Seyyid Ebu Bekir: Difference of Contracts in Islamic and Conventional Banks

The basic difference between Islamic and conventional banking is in the underlying contracts on which the products are structured. Therefore it is very important to understand the nature and types of these contracts in order to understand the difference between Islamic and conventional banking. In this short article, we would try to explain the basis contracts and their nature used in Islamic and conventional banks.

This is a matter of fact that both the Islamic and conventional banks are established to make profit. However, the contract used by the conventional banks is not Halal therefore their income and profit is not Halal. On the contrary, the contracts used by the Islamic banks are Halal therefore the profit earned through these contracts is Halal.

Conventional Bank

In conventional banks, the contact of loan is used. The bank takes money from the depositors and guarantees its repayment with the profit. This is loan with interest. Similarly, the bank lends money to its customer for financing which is also a loan contract with interest because repayment of this money with the profit is guaranteed. So, the main contract used by conventional banks for fund mobilization and financing (asset side and liability side) is loan or qardh. In Shariah law, the contract of loan cannot be used to make profit because any amount given above the loan amount shall be interest or Riba which is prohibited in Quran and Sunnah.

Islamic Bank

Islamic banks do not use loan contract because if they use this contract they will not be able to make profit. Therefore, the Islamic banks use sale or partnership contracts. In suarh Al Baqara Allah Almighty says that “Allah has prohibited Riba and allowed Trade.” So Islamic banks use trade and partnership based contracts. Let`s see now what kind of sale or partnership contracts are used by Islamic banks.

Islamic Banks` Saving Account/Deposit

On deposit side, when a depositor deposits its money in a savings account the Islamic banks use a partnership contract.  This partnership contract is called mudarabah. Under this contract, the depositor is considered capital provider, rabb ulmaal, and the bank is considered as fund manager, mudarib. The bank and the depositor agree on a profit sharing ratio like 50:50 or 40:60 etc. This means that the bank will use the depositor`s money and invest it in income generating activities and the profit earned on this investment shall be shared between the bank and the depositor as per the agreed profit sharing ratio. For example, a depositor gives TL 1,0000 to the bank under mudaraba contract and the profit sharing ratio is 50:50. Now the bank invests this 1,0000 and earns a profit of 1,000. This 1,000 will be shared between the bank and the depositor as per 50:50 so the bank will get 5,00 and the depositor shall get 5,00. And if the profit is 2,000 the bank will get 1,000 and the depositor will get 1,000. As you can see, the profit of the bank and the depositor will change as per the actual profit earned on the capital and there is no guaranteed profit. And if there is no profit on the capital, the bank shall give no profit to the depositor. On contrary, the conventional bank fixes the profit for the depositor whether the actual profit is earned or not.

Islamic Banks` Financing

On the asset side, the contracts of sale and partnerships are used. There are many types of sale contracts like murabaha, musawamah etc. In some contracts the goods are sold and in some contracts the services are sold. Now let`s take an example. A car manufacturing company comes to an Islamic bank and it needs TL 10,000 to purchase the machinery for its plant. Unlike conventional bank, the Islamic bank shall not give 10,000 as loan to the customer with interest. Instead, the Islamic bank shall ask the customer that we will not give you loan but we shall purchase the machinery for you and then sell it to you. So the bank shall purchase the machinery from the market and after taking its possession it shall sell it to the customer with the profit.

We should understand that in this contract the bank shall face many risks. For example, if the machinery is not delivered or is destroyed before the bank sells it to the customer the bank shall bear this loss and the customer shall not bear any loss. Therefore, Islamic banking is called asset based banking because the bank deals in assets and real economic activity. However, in conventional banking the bank does not bear this loss. If a customer comes to a conventional bank and it needs 10,000 the bank shall simply give him 10,000 with interest and the customer shall guarantee that he shall repay this loan with interest. If the asset is lost or destroyed, this will make no difference and the customer shall still be liable to repay its loan.

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