The fundamental difference between Islamic banks and conventional banks is based mainly on the principles and foundations upon which they operate, as well as the rules governing their transactions. Islamic banks rely on Islamic Shariah principles and rules, adhering to the prohibition of usury (interest), excessive uncertainty (gharar), and financing prohibited items or activities like pork, alcohol production, gambling, etc. Products and services in Islamic banks are structured based on Shariah-compliant contracts like Murabaha (cost-plus profit sale), Mudarabah (profit-sharing), Investment Wakala (agency), and Ijarah (leasing), all of which are in compliance with the principles and rules of Islamic Shariah, following the virtue of the words of Allah Almighty:
As for conventional banks, they are primarily based on the usurious financial system, where the bank's return is derived from the interest on loans. Conventional banks provide loans to customers at a fixed or variable interest rate, depending on the market interest rate, as most of their transactions are based on the principles of lending and borrowing.
The most important and fundamental differences between Islamic banks and conventional banks can be summarized as follows:
| Islamic Banks | Conventional Banks |
|---|---|
| Islamic banks receive deposits from customers and invest such deposits on customer's behalf with an intention to generate profit. Islamic banks earn their income through profit sharing and the loss and risk is shared to the extent of capital contribution. | Conventional banks take deposits from customers and lend to customers at predetermined interest rates, without incurring any risk. |
| Islamic banks trade and invest (including other mode of Shariah compliant investments) with depositors' funds. Islamic banks do not lend money. | Conventional banks lend money to depositors and have no right to trade or invest using the depositor's funds. |
| Islamic banks do not pre-determine profit rates on depositors' funds, but the contribution rates are determined, and the profits are calculated pursuant to the actual and realized investment results. | Conventional banks' interest rates on deposits are calculated based on a pre- determined agreed ratio. |
| The investment relationship with customers varies according to the underlying Shariah nominate contract of Musharaka, Ijarah, Murabaha, Mudaraba, Wakala (Investment Agency), etc. | The relation with customers is based on creditor and debtor relationship (lender and borrower). |
| If the due and payable amount is owed by the customer (under a Sale contract by way of Murabaha or otherwise), it remains fixed and may not be increased. | The debt is variable and increases in case of delayed payment. |
In more detail:
Both Islamic banks and conventional banks receive deposits and grant financing. However, regulating customers relationship is one of the fundamental differences between Islamic banks and Riba based conventional banks.
In the event of depositing funds with the conventional bank, a debt relationship will be established between the conventional bank and the customer, in which case the bank will owe the customer the principal amount of the deposit in addition to the interest, which is a fixed return on capital. In all cases, the bank will be the guarantor of the deposit.
However, Islamic banks do not receive funds on the basis of indebtedness, as the Islamic banks receive funds from depositors on the basis of Mudaraba contract: it is a contract where one party provides the funds while the other party provides expertise, as the customer is "Rab Al- Mal in a Mudaraba contract", while the bank is "Mudarib", i.e. the bank invests the funds, whereas, the depositors' funds are not guaranteed by the bank except in the event of violation, negligence, misconduct, default, or breach of the contract terms or Wakala Bi Al Istithmar (Investment Agency): it is a contract where the customer (as Muwakkhil) provides his funds to the Islamic banks for the purpose of investing in its Shariah compliant common pool of assets/ business, in its capacity as the Wakil (as Agent) of the customer for the purpose of generating profit, against a fee.
There is no indebtedness relationship in Islamic banks except for the Qard al-Hasan contract, if any, where the Islamic bank provides the fund as a benevolent loan without consideration or increase for the debtor.
In general, the difference between Islamic banks and conventional banks: the Islamic bank does not receive any usurious interest on the principal amount, such interest is prohibited pursuant to the principles and provisions of Shariah, such term is named "Riba" (usury), referring to the conditional increase over the capital without consideration.
The difference between Islamic banks and conventional banks is reflected in the investment mode and structures. Conventional banks rely on the interest-bearing loan structure as the main structure for investing funds, thus the Conventional banks receive funds in the form of an interest-guaranteed loan and lend an interest-bearing loan to customers.
However, Islamic banks receive funds by way of "Mudaraba" as referred above, where the customer is "Rabu Al-Mal", i.e. the capital owner, and the bank is the "Mudarib",or “Wakala Bi Al Istithmar (Investment Agency) ”, as referred above, the customer is the “Muwakkhil” i.e. the capital providers and the Islamic bank is the “Wakil” i.e. the fund's investor. Islamic banks have a set of Shariah structures based on actual buying and selling, and such structures may be used in granting financing, such as: Murabaha and Ijarah – lease buy back. , Exchanging cash for cash along with a conditional increase over the capital is prohibited pursuant to Shariah principles and provisions.
Islamic banks rely on Shariah contracts such as Murabaha, Ijarah, Istisna, Salam, etc. Financial transactions are conducted according to Shariah rules and principles that avoid usury (Riba). In contrast, conventional banks rely on traditional contracts based on loans with interest, such as house loans, corporate loans, and auto loans with fixed or variable interest.
The risks sharing is the main concept of Islamic finance that distinguishes Islamic banks from other conventional banks. In conventional banks (Riba based banks), the borrower shall bear all the risks. A person availing a loan from the conventional bank for investment purpose, shall bear all the investment risks, and shall return the loan amount to the bank plus the incurred interest even in case of project loss.
Whilst, Islamic banks are expanding the circle of risks in investment, whether the bank is a financier, or a receiver of fund. The Islamic bank when granting financing shall bear part of the risks pursuant to the contract based on which the financing was granted. The investor shall be involved in the investment's results unless there is violation, default, negligence, misconduct or breach of the terms from its part. If the Islamic bank is the investor, the depositor will bear part of the investment risks.
Accordingly, the difference between Islamic banks and conventional banks (Riba based banks) is that the conventional bank guarantees capital if the fund is deposited with it, and the Islamic bank does not guarantee the capital unless an event of violation, default, negligence, misconduct or breach of terms occurs.
We note the difference between Islamic banks and Conventional banks (Riba based banks) in the manner of distributing returns and profits, as conventional banks determine profits on the basis of a specific percentage of the capital; if a person deposits an amount of AED 1K (One thousand dirham) at 5% interest rate with a conventional bank, he would certainly receive the AED1k (One thousand dirham) in addition to (AED 50 dirhams) as fixed return.
In Islamic banks, the return is determined on the basis of a common percentage of the profit actually realized from the investment activity, if the same person as in our previous example decided to deposit a AED 1k (thousand dirhams) with the Islamic bank, and the bank employee informed him that the expected profit will be (5%), this does not mean that he will be entitled to (5%) of the profit unless this profit is actually realized, and since it is not possible to know the profit that will be achieved for certain, this Profit (return) is named "expected profit", i.e. the profit may or may not be realized.
From the forgoing, the difference in respect of the profit (return): the profit in a conventional bank is determined and known from the first moment of depositing the fund with the bank, while in an Islamic bank, it is an expected return determined on the basis of a percentage of the profit actually realized at the end of the investment period.
In Islamic banks, there must be Shariah supervisory bodies involved in reviewing and auditing in order to ensure the validity of banks operation, where Islamic banks and conventional banks have some supervisory bodies in common, such as: the Central Bank, the General Assembly, the auditor, and the legal controller. However, the Higher Shariah Authority, the Internal Shariah Supervision Committee, and the two departments: Internal Shariah Control and Internal Shariah Audit, are peculiar for Islamic banks in order to control banks' compliance with the principles and provisions of Shariah, and contract validity to ensure no Shariah breach.
Shariah Governance for Emirates Islamic Bank
Emirates Islamic Bank implements a robust Shariah governance mechanism to ensure that all offered activities, products, services and contracts comply with Shariah standards and provisions via the supervision of the UAE Central Bank's Higher Shariah Authority ("HSA") and its guidelines and regulations.
In line with the UAE Central Bank's Shariah governance framework, Emirates Islamic Bank has established a three-line defense approach which includes: Business Units, Internal Shariah Control Department, and Internal Shariah Audit Department, such units support Emirates Islamic Bank's Shariah governance activities as well as the supervision and reporting scope.
The Bank is generally under the supervision of the Internal Shariah Supervision Committee ("ISSC"), which consists of professional and independent Shariah scholars. The ISSC operates in accordance with the resolutions, standards and guidelines issued by the UAE Central Bank Higher Shariah Authority and oversees all businesses, activities, services and products to ensure their compliance with Shariah.
Fatwas and resolutions issued by the "ISSC" are binding on Emirates Islamic Bank. In addition, the "ISSC" issues annual reports on the respective activities, which include confirmation of the Bank's compliance with Shariah principles and ISSC 's resolutions.
The Internal Shariah Supervision Committee of Emirates Islamic Bank consists of a group of members: