Monday, March 10, 2008

Islamic banking introduced

I thought i would write about this topic, because some people do not know what Islamic banking is or haven't even heard of it at all. Education is the key to financial success and knowing about Islamic banking might only help you in your chosen path, that's why this topic must not be omitted. I will not write too in depth about it, but i just thought everyone should know, what Islamic banking really is and what is the difference between Islamic and Conventional banks.

Interest-free banking

Some financial institutions do not charge interest on loans or pay interest on savings, because it is against certain ethical or religious beliefs. For example, in Islamic countries and major financial centres there are Islamic banks banks that offer interest-free banking.
Islamic banks do not pay interest to depositors or charge interest to borrowers. Instead they invest in companies and share the profits with their depositors. Investment financing and trade financing are done on a profit and loss sharing (PLS) basis. Consequently the banks, their depositors, and their borrowers also share the risks of the business. This form of financing is similar to that of venture capitalists or risk capitalists who buy the share of new companies.

Types of accounts

Current accounts in Islamic banks give no return - pay no interest - to depositors. They are a safekeeping arrangement between the depositors and the bank, which allows the depositors to withdraw their money at any time, and permits the bank to use this money. Islamic banks do not usually grant overdrafts on current accounts. Savings accounts can pay a return to depositors, depending on the bank's profitability: that is, its ability to earn a profit. Therefore the amount of return depends on how much profit the bank makes in a given period. However, these payments are not guaranteed. There is no fixed rate of return: the amount of money the investment pays, expressed as a percentage of the amount invested, is not fixed. Banks are careful to invest money from savings accounts in relatively risk free, short-term projects. Investment accounts are fixed-term deposits which cannot be withdrawn before maturity. They receive a share of the bank's profits. In theory, the rate of return could be negative, if the bank makes a loss. In other words, the capital is not guaranteed. However, this rarely happens, especially in well established banks, due to their good management.

Leasing and short-term loans

To finance the purchase of expensive consumer goods for personal consumption, Islamic banks can buy an item for a customer, and the customer repays the bank at a higher price later on. Or the bank can buy an item for a customer with a leasing or hire purchase arrangement. Another possibility is for the bank to lend money without interest but to cover its expenses with a service charge.
If a business suddenly needs very short-term capital or working capital for unexpected purchases and expenses, it can be difficult to get it under the PLS system. On the other hand, PLS means that bank-customer relations are very close, and that banks have to be very careful in evaluating projects, as they are buying shares in the company.


Conventional banks:

  • Pay interest to depositors
  • Charge interest to borrowers
  • Lend money to finance personal consumption goods
Islamic banks:
  • Give no return on current accounts; share profits with holders of savings and investment accounts
  • Share borrowers' profits (or losses)
  • Buy items for personal consumers with a leasing or hire-purchase arrangement
Well, these would be the main differences between conventional and Islamic banks. The question which one is better cannot be answered one sided, as they both have their pros and cons.

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