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)