Introduction to Islamic Finance: Islamic Finance and Conventional Finance

There are some differences between Conventional Banking and Islamic Banking, I want to share the table below:

Conventional Finance	Islamic Finance
Earning interest, the basis calculation of interest is time value of money	Earning profit, prohibiting usury (interest), instead of interest charged, the islamic bank makes “ a profit on the sale of goods”
No concept of sharing loss/risk	Encouraging sharing risk
The loan given not backing by assets or services	Assets and service backing
Based on loan which is represent the underlying contract of the activities	Contractual certainty, contract is the important thing in Islamic Finance to avoid ambiquity or uncertainty, profit rate is defined in the contract and contract also promote risk sharing between provider of capital and the entrepreneur
Conventional Finance does not care of the type of investment wether halal or haram	Some investment are prohibited, it is prohibited to invest in activities deemed contrary to Islam such as selling alcohol, pork industry, pornography and other haram investment
Money as commodity, this condition leads to inflation	Money as the medium of exchange, this situation contributes to economic development due to trading the real sector
No space for shariah board to monitor & advised	Shariah board monitor and advised

An Islamic bank different from conventional counterpart by the basic principles. The basic principles of Islamic bank that govern 80% of all Islamic transactions are: 

1. Riba free transactions
2. Risk sharing
3. Asset and services backing
4. Contractual certainty.

Different between Islamic  Financing & Conventional  Loan

Items	Conventional Banking	Islamic Banking (IB)	Commentary
Banking Relationship	Loan arrangement and services	Financing arrangement based on Partnership, Profit Sharing, Trading, Buy and Sell, Agency, Commodity Sale, Services	IB relationship is based on actual economic transaction, which must be effected, and where applicable must involve a real asset and ownership
Contractual Term	Borrower and Lender	Partners, Fund Provider and Entrepreneur, Buyer and Seller, Agent, Supplier and Buyer , Service Provider	Under IB, each relationship is tied to specific contractual obligations where the roles and responsibilities of each party to the transaction is clearly defined and agreed up front
Governing Authority	Bank Negara Malaysia	Bank Negara Malaysia and Shariah Committee	A Bank’s Shariah Committee may over – ride a Bank Negara Malaysia instruction if it deems non-compliant or for differing views/interpretation
Determinant of Returns	Contractual obligation on the loan amount	Reliant on the activities done to justify earning the returns on the transaction	In IB, an economic action is crucial to formalise the agreement to pay the Bank return on capital, efforts or assets. For example, a processing fee for IB requires the Bank to show proof of the processing actions required to justify charging a fee to customers. Otherwise, this will be considered “back-door riba”
Payment Structure	Only monthly instalment is calculated	Monthly instalment is calculated for Buy and Sell contracts, a maximum price must also be calculated and agreed up front	The maximum price calculated is merely monthly instalment x tenure to arrive at selling price. This is the maximum amount payable if rate are high, but if rate remain low, a rebate is given daily or monthly
Late Payments	Up to 1 % p.a on the arears, compunded for next month interest	Up to 1% p.a on the arears amount. No compound charge allowed	In general, the late interest charged by conventional bank can be capitalised the following month and used to calculate further late interest (compounded)
Punitive Pricing	Additional up to 2.5% on top of loan rate for 3 months and above (default period)	Not allowed. Some reduction in rebate amount allowed to be taken by Bank if floating rate BBA structure	Generally, scholars reject punitive pricing for Islamic product, as it is injustice to customers for setting their debt
Tenure	Indicatively up to 30 years. Could be more	Contracted up to 30 years	IB could not exceed the contracted tenure unless customer consent  to it
Early settlement	1% charge on Loan Balance Outstanding to compensate loss of interest	Not allowed	Conventional banks charge customers for early settlement of the loan within certain period to maximise their returns. For IB, unless there is strong justification on actual loss to the bank, only then it can be considered by Shariah Committee for approval
Product features approval	Bank	Bank, Bank’s Shariah Committe and Bank Negara Malaysia (Islamic Banking and Takaful Department)	Islamic product goes through more layers of regulators to ensure product offered are in line with the Shariah principle of justice
Bank charges	Approval by Bank and Bank Negara Malaysia	Approval by Bank, Bank’s Shariah Committee and Bank Negara Malaysia	All IB fees and charges must be approved by Shariah Committee to ensure the charges are fair, equitble and not transparent to customers. No hidden cost are allowed
Payment Collected	All recorded as revenue to the Bank	Recorded as revenue to the Bank unless a Shariah rule is broken	IB requires the adherence to strict Shariah rules of trading, partnership, agency or service, failure to adhere to the rules, the amounts collected must be taken from Bank’s income and given to charity
Risk ownership	Customer bear all risk to loans (risk transfer)	Based on contract, Bank must bear some risk to earn the return (risk sharing)	IB business is essentially riskier based on the various relationship and dependence of ownership and sequencing
Business scope	Able to provide loans to any business or individuals that does not engage in illegal activities	Able to provide financing to any business or individuals that does not engage in illegal activities or uses the money or facilities in activities restricted by Shariah	Gambling related companies, riba based, non-halal produce, alcohol supplier and sellers, pork products, entertainment businesses and other non Shariah compliant activities are not allowed to be financed by IB
Change of term and conditions	Bank has the right to change or vary the Terms and Conditions by way of giving sufficient notice to customers	Bank can only change or vary the Terms and Conditions by giving sufficient notice to customers if the change benefits the customers	For IB, if the change or variation to the Terms and Conditions benefits the Bank or imposes on the customers, customer’s consent to the changes must be obtaied, otherwise the changes cannot be effected
Cancellation of contract	Bank has the right to cancle the contract, at their sole discreation. Usually, a contract is cancelled during events of default, or if the customers financial position becomes worse, of there is higher risk to the Bank	Bank do not have the right to cancel the contract at their sole discreation	IB can only cancel a contract if there is a clear breach of contract by the customers for example, event of default or non-payment. If cancellation is proposed for the changes in the customers financial position (but payments are still prompt) then a mutual consent is required for the cancellation
Event of default	Bank can classify all the customer’s facilities as default when one of the loan is defaulted by the customer	Bank can only classify default on the specific financing, as other financing facilities held by the customers should be independent contracts	As each facilitiy is governed by the individual contract, there should not be alingkage to other financing facilities, unless the facilities are all offered as abundled package
Financial benefit	Stamping of legal documents at fixed rate	Stamping of legal documents ar fixed rate less 20% discount	A 20% discount on stamp duties are aloowed for the legal document (until 2016, unless further renewed)
Common terms used	Interest rate, loan, borrowe, lender, penalty	Profit rate, Financing, customer, Financier, Compensation	Different term inologies used in IB to reflect the contractual relationship of each agreement and transaction

Sources:

 https://www.openlearning.com/inceif/courses/intro-to-islamic-finance1/islamic_finance_and_conventional_finance

https://islamicbankers.me/2015/07/11/the-difference-between-islamic-banking-financing-and-conventional-banking-loans/