THE DIFFERENCE BETWEEN ISLAMIC BANKING AND CONVENTIONAL BANKING

By Kelvin Mkwawa, MBA - Seasoned Banker.

There are different banking systems in the world but the most famous and common one is conventional banking. The main function of a conventional bank is to borrow and to lend. They borrow in the form of deposits and lend this money to earn interest. There is another form of banking system known as Islamic Banking. Islamic banking is an alternative to conventional banking that is available to anyone who seeks a different approach to banking services. Islamic banking is not only for members of the Muslim community but for anyone who wishesto operate his/her banking services in line with Islamic (Shariah) laws. Islamic banking is considered as an ethical banking system where a customer (individual or corporate) isn’t just a customer but is a partner with the bank.

Although Islamic and conventional banking systems have many similar products, the two differ conceptually. Banks in the conventional banking system earn their money by charging interest and fees for their services while banks in the Islamic banking system earn their money by profit and loss sharing. To say that Islamic banks are different from conventional banks because the former don’t charge interest is accurate, but it’s only the tip of the iceberg. Islamic banking is unique in the way that it helps individuals and businesses build tangible assets and also encourages the spirit of entrepreneurship amongst its customers. In addition, Islamic banks cater for the public interest first, its primary objective is to ensure halal (lawful) economic growth whereas the conventional banks focus solely on making a profit and the interest of the bank comes first. Below I share some of the differences between Islamic banking and conventional banking:

• Sharing Loss – In conventional banking, interest is charged even when the bank suffers losses hence there is no concept of sharing loss. Meanwhile, in Islamic banking, the loss is shared when the organization suffers loss. Additionally, in conventional banking, when a corporate loan goes bad it is written off and categorized as a non-performing loan, while in Islamic banking, the management of that company can be taken over by the bank and the bank will appoint a new management team to manage the business. In addition, in Islamic banking, they have no provision for charging any extra money from defaulters while in conventional banking, there is an additional charge (penalty and compound interest) in case of defaulters. 

• Assets Principle – One of the main functions of a bank is to lend. These two banking systems have a fundamental difference inlending. In Islamic banking, the bank (creditor) should not take advantage of the borrower. According to the Islamic principle, when money is lent out on the basis of interest, more often it leads to some kind of injustice hence there are no interest charges on loans issued to customers. On the other hand, conventional banking considers interest to be the price of credit hence charging interest on loans is a normal business practice.

• Liability Principle – Another main function of a bank is to take deposits from the general public (consumers) and offer investment facilities to its clients. In the conventional banking system, a bank accepts deposits from its client and use them to extend facilities with interest to other clients who require financing. The interest that accrues on those facilities is distributed amongst the depositors as interest earned on their deposits and the bank as income earned. On the other hand, in the Islamic banking system, a bank receives deposits on the basis of Musharakahor Mudarabahand invests these funds in a Shariah - compliant manner. The profit that is earned on those deposits is shared amongst the bank and the depositors based on a pre-agreed profit sharing ratio.

To summarize, there are two banking systems; the normal banking known as conventional banking and Islamic banking system. We have seen that although Islamic and conventional banking systems have many similar products, the two differ conceptually. Banks in the Islamic banking system do not charge interest on loans while banks in the conventional banking system do. In addition, in the Islamic banking system, the profit earned on deposits is shared amongst the bank and depositors based on a pre-agreed profit ratio while in conventional banking system, the depositors are earning interest on their deposits but the profits earned from those deposits belong only to the bank. Lastly, Islamic banking has no provision to charge any extra money from defaulters while in conventional banking, there defaulters incur additional charges (penalty and compound interest).

Written by Kelvin Mkwawa, MBA
Seasoned Banker
Email address: Kelvin.e.mkwawa@gmail.com