Fundamental Differences of IB and Riba’-based Banks

One of the on-going running discussion with regards to Islamic Banking is the deep suspicion that Islamic Banking is nothing but a rename or change of terminologies of conventional banking, giving the rise to the term “conventional banking with an Islamic wrapper”. This perception is hard to dispel as most Islamic Banks still leverage on the conventional banking infrastructure, so there is the impression that it is all but the same.

Over the years, though, the Islamic Banks have been guided with more and more guidelines where demarcation between conventional and Islamic business are surely becoming more apparent. Shariah guidelines have reduced its commonality with conventional banking, making a lot of stand-alone policies as part of the new make-up for Islamic Banking.

There are still many similarities between the two banking models, however there were identifiable separation as listed below. Please note the list is by no means exhaustive, as there are many other smaller differences that makes it too many to list down.

Items Conventional Banking Islamic Banking (IB) Commentary
Banking Relationship Loan arrangement and services Financing arrangement based on Partnership, Profit Sharing, Trading, Buy and Sell, Agency, Commodity Sale, Services IB  relationship is based on actual economic transaction, which must be effected, and where applicable must involve a real asset and ownership
Contractual terms Borrower and Lender Partners, Fund Provider and Entrepreneur, Buyer and Seller, Agent, Supplier and Buyer, Service Provider Under IB, each relationship is tied to specific contractual obligations where the roles and responsibilities of each party to the transaction is clearly defined and agreed up-front.
Governing Authority Bank Negara Malaysia Bank Negara Malaysia and Shariah Committee A Bank’s Shariah Committee may over-ride a Bank Negara Malaysia instruction if it deems non-compliant or for differing views/interpretation.
Business Scope Able to provide loans to any business or individuals that does not engage in illegal activities Able to provide financing to any business or individuals that does not engage in illegal activities or uses the money or facilities in activities restricted by Shariah Gambling related companies, riba’ based, non-halal produce, alcohol suppliers and sellers, pork products, entertainment businesses and other non Shariah compliant activities are not allowed to be financed by IB
Common terms used Interest rate, loan, borrower, lender, penalty Profit Rate, Financing, customer, financier, compensation Different terminologies used in IB to reflect the contractual relationship of each agreement and transaction.
Sources of Funds Any depositors funds Depositors funds received must be derived from Shariah-compliant activities Ideally, all funds received by IB should come from Shariah compliant sources. However, there are exceptions to allow receiving funds from conventional banks with the view of taking out funds from the riba-based financial system and keeping it within IB financial system
Application and Deployment  of Funds Any available instruments Any available Shariah compliant financial instruments A lot of restrictions are imposed for the deployment of IB funds i.e. To deploy only into business activities that is compliant to Shariah in order to earn Shariah compliant returns
Pool of Funds Management Not Required For Investment Account defined products (such as Mudharabah, Musyarakah, or Wakalah fil Isthihmar), the pool of funds to be managed as per BNM guidelines The funds of IB investors must be managed in a pool of funds and tagged to specific financial portfolio of the bank (investment assets). Only returns from these investment asset shall be paid to customers on maturity
Determinant of Returns Contractual obligation on the loan amount Reliant on the activities done to justify earning the returns on the transaction.` In IB, an economic action is crucial to formalise the agreement to pay the Bank a return on their capital, efforts or assets. For example, a processing fee for IB requires the Bank to show proof of the processing actions required to justify charging a fee to customers. Otherwise, this will be considered “back-door riba’.
Bank Rate calculation Monthly or daily rest interest calculations based on floating or fixed rate loan Monthly or daily rest profit calculations based on floating or fixed rate financing IB are on par with conventional loan at the same bank rate strategy, but must not be deemed excessive.
Payment structure Only monthly instalment is calculated Monthly instalment is calculated but for Buy and Sell contracts, a maximum price must also be calculated and agreed up front The maximum price calculated is merely monthly instalment x tenure to arrive at Selling Price. This is the maximum amount payable if rates are high, but if rates remain low, a rebate is given daily or monthly
Late Payments Up to 1.0% p.a. on the arrears, compounded for next month interest Up to 1.0% p.a. on the arrears amount. No compound charge allowed In general, the late interest charged by conventional bank can be capitalised the following month and used to calculate further late interest (compounded)
Punitive Pricing Additional up to 2.50% on top of loan rate for 3 months and above (default period) Not allowed. Some reduction in rebate amount allowed to be taken by Bank if floating rate  BBA structure Generally, scholars reject punitive pricing for Islamic products, as it is injustice to customers for settling their debt
Tenure Indicatively up to 30 years. Could be more. Contracted up to 30 years IB could not exceed the contracted tenure unless customer consents to it
Early Settlement 1.0% charge on Loan Balance Outstanding to compensate loss of interest Not allowed. Conventional banks charge customers for early settlement of the loan within certain period to maximise their returns. For IB, unless there is strong justification on actual loss to the bank, only then it can be considered by Shariah Committee for approval
Product features approval Bank Bank, Bank’s Shariah Committee and Bank Negara Malaysia (Islamic Banking and Takaful Department) Islamic product goes through more layers of regulators to ensure product offered are in line with the Shariah principles of justice.
Bank charges Approval by Bank and Bank Negara Malaysia Approval by Bank, Bank’s Shariah Committee and Bank Negara Malaysia All IB fees and charges must be approved by Shariah Committee to ensure the charges are fair, equitable and not transparent to customers. No hidden costs are allowed.
Payments collected All recorded as revenue to the Bank Recorded as revenue to the Bank unless a Shariah rule is broken IB requires the adherence to strict Shariah rules of trading, partnership, agency or services, failure to adhere to the rules, the amounts collected must be taken from Bank’s income and given to charity
Risk ownership Customers bear all risk to loans (risk transfer) Based on contract, Bank must bear some risk to earn the returns (risk sharing) IB business is essentially riskier based on the various relationship and dependence of ownership and sequencing
Change of Terms and Conditions Bank has the right to change or vary the Terms and Conditions by way of giving sufficient notice to customers. Bank can only change or vary the Terms and Conditions by giving sufficient notice to customers if the change benefits the customers. For IB, if the change or variation to the Terms and Conditions benefits the Bank or imposes on the customers, customer’s consent to the changes must be obtained, otherwise the changes cannot be effected.
Cancellation of contract Bank has the right to cancel the contract, at their sole discretion. Usually, a contract is cancelled during events of default, or if the customers financial position becomes worse, or there is higher risk to the Bank. Bank do not have the right to cancel the contract at their sole discretion. IB can only cancel a contract if there is a clear breach of contract by the customers for example, event of default or non-payment. If cancellation is proposed for the changes in the customers financial position (but payments are still prompt) then a mutual consent is required for the cancellation.
Event of default Bank can classify all the customer’s facilities as default when one of the loan is defaulted by the customer. Bank can only classify default on the specific financing, as other financing facilities held by the customers should be independent contracts. As each facility is governed by the individual contract, there should not be a linkage to other financing facilities, unless the facilities are all offered as a bundled package.
Financial benefits Stamping of Legal Documents at fixed rate (ad-valorem) Stamping of Legal Documents at fixed rate (ad-valorem) less 20% discount A 20% discount on stamp duties are allowed for the legal document (until 2016, unless further renewed)
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