islamic principles can be often a confusing matter for an individual. However, let us get one thing straight at the beginning and that is – Islamic financial institutes also earn profits and they do so by staying within the realm of the methods that are allowed in Islam. Conventional banks, on the other hand, employ methods such as interests. These methods, usually, do not conform to the Islamic way of banking. There are certain profit-sharing methods that are employed in Islamic banking, such as revenue sharing models etc. Hence, the primary difference lies in the way profit is earned.
How does the profit gets generated?
Once we’ve identified that both conventional and Islamic banking is based on profit-earning. We now look closer into how the profit-earning method differs between the two. Many people are of the view that it’s the same in conventional and Islamic banking, but it is not the case. While conventional banking is based on interest rates, profit in Islamic banking is based on some unique concepts (from a current secular point of view) like Modaraba and Ijarah etc. In terms of Islamic banks, these tend to engage the customer in a normal trade relationship, which is absolutely halal (permissible) in Islam. For example, if you’d like to purchase a car and have it leased by the bank, under the Islamic way of banking, the bank would purchase the car for you and you would agree to buy the car at a higher price from the Islamic financial institute like ICFAL. When the customer consents to buy the car directly from the bank at a higher price with the agreement that the customer would pay the price in fixed monthly instalments. This is how the institute makes profits in Islamic banking. Islamic banks/institutes establish a sale-purchase agreement with the customers that make it in line with the Islamic principles. These concepts, however, are not there in the case of the conventional banking system. Which operates under the interest rate method, where the price the customer may end up paying would be different from the initially agreed due to interest rate changes.
How does the concept of asset and liabilities work in Islamic and conventional banking?
Whether you have a fair idea of financials or not, it is likely that you might have come across the terms ‘assets and liabilities. There are pretty basic, right? However, Islamic and conventional modes of banking have different perspectives on these terms. In conventional banking, the asset is based on the amount of interest charged. For instance, in a case of a leased car, a conventional bank would charge interest in addition to the principal amount and that would be the bank’s asset. However, in the case of Islamic banking, there’s no concept of interest. Financing in Islamic banking is provided based on a sale and purchase agreement between the financial institute and the customer. In the case of deposits in the bank, i.e. the liability side, conventional banks offer interest to the customer, and the deposited money. That is used to finance other clients or invest in other investment plans. Whereas, in the case of Islamic banking, depositors are provided with profits based on Musharakah, which is a revenue-sharing model approved by Islam. You can also read this article to get more understanding.
The amount of profit
Another significant difference between Islamic and conventional banking lies in the amount of profit being generated from each category. The actual profit earned varies, but the point where the difference arises is that Islamic banking cannot pre-set the amount of profit to be given to a particular customer. This is the case in conventional banking where a customer already knows the amount of profit he/she will be getting from the bank. However, in the case of Islamic banking, the amount of profit is determined based on the market terms and fluctuations. And when the rate is fixed in advance, it no longer conforms to the Islamic way of banking. Hence, another pertinent point you need to consider in terms of evaluating the differences between conventional and Islamic banking is that one cannot determine the amount of profit on deposits in advance. This is also one of the basics of Islamic banking. When you deposit money with an Islamic bank, the bank can offer you any rate of return, but the point for Islamic principle is that this rate cannot be agreed upon in advance. Based on the banking in Islam that the bank would engage itself in, you’ll be offered a specific rate of return based on the partnership agreement you have with the bank. Yes, you heard it right. Islamic banks will establish a certain type of partnership agreement with the customer. Both the bank and the customer would then stand on equal footing with each other. This is different from how conventional banking works. Thereby, whenever you feel like knowing more about the profits you are likely to receive from a particular banking system. Then make sure you already have the know-how about how profit-sharing and profit-determination work in both Islamic banking and conventional banking.
Don’t fall for the trap of lack of knowledge
After reading through the post, it’s our sincere wish that you have a better understanding of some basic differences between Islamic and conventional banking systems. Even today, when you can find all the information you need close to your fingertips. People tend to feel confused about Islamic and conventional banking. The operational procedure of both two streams is actually entirely different. Whether you look to make financial investments now or anytime in the future. Accurate information pertaining to the basic differences between Islamic and conventional banking can always come in handy. ICFAL is a member-funded Islamic financial institute. If you have any questions on how Islamic finance work and how you can benefit from it, please do not hesitate to give us a call or contact us .