Differences Between Islamic and Conventional Banks

The conventional banking system forces the emerging financing platforms to resemble its image. This includes Islamic banking system which is based on the principles of Islamic law.

Thus, the question one asks is, what are the differences between the two?

An average banking customer does not see any difference since the end result is the same. Admittedly, from outside the Islamic banking practices look like those made by conventional banks. That is the result of many regulatory and legal challenges facing Islamic banks.

But, Islamic banks differ in their operations since they uses Islamic contracts. It is critical to understand that conventional banks operate by charging interest (riba) to the customers. Allah forbids this in the Holy Qur’an. Severe warnings in various hadiths confirm its dangers.

Now, let us see some of the differences between the Islamic banks and the conventional banks.

Difference #1: Islamic bank earns a profit (ribh). They DO NOT charge interest (riba)

The most critical difference is that Islamic banks DO NOT charge “interest” (riba). Rather they earn “profit” known as “ribh” in Arabic. Failing to realize this distinction will only lead to confusions.

So, the question is that how is earning profit different than charging interest?

Consider the following scenarios.

Scenario 1: Interest

Let’s say A lends $100 to B. A tells B to return his capital ($100) + interest (say $20) at the end of the month. So, B will return $120 at the end of the month to A. This is riba (interest). Because B paid $20 extra to A for nothing.

Scenario 2: Profit 

In this scenario, A wants to earn a lawful profit according to the injunctions of Islam. So, he goes to a wholesale market and buys a product worth $100. Notice that A is now putting physical efforts and travelling to the wholesale market in real time. A returns to his shop and displays the product on the shelf for $120. B visits A’s shop and buys that product for $120.

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The $20 extra that A earned on the product is “profit” (ribh). This is NOT riba or interest. Because in scenario 1, A only extended a $100 bill to B and asked B to return $120 at the end of the month. A did not put any efforts. As such, charging $20 extra is unjust. This is interest.

In scenario 1, A treated money, i.e. the $100 bill, as commodity or product. Islam forbids treating money as commodity. Because money itself does not have any intrinsic value. Meaning, if someone is hungry they cannot eat money to fulfill their hunger. They must USE that MONEY to buy something to eat. If someone wants to travel, money itself cannot carry them. They must USE that MONEY to buy an airline, bus, or a train ticket to travel.

Thus, Islam treats money as only a MEDIUM OF EXCHANGE. It is not a commodity to buy and sell as the conventional banks do. Islamic banks buy and sell the commodity (e.g. a house, machinery, land etc.) not the money.

Extending a $100 bill and charging $20 extra is riba. Whereas buying a product worth $100 and selling it for $20 extra is profit. This is trade (bay’). They are not the same. Allah the Exalted says,

{But Allah has permitted trade and has forbidden interest} (Al-Baqarah 2:275).

This distinction is of utmost importance so let it sink in.

Difference #2: Where is your money invested?

In investment accounts, conventional banks costumers do not know where the bank invests their money. More often than not, they invest in non-halal activities. This includes casinos, alcoholic beverages, pork-related businesses, and pornography to name a few.

In deposit accounts, the bank keeps a fraction of the money with them. The rest is loaned out on interest (riba) for various non-halal activities. So, a faith-based consumer indulges in riba in an indirect way. The bank uses that money to loan it to the businesses conducting non-halal activities. This includes conventional banks giving money to buy houses and charging riba.

In Islamic banks, the Shariah scholars mandate to disclose where Islamic banks invest the capital. The investment is only allowed in halal activities. So, faith-based consumers are safe.

Difference #3: Late payment charges

For late payment, the conventional banks will charge a certain percentage of interest. It will be on the outstanding principal amount. It compounds (interest upon interest) if carried forward. But Shariah scholars forbids Islamic banks from indulging into such unethical practices.

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Until now, the Shariah scholars didn’t even allow the Islamic banks to charge late payment fees. But then consumers started being delinquent and abused the system. So, the Shariah scholars allowed to impose “Ta’widh“. A compensation for actual loss suffered by the financier.

In most cases, the cap is set to a minimal fixed dollar amount instead of a fixed or floating percentage rate. Introducing this practice is to discipline the consumers to make timely payments. Special harmonious provisions are set for genuine hardship cases.

To sum up, it is the underlying Islamic contracts that differentiates Islamic banks from the conventional banks. The outcome of both entities may look alike, but the difference is in its composition. Mere outcome does not determine the difference.

It is not only about the end result. Because if it is, then it seems reasonable to be in a relationship with the opposite gender forever. Why perform faith-based rituals since outcome will be the same either way?

Prohibition on consumption of non-halal meat seems unreasonable. A faith-based consumer may choose to buy meat without restrictions. But that is not the case. Instead, we use a proper faith-based procedure to make things permissible.

And Allah knows the best.