4. Cost plus agreed profit
3. Goods
2. Good 1. Cash Payment
• Foundation:
The foundation of Islamic bank is based on the Islamic faith and must stay within the limits of Islamic law or the Shari’ah in all of its actions and deeds. The meaning of Shari’ah is the way to the source of life and is now used to refer to legal system in keeping with the code of behavior called for by the Holly Qur’an.
On the other hand, the conventional bank is based on man made principles. There many fundamental and functional differences exist in these principles. As a result various conflicts arise within the internal and external management systems. These principles vary man to man, place to place. As a result it increases complexity in the conventional banking systems.
Bank Client Bank
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• Maintenance of CRR/SLR:
All Islamic Banking Companies shall maintain Cash Reserve Ratio (CRR) and
Statutory Liquidity Ratio (SLR) as per rates prescribed by Bangladesh Bank from time to time. Every commercial Bank having Islamic bank branches shall maintain SLR/CRR for its Islamic branches at the same rate as prescribed for the Islamic banks and shall, for the purpose, maintain a separate Current Account for the Islamic branches with Bangladesh Bank. For Islamic banks, SLR is 10.5%, CRR is 4.5% & LRR is 5%. But Conventional banks SLR is 18.5%, CRR is 5.5% & LRR is 13%.
• Project appraisal and evaluation:
Islamic banks share profit and loss of any project financed. So the banks pay greater attention to developing project appraisal and evaluations. It gives more emphasis on the viability of the project. As the bank’s interest is linked with the earnings capability of the enterprise, it has to judge the worthiness or suitability of the project by applying suitable appraisal criteria. Any failure on the part of the bank to assess the soundness of the project would seriously affect the profitability of the enterprise.
But in the conventional banking system, the bank is simply a financier and is not directly concerned about the success or failure of the project for which loan was made, as long as it receives its payments. This is so because the banks income (interest income) does not fluctuate with the fluctuations in the profit generated from the specific projects. Since return from loan is fixed, it gives little importance to project appraisal and evaluations.
• Basis for collection of deposit
Islamic banks collect the deposits on the basis of profit sharing. The main function of Islamic banks is to mobilize savings and provide financial support to the entrepreneurs. Like the conventional banks, the Islamic banks neither pay nor receive interest from any of its transactions thereby saving everybody from the course of interest. It disapproves hoarding of savings and encourages its productive investment. It mobilizes savings of the common people in line with Islamic Shari’ah.
In the conventional banking system, the collection of the deposit is on the basis of interest.
Here depositors receive interest in a predetermined rate of their deposits. Investors are to pay a predetermined rate of interest to the bank. The techniques, thus, involves each and every partner in the transaction process with the element of interest.
• Moral Dimension
In the Islamic banking system all economic agents have to work within moral value system of Islam. They can not finance any project which conflicts with the moral value system of Islam.
They will not finance a wine factory, a casino, a night club or any other activity which is prohibited by Islam or is known to be harmful for the society.
But the conventional banking is secular in its orientation. It has no restriction to finance any project like Islamic banking systems. It emphasizes on the possibility of earning maximum profit. It does not follow any religious rules and regulations or does not obey any restriction.
• Emphasis on Productivity as compared to credit worthiness Islamic banks give greater emphasis on the viability and soundness of the project and the business acumen and managerial competence of the entrepreneur. Under profit loss sharing banking, the Islamic banks will receive a return only if the project succeeds and produces a profit. Islamic banks have very careful attitude towards evaluation of applications for equity oriented financing. Since Islamic banks have a built in mechanism of risk sharing, it would need to be more careful in how it evaluates financing requests. It adds a healthy dimension in the whole lending business and eliminates a whole range of undesirable lending practices.
On the other hand, conventional banks give greater emphasis on credit worthiness of the clients. It is customary that conventional banks evaluate applications, consider collateral and avoid risk as much as possible. Their main concern does not go beyond ensuring the security of their principal and interest receipts.
• Scope of the activities:
An Islamic Bank has wider scope of activities compared to a conventional bank. A substantial distinguishing feature is that Islamic banks are universal or multipurpose banks and not purely commercial banks. These banks are conceived to be a crossbreed of commercial and investment banks, investment trust and investment management institution and would offer a variety of service to their customers. A substantial part of their financing would be for specific projects or ventures. Their equity oriented investment would not permit them to borrow short term fund and lend to long term investment. This should make them less crisis prone compared to their capitalist counterparts, since they would have to make a greater effort to match the maturity of their liabilities with the maturity of their assets.
Compared to the Islamic banks, conventional banks have narrower scope of activities. The main function are collecting the deposits and ending to the borrower in different purposes in exchange of rate of interest.
• Guarantee for deposit:
There is no guarantee for deposit money in the Islamic bank system. Without taking risk financial transactions are not allowed in Islam. Under Islamic framework, depositors are taking risk as Sahib-al-Mal. Therefore the earning of the depositors is uncertain. As Islamic banks works on the basis of profit loss sharing system, depositors or Sahib-al-Mal have to bear the loss if any. On the other hand conventional banks have to guarantee all its deposits.
Without considering the trend of income these banks have to give interest on the deposits money at predetermined rate. They do not share any profit or loss with their clients. They only maintain a debtor-creditor relationship with their clients/depositors.
• Distributive justice and economic stability:
Since profits are shared between the entrepreneurs, the bank and depositors in the Islamic banking system, there is no bias towards any income sector. In fact, the banks welcome profitable business ventures form all income sectors. Islamic banks share a proportion of the profits accrued from a project implying an equitable distribution. The distributors remain unaltered since the Islamic banks receive a share of total profits accrued from different projects financed by the bank. But the conventional banking maintains a flat rate of interest regardless of the profitability of the projects financed by it. This system of fixed interest rate is somewhat biased against the borrower rate is determined in a way that assures profits to the other parties in the transaction. This limits investment opportunity utilization capacity of the conventional bank thereby reducing productive efficiency ofconventional banking.
• Allocate Efficiency:
The income distribution scheme under conventional banking works against the goal of optimum allocation of scarce financial resources. This is because of the fact that conventional banking, instead of financing in terms profitability of projects, diverts funds to projects with sound collateral. These results in loans being made to higher income borrower that can be meet the collateral requirements. But in Islamic banking, the productivity of the projects is more important. In this way, the resources instead of going to low to higher return projects even if the creditability of the borrower is lower. Therefore, this system is more efficient in allocation of resources. Since, they are specialized in the area of finance and investment; their expertise will be improving the profitability of the project as well as contribute in the management of that project.
• Stability of banking system:
The Islamic banking model is more stable than the conventional banking model. In an interest based system, there is lack of symmetry in the cash flow of the banks and the cash flow of the enterprise. The entrepreneurs of the businessman have to give a fixed interest to the banks that has no relationship to the actual return of the project. This creates instability in the entire business sector. The bankers also lack equilibrium in their assets and liability side because their assets are fixed while liabilities are variable.
In case of Islamic banking system, the liabilities of the bank are on the basis of mudarabah and hence are also variable. If there is any stock, it affects equally both asset and liability side of the banker's balance sheet. Thus their liabilities are related with actual performance of the projects hey financed. The asset and liabilities are mutually linked and this mechanism returns equilibrium between the assets and the liabilities of the Islamic banks. So there is a very likelihood of bank failures.
• Growth of the banking system:
From growth point of view the Islamic banking system is better than the conventional banking system. Islamic banking model promotes innovation. In Islamic banking small and medium entrepreneur has a better project he has a possibility of getting it's financed. Since risk is shared between the financer and entrepreneur. It results in a better distribution of risk.
Therefore ingenious efficient entrepreneurs will be forthcoming and innovation will be promoted. Moreover conditions of the cost of capital are more favorable under the Islamic system. Here the cost of capital varies with productivity. It does not have any deterrent effect on investment which a fixed cost of capital has.
• Emphasis on the character of the loan applicant:
When money is deposited with an Islamic bank, the bank in turn makes investment in different forms approved by the Islamic Shari’ah. When a client make an offer or a proposal regarding loan or investment the bank emphasizes more on the character of the applicants.
The bank must verify the character of the applicant before allowing his application. The banks deal with their client based on faith and trust. So it is necessary for the bankers to know the background, family status, educational qualification, business experience, reputation of the applicant. Again the bank may meet with the prospective client regarding his investment needs and business experience prior to an application/proposal is submitted. The bank may review the client's past performance and other financing arrangement he may have had with the bank in the past. When the banks become contain that the applicant is not involved with any activities violating the Islamic Shari’ah they grant his proposal.
On the other hand, conventional bank emphasizes on the financial strength, collateral security, and creditworthiness of an applicant more than his character. Without considering the character the bank will grant that proposal which will certainly give a maximum profit at a predetermined fixed rate.
Islamic banks perform mostly the same functions as the conventional banks but they do it in distinctly different manners. These differences make the Islamic banking system distinct from the conventional banking system. It may be mentioned that if the Islamic banking system, is to become truly liquid and efficient it must develop more standardized and universally tradable financial instrument. Islamic banks can provide more efficient banking services if they are supported with appropriate banking laws, regulations and guidelines. It would be better if Islamic banks had the opportunity to work as a sole system in an economy. That would provide Islamic banking system to fully utilize its potentials. Thus it can be free from all difficulties and problems that are in the conventional banking system. It can be hopefully expected that if the overall economic system as well as the banking system can be executed according to Quran, Sunnah and Hadit it will bring the maximum prosper in the entire economy.