An Overview of Conventional Vs Islamic banks

As a key component of the financial system, the banking industry plays a vital role across all nations’ economies as it helps make the overall cycle more efficient. Banks are the lifeblood that sustains any modern economy with such an established sector serving as the vein through which the blood circulates throughout the body.

Conventional banking is essentially based on interest-based transactions, which led a lot of people to refrain from dealing with such usurious terms, and thus many resources were lost since collecting or paying interest are not permitted under Islamic law.

On this ground, scholars, financial and economic experts teamed up to develop an inclusive model for Islamic banks which theoretically allow all undertakings to follow Shariah morals. This way, a major percentage of clients especially in Islamic Countries are not feeling embarrassed to deal with banking institutions while attracting more depositors to pump their savings into the economic system.

Banks are one of the most important and oldest intermediary financial institutions. Its primary functions include accepting deposits and opening bank accounts of all types (current, savings and time deposits) for individuals, corporations and public entities. The banks then re-use clients’ deposited funds in its common activities such as credit granting, commercial paper discount and financial operations of non-bank economic units.

So, What is the Islamic Bank?

Islamic Bank is a financial institution that accepts funds on the basis of two principles, the sharing of profit and loss, and the prohibition of interest-based transactions. Under this model, the bank doesn’t act as a neutral broker. Instead, Islamic banks use equity-participation systems, where it acts as a seller, buyer or partner.

Sharia-compliant finance is based on participatory modes used by Islamic banks according to the profit and loss principles. The client in this case acquires one of four statuses: “A current account holder on the basis of interest-free loan, with gains accompanying liability for loss; Owner of an investment account, which is labeled as a participant banker, buyer / seller - lessor / tenant in all types of sales." 

Islamic banks are allowed to practice commercial and industrial activities, buy goods and real estate, and to transact the shares of commercial companies, all under Islamic controls.

The bulk of funds are invested in accordance with Islamic financing models, such as sales, partnerships, speculation, among many other forms. All in all, investing or trading with the available funds should be only carried out in a sharia compliant manner.

As for profit and loss, Islamic banks scrutinize the legitimate status of all investment tools to ensure that "money, work, guarantee" are all being handled according to Shari'ah standards. But the loss, if any, is borne by the bank as the owner of the capital on a pro rata basis.

The shari’ah governance system encompasses three bodies that oversee and strictly monitor all transactions: "Shari'a Supervisory Boards, the General Assembly through the auditors’ reports, and the monetary authorities."

What is the conventional bank?

The conventional bank is one of the money market institutions that deal in cash credit. Its main function is to accept deposits, which are then reinvested in banking operations such as lending, discounting commercial papers, buying and selling securities, and other credit operations. The bank also operates as a financial intermediary between savers, depositors and investors, where all financing operations involve charging or paying interest.

Conventional banking looks at the client as a tenant for certain banking services such as trust funds. In this capacity, the client is considered a "depositor / saver, a lender/creditor or a borrower / debtor and both depend on interest as a basis of financial transactions.

It is prohibited for conventional or traditional banks to practice commercial and industrial activities or buy real estate other than those needed to conduct business. Such banks may buy for their own account the shares of other commercial companies, but only within a specified percentage of their own funds or upon a prior approval of the central bank. As mentioned before, banks basically make money by lending bulk of its assets at rates higher than the cost of interest paid on clients’ deposits.

Under the conventional banking model, loss and profit are realized from the spread or net difference between the interest income and payments. The loss, if any, is borne by the borrower alone, even if he has nothing to do with loss reasons.

The operations of conventional banks are overseen by two watchdogs: "the General Assembly through the auditors’ reports, and the monetary authorities."

Both types of institutions (Islamic and Conventional) offer solutions and advantages that cover the entire spectrum of client’s needs, particularly providing a convenient, secure, and easy way to deposit their funds.