The Difference between Conventional and Islamic Banks : Cases in Saudi Arabia
Abstract – Modern convectional banking is based on the model developed in Renaissance Europe, whereby based on this model companies have the sole objective of lending money for a price. In conventional banking, therefore, money is seen as a commodity to be sold for a fee (Taylor & Francis Group, 2003) lent to customers to be returned later. Due to this business model, Song and Oosthuizen (2014) point out that commercial banking is dominant and commands over 95% of the global financial system.
Keywords – Islamic banking, conventional, sharia, banking, banking ethics
NCB: National Commercial Bank
Banking has been at the core of modern economies since its inception in Italy when the Medici family revolutionized the preexisting process of lending money to investors in the 14th and 15th century (Richards, 2012). In addition to being used by states to introduce economic reforms (Richards, 2012), banks have also evolved in their role to include printing of currency, regulation and financial institution.
king that is based on the model developed in Renaissance Europe, money is treated like a commodity that can be sold at a price rather than as a store of value (Pons, 2013, p. 231). Modern conventional banks operate like retailer shops, with the primary difference that money has to be returned to the bank unlike commodities that remain the property of the customer. Based on statistics provided by Ernst and Young (2015, p. 25), conventional banking has grown to become dominant such that it controls over 95% of the global finance system in terms of profits, revenue, asset base and economic aspects.
Changes in the second half of the 20th century emanating from economic uncertainty facing banks, customers and countries, the financial system had to undergo reforms, and many major economies faced destruction under the pressure of a rapidly changing global economy (Barut, Rouillé, & Sanchez, 2015, p. 93; Laeven & Valencia, 2013, p. 230; Laeven & Valencia, 2013, p. 229). Based on findings from economic analysis, researchers have questioned the positive consequences of financial industry liberalization and economic growth, which has led to seeking alternative approaches to banking, primarily Islamic banking. According to
According to Alexakis and Tsikouras (2009, p. 93), Islamic banking is the form of banking that adheres to Islamic tenets, and like conventional banking, Islamic banking has been used in the global financial systems for several millennia (Iqbal & Molyneux, 2005, p. 38). Islamic banking can be traced to the financial institutions that emerged as Islam spread globally, and its growth has been continuous such that by the end of 2015 it had a base of over $2 trillion (Ernst & Young, 2015). Ernst & Young (2015) estimate that Islamic banking had a growth rate of 17% between 2009 and 2015, and is expected to have an annual growth rate of 19% between 2014 and 2019.
- LITERATURE REVIEW
- Banking theory
According to the International Monetary Fund, financial intermediaries serve five primary roles under different capacities (Elton, Gruber, & Blake, 2003, p. 793) including risk polling and diversification (Imam & Kpodar, 2015, p. 7) by turning short-term liabilities into long-term assets, and savings mobilization and allocation to deserving investors (p. 8). In addition, banks have the role of supervising managers and controlling companies (Allen, Gottesman, Saunders, & Tang, 2012, p. 593), and enhancing, and enhancing transfer of goods and services through enabling fund transfer between buyers and sellers (Imam & Kpodar, 2015, p. 8).
hared between the bank and the customer.
Both Islamic and conventional banking are controlled by the central bank (Mahmood, Khan, Mehmood, & Khan, 2014, p. 193) in playing their role of enhancing liquidity within an economy by transforming short-term liabilities into long-term assets. This transformation presents a risk for the bank because deposits may either not be enough as customers withdraw their money, or customers may default in paying money lent out to them (Hassan, 2009, p. 25). In order to prevent the effects of banks like the role they played in the 2007 global recession and the 1932 depression (Said, 2013, p. 3), banks must adhere to sustainable practices in their lending, but in case they fail, the central bank bails out banks considered the most important for the economy (2008, p. 2). The central bank plays this role by acting as the lender of last resort, which has necessitated governments to establish a central bank to oversee the operations of the banking sector.
The theory of lender of last resort is based on Bagehot’s 1873 seminal work, where the theory states that the central bank is expected to act like a safety net for the liquidity risks that might face an economy’s banks (Bignon, Flandreau, & Ugolini, 2012, p. 593). Those who support the theory of lender of last resort correctly argue that asset prices depreciate rapidly during an economic crisis and risk faced by investors in the market increases appreciably (Bignon, Flandreau, & Ugolini, 2012, p. 593). The central bank offers assistance to banks at this time when banks cannot hold fire sales to compensate for the negative effects of a bank run, and also protects the entire economy from the knock-on effects of the bank run (De Grauwe, 2013, p. 523). Fire sales affect the quality of assets held by banks such that they may fail to be adequate even when a bank has enough assets to meet customer needs.
A primary shortcoming of the theory of last result is that it is reactive (Buiter & Sibert, 2008, p. 6), whereby the effects of an economic crisis is felt before the central bank can lend money to troubled banks. In addition, the theory supports the idea of banks taking unsustainable risks (Bignon, Flandreau, & Ugolini, 2012, p. 583), which means that in case the central bank has a bank run and loses liquidity there is no one to bail out other banks. In this case, numerous banks undergo a liquidity crunch at the same time and are in dire need of the central bank’s help (Buiter & Sibert, 2008, p. 5). However, the central bank hardly has adequate funds to fulfil all these requirements, which causes undue pressure on the general economy, exacerbating the already bad state of social costs. The theory of lender of last resort requires the central bank to take punitive measures when lending to defaulting banks, but the imposition of interests is not compatible with Islamic banking and central banks where they operate have to find alternative means of dealing with defaulting banks (Grais & Rajhi, 2015, p. 209). The theory also assumes that the central bank will lend on an overnight basis. However, the recent financial crisis showed that this assumption is flawed with central banks extending credit for prolonged periods.
An alternative to the theory of last resort is the use of regulations in ensuring that banks maintain adequate liquidity in the course of their operations, which are based on Basel III set of rules over financial institutions (Schoon, 2008). Liquidity can be defined as the ability of a bank to meet bridge the gap that exists between cash withdrawals and deposits made by customers. Ideally, a bank should be able to obtain sufficient long term funds that can be used to match the long term needs of its assets. However, the bank only retains a small portion of customer deposits and uses the rest in extending credit at a profit. It is the aim of the central bank and other regulators to ensure that banks do not over-lend and lose liquidity. One factor that leads to the difference between regulatory measures adopted by conventional banks and those adopted by Islamic banks is the gap in risk appetite.
- Differences between Conventional and Islamic Banking
The rise of Islam has been experienced in many fields, including the economic sector, which has led to the rise in Islamic banking (Grais & Rajhi, 2015, p. 212). Participation entails having a contract between the chairs of a company (Ernst & Young, 2015) to govern the transfer of money between the individual and the financial institution. Another approach used by Islamic banks is speculation in which money transferred from one party who has money to another one who does not to help in improve some form of work rather than acting as an investment by the lender. Profits accrued from the partnership are shared between the two parties in a profit-sharing plan. Islamic banks also the take the approach of a tout, whereby an increase in price increases profit from sales, and the primary difference between the two forms of banking is how these two systems apply these formulas (Barut, Rouillé, & Sanchez, 2015, p. 93).
Islamic banks fight usury and monopoly in addition to maximizing the owners’ wealth and that of the depositors who are the customers of the banks to help the social and economic development of the Muslim communities (Abu Hussain & Al-Ajmi, 2012, p. 217). By ensuring that depositors are refunded in case of mismanagement, Islamic banks protect depositors from costs incurred except in case banks have not been mismanaged, which is in contrast to interests offered in conventional banking (Choughury & Alam, 2013, p. 193). The depositor gets the return on the money deposited based on the amount deposited, the period of the deposit, and the interest rate. In Islamic banks, the depositor gets a return on the amount deposited based on profits realized by the Bank, the basis of the value of the money, and the duration that the money has been deposited.
In another comparison, as regards the relationship held by the users of money, Islamic banks rely more on speculation. Instead of having predetermined terms and conditions like in conventional banks, Islamic banks have a system in which a relationship is defined by terms between the customer and the bank, and the Islamic bank diversifies its investments to minimize risk. In terms of the control mechanisms, Islamic central banks, general assemblies, government central banks, and depositor representatives regulate Islamic banks, but Islamic banks do not use the central banks for liquidity purposes.
prohibit consumer loans and productivity.
- Research Philosophy
sferring past research errors.
- Role of Islamic banks in KSA
Leading firms that offer Islamic banking in KSA include the NCB (the largest in KSA and Middle East based on assets), Al-Rajhi investment bank, and Albilad bank. NCB has over 300 branches KSA alone, an asset base of 435 billion riyals as of the year ended 2014 and the highest profits yet of 8.7 billion riyals (NCB, 2015). NCB begun transforming itself into an Islamic institution in the 1980s, about 20 years after its founding (NCB, 2015). At the time, the financial environment in KSA was just beginning to take shape with material investments being made in the mining industry. Over the course of the next twenty years, NCB ensured that over 240 of its branches complied with sharia, which made NCB the largest Islamic bank globally.
Like other conventional banks, NCB also offers financial services that are targeted at the business community. These services include the management of payroll payments and letters of guarantee (NCB, 2015). However, it is the escrow services that offer the best insight into the application of sharia in banking NCB’s escrow accounts are meant to provide for the east flow of cash from one person to the other. The service has been in use in the Arab world for several centuries (El-Gama, 2000). Using escrow services allows the bank to hold deposits for a limited period during which parties perform their duties. Other services directed at the corporate market include asset financing. Unlike conventional banking where interest is charged on these financing options, NCB uses a profit sharing formula that leads to the borrower paying some part of the gains made from using the asset to the bank. This is one of the core differences between conventional banking and what is offered at NCB. Under the traditional setup, the bank has no interest in how the asset is used or the benefits and risks that may arise. However, NCB takes measures to ensure that the borrower engages in practices that are allowed by the Koran, whereby a failure by a customer results in sharing of losses with the bank.
- Governance at NCB
As is the case with other conventional banks, NCB has a board of directors that oversees the company’s general strategic direction (NCB, 2015). These directors are elected at the bank’s annual general meeting with shareholders and in accordance with the regulations governing such matters in KSA. NCB also has a management team that carries out the strategies pointed out by the board. However, a remarkable difference between the governance of an Islamic bank and the traditional bank is the presence of a sharia board. The sharia board is there to guide the board of directors on matters of Islamic law, banking, and other financial services (Abedifar, Molyneux, & Tarazi, 2013).
The KSA Monetary Agency acts as the central bank in KSA and is mandated with the duty of overseeing the conduct of companies that offer financial services. In addition, the central bank is charged with the responsibility of promoting growth and stability within the financial services industry. As of the year ended 2015, the central bank in KSA requires banks to hold at least 15% of client deposits in a reserve account (KSA Monetary Agency, 2015). The percentage may not go below 10% and must not exceed 17.5% (KSA Monetary Agency, 2015). These provisions are necessary to prevent banks from holding too much cash in reserve accounts.
As part of an ongoing program to adjust to global financial trends, the central bank of KSA has introduced Basel regulations on the banking industry. Initially, Basel regulations on bank liquidity and regulation were targeted at large conventional banks with the aim of reducing risk taking and speculative activities. The application of these laws and regulations is mandatory in several major economies, including the US, Europe, and much of Asia-pacific region. However, it is a hotly contested topic on whether these rules should apply across the board (Alexakis & Tsikouras, 2009, p. 93).
The aim of this study was to present an understanding of the key differences that exist between conventional banks and Islamic banking systems. It is found that Islamic and conventional forms of banking share numerous similarities yet they differ in significant ways too. The study finds that both systems of banking offer important services to the economy in acting as intermediaries that convert short-term liabilities into long-term assets. Banks also pool risks through mutual funds. Despite these similarities, conventional banks differ from Islamic banks by virtue of the fact that Islamic banks are guided by the religious tenets of finance. Therefore, banks using the Islamic financial system do no charge interest on loans advanced to clients. Instead, Islamic banks use a profit sharing formula that allows the firm to take some of the gains made from using the loan. Secondly, Islamic banks do not lend money if it is to be used in certain ventures that are considered to be contrary to the teachings of the Koran. Thirdly, Islamic banks do not engage in speculative activities with the aim of making profits.
The study’s second objective was to investigate how Islamic banking has been applied in Saudi Arabia by taking NCB as the case example. NCB operations offer insight into how different Islamic banking is from the well-understood conventional banking. NCB differs from conventional banks in that its services are tailored along Islamic teachings. Therefore, the bank does not charge interest on loans to customers but shares in profits made from investing these loans. In addition, NCB does not lend to ventures that are restricted by Islamic teachings. The study concludes that while there are a number of differences between the operation of an Islamic bank and the traditional financial system, there are also profound similarities between the two. Future research should investigate the use of regulation to guide the two banking systems, and evaluate the differences that exist in risk taking and basic operational activities.
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This paper addresses a controversial issue whether the money should be treated as a commodity and/or a medium of exchange between and among goods and services transactions. This paper discusses both points of view in light of existing literature under recent economic and financial crises. It takes a position that just and ethical approaches to banking and finance industry enable both parties to prosperity and economic sustainability.
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