Islamic loan Vs Conventional loan

My last post attempted to make a fundamental comparison between riba and al-bay. So on this post I seek to differentiate the concept of loan from the Conventional and Islamic banking prospective.  

In order to explain the differences between the Islamic and conventional loan, first the general concept of loan needs to be addressed, from both conventional and Islamic prospective in terms of banking.  From the conventional point of view loan is a type of debt which involves two parties’ lender and borrower.  In a loan the borrower receives a certain amount of money from the lender which here is the bank; this borrowed money is called the principal amount, which needs to be paid back by the borrower at a later period through installment and these terms are enforced by legal contract.  Now the bank requires the borrower to pay back the principal at a cost which is the interest that is the incentive for lender (bank) to engage in providing loan. Similarly Islamic loan (qard) are also form of debt where there is transfer of ownership of fungible wealth (loans in terms of Islamic banking does not necessarily be money it can be any tangible asset) to a person on whom it is binding to return wealth similar to it¹.   

From the above we can say that both Islamic and Convention loans are form of debt.  So what really is the difference here? The prime difference lies in the incentive aspect. Interest is the dominated aspect of Conventional loans which is excess amount paid over the principal. In contrast Islamic banks cannot charge excess over the principal as interest constitutes riba which is prohibited in Shariah (Islamic Law).  “Allah permitted al-bay (trading) and prohibited riba  (Al-Baqarah: 225); Quran refused to accept the contract of interest-bearing loan as fair business trade. Hence loan for Islamic banks has no monetary gain in comparison to conventional banking where loan is their prime profit generating tool. 

Taking profit from interest-bearing loan is unjust from an Islamic prospective therefore loan is not a profit generating tool in Islamic banking. However it is permitted for banks to charge for services rendered, that is the operational cost involved in issuance of the loan any excess amount is prohibited. Therefore it is mandatory for the loan contract to clearly state the operational cost of the service.  Islamic Banks do issue Qard Hassan (benevolent loan) to fulfill part of its social responsibility; it’s given to employees of the banks or to students in many cases.  

 From here we can conclude that loan is not a mechanism for generating profit for Islamic banks compared to conventional banks. Trade contracts (al-bay) are used to earn profit they involve buying and selling of assets. (the next few posts will talk about the trading contract that drive Islamic banks and financial institutions)

Al-bay vs Riba

My previous post talked about Islamic world view as the driver for all Islamic economic activities now financing those activities is imperative, without financing economic activities will not take place; this is where banks and financial institutions come in. Islamic banks need to adhere to the notion of the Islamic world view as well, so let me try and make a fundamental comparison between Islamic banking and Conventional banking.  

Conventional Banks are financial intermediaries that hold capital, borrow from depositors the surplus sector then give out loans to the deficit sector, where these loans are based on interest when doing this bank bares financial risk. Here households, businesses and government bodies makeup both the deficit and surplus sectors. In a conventional bank the market for Deposits that is the demand for deposits and its supply as well as the market for loans which is the demand for loans and its supply are both based on interest rates, meaning that banks pays interest to depositors for borrowing their money and receiving interest from the loans that they give out.  

Like the Conventional banks, Islamic banks are also financial intermediaries, that take deposits from surplus sector and extend financing towards the deficit sector but unlike Conventional banks Islamic banks cannot take or receive interest as it is not permissible according to Shariah (Islamic Law). So if the prime factor that generates profits for conventional banks is interest the question to ask is how Islamic banks and financial institutions make profit? Certainly an Islamic bank is not a charitable organization, in order to answer this question one needs to understand the concept of al-Bay in comparison to riba (interest).  

First what is Riba?  It is predetermined surplus over and above the loan.  Also three conditions must be fulfilled for transaction to constitute Riba 

1.   excess or surplus over and above the loan capital to be returned to the lender;
2.  determination of this surplus in relation to time with definite date of redemption;
3.  stipulation of this surplus in a loan agreement. ¹

From this one can easily conclude that Interest constitutes Riba. Its stated in Quran “O ye who believe do not consume riba with continued redoubling and protect yourselves from God, perchance you may be blissful” (Al-Baqarah:130). In the conventional banking system depositors are promised a guaranteed sum of principle and interest payments. Likewise a bank charges interest with serious legal implications when loan is defaulted. 

This seems all good however, when small businessmen and those who aspire to expand operations but lack the credentials of giant corporations, conventional banks usually close their doors to these group of businessmen, taking them as business partners is taboo in banking. Is causes income disparity².  Its stated in Quran “wealth must not circulate only among the rich ones among you” (Sura 59:7) 

Now that we have established that interest constitutes riba and its implications we can go back to our initial question; what is the alternative that Islamic banks use to generate profits. What then is the key factor that drives deposit market and financing market for Islamic banks? The answer is al bay 

What is al-bay? It means trade which is money exchanged for goods and services meaning that the key principle here is profit sharing and loss sharing in financial terms risk sharing. (I will talk about the concept of risk sharing in detail in my next post). Therefore in Islamic banking, banks are agents (mudarib) and depositors as investors, the banks manage the deposited funds.  So the deposit and financing markets for Islamic banks is based on Trade contracts and not based on lending and borrowing contracts in comparison to how conventional banking is structured.  This means that Islamic banks are faced with business risk, where as Conventional banks are faced with financial risk this another element that differentiates Islamic banks from the conventional. This is because conventional banks face capital loss due to credit default and interest rate volatilities where as Islamic banks faces capital loss due to adverse price movement. (In the next few posts I will talk about risk as it is an important aspect for Banking and financial institutions). 

¹ Murat Cizakca ‘Islamic capitalism and finance’ Page 74-75

² Saiful Azhar Rosly ‘Critical Issues on Islamic Banking and financial Markets’ Page 37-38