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Difference between Islamic and Conventional banking

When you hear the word ‘banking,’ your mind probably turns to the conventional methods of banking that we are familiar with. Hence it might get confusing when you hear the term ‘Islamic banking.’ You might think that Islamic banks are financial institutions catering to Muslims alone, but that is not correct.

If you want to know more about Islamic banking, this article will help you out. The article focuses on the main tenets of Islamic banking, and the main points of difference with the conventional banking system. Let’s get started.

What is Islamic Banking?

This form of banking operates on the basis of Sharia Laws and are open to people across all religions and ethnic backgrounds. The goods that are prohibited under the Sharia Law cannot be traded though these banks. For example, if you want to open a bar, you can’t approach an Islamic bank for a loan, as alcohol is banned under the Sharia law.

Islamic banks have a Sharia advisory board consisting of Islamic scholars who provide guidance on business dilemmas, bank operations, and morality of business decisions.

Major differences between conventional banking and Islamic banking

The traditional banking system very different from the Islamic banking system. The list of the major differences is given below.

  1. The conventional system uses money as a medium of exchange as well as an object of value. In the Islamic system, money is used only as a medium of exchange. Real assets such as land and ornaments are considered as objects of value.
  2. Time is a major factor in calculating the interest charged on the loan capital in the conventional set-up. The Islamic system employs the profit earned on exchange of goods and services as the major factor for calculating interest.
  3. There is a risk of deficit financing and inflation in the conventional banking system if money is used without any backing of real assets. In the Islamic set-up, there is no risk of inflation as money is used only as a medium of exchange.
  4. If a loan-taking business suffers losses in business, it does not affect the amount of interest charged from them in the conventional banking system, as there is no concept of sharing losses. The Islamic system often shares the burden of loss.
  5. Conventional banking does not require formal agreements for cash disbursal for running financial institutions and exchange of goods and services. The Islamic set-up requires execution of agreements for exchange of goods and services and cash disbursal under the Murabaha, Istisna, and Salam contracts.
  6. Conventional banking institutions often write off certain loans as non-performing if the sanctioned projects fail or remain incomplete. Islamic institutions, on the other hand, hand over non-performing projects to a better management.
  7. Traditional banking creates a huge burden of taxes for salaried people as debt financing leads to the interest being deducted from the taxable income of the people. In contrast, the Islamic system shares profits under the Mudarabah system and provides extra tax to the government under the Musharakah system. This minimizes the tax burden on the people and increases the GDP.

As the Islamic banking institutions are very different from the traditional ones, it is vital to study their rules and regulations, especially in countries where it is followed. If you want to learn more about this type of banking system, there are different Islamic finance courses online that can help you master the Islamic banking system.

Claire James

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