Back in 2007 and 2008, most of the world economies faced a crisis. However, Islamic finance prospered – it experienced a growth of 25%! It is no surprise that more and more people are noticing the benefits of Islamic banking and finance then. Over the past decade, it has grown at an exponentially high annual rate of between 10% to 12%.
Malaysia is seen as a pioneer in this industry. The government created the Islamic Banking Act in 1983, the Takaful Act, which regulates Islamic insurance in 1984, the first-ever Islamic bond (Sukuk) in 1990, and the launch of the Islamic Interbank Money Market in 1994.
Since then, more initiatives have been rolled out, especially in recent times. This includes setting up the International Centre for Education in Islamic Finance, the Islamic Banking and Finance Institute Malaysia, the International Shariah Research Academy, and the Asian Institute of Finance.
We know that Islamic banking is an ethical banking system, and its practices are based on Islamic (Shariah) laws. But, what makes Islamic banking better than conventional banking? Here, we look at the major differences:
- Money
In Islamic banking, real assets are a product. Money is just a medium of exchange.
In conventional banking, money is a product, as well as the medium of exchange and store of value.
- Shariah principles
Islamic banking follows Shariah principles and is completely free from unethical elements such as riba (interest/usury), gharar (deceit), maysir (gambling) and zulm (immoral practices).
Conventional banking follows no such principles.
- Loss and risk-sharing
With the concept of “Mudarabah” in Islamic finance, any risks, losses, or damages will also be shared amongst shareholders and not just with the financiers.
Interest is charged even when the organisation suffers losses. Thus, there is no concept of sharing loss.
- Exchange of goods
In Islamic banking, the execution of agreements for the exchange of goods and services is a must, while disbursing funds under Murabaha, Salam and Istisna contracts.
In conventional banking, while disbursing cash finance, running finance, or working capital finance, no agreement for the exchange of goods and services is made.
- Fees
In Islamic finance, the maximum amount of payment has been agreed on beforehand. This way, payments are fixed for the entire tenure.
This differs from conventional loans, where the amount of payment is dependent on BLR (Base Lending Rate). In layman’s terms, this is the rate that banks refer to internally before deciding how much to charge (i.e. interest rate) for your loan.
- Inflation
Due to the existence of goods and services in Islamic financing, no expansion of money takes place and thus no inflation is created.
In conventional loans, due to the non-existence of goods and services behind the money while disbursing funds, the expansion of money takes place. This creates inflation.
- Growth of wealth
In Islamic banking, real growth in the wealth of the people of the society takes place, due to the multiplier effect hence, real wealth becomes the ownership of a lot of hands.
In conventional banking, real growth of wealth does not take place, as the money remains in the possession of only a few hands.
- Late penalty fees
Unlike conventional loans, which apply the concept of compounding interest, late penalty fees in Islamic finance are only charged on the amount of remaining principal debt.
Below is an example between the two systems. The scenario given is for loan of RM100,000 and a late penalty of 3%:
ISLAMIC FINANCING:
First month: RM100,000 x 3% = RM3000
Second month: RM100,000 x 3% = RM3000
Third month: RM100,000 x 3% = RM3000
Total penalty for three months:
RM3000 + RM3000 + RM3000 = RM 9000
CONVENTIONAL LOAN:
First month: RM100,000 x 3% = RM3000
Second month: (RM100,000 + RM3000) x 3% = RM3090
Third month: (RM100,000 + RM3000 + RM3090) x 3% = RM3182.7
Total penalty for three months:
RM3000 + RM3090 + RM3182.7 = RM 9272.7
- Failure of projects
When a project fails in Islamic banking, the management of the organization can be taken over to be handed over to a better management.
When a project fails in conventional banking, the loan is written off as it becomes a non-performing loan.