A brief comparison between Islamic banking and conventional interest based banking system

Shareholder capital plus the investors capital combined is the strength of a Bank in an Islamic Economic System.

The crux of the Islamic Economic System is sharing of profit and losses. All the assets in the balance sheet are risk capital. It is a logical protection for all the concerned parties, the depositors, the Central Bank and the bank itself. In bad times they share the losses and in good times they share the profits. Thus the sharing and caring. Unlike the conventional system, there is no additional interest on genuine delay if non-payment on maturities but there is a bonus for payments earlier than maturities.

In the conventional banking system the value of the deposits is guaranteed by the bank (unlike Islamic Banks) plus there is a guarantee for the interest. Any economic shock or a business downturn adversely affects the quality and value of the assets of the conventional bank leading possibly to negative net worth of the bank. On the other side an Islamic Bank operates on an equity based system and not a debt based conventional system. In a Islamic financial system, shocks to the assets position of bank are immediately absorbed by investors and shareholders in proportion to their share.

Apart from its own funds (Capital + Reserves + Retained Profits), an Islamic Bank, relies mainly on investments which are also termed as Profit and Loss units/ Managed Fund certificate and are the principal resources of funds for Islamic Bank, which in both intent and content are much more nearer to shares in the bank rather than fixed or saving deposits of a conventional bank.

Terms & Conditions given in the Islamic Bank Managed Fund Certificate are made clear to the investors concerning their participation in the loss, if any, which enables the investors to take a calculated decision as far as the risks are involved in his investment with the bank. The difference between a share and investment certificate is that the share capital is permanent and cannot be moved whereas the investment certificates are term investments. In order to maintain liquidity at all times, ensuring availability of funds for financing and to avoid the mismatch, a Treasurer of an Islamic Bank watches the maturities of the investors' funds with the investments & financing. Based on the bank track record of stable investments, a prudent ratio of availability of investors' funds helps in projecting and preparing a business plan for mobilization of the funds as to be able to meet the liquidity requirements at all times.

The conventional system is based on short term borrowing for pre-agreed, guaranteed fixed return, the small spread between the two rates of interest is not enough to bear the shock of bad times/losses as explained below.

Example:

Outlined below are the comparative figures of both, the interest-based banks and the Islamic Banks. Let us suppose that the two banks are located in the same city and the same market and under the umbrella of the same Central Bank. The working capital of each bank is AED 50 million. One of the banks is following the Islamic system and the other the usurious system of banking. The Central Bank, we are told, allows withdrawal of money equal to 15 times each bank's initial capital. Thus, each bank has an extra deposit of AED 750 million at its disposal. It's total capital, thus, amounts to AED 800 million. We presume that each of the two banks registers a profit of 11%, thus raising the gross capital to AED 88 million. The interest -based bank, however, pays AED 75 million to the depositors @ 10%, this being the rate of interest already fixed and made payable to the depositors. As for the Islamic Bank, it does not pay anything to anyone of its clients until the net profit of the bank has been worked out at the end of the year when it is evenly distributed among the depositors. The net profit is calculated by deducting the total expenses incurred by the bank under different heads - services, contingency expenses, etc. Each bank, however, suffered negatively as a result of losses and bankruptcies worth AED 40 million. So, their comparative position would be as follows:

Particulars	Islamic Bank	Usurious Bank
Capital	50	50
Deposits	750	750
Total	800	800
Profit @11%	88	88
Interest paid to depositors	-	75
Balance	88	13
The balance with the Usurious Bank does not cover the losses, so we add the capital, then deduct the losses	-	50
In hand at this stage	88	63
Losses	40	40
Balance	48	23

The net balance in hand with the interest-based bank is a paltry AED 23 million which is less than half the initial capital. So, according to the current system, the interest-based bank has gone bankrupt. The Islamic Bank, on the other hand, is still distributing the profits, after the deduction of losses worth AED 48 million. The profit to be distributed on the total amount of 800 will be @6%.

The interest-based bank went bankrupt because it alone had to bear the brunt of the entire loss. The Islamic Bank, on the other hand, distributed the profit evenly, taking its cue from the Islamic injunction of mutual co-operation and liability, for Allah says in His Book.

"Co-operate with one another in righteousness and piety, and do not co-operate in sin and transgression" (5:2)

It is in view of this divine injunction that the depositors and the bank together share the losses as well as the profits.

So, the Islamic Bank was not affected like its interest-oriented counterparts. Consequently, the Islamic Bank is still operating and is serving its clients without any hindrance and is expected to fulfil all the desired functions and achieve all the expected goals. This is just one example of what has happened in the past and may happen in the future.