BASIC DIFFERENCES BETWEEN CONVENTIONAL AND ISLAMIC BANKING

Conventional Banking Islamic Banking

Conventional banks only have one mode of financing for its customers and that Islamic banks primarily work upon three modes of finance, namely, rental
is ‘Loan’. arrangement (Ijarah), trade/ sale basis (Murabaha, Musawammah, Salam, Istisna &
Tijarah) and partnerships (Mudarabah & Musharakah).
Be it an individual customer, a business partnership or a corporate client. They
all can avail an array of products with an underlying mode of debt only from a Rental Basis (Ijarah): -
conventional bank. However, conventional banks have designed several
Ijarah or rental arrangement is where the usufruct of a durable asset is leased out
products such as credit cards, running finance, car/house loans and long-term
to a customer against a certain rental payment for a mutually agreed tenor.
loan facility for different customer segments but all of them simplify to a loan
advanced by a bank to its customer. Trade/ Sale Basis:
For instance, a credit card is also a debt instrument, also a car lease finance Murabaha: -
translates into an accrued loan for any customer.
It is that sale where bank (seller) discloses the cost and profit to the customer
Likewise, a registered partnership/ corporate customer avails both short-term (buyer).
and long-term financing facilities. All of them are essentially outstanding loans
Modes of Finance: Musawammah: -
to a company and they pay interest/mark-up to the bank on quarterly/annual
basis. It is an ordinary sale where bank (seller) does not disclose cost and profit to its
customer (buyer).

For example, if a customer avails a house/car finance from a bank and due to Salam: -
some reason car/house gets destroyed (total loss). The bank would then ask the It is a sale where 100% payment is made in advance and goods delivery is set on a
customer to keep paying monthly installments despite the asset loss till future date. Also, it has a limitation to be done upon homogenous goods.
insurance settlement comes in or else the customer would be reported
defaulter in case of non-payment of the same and their e-CIB shall also be Istisna: -
adversely affected
Sale transaction with spot or part payment for manufactured goods. An order is
placed with the manufacturer to make a specific commodity to the purchaser.

Tijarah: -
It is a sale and agency based financing facility where finished stock is sold by
customer (seller) to bank (buyer) to generate working capital for further business
operations.
 BASIC DIFFERENCES BETWEEN CONVENTIONAL AND ISLAMIC BANKING
Conventional Banking
Banks may offer this facility to manufacturer/producer/trader who sell finished
goods on credit basis.
Partnership Modes:

Musharkah: -
Musharakah is a partnership where all the partners invest capital in a joint business
and become owners of the business with their ratio of investment

They share profits as per agreed profit sharing ration and share loss as per
investment ratios.
Mudarabah: -

Mudarabah is a partnership where one party invests capital (Rab Ul Maal) and the
other party renders services (Mudarib) in a joint business.
Modes of Finance: Mudarabah
Islamic banks operate all types of savings/ remunerative accounts and term
deposits on Mudarabah basis.
Islamic banks invest customer’s deposits in Shariah-compliant avenues and share
the profits with customers as per profit sharing ratios agreed on monthly basis.
Other Banking Modes:

Kafalah: -

It refers to the guarantee an Islamic bank provides to a third party (probably

another bank or company)on behalf of its customer, in case they fail to pay the
third party in due time.

Wakalah: -
It is usually a paid agency contract, where a customer hires a particular service from
an Islamic bank for a certain price.
Product Name/ Type/ Desc. Conventional (Underlying Mode) Islamic (Underlying Mode) Difference

LIABILITY SIDE:

Islamic Current Account are Qard based and funds

are invested in shariah compliant avenues.
Current A/C – All types & variants for
Loan Based Qard (Loan) Based However in Conventional banking, customer’s
Businesses/ Individuals deposited funds are used in money lending and
interest earning businesses.

Savings Account in Conventional banks are based

on loan/qard basis and Conventional banks pay
interest earned on loans to its depositors as
returns whereas in Islamic banks saving account
are based on the concept of Mudarabah and
Islamic banks pay out actually earned profits on
shariah compliant transactions.

Savings A/C & Term Deposits -

Interest Based Mudarabah based
Businesses/ Individuals Mudarabah is a partnership of services and capital
between two parties. In Islamic banks, banks
render their services/ expertise against a capital
(deposit) of a customer. It is a partnership where
the returns are shared between the bank and
client as per the agreed profit sharing ratio
whereas, the loss is borne by the investor.

Conventional banks pay a fixed rate of return on

depositor’s principle amount kept with the bank.
Interest rate/ profit rate However, Islamic bank pays a proportion of actual
profit earned and realized to its depositors as per
weightages and profit sharing ratios.
 ASSETS SIDE:

The risk of conventional and Islamic bank varies

significantly.
Conventional banks only risk is if customer defaults
and does not pay back the loan along the interest
Alfalah Running Musharkah/ accrued.

Alfalah Salam/ Islamic bank’s risk changes with the mode of

financing, each mode has a different risk profile,
Alfalah Istisna/ and customer’s business nature also adds in Islamic
Running Finance/Working Capital
Loan/revolving credit facility Falah Tijarah Finance/ bank’s risk of financing.
Limits
Alfalah Murabaha Finance For example, in trade modes like Murabaha/
Musawammah, Islamic bank actually owns the very
(Underlying mode is chosen as deemed suitable asset(s) in the transaction and assumes all
for a certain customer) associated risks of the asset(s) before selling them
to the customer. If asset(s) go into total loss during
the process of sale to customer, Islamic bank
would solely bare the loss.

Trade based modes: Both Islamic and conventional banks charge a fee
against these non-funded facilities, which is
Murabaha/Musawamah allowed in Shariah. However if conventional banks
(As explained above) make payments on behalf of its customer, it
Credit warranty against a Fee(as per SOC) & mark-up on
LCs/Contratcts/ Guarantees credit advanced
charges interest to them on delayed payments to
Service based modes: the bank. Islamic banks cannot charge interest but
Wakala/ Kafalah they charge profit on credit sale of imported goods
to the customer, as the import is made on risk of
(As explained above) the bank in such case.(under bank’s ownership)
 ASSETS SIDE:

Conventional banks provide loans to their

customers and charge mark-up (interest quarterly)
to their customers on the outstanding principle
amount. Compounding of interest also takes place
on annual basis. Whereas in case of DM, Islamic
banks form joint ownership in a new asset and rent
out their share of asset to the customer and also
sell its’ ownership share in that very asset to the
customer on periodic basis. Thus called diminishing
musharakah, a declining partnership, where bank’s
Alfalah Diminishing Musharakah/ ownership share decreases and customer’s
increases over the tenor.
Long-Term Finance A loan facility spread over years of tenor.

Alfalah Ijarah
In Ijarah, an asset is bought on behalf of customer
and its usufruct is leased out to the customer for a
certain tenor, the bank remains owner of the asset
throughout the tenor and receives monthly
installments from customer. However, transfer of
asset is done either by gifting (Hiba) the asset to
the customer at the end of tenor, or by recognizing
last installment/ security deposit of the customer
as consideration for the sale of asset to the
customer.
 KEY DIFFERENCES

Conventional banks collect funds on debt basis and

advance money on debt basis, charging interest to
customers, as their profit. Also, the return they
Islamic banks collect deposits on qarz in current give to depositors is Riba (Interest) as it’s a benefit
Conventional banks borrow funds from depositors on account. on Qard (debt).
qarz and further advance money to customers on loan.
Keeping a spread between rate of deposit and rate of Savings Accounts are Mudarabah based.
lending, which is their profit margin.
Islamic banks collect funds either on qard basis or
Islamic banks offer financing under three on Mudarabah basis.
shariah modes mainly; Rental, Partnership and Offering returns/profits only on Mudarabah based
Trade.. accounts as return on Qard is Riba(Interest), which
Lending & Borrowing Mechanism. is strictly forbidden in Islam.

Conventional banks treat money as commodity so

they rent money for interest and sell money on
interest.
Islamic banks do not recognize money as
Conventional banks identify currency/money as commodity; therefore, they cannot sell money
Treating Money/Currency as
commodity, thus they can trade or rent it and make and rent money to make profits. Charging
Commodity profit of it. money over money in a debt contract is Interest
Islamic banks deem currency/money as a ‘mode of
exchange’, thus Islamic banks do not sell/ rent
(Riba).
money for profit. However, they may rent a fixed
asset or sell a Shariah-Compliant asset to customer
for a profit.
 KEY DIFFERENCES

Conventional banks only offer debt to customers; Conventional banks offer services on debt for both
Islamic banks have participatory modes such as
contract of debt does not have any other risk than depositors and borrowers, so they do not share
Musharakah and Mudarabah. Both are
default for the lender. risk with any of the customers. Whereas, Islamic
partnerships and by default that means sharing
Risk Sharing of profit as per agreed ratio and sharing of loss
banks share risks with their customers, both
Thus, they do not share any risk with their customers at depositors and financed, as per the underlying
all. All the financial risk is borne by the borrower i.e. the as per investment ratio. Thereby, Islamic banks
participatory mode and their risk profile,
customer do share risk with customers in such modes.
respectively.

Late payment charges are conventional bank’s

income and constitute a sizable chunk in their
Islamic banks only charge charity to discipline overall profitability of the bank.
the clients from delaying payments from due In contrast, Islamic banks understand that if they
Conventional banks make significant chunk of their net dates. More importantly, Shariah bars Islamic do not make due payments timely to the bank, the
profits from late payment charges levied on their banks from repricing the outstanding amount, bank would not be able to dispense profits to its
customers. Late payments are considerable income for which becomes a debt. depositors on time. In order to maintain financial
Late Payment Charges all the banks and add to their profitability. Moreover, discipline among the clients undertake that binds a
conventional banks do not waive off these charges in client to pay charity in the name of Allah in case of
business as usual, as this compounds their interest In addition, charity income does not add to deliberate late payment or intentional delays to
amount and reaps more monetary benefit for the bank. Islamic bank’s profitability but collected and the bank. Islamic banks collect charity from such
used for welfare support in health and customers and the amount collected does not
education sectors only. boost their profits and can only be used for welfare
in health and education sectors as per SBP charity
policy.