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Conventional finance versus Islamic finance

Islamic financial institutions perform the same functions as conventional financial institutions as the intermediary between savings surplus units and savings deficit units. The main difference between these two financial systems is interest. Riba or usury which takes the form of interest in conventional finance is absolutely prohibited in Islamic finance. 

Instead of interest, Islamic banks share profit and loss sharing (PLS) that occurs in investments and business partnerships through trade, exchange, leasing, and advanced funds. It earns from purchasing assets on a fixed return basis; and are also allowed to earn Wakala or agency fees.

The Islamic financial system is equity-based while conventional finance is debt-based. Deposits in conventional banks are guaranteed by the banks themselves and by governments. This is recorded as the liability of conventional banks. 

In contrast, deposits in Islamic finance are recorded as equity. Since the depositors are also part owners of the bank in Islamic banks, liability or loss of business undertakings are borne by them as well forming a PLS scheme between the bank and the depositors.

Islamic banks mobilize deposits through demand deposits or short-term interest-free loans offered to customers, and through mudarabah or wakalah agency contracts. They are expected to innovate in deposit mobilization and protect customers from losses. One of the protection measures if to get an explicit agreement of depositors on the Islamic bank’s fund placements in businesses and partnerships.

Mudarabah, a partnership agreement commonly used in Islamic banking has the following process flow. First, the bank creates an investment pool through deposits with different terms or tenors. Second, the depositor chooses to place deposit with the specific term or tenor to his/her liking within the investment pool. A musharakah relationship at this stage is therefore established between the bank and the depositor. Specific weight for PLS is assigned to each depositor. According to the rules of musharakah, losses are distributed to the depositors in the pool.

Third, the investment pool enters into a mudarabah contract with business entities through trade and exchange. Fourth, the bank undertakes business activities using the fund from the investment pool, and the profit earned is shared between the bank and depositors based on the PLS ratio.

The bank earns through the musharakah relationship between the bank and the depositors. It also earns a second way since the bank may choose to participate and place its own funds in the same investment pool. The bank then also earns profit based on the PLS ratio assigned in the investment pool.

Equity-based arrangement of the Islamic financial system may be better able to adjust or absorb shocks from non-performing assets versus the interest-based system. This is mainly because losses are immediately translated or reflected in the nominal values of deposits. The conventional interest-based system, where deposits are guaranteed, causes a discrepancy between real and nominal values of deposits in times of crisis or shock.

The Islamic financial system is far superior to conventional finance because ethics is at its core. Its goal is to promote progress for all in the community where those with more physical and mental capacities are obliged to share more and bear more responsibility. In contrast, conventional finance emphasizes its actions and decisions largely based on efficiency and profit.


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