Islamic banking and Commercial Banking

Islamic banking and Commercial Banking

Islamic banking and Commercial Banking: Discussion of Islamic banking and Commercial Banking

1.0               Islamic Banking: Banking run on Islamic Principle. The Organization of Islamic Conference (OIC) defined an Islamic Bank as “a financial institution whose statutes, rules and procedures expressly state its commitment to the principles of Islamic Shariah and to the banning of the receipt and payment of interest on any of its operations.”

2.0               “Allah has permitted trade and                 forbidden usury “– Sura –Al-Baqarah – Ayat No. 275.

3.0               The basic difference between Islamic Banks and Conventional Banks is that, in Conventional Banking system, Banks mobilize deposits giving assurance to the depositors to pay certain amount/percentage of return (i.e. interest), either flexible or fixed.

4.0               In Conventional Banking system Bank also deploys mobilized deposits to the clients with the condition that, the clients are to pay certain amount of return (i.e. interest) to the Bank irrespective of profit or loss on the part of the client.

5.0               Where as in Islamic Banking system Banks mobilize deposits on the basis of Mudaraba principle (i.e. profit sharing & loss bearing basis) i.e. depositors’ money is not guaranteed rather it may earn profit or may bear loss, if the Bank earn profit or incur loss respectively.

6.0               Similarly Islamic Bank deploys mobilized deposits on the shariah based mode of Investment including Musharaka (profit/loss sharing basis), Mudaraba (profit sharing and loss bearing basis). In all cases, Investment items should be shariah permissible items.

7.0               The basic Accounting Principle (Golden Rule) in determining Debit or Credit for Accounting Entries:
The basic Accounting Principle (Golden Rule) in determining Debit or Credit for Accounting Entries is universally accepted. In banking transactions the Golden Rule is also accepted. In Islamic Banking the Golden Rule is also accepted.

The Golden rule is as under:

Assets                   :               An increase – Debit

A decrease         – Credit

Liabilities              :               An increase – Credit

A decrease         – Debit

Capital                  :               An increase        – Credit

A decrease                         – Debit

Income                 :               An increase        – Credit

A decrease                         – Debit

Expenditure       :               An increase        – Debit

A decrease                         – Credit

5.00        In Accounting System, Islamic Banks      are to comply with following:-

a)            The Holy Quran, Sunnah, Isma & Kiyas   i.e. Shariah (Anything prohibited by        Shariah Can’t be taken into account                under any circumstances).

b)            The Bank Company Act-1991

c)            The Companies Act-1994

d)            The Income Tax Ordinance -1984

e)            The Securities & Exchange           Commission Regulations.

f)             Guidelines for Islamic Banking issued by                Bangladesh         Bank as per BRPD circular no.15 date-                09.11.2009

g)            The Memorandum & Articles of Association        of            the         Bank.

h)            International Accounting Standards         (IAS)/International Financial Reporting Standards            (IFRS) set by International      Federation of    Accountants.

i)             Bangladesh Accounting Standards (BAS) Bangladesh       Financial Reporting Standards (BFRS) set               by                 the         Institute of Chartered Accountants of    Bangladesh.

j)             Accounting Standard set by the Accounting         and        Auditing Organisation for Islamic               Financial                 Institutions (AAOIFI), Manama,                 Bahrain.

 

6.00        Double Entry System of Accounting is     followed in         Islamic Banks.

 

7.00        Though the operations of the Islamic Bank are in strict compliance with the rules of Islamic Shariah relating to business activities and the Financial Statements i.e. Balance Sheet, Profit & Loss Account, Cash Flow Statement, Statement of changes in Equity, Notes to the Financial Statements etc. are prepared basically in line with the formats prescribed under the Bank Company Act-1991 and as per rules of Securities and Exchange Commission and also as per Bangladesh Bank’s BRPD circular no.15 date-09.11.2009.

8.00        Conventional Banking is essentially based on the debtor-creditor relationship between the depositors and the Bank on the one hand, and between the borrowers and the Bank on the other. Interest is considered to be the price of credit, reflecting the opportunity cost of money.

The first Islamic principle underlying such kinds of transactions is that “deals not unjustly and yet shall not be dealt with unjustly”. Hence, commercial Banking in an Islamic framework is not based on the debtor-creditor relationship.

The second principle regarding financial transactions in Islam is that there should not be any reward without taking a risk. This principle is applicable to both labor and capital. As no payment is allowed for labor, unless it is applied to work, there is no reward for capital unless it is exposed to business risk.

Thus, financial intermediation in an Islamic framework has been developed on the basis of the above two principles. Consequently financial relationships in Islam have been participatory in nature.

9.00 Point wise difference issues between conventional Banks and Islamic Banks are summarized below:

Islamic Banking Conventional Banking
i) The functions and operating modes of Islamic Banks are based on the principles of Islamic Shariah. i) The functions and operating modes ofconventional Banks are based on manmade
ii) It promotes risk sharing between provider of capital (investor) and the user of funds (entrepreneur). ii) The investor is assured of a predetermined rateof interest.
iii) It gives due importance to the public interest. Its ultimate aim is to ensure growth with equity. iii) In it very often, Bank’s own interest becomesprominent. It makes no effort to ensure growthwith equity.
iv) Islamic Banks are to follow Quran, Sunnah, Ijma (ivm~j mv: Gi BbwZKv‡ji ci agx©q †h †Kvb e¨vcv‡i gymwjg m¤cÖ`v‡qi wewkó gR&Zvwn`M‡Yi GKgZ nIqv‡K cwifvlvMZfv‡e BR&gv ejv nq) and Kiyas (cÖPwjZ Bmjvgx AvBb‡K wfwË a‡i Abyi“c †Kvb mgm¨vi Abygvb wfwËK mgvavb Kiv‡K wKqvm e‡j) i.e. Shariah, in all the business transactions including Accounting Entries. iv) Conventional Banking follows the man madepractice and rules.
v) They can not engage in any interest transactions. v)They conduct their transactions on interest basis.
vi) If any interest is included / entered in the operations of the banks, that should be excluded from the regular income of the Bank. vi) Interest is their main income.
vii) If any income is earned violating Shariah Principles that can not be included in the distributable income of the Bank. vii) They do not follow shariah rules & regulations.
viii) In Musharaka, Mudaraba, Bai-Salam modes of Investment, Income can not be accounted for on accrual basis. viii) In Conventional Banking there is no practice ofMusharaka, Mudaraba, Bai-Salam modes ofInvestment and most of their income arerecognized on accrual basis.
ix) For delay of Payment of Investment by the clients, in case of Bai-Murabaha and Bai-Muazzal etc. Investment further amount of profit can not be charged. ix) No such Bai- Muraba and Bai MuazzalInvestment in conventional Banks. They Chargeinterest/ penal interest for delay in payment/repayment.
x) In case of overdue Investment compensation may be charged if an independent committee like Review Committee decides to impose the Compensation. x) They charge interest/ penal interest on overdueInvestment (Loans and Advances).
xi) Islamic Bank is to pay Zakat 2.50% or 2.58% on its reserves. xi) They do not pay any Zakat on reserves.
xii) Islamic Banks are to pay a certain minimum percentage of Investment Income to the Mudaraba Depositors. xii) They do not pay a certain amount to the depositors from their Investment income, rather they pay fixed rateof interest irrespective of any amount ofInvestment Income.
xiii) Mudaraba Depositors are to share the loss, if any, incurred out of Investment made from Mudaraba Deposits. xiii) Their depositors neither share any profitnor bear any loss.
xiv) Islamic Banks are to follow i) Islamic Banking Guidelines date 09.11.2009 ii) Accounting, Auditing and Shariah Standards developed by Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) in addition to iii) International Financial Reporting Standards (IFRS) developed by International Federation of Accountants, Bangladesh Bank guidelines, The rules of the Income Tax , The rules of the companies Act, The rules of the SEC. xiv) They only follow International FinancialReporting Standards (IFRS), Bangladesh Bankguidelines, The rules of the Income Tax ,The rules of the companies Act, The rules ofhe SEC.

 

10.00 Distinguishing Features of Islamic Banking:

An Islamic Bank has several distinctive features as compared to its conventional counterpart.

i)             Abolition of Interest (Riba):

The first distinguishing feature of an Islamic Bank must be that it is interest-free.

ii)            Adherence to Public Interest:

Activity of commercial Banks being primarily based on the use of public funds, public interest rather than individual or group interest will be served by Islamic commercial Banks.

iii)          Multipurpose Bank:

Another substantial distinguishing feature is that Islamic banks will be 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 institutions, and would offer a variety of services to their customers.

iv)           More careful evaluation of investment demand:

Another very important feature of an Islamic bank its very careful attitudes towards evaluation of applications for equity oriented financing.

v)            Risk sharing:

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. Since Islamic bank has a built in mechanism of risk sharing.

Islamic Banking system promotes risk sharing between the provider of the fund (investor) and the user of funds (entrepreneur). By contrast, under conventional Banking, the investor is assured of a predetermined rate of interest. Since the nature of this world is uncertain, the results of any project are not known with certainty ex-ante. Therefore, there is always some risk involved. In conventional Banking, all this risk is borne by the entrepreneur. Whether the project succeeds and produces profit or fails and produces a loss, the owner of capital gets away with a predetermined return. In Islam, this kind of unjust distribution is not allowed and hence in Islamic Banking both the investor and the entrepreneur shares the results of the project in an equitable way. In case of profit, both share it in pre-agreed proportion. In case of loss, all financial loss is borne by the capitalist and the entrepreneur loses his labor.

vi)           Emphasis on Productivity As Compared To Credit Worthiness:

Under conventional Banking, all that matters to a Bank is that its loan and the interest thereupon are paid to it on time. Therefore, in granting loans, the dominant consideration is the credit-worthiness of the borrower. Under profit loss sharing (PLS) Banking, the Bank will receive a return only if the project succeeds and produces a profit. Therefore, an Islamic Bank will be more concerned with the soundness of the project and the business acumen and managerial competence of the entrepreneur. This feature has important implications for the distribution of credit as well as the stability of the system.

vii)         Moral Dimension:

The conventional Banking is secular in its orientation. As against this, in the Islamic system all economic agents have to work within the moral value system of Islam. Islamic Banks are no exception. As such, they cannot finance any project which conflicts with the moral value system of Islam. For example, 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.

viii)        Equity:

Islam is a religion which emphasizes justice to all parties. A contract based on interest involves injustice to one of the parties, sometimes to the lender and sometimes to the borrower.

On the basis of pure economic reasoning, Islamic Banking is superior to an interest based arrangement because it ensures equity between the borrower and the lender. Both parties share the accrued return which the project generates.

ix)           Allocation of Efficiency:

A profit sharing system is also more efficient. It is more efficient, because the Islamic Banks would be interested in the productivity of the project. For example, in an interest based system the sole criteria for the distribution of credit are the credibility of the borrower. In Islamic Banking, the productivity of the project is more important. Therefore, the finance will go to more productive projects. In this way, the resources instead of going to low return projects of people having credibility will flow to high return projects even if the credibility of the borrower is lower. Therefore, the system is more efficient in allocation of resources. It is also more efficient because the Bank’s interest is now linked to the project evaluation.

In case of interest based system, Banks need not care much about project evaluation. Their interest is with the borrower. In case of profit sharing, they have interest in the project itself. Therefore, they will evaluate the project very carefully and allocate funds to more efficient projects. Thirdly, since the return of Islamic Banks depends on the success of the project, they may also contribute in the management of the project. Since they are specialized in the area of finance and investment, their expertise will improve the profitability of the project.

x)            Stability of Banking System:

The third criterion usually we talk about in economics is stability. From the stability point of view also, the Islamic Banking model is more stable than the conventional Banking model. (Here, we are talking about the stability of the Banking system and not of the economy.) 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 or the businessmen have to give a flexed interest to the Banks that has no relationship to the actual return of the project. Therefore, if the project is not going well in some stage of the project or in the entire life of the project, there develops an asymmetry between the cash inflow and cash outflow of the projects.

x)            Stability of Banking System:

The third criterion usually we talk about in economics is stability. From the stability point of view also, the Islamic Banking model is more stable than the conventional Banking model. (Here, we are talking about the stability of the Banking system and not of the economy.) 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 or the businessmen have to give a flexed interest to the Banks that has no relationship to the actual return of the project. Therefore, if the project is not going well in some stage of the project or in the entire life of the project, there develops an asymmetry between the cash inflow and cash outflow of the projects.

That creates instability in the entire business sector. From the other end, the Bankers also lack equilibrium in their assets side and the liability side because their assets are fixed while their liabilities are variable. When there is any external shock, there is no automatic mechanism which can restore equilibrium between assets and liabilities of the Bank. In case of Islamic system, the liabilities of the Bank are on the basis of Mudarabah and hence are also variable. If there is any shock, it affects equally the assets side as well as the liabilities side of the Bank’s balance sheet. For example, if recession occurs, Bank’s assets will go down. But at the same time, their liabilities are related with the actual performance of the projects they finance. The assets and liabilities are mutually linked and this mechanism restores equilibrium between the assets and liabilities of the Islamic Banks. So, there is a very small likelihood of Bank failures.

xi)           Growth:

The fourth criterion on which economists usually judge a scheme is that of growth. From growth point of view also the Islamic Banking system is better than the conventional Banking system for the following reasons. Firstly, Islamic Banking model promotes innovation. Innovation is not something on which the big industrialists have monopoly.

Anybody can be enterprising. Anybody can have good idea. In Islamic Banking, if small or middle class entrepreneur has a better project, he has, one- a possibility of getting it financed and, two- he will not be held back by the fear of tremendous risks. We know that innovation involve risks. Since risk is shared between the financer and entrepreneur, Islamic Banking system results in a better distribution of risk. Business risk is spread over a large number of people.

The entrepreneur is risking only his labor and the Bank is risking its capital. Therefore, ingenious entrepreneurs will be forthcoming and innovation will be promoted. Secondly, conditions of the cost of capital, one of the determinants of the rate of investment in an economy, are more favorable under the Islamic system. The cost of capital in an interest based system, which is the rate of interest, is fixed. In an Islamic economy, the cost of capital varies with the productivity. There is no fixed cost of capital.

In the periods when there is a recessionary trend in the economy, productivity goes down. Thus, it does not have that deterrent effect on investment which a fixed cost of capital has. Therefore, even in that period, relatively speaking, there will be greater investment in an Islamic economy or in the profit sharing economy has as compared to an interest based economy. So, for these reason, from the growth point of view also, the Islamic Banking system fares better.

Ref:

i)  The Holy Quran

ii)  ‘Review of Islami Economics’ by Mr. M. Omar Chapra.

iii)  Accounting, Auditing and Governance Standards for Islamic Financial Institutions. Prepared by Accounting and Auditing Organization for Islamic Financial           Institutions, Manama, Bahrain <http://www.aaoifi.com>).

iv)  Guidelines for Islamic Banking issued by Bangladesh Bank as per BRPD circular no.15 date-09.11.2009

v)   Islami Bishwakosh, Published by Islamic Foundation Bangladesh.

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