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Islamic Banking Vs Western Banking
Differences and Similarities in Conventional and Islamic Banking
Religion and banking
Profit and loss paradigm (interest)
Financing and investments
Loans (short-term, medium and long-term loans)
Medium and long-term loans
Overdrafts and credit cards
In retrospection, the history of banking in this context can be of paramount significance to understand the broad paradigm of banking, its relation to the history of money which gradually became the medium of exchange in the modern world. Banking transactions preceded the invention of money in the ancient world. In those ancient times, agrarian revolution is known to have led to production of agricultural produce owing to tilling of land using iron implements invented during the iron-age. Trade flourished as people exchanged various goods for other goods. Consequently, surplus and inadequate production saw the emergence of such practic3es as deposits and loans. For instance, loans acquisition dates back to the 2nd century BC IN Mesopotamia. Moreover, banking transactions such as deposits of grains, cattle and later the precious metals such as gold are documented to have been practiced as basic tools of trade. Gold and other precious metals gradually emerged as the medium of trade, in the form of easy-to-carry plates. Palaces and temples are known to have served as ancient banks where gold could be stored for matters of safety. Temple priests and monks issued loans to merchants. Later on, laws to govern banking operations were laid down as banking practices became wide spread. The merchant banks invented by Italian grain merchants were the first banks in the middle Ages (Hoggson, 1926). Afterwards, civilization over generations led to two distinct banking systems partially based on religion: the Islamic and western (conventional) banking systems. Variant banking systems in operation today can be accrued to matters of religious doctrines with Islamic banking showing a distinct paradigm owing to the strict sense of Islamic law from the conventional western banking in common practice. A comprehensive comparison is therefore mandatory if a clear distinction based on the fundamental similarities and differences between Islamic banking and western banking paradigms are to be unearthed.
In a nutshell, Islamic banking and western (conventional) banking has the same purposes and practice except that Islamic banks operate strictly in accordance with Islamic (Sha’riah) laws. Precisely, Islamic banks offer facilities more or less the same segment of the economy as western banks, in accordance with the welfare principles of Islam. Generally, the banking paradigm between the two is not so different since fund s is related to interest rates. In addition, guarantees are deemed necessary in conventional banking as they are in Islamic banking. Despite the clear cut difference on matters of religion, the fundamental concern of the current world is based on whether the financial institutions fulfill the wide range of requirements of communities worldwide. The perceived difference is gradually becoming narrow owing to the urgent need for financial services throughout the world. Accessibility to financial services both to the Muslim community where Islam hold as well as the non-Islamic community is now the major interest in all aspects of business. This principal necessity has of late led to emergence of corporate merging of the two banking systems. For instance, major banks offering Islamic banking services as well as conventional banking have been opened, e.g.; Saudi American bank, Citibank and Saudi British bank. Virtually, conventional banking exists in the same society where Islamic banking exists too, performing all the functions expected from financial institutions though their philosophy and operations are quite different. As evidenced by the rapidly growing trend of financial institutional setup merging to fulfill the requirements of the high commercialized community, a brief digression into the underlying similarities and differences between the two seems necessary in order to comprehend the entire banking paradigm.
Direct comparison between Islamic banking and western banking may not necessarily expose all the underlying differences and similarities but a broad analysis from various perspectives is pivotal for focusing the ambient features of comparison.
Entirely, a cross-sectional outlook of the principal paradigm in both Islamic and western banking set up conspicuously expose two major differences in a very wide scope of banking. More precisely, Islamic functions and modes of operation are primarily based on the principles of Islamic Shariah law. In contrast, the western banking functions and operation modes are designed and governed on precepts of manmade principles. These major differences between Islamic banking and western banking are made obvious owing to the aspects of how the two banks approach liabilities and risks.
As an overview, Islamic banks absorb all the liability in transactions with their clients in accordance with Islam law which require bearing of the involved liability by the beneficiary, whereas conventional banks do not in any means take liability involved in transaction with their clients; instead, they exclusively take benefit in form of interests from customers. On the other hand, Islamic banks “bear the risk” involved in all financial transactions with their clients contrary to the witnessed scenario in western banking where the main approach is towards “elimination of risk”. In capitalism, it is entrepreneur who bears all risk owing to the fact that capital is a factor of production thus the fixed risk-free reward in form of interest. Moreover, based on these major aspects which characterize each of the two banking paradigm distinctively, close relationship can be explained through intuitive specification of various smaller aspects encompassed in the major broad issues. These smaller aspects include; deposits, financing (loans and mortgages), investment and interests which can be further broken down to account for all aspects for the sake of comprehensive and genuine comparison of the two banking entities.
From a religious perspective, the role of religion appears to be the primary factor which facilitated existence of both western banking paradigm and the Islamic banking paradigm throughout the banking history. To start with, it is true to assert that, conventional banking is virtually not restricted to religious doctrines but purely on capitalism. Universal tenets of capitalism determine the entire relationship between the bank and its clients; depositors and borrowers. In other words, it is functions and operates basically on “debtor-creditor” relationship.
On the other hand, Islamic banking unlike western banking is essentially based on the eternal verities of the Shariah law (‘the way to the source of ‘used to refer to the legal system in keeping with the code of behavior called for the Holy Qur’an). In this case, function and operation modes of banking are designed in accordance with the Islamic Shariah law. The relationship between the bank and customers is governed by the tenets of Shariah law. Some of these principles under which the Islamic banks operate includes; riba -the absence of interest based transactions, ghamar -avoidance of economic activities involving speculation, zulm -avoidance of economic activities involving oppression, zakat -islamic tax paid by all customers and, haram which discourage production of goods and services contrary to Islamic value. Moreover, contracting in Islamic banking is predominantly by two basic principal concepts, notably; musyarakah (joint venture) and mudarabah (profit-sharing).
In contrast to the approach by conventional banks of charging interest on loans and having a fixed rate of return on deposits, Islamic banks does not charge any interest (riba) because Islam prohibits such operations. In addition, the additional fees charged on defaulters as penalty and compound interest in western banks is per potently absent in Islamic banking. Usually a little amount of compensation is paid by defaulters, which is deemed to use for charity. Consequently, rebates are occasionally offered for early repayment with respect to the bank’s discretion. Another unique characteristic feature is that profits and losses are equitably shared among the banks, depositors and the borrowers. For instance, mudarabah contracts are clear example of profit sharing agreement. The banks finance projects by providing the capital required while the customer manage the project by providing the required expertise and labor. In addition, the joint venture agreements referred to as musyarakah contracts, entrepreneurs and the banks jointly raise the capital and manage business projects (Badawy, 2005.). As a result of this unique phenomenon of profit and loss sharing in Islamic banking, the two financial institutions appear distinctively different. Conclusively, the western banking aims at maximizing profits without any restrictions whereas the Islamic banking, like the former aims at maximizing profit but under extreme restrictions of the Shariah law. A little digression into the risks the western banking whose principal goal is to eliminate risk, the entrepreneur adversely bear a great loss in case of risk occurrence but the bank is rarely affected: whereas in Islamic banking paradigm of profit and loss sharing the borrower is buffered with lots of incentives to carry out projects involving extremely high risk. The entrepreneur is cushioned against losses in case a risk occur and on the other hand enjoying great benefits on successful projects, but the bank bear all the losses incurred in the event of risk. It is therefore important to compare the two banking structures in term of risk and liability. In respect to this aspect, the Islamic banking require extensive cost monitoring on projects undertaken by borrowers so as to avoid incurring high magnitude of risk (i.e. incase risk occur). In retrospect, western banking structure completely eliminates risk for banks or rather, incur very minimal risk if any: but the entrepreneur suffers great loss at such events of risk occurrence (Mills & Presley, 1999).
In virtually exceptional manner, the issue of deposits brings out an outstanding similarity between Islamic banking and western banking. Depositors in both systems of banking enjoy full benefits on deposits made to the banks. They actually receive fair correlated rewards attached to deposits. The only remarkable difference lies on the reward agreement. Terms and conditions on reward agreement are entirely different with conventional banking system having a predetermined fixed reward in contrast to the Islamic banking system where reward is variable with very little terms and conditions or none attached to it. Long-term deposits reap high returns compared to short-term ones with a proportional low returns in conventional banking system. Similar practice is also observed in Islamic banking system where profit is shared, long-term deposits attract very high profit share whereas the opposite appear true. Due to this conventional nature of returns on deposits, it is true to assert that high deposits relate directly proportional to high returns. Likewise, low deposits on the inverse side also relate directly proportional to low returns. Generally From the perspective profit and risk sharing, depositors are serviced under fixed rates with regard to risk and profit in conventional banking system unlike non-fixed rates in Islamic banking systems. The former receive total profits and risks but the latter usually have both rewards and risk shared with depositors.
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