Both types of institutions (Islamic and Conventional) are providing financing to productive channels for reward. However, the difference lies in financing agreement.
In conventional financing, the bank gives money to his client as an interest-bearing loan, after which he has no concern as to how the money is used by the client. In the case of Islamic banking, on the contrary, the financier advances no money. Thus, Islamic financial institutions can charge profit on investments but not interest in the form of murabahah. “Murabahah” is a contract whereby the Islamic bank sells to a customer, at acquisition, cost plus at an agreed profit margin, a specified kind of asset that is already in its possession (such as a manufactured good). The customer usually pays the total cost in instalments. Murabaha as a banking instrument involves the bank buying the underlying assets and selling it at a premium in return for a deferred payment. The asset has to come under the ownership of the bank before it can be sold to the customer. This ownership requires that for a particular time period, the bank bear the risk of the underlying asset getting destroyed. The absence of this risk makes the structure non-Shariah compliant and tantamount to Riba. Islamic banks, therefore, ensure that they take possession of the asset even if it is for a very small time period. It is the ownership risk born by the Islamic bank that entitles it to the excess premium. Moreover, Islamic banks have to bear a supplementary cost associated with the ownership transfer and possession of the underlying asset. At some point, Islamic banks might have to hire trained personnel to ensure that the asset comes under their ownership before the offer of sale is made to the client. The asset possession also entails a storage cost for the bank. Thus, ownership transfer cost and storage can significantly increase a Murabaha structure’s total cost compared to a conventional loan. Since, this extra cost is very negligible, the paper ignores this element of cost while developing the model. On the contrary, a conventional bank is free from such risk as the conventional bank’s concern is with the loaned amount and the underlying risk of asset being destroyed at no time comes under the bank’s ownership.
Moreover, in conventional banking three types of loans are issued to clients including short-term loans, overdrafts and long-term loans. On the contrary, Islamic banks cannot issue loans except interest free loans for any requirement. However, they can do business by providing the required asset to client in the form of a murabaha contract as stated above. Conventional banks offer the facility of overdrawing from account of the customer on interest. One of its forms is use of credit card whereby the bank sets limit of overdrawing for customer. Credit card provides dual facility to customer including financing as well as facility of plastic money whereby customer can meet his requirement without carrying cash. On the other hand, as far as facility of financing is concerned, Islamic banks except in the form of Murabaha do not offer this. However facility to shop/meet requirement is provided through debit card whereby a customer can use his card if his account carries credit balance.
Under conventional, banking a customer is charged with interest once the facility available. However, under Murabaha only profit is due when the commodity is delivered to the customer.
Furthermore in case of default, customer is charged with further interest for the extra period under conventional system whilst extra charging is not allowed under Murabaha.
However, in the conventional financing system, loans may be advanced for any profitable purpose. Eg a gambling casino can borrow money from a bank to develop its gambling business. Thus, conventional financing is not bound by any divine or religious restrictions. In contrast, the Islamic banks and financial institutions cannot affect murabahah for any purpose, which is either prohibited in Shariah or is harmful to the moral health of the society.
Finally, in conventional banking, in an interest-bearing loan, the amount to be repaid by the borrower keeps on increasing with the passage of time. In murabahah, on the other hand, a selling price once agreed becomes and remains fixed. As a result, even if the purchaser (client of the Bank) does not pay on time, the seller (Bank) cannot ask for a higher price, due to delay in settlement of dues. This is because in Shari‘ah, there is no concept of time due of money.