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ISLAMIC BANKS ARE OPERATNG UNDER THE SHARIA COMPILED RULE. CONVENTIONAL BANKS OPERATING UNDER THE CENTRAL BANK RULES AND REGULATIONS.
The key difference is that Islamic Banking is based on Shariah foundation. Thus, all dealing, transaction, business approach, product feature, investment focus, responsibility are derived from the Shariah law, which lead to the significant difference in many part of the operations with as of the conventional.
On the other hand, conventional banking is essentially based on the debtor-creditor relationship between the depositors and the bank on one hand, and between the borrowers and the bank on the other. Interest is considered to be the price of credit, reflecting the opportunity cost of money.
Islamic banks are distinct from conventional banks. They disagree on certain aspects. Principal area of disagreement between Islamic banks and conventional banks are described herewith.
Ownership Risks
The fundamental difference between an Islamic bank and a conventional bank is the way they finance a project. It takes us to the argument of Risk Capital and Loan Capital.
Risk Capital is the capital that is rewarded for its participation in a productive process to the extent of the value that its participation creates, whether positive or negative, and which was unknown at the time of deployment of capital.
To the contrary, the Loan Capital dictates its price of participation in the shape of a pre-determined rate and irrespective of the outcome of its application, whether positive or negative.
Thus under an Islamic financing environment, risk participation by the financiers is encouraged by way of becoming an owner of all or part of the assets. Naturally it entails ownership risks and responsibilities.
Such risks and responsibilities are non-existent when a conventional bank simply lends money on the basis of conducting its due diligence but without assuring the ownership rights in the financed assets.
Being the owner of an asset under an Ijara (Leasing) financing makes the Islamic bank responsible for keeping the asset in good working order so that the client can have quiet enjoyment over its usufruct for which he is required to pay the least rent. Then there is the responsibility of bearing taxes relating to the ownership of the asset as well as on the income generated from the asset.
What if the asset has a major breakdown depriving the lessee of the usufruct? With immediate effect the lease rent ceases to accrue till such time that the asset brought back to normal working condition by the Islamic bank as the owner of the asset.
A conventional banker who is not familiar with taking aforesaid risks will naturally be reluctant to walk hand in hand with its Islamic counterpart. As such he would endeavor his best to cover the “shortcomings” which may seen weird to an Islamic banker to whom risk taking comes naturally.
Risk and reward
Another point where a conventional bank has difference of opinion is the level of return it receives compared to the risk it takes in an Islamic transaction.
Whilst a conventional bank may traditionally be content whit a set return level on its lending, it is averse to the idea of getting exposed to a greater risk in an Islamic transaction by way of becoming part of owner in the asset, unless there is a convincing increase in its return.
On the other hand, an Islamic bank remains at a dilemma due to its inability to obtain higher return owing to market forces working against such increase.
Jurisdiction
Conventional banks draw the facility agreements based on civil code and are comfortable with it. However, when it comes to participating in an Islamic facility, they have to reply on Shari'ah, which is not their domain.
Although many Muslim countries do recognize Shari'ah to be the supreme source of jurisprudence, they also have parallel and highly active legal systems based on civil code. As such, when an Islamic bank declares Shari'ah as the governing law, naturally the conventional banks do get worried.
At time the task of convincing a conventional banker to accept Shari'ah as jurisdiction becomes monumental and there have been instances where the issue turned out to be the deal breaker.
Potential of increase in the cost of asset being leased
In conventional leasing agreement of large value, it is common to find a clause relating to the potential of increase in the cost of the asset being leased.
The clause stipulate that if later on the lessor (lead bank) determines that any of the banks forming part of the lessor group has incurred any increased cost as a result of the introduction of any new tax in its area of operation making the financing expensive, or any new tax on the asset with retrospective effect or enhanced capital adequacy ratio leading to making the lending less attractive or for any other reason, then the lessor bank(s) will have the right to add such increased amount to the lease rent.
Moreover, the lessor bank(s) shall not be obliged to disclose any calculation to the lessee while claiming the increased costs.
A conventional bank would like to see this point in the lease agreement while participating in an Islamic financing transaction. However, from a Shari'ah scholar's perspective, the point falls under the category of Gharar or element of uncertainly which makes an agreement null and void.
It may not be correct to assume that Shari'ah is rigid to accommodate subsequent increase in the cost of financing an asset. Following are the Shari'ah parameters to address such situation:
The lessee must undertake in the lease agreement that it will be willing to pay higher lease rent to allow the lessor to be able to bear the increased cost related to the financed asset in future, if any,
The Undertaking should include, inter-alia, the foreseeable elements of increased cost such as insurance expense, major repair and maintenance, ownership and income taxes, etc. All this may have been paid by the lessor or the lessee in the capacity of lessor's service agent.
Lessee will not be obliged to pay for the increased costs to lessor if it is uncertain and cannot be arrived at with the help of a formula or if the lessor declines to provide the details of such increased costs, claiming it to be confidential.
In short, any element of uncertainty in a financing agreement is knocked down by the Shari'ah Supervision Board of an Islamic bank and which act is not looked with favour by a conventional bank.
Penalty for late payment
It is a practice unanimously adopted by the conventional banks to charge penalty on the amounts delayed for payment by the client. The insist to include this clause in an Islamic facility agreement since they always have it in their own documentation and hence find it difficult to live without it.
Whilst Islamic banks are not allowed by Shari'ah to charge any such penalty since it will be tantamount to Riba (Interest), they usually accommodate this demand from conventional banks but add the phrase that such penalty amount will not be taken by them to their profit and will be donated to charity organisations of non-religious nature.
Why emphasis on non-religious charity? Because penalty amount being usurious in nature cannot be compared to Zakat money which is spent on supporting widows, orphans, religious students, Islamic schools, marriages and the likes. This less contentious issue works in favor of Islamic banks as it discourages the customer from intentionally delaying the payment.
Events of Default
In conventional financing scenario, a long list of the events of default is provided which includes several events outside the borrower's control, such as, force measure, nationalization, requisition, etc.
To the contrary, in an Islamic financing transaction, imposing something on the customer over which he has little or no control is disallowed by Shari'ah.
Shari'ah accepts those events as default which are caused by the customer are redefined as 'events of mandatory prepayment' and are covered under a separate document, rather than in the main facility agreements. This is to comply with Shari'ah requirement that events of default should only consist of the ones controlled by the customer.
Interestingly, upon the occurrence of an events of mandatory prepayment, the customer will technically not be in default from Shari'ah point of view. however, he will be required to purchase the asset and upon his failure, the financier banks will have the right to auction the asset in order to recover their dues. financiers can also waive the occurrence of such an event; however, this will require their unanimous decision.
