Difference between Islamic mode of Financing and Conventional mode of Financing

Like conventional bank, Islamic bank is an intermediary and trustee of money of other people but the difference is that it shares profit and loss with its depositors. This difference that introduces the element of mutuality in Islamic banking makes its depositors as customers with some ownership of right in it.[1]

Islamic banking and conventional banking differs in that while the conventional banking follows conventional interest-based principle, the Islamic banking is based on interest free principle and principle of Profit-and-Loss (PLS) sharing in performing their businesses as intermediaries[2] . Rationale behind prohibition of interest and the importance of PLS in Islamic banking has been discussed in many Islamic economics

studies8. Moreover, Islamic PLS principle creates the relationship of financial trust and partnership between borrower, lender, and intermediary.[3]

5.1     Main reason of differences

In particular, Shariah prohibits transactions in which some or all of the following elements are present:

·                    Uncertainty (gharar) in contracts – there is a prohibition on the sale of items whose existence or characteristics are not certain, and upon contractual terms that are ambiguous or unclear. This may mean that certain contracts containing obligations to insure another person or to grant an option to purchase an asset may be unacceptable.

·                    Gambling (maisir) – may apply to dealings in futures and options to the extent that they are speculative.

·                    Prohibited (haram) commodities and activities – this involves a blanket prohibition on involvement in activities relating to the provision of pork, alcohol and gambling services, among others. Nevertheless, different views exist on borderline cases such as hotels, or aircraft in which, for example, alcohol may be served.[4]

5.2     Differences between Islamic & Conventional Banking[5]

An Islamic bank is essentially a partner with its depositors, on the one side, and also a partner with entrepreneurs, on the other side, when employing depositors' funds in productive direct investment as compared to a conventional bank which is basically a borrower and lender of funds. Difference between the two banking systems also lies in terms of governance structure. Islamic banks must obey a different set of rules – those of the Holy Qur’an – and meet the expectations of Muslim community by providing Islamically-acceptable financing modes[6]

Characteristics	Islamic Banking System	Conventional Banking System (Interest based system)
Business Framework	Based on Shari'a laws - Shari'a scholars ensure adherence to Islamic laws and provide guidance.	Not based on religious laws or guidelines - only secular banking laws
Balance Between Moral and Material Requirement	The requirement to finance physical assets which banks usually take ownership of before resale reduces over extension of credit.	Excessive use of credit and debt financing can lead to financial problems.
Equity financing with risk to capital	Available. Enables several parties, including the Islamic Bank to provide equity capital to a project or venture. Losses are shared on the basis of equity participation while profits are shared on a pre-agreed ratio. Management of the enterprise can be in one of several forms depending on whether the financing is through Mudarabah, Musharkah, etc.	Not generally available through commercial banks, but through venture capital companies and investment banks which typically take equity stakes and management control of an enterprise for providing start-up finance.
Prohibition of Gharar	Transactions deemed Gharar are prohibited. Gharar denotes varying degrees of deception pertaining to the price and quality of goods received by a party at the expense of the other. Derivatives trading e.g. options are considered as having elements of Gharar.	Trading and dealing in derivatives of various forms is allowed.
Profit and Loss Sharing	All transactions are based on this principle. Returns are variable, dependent on bank performance and not guaranteed. But the risks are managed to ensure better returns than deposit accounts. Consumers can participate in the profit upside i.e. in a more equitable way than receiving a predetermined return.	This principle is not applied. Returns to depositors are irrespective of bank performance and profitability. The customer as depositor is like a lender and does not share in the success of the enterprise beyond receiving a fixed rate of predetermined interest. Unlike the Islamic system the depositor cannot theoretically gain subject to improved bank performance.

5.3     Difference between Sale and Interest

i.                        As far as the difference between sale/trade and Riba transactions is concerned, the first category of transactions is subject to the natural conditions of uncertainty and risk in relation to time and the second is not. As a result, the capital involved in trade may grow or decline through time, while in riba-based transactions, capital automatically increases over time, and

ii.                        The difference between debt created by loan (qard) and debt created by credit sale was not clearly discussed. As a result, the liability creating potential of trade (i. e., its financing potential) did not attract the attention of these earlier scholars. The financing aspect of the differences between sale and Riba was also not discussed by them.[7]

5.4     Conventional Partnership and Musharaka

Major characteristics between conventional partnership and the Musharaka

1.         Conventional partnership is a long term contractual agreement.

Musharaka is a limited contractual agreement with similar rights and liabilities.

2.         In conventional partnership capital, financial property and good will can be contributed.

In Musharaka capital, labor and financial value of asset depreciation contributed. Contribution is in varying proportions and a partner may not contribute financial capital.

3.         Conventional partnership withdrawal and addition is allowed during the life time of contract.

In Musharaka it is not allowed except by mutual consent. The contract will be change accordingly.

4.         Conventional partnership profit allocation either fixed percentage, or according to the partners, contribution of capital and services, or in proportion to capital balance

In Musharaka profit allocation will be according to partners contribution with profit and loss shearing ratio agreed is advance and cannot be altered during the life time.

In conventional net income of business is allocated periodically leaving the project in operation. Partners may entitle commission or salary.

In Musharaka profit and loss allocation is made when project finished. No partner is entitled to salary or commission. Allocation is made for financial contribution and management affords.

5.         Conventional commandment is known, but liquidation is unknown and not recorded in the contract.

In Musharaka commencement and liquidation is known in advance and recorded in the contract.

6.         Conventional partnership is usually undertaken financially equal parties, Musharaka partnership is undertaken financially unequal parties.

In diminishing Musharaka ownership of the assets can be passed to a partner after systematically paying rations of the assets.

The highlighted discussion above that the unfamiliar Islamic partnership mode of finance it is just a simplified, short-term, fixed contribution conventional partnership. If the Islamic system, guided by its principle of profit and loss sharing as opposed to fixed interest, managed to modify the conventional partnership for financing small enterprises, why can’t the interest-based banking system apply whatever sort of partnership, based on its conventional one to extend finance for small enterprises? This applies to a system of both Musharaka. As a result, interest avoidance is not an issue here, and Musharaka or any kind of partnership cannot easily be rejected on economic grounds. The basic difference between interest and interest- free banking systems makes no difference in the application of any sort of partnership arrangement as a supplement to interest financing to extend credit to small and medium enterprises. [8]

5.5     Lease and Ijara

Conventional Leasing Contracts: 

A conventional leasing contract is a contract between a Lessor and a Lessee for the hire of a specific asset. The lessor retains the ownership of the asset but the right to use the asset is given to the lessee for an agreed period of time in return for a series of payments paid by the lessee to the lessor.  

An Operating Lease is a pure rental agreement with three distinctive features:  

1. The cost of the asset is not fully amortized over the lease period,
2. the lessor provides maintenance of the asset and
3. The asset is usually returned to the lessor.

Therefore, the lessee has the advantage of procuring an asset, utilizing it for its benefit and returning the same when it has served its purpose.

The features of an operating lease are different from that of a financial lease, and could be listed as:

1.                  Title to the asset must not automatically pass to the lessee as one of the conditions of the lease term.

2.                  The lease contract must not contain an option to purchase the asset at a bargain price.

3.                  The lease term must be for less than 75% of the economic life of that asset.

4.                  The present value of rental, or lease, payments excluding executor costs

(Insurance, maintenance, taxes, etc) must be less than 90% (not equal to) of the fair market value of the asset.

The rationale underlying these features is to determine the intent of the parties to a lease transaction. A lease that doesn’t transfer all the benefits and liabilities associated with ownership is said to be an operating lease.  

Ijara Contract

The term “Ijara” has been defined as a contract between two parties, the lessor and the lessee, where the lessee enjoys or reaps a specific service or benefit against a specified consideration or rent from the asset owned by the lessor. It is a lease agreement under which a certain asset is leased out by the lessor to a lessee against specific rent or rental for a fixed period.

In an “Ijara” contract the lessor maintains its ownership in the leased asset while transferring the right to use the asset, or usufruct, to an enterprise as the lessee, for an agreed period at an agreed consideration. All liabilities and risks pertaining to the leased asset are to be borne by the lessor including obligations to restore any impairment and damage to the leased asset arising from wear and tear and natural causes which are not due to the lessee’s misconduct or negligence. 

“Ijara” is a contract of a known and proposed usufruct against a specified and lawful return or consideration for the service or return for the benefit proposed to be taken, or for the effort or work proposed to be expended. [9]

References

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[1] Dar, H. and Presley, J.R. (2000), “Lack of profit loss sharing in Islamic banking: management

and control imbalances.” International Journal of Islamic Financial Services, Vol. 2, No. 2.

[2] Ariff, Mohamed (1988), “Islamic Banking.” Asian-Pacific Economic Literature, Vol. 2, No. 2, pp.46-62.

[3] Yudistira, Donsyah (2003), “Efficiency of Islamic Banks: an Empirical Analysis of 18 Banks,”

Finance No. 0406007, EconWPA.

[4] Lovells Client note (2004)  “Islamic finance Shariah, Sukuk & Securitisation”

[5] Bank, Abudahabi islamic. (2009) Difference between islamic and conventional Bank. Abu Dahabi Islamic Bank. [Cited: 5, 2, 2009.] http://www.adib.ae/web/guest/about-us/about-islamic-banking/islamic-vs-traditional.

[6] Suleiman (2001).

[7] Tariqullah, Khan Monzer Kahf (1992) Principles of Islamic Financing Paper No 16 . s.l. : Islamic research and training institute Islamic Development Bank.,

[8]  Ibrahim, Badr-El-Din A. (2003) Poverty Alleviation via Islamic Banking Finance to Micro-Enterprises (MEs) in Sudan:Some lessons for poor countries. Bremen Germany : Institute for World Economics and International Management (IWIM) D-28334 ,

[9] Mateeha.(2006) Differences and similiarities between Ijara and conventiona oprating lease contracts. Karachi Pakistan : College of Management Sciences PAF Karachi Institute of Economics and Technology, 

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