Banks in several Muslim nations function very differently from conventional western banks. The style in which they operate is called ‘Islamic Banking’. It is broadly governed by the law of Sharia. Here is a look at key differences between Islamic and conventional banking practices.
Overview
Islamic banking is characterized by profit and loss sharing (PLS) between the bank and client. Central banks certainly maintain oversight. Moreover Islamic banks come under the supervision of Sharia boards. They ensure that the products and services offered by Islamic banks are Sharia-compliant. Islamic finance is as broad-based and complex as banking systems anywhere in the world. Yet, it is solidly based on a few core principles. These include:
- Prohibition of usury (riba)
- Prohibition of uncertainty (gharar)
- Prohibition of speculation
- Prohibition of gambling
- Ethical investments
Key differences
Operationally and structurally Islamic banks are somewhat similar to conventional banks. Yet, a number of dissimilarities exist between the 2 systems. The most fundamental of these is in the area of charging interest. Compound interest (riba) is the foundation of conventional (ribawi) banking. Under Sharia law this is expressly forbidden. In Islam and Sharia all profit must be generated solely from work. Lending to a borrower for the sake of interest income is not seen as the effect of work (effort). Instead, interest income is considered the result of an unethical process, and is prohibited (haraam).
Islamic banks do give out loans to buy property and assets, which clients repay in installments. However clients don’t pay interest. Instead they pay a fee. In addition to the principle clients pay a fixed cost for the service (access to funds). This fee is based on the time value of money.
To be profitable without adopting the interest-charging model, Islamic banks follow other principles. These are characterized by equity participation and a lack of deposit insurance. There is a PLS arrangement between bank and client. In a nutshell Islamic banks are guided by religious law while conventional banks operate on secular law.
The global Islamic banking industry
Islamic Banking has recorded positive growth in recent years. In 2019 the global Islamic financial services industry was estimated to be worth $2.6 trillion. This amounted to merely 0.7% of the global banking industry. Islamic banks account for just 1% (or $1.6 trillion) of global banking assets. Despite this they enjoy a 15% or higher share of the entire banking sector in 14 countries. Most prominent of these are Iran and Sudan. The financial systems of both countries are wholly based on Islamic laws. The IMF identifies Iran as the major global center for Islamic banking. As of 2017 Iran accounted for 34.4% of the global Islamic Banking industry. Other notable centers include Saudi Arabia (20.6%), UAE (9.6%), Malaysia (9.1%), and Kuwait (6.0%). Millions of migrant workers from India and elsewhere live and work in these nations. They regularly send money to India and other countries as remittances to support their families. Many of these remittances flow through Islamic financial institutions.
Comparing Islamic and conventional banking
Home loans are a good way to explain key differences between Islamic and conventional banking systems. Ijara (lease and ownership) is one of the various Sharia-based products in Islamic finance.
Assume a client intends to buy a property worth $3 million and opts for a loan from an Islamic bank. The client makes a downpayment of $600,000 (legally required) and owns 20% of the property. The bank extends a loan for the remaining $2.4 million and owns 80% of the asset.
The client repays this amount in monthly, quarterly, bi-annual, or annual installments. Meanwhile the bank is a joint owner of the property. This means the client is obliged to pay rent in addition to principle repayments. Each installment has a rent component and a principle repayment component. With each installment the client’s share of ownership of the property increases. In case of equal monthly installments the rent component continuously drops while the principle repayment component increases. This continues for the agreed-upon term, till all the principle is repaid in full and the client becomes 100% owner of the property.
The future of Islamic Banking
Islamic finance was growing continuously till 2020. The coronavirus situation reversed the growth prospects for a while. The Islamic Corporation for the Insurance of Investment and Export Credit (ICIEC) published a report titled ‘The Future of Islamic Finance in a COVID-19 World’. The report predicts slower growth for the sector in 2021 than previously projected. Even with the present global health situation, S&P predicts some growth for the industry in 2021. In 2018 the IMF noted that “the Islamic finance sector continues to grow and evolve in size and complexity, with Islamic banking offered in more than 60 countries.” Despite all challenges Islamic banking is poised to continue its growth trajectory in the years to come.
About the author:
Hemant G is a contributing writer at Sparkwebs LLC, a Digital and Content Marketing Agency. When he’s not writing, he loves to travel, scuba dive, and watch documentaries.