Difference between conventional banks and Islamic banks

By Ankita Agarwal on May 26, 2014
Image by Ronan Shenav on Flickr.com

Banking in common parlance refer to an organization which transacts in money. This term has been in use for a long time but its inception is still mysterious. Few believe the term ‘Bank’ has its origins in Italy from the term ‘Banchi’ while some believe that it has originated from Greek term ‘Banque’; both of them mean Bank (Singla, 2010-11).

Understanding different types of banks

Banks are organizations, where deposits can be kept to earn interest income over the time. However, there are banks which do not work on any interest income model and still are called banks. These are Islamic banks.

Let’s find out more about these banks by listing the differences between conventional banks and Islamic banks.

  • Islamic banks are based upon Sharia (Islamic law) and cannot act beyond the boundaries set by Sharia whereas conventional banks are based upon secular banking laws and financial practices of the respective countries (International Finance, 2013).
  • Conventional banks work on the fundamentals of creditor-debtor relationship where interest acts as the cost of money borrowed and the reward for money deposited whereas Islamic banks work on the participatory relationship between banks and the customers. Interest or Riba is prohibited under Sharia hence profit-and-risk-sharing relationships exist between bank and the customers. Thus, where conventional banks offer predetermined returns, Islamic banks offer variable returns to investors. Also, in case the entrepreneurs suffer a loss on the funds they borrowed from the Bank, Islamic banks share such losses (Bakar, 2010).
  • Islamic banks are based upon the notion that Allah is the owner of all wealth in this world and humans are only the trustees. As such, this wealth should be managed in a manner which promotes justice and eliminate unlawful and undesired activities. It is therefore investment in few businesses is prohibited in Islam including alcohol, gambling, drugs, pork, pornography, environmentally harmful or anything else that has been mentioned in the Sharia as ‘haram.’ However no such restrictions exist in the case of conventional banks (International Finance, 2013).
  • Under conventional banking, money is considered a commodity and thus it can be sold at a value higher than its face value however under Islamic banking, money is not treated as a commodity hence selling at a value higher than its face value is prohibited. Thus, any transactions involving speculation or high risk are prohibited under Sharia (Hassan, 2007).
  • Islamic Banking does not have any provision for charging extra amount as penalty from the defaulters. It can only charge compensation which is usually further donated as charity. However, conventional banks can charge additional money in the form of penalty and compound interest from the defaulters (Bakar, 2010).

False notion about Islamic banks

These are the basic differences between conventional and Islamic banks. Lack of knowledge about Islamic banking often gives birth to misconceptions. Some assume that Islamic finance is a mean to promote financial terrorism, others also assume that it is only for the Muslims or that it is essentially welfare finance; however the truth is that Islamic finance is legitimized and standard finance which follows the tenets provided in Sharia and is not restricted to Muslims; anybody Muslim or non-Muslim can avail Islamic finance and it also aims for maximization of profits. However, welfare is also an integral part of Islamic finance (Zawya Business Pulse, 2013).

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