2.4 What Constitutes ‘Islamic Banking’?
2.4.1 The Differences between Islamic and Conventional Banking
In addition to some of the differences discussed above, it is important note that unlike conventional banks, Islamic banks are more likely to be asset-based and more focused on risk sharing.179 Conventional banks are generally based on a high level of debt and allow the transfer of risk. Moreover, conventional banks collect a predetermined rate of return for their
174Z Iqbal &A Mirakhor, An Introduction to Islamic Finance (John Wiley & Sons 2011) 18.
175 BJ Khoutem & BA Nedra, ‘Islamic Participative Financial Intermediation and Economic Growth’ (2012) 8
Journal of Islamic Economics, Banking and Finance 45, 45-59.
176 Z Iqbal, Islamic Financial Systems (Finance and Development 1997) 3.
177 SS Ali, ‘Financial Distress and Bank Failure: Lessons from Closure from ihlas finans in Turkey’ (2007) 142
Islamic Economic Studies 21, 85.
178 Ibid.
179 M Hasan and J Dridi, ‘The Effects of the Global Crisis on Islamic and Conventional Banks: A Comparative
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investments; whereas Islamic banks normally share their profits and losses with their customers or investors, and do not have a guaranteed return on their investments.180
Also, the Islamic banking sector prohibits gharar and maysir. Gait & Worthington describe
gharar as ‘any contract for sale or purchase that includes uncertainty in genus, species, quantity of the object, price, time of payment in deferred sales, existence of object, and identity of object.’181 In the same vein, they define maysir as ‘the act of betting on the realisation of an event, based on subjective and future expectations, i.e. [a] high degree of asymmetric information.’182 As such, these are regarded as ‘gambling or games of chance.’183 Ahmed notes that without gharar and maysir, Islamic banks have no opportunity for speculative behaviour, and this explains why Islamic banks were more stable than conventional banks during the global economic crisis.184 Table II below summarises the differences between Islamic and conventional banks captured in the literature.
Table II: Overview of the differences between these two banking systems
Conventional Banking Islamic Banking
Ø The notion of ‘time value of money’ and the associated risk determine how money is priced.185
Ø Money is not priced because it is not considered to be a commodity, product or service. It also cannot be resorted to for price borrowing or financing (i.e. interest).
Ø Financial assets are the main focus of transactions.
Ø Real assets are the main focus of transactions.
180 F Ouerghi, ‘Are Islamic Banks More Resilient to Global Financial Crisis than Conventional Banks?’ (2011)
4 Asian Economic and Financial Review 941, 941-955.
181 A H Gait and A C Worthington, ‘A Primer on Islamic Finance: Definitions, Sources, Principles and
Methods’ (2007) 7 School of Accounting and Finance Working Paper Series 1, 1-27.
182 Ibid.
183 I Warde, above note 132, 859.
184 H Ahmed, A Microeconomic Model of an Islamic Bank (Islamic Research and Training Institute 2002) 59. 185The ‘time value of money’ refers to the notion that money taken at the present time is worth more than it will
be in the future due to its potential earning capacity. See P Abedifa, M Philip & T Amine, ‘Risk in Islamic Banking’ (2013) Review of Finance 2035, 2036.
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Ø In the case of money loans, a fixed interest rate considered as the financial institution’s liability is offered to the party.
Ø Enormous importance is attributed to the conditions of share of profits and losses among the financial institution and the holders of investment accounts, with investment accounts considered not as debt but as quasi equity.
Ø Defaulting may attract extra costs, such as fines and compounded interest.
Ø No extra costs can be imposed by Islamic Financial Institutions (IFIs). Fines are given to charity and
occasionally reimbursement is
provided if the accounts are settled early.
Ø The financial institution adopts the role of creditor while the client is the debtor.
Ø IFIs play the role of investor, partner, trader, buyer and seller, lessor and lessee in relation to their clients.
Ø Deposit guarantee is an obligation of standard banks.
Ø Deposits are guaranteed by IFIs solely for current accounts.
Ø The financial institutions’ liquidity
management and investment
practices sometimes remain
Ø IFIs ensure that their activities are transparent to investment account holders who also participate in
53 unknown to depositors, although Basel III addresses this issue as shown in Chapter 6.
projects using their money.
Ø Some level of risk is attached to most banking transactions.
Ø Practices and transactions that are
speculative regarding outcome
and/or implementation or delivery timing are strictly prohibited.
Ø The nature of clients’ business is not important, provided that it is not illegal.
Ø IFIs do not undertake transactions with businesses contravening Islamic precepts (e.g. gambling, cigarette or alcoholic beverage production, etc.).
Ø Standard financial institutions do not engage in Zakat.186
Ø Aside from undertaking Zakat
payment, IFIs also serve as Zakat collection centres.
Ø The priority is provision of loans and recovery with compounding interest.
Ø The priority is participation in partnership organisations.
In light of the above, it may be contended that there are clear differences between Islamic and conventional banking systems, and the argument that Islamic banks are more resilient to financial crises is based on the notion that the above features of Islamic banking increases the resilience of a bank. Thus, regulators and supervisors in jurisdictions that host only conventional banks may enhance the resilience of these banks by adopting and enforcing standards that are Shariah-compliant. Given the delineation of what constitutes a financial
186 Zakat may be said to refer to the process where a wealthy Muslim person gives a percentage of his income to
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crisis, the mapping of the features of the financial institution that is more resilient to financial crises, the next section critically examines studies that have concluded that Islamic banks are more resilient. It seeks to determine whether their conclusions are justified. The analysis considers the methodologies used in these studies, as well as the context in which Islamic and conventional banks were compared or contrasted.