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COMPARATIVE CONVENTIONAL AND ISLAMIC BANKING - PS601 RISK MANAGEMENT IN ISLAMIC BANKING CHAPTER 06
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CHAPTER SIX
THE RISK IN CONVENTIONAL BANKING vs THE RISK IN ISLAMIC BANKING(06 : 02) – CLO1 & CLO3
TEST 2 (CHAP 4-6)TUTORIAL EXERCISE 4 (CHAP 6)
Risk in conventional and Islamic banking
on management and the financial
products
THE RISK IN CONVENTIONAL BANKING vs THE RISK IN ISLAMIC
BANKING
6.1 ; Distinguish between the risk management in conventional banking and Islamic banking
THE RISK IN CONVENTIONAL BANKING vs THE RISK IN ISLAMIC
BANKING
6.1.1
Differentiate between the risk management in conventional banking and Islamic banking
FUNDAMENTALS• Shariah laws are the tenets of Islamic Banking. As such,
the comparison with that of the conventional are not exactly like-to-like.
• Conventional banking was build upon the fundamentals of debtor-creditor relationship with interest being the price of credit and reflecting the opportunity cost of money. Hence, money is a commodity somewhat.
• Financial relationship in Islam is generally participatory in nature. E.g. the Financial relationship in Islam is generally participatory in nature. E.g. the principles of Musharakah and Mudharabah, or contractual transaction.
• In addition, risk and reward relationship is guided by the socio-economic principles.
There are two major difference between Islamic Banking and
Conventional Banking
• Conventional banking practices are concerned with "elimination of risk" where as Islamic banks "bear the risk" when involve in any transaction.
• When Conventional banks involve in transaction with consumer they do not take the liability only get the benefit from consumer in form of interest whereas Islamic banks bear all the liability when involve in transaction with consumer. Getting out any benefit without bearing its liability is declared Haram in Islam.
There are two major difference between Islamic Banking and
Conventional Banking
Conventional Banking System Islamic Banking System
Depositors are paid interest Depositors are entitled to profit sharing
The customer has no say where banker invest money
Under special investment account, the customer can decide where banker invest the money
Borrowers are charged interest Financing is done through purchase and resale to the customer, thus earning profit. If a loss is incurred under Mudharabah, the capital provider will bear the loss, whereas under Musharakah, the loss will be shared according to the financing ratio
Except for financing under leasing, margin of financing will be less than 100%
Under Mudharabah or BBA concept, 100% financing can be availed
Repayment is not fixed Repayment price is fixed
Conventional Banking system vs Islamic Banking system
Conventional Banking system vs Islamic Banking system
Conventional Banking System Islamic Banking System
Legal relationship: •Debtor and Creditor
Legal relationship:•Seller and buyer•Lessor and lessee•Partner and partner
Commodity, e.g. example house, become the security
Commodity, e.g. house is the subject matter and major element.
A COMPARISON BETWEEN ISLAMIC
AND CONVENTIONAL BANKING
OVERALL
ISLAMIC BANKING CONVENTIONAL BANKING
The functions and operating modes of Islamic banks are based on the principles of Islamic Shariah.
The functions and operating modes of conventional banks are based on fully manmade principles (largely capitalism theory).
It promotes risk sharing between provider of capital (investor) and the user of funds (entrepreneur).
The investor/lender is guaranteed of a predetermined rate of interest or returns.
It also aims at maximizing profit but subject to Shariah restrictions.
Unrestricted profit maximisation illustrated by derivatives trading.
In the modern Islamic banking system, it has become one of the service-oriented functions of the Islamic banks to be a Zakat Collection Centre and them also pay out their Zakat
It does not deal with Zakat.
ISLAMIC BANKING CONVENTIONAL BANKING
Participation in partnership business is the fundamental function of the Islamic banks. Understanding the venture is therefore essential. Embedded know-your-customer orientation.
Lending money and getting it back with compounding interest is the fundamental function of the conventional banks. Money is a commodity and the motivation.
Islamic banks have no provision to charge any extra money from the defaulters except for compensation (typically such proceeds are given to charity). Rebates early settlement at the Bank's discretion.
It can charge additional money (penalty and compounded interest) in case of defaulters
Due importance to the public interest/ maslahah. Its ultimate aim is to ensure growth with equity.
Often, lenders/banks interest becoming forefront. It makes no effort to ensure growth with equity
For the Islamic banks, it must be based on a Shariah approved underlying transaction.
For interest-based commercial banks, borrowing from the money market is relatively easier.
ISLAMIC BANKING CONVENTIONAL BANKING
Since it shares profit and loss, the Islamic banks pay greater attention to developing project appraisal and evaluations.
Since income from the advances/loans is fixed, it gives little importance to developing expertise in project appraisal and evaluations. Risks are transferable at a price (and sometimes incremental).
Greater emphasis on the viability of the projects.
The conventional banks give greater emphasis on creditworthiness of the clients where credit equals to ‘commodity pricing’.
The status of Islamic bank in relation to its clients is that of partners, investors and trader, buyer and seller.
Relationship is often defined as that of creditor-debtor.
Islamic bank can only guarantee deposits for deposit account, which is based on the principle of al-wadiah, thus the depositors are guaranteed repayment of their funds, however if the account is based on the mudharabah concept, client have to share in a loss position.
A conventional bank has to guarantee all its deposits.
THE RISK IN CONVENTIONAL BANKING vs THE RISK IN ISLAMIC
BANKING6.1.2 Compare the conventional risk of Financial Products
such as:a. Personal Loanb. Housing Loanc. Hire Purchased. Mortgage
6.1.3 Compare the risk of Financial Products in Islamic banking such as:
a. Personal financingb. Housing financingc. AITAB (Al Ijarah Thumma al Bai)d. Ar Rahnu
THE RISK IN CONVENTIONAL BANKING vs THE RISK IN ISLAMIC
BANKING
Personal Loan
vs
Personal financing
Personal Loan vs Personal financing• The main difference between Islamic
Banking and Conventional Banking arises on the charging of interest on loans without the lender taking a share of the risk involved in the investment of the loan; something traditionally known as usury. • Usury is making money by lending money;
put in other words, it is making money from absolutely nothing, and is exactly what is happening around the globe today on an absolutely massive scale.
CONVENTIONAL SIDE• The charging of interest discourages people from
working to earn money, and the value of work is undermined. Therefore money lies idle in banks as people are earning money over their bank deposits. This discourages investment, and risking money in business. It also discourages the borrower from borrowing money for investment, because the risks involved in borrowing are not shared by the bank so the borrower has to return his loan to the bank with the interest whether his business results in failure or success.
ISLAMIC SIDE• Islamic banking on the other hand, is based on the
concept of risk sharing. The bank enjoys a share in the profit of the company if it thrives, but also provides extensions for loan repayment if required, and shares the loss if the business fails, and in extreme cases, it may forgive the loan altogether.
Personal Loan vs Personal financing
CONVENTIONAL P/L ISLAMIC P/F
USURY RETURN ; PROFIT / LOSS
LAW; MAN MADE LAW LAW; USUL FIQH AND QAWAID FIQH
CUSTOMER SUFFER THE RISK RISK SHARING CONCEPT
INVOLVE RIBA, GHARAR & MAISIR PROHIBITED RIBA, GHARAR & MAISIR
BASED ON LENDING/BORROWING CONTRACT
NORMALLY BASED ON SALE AND TRANSACTION
REIMBURSEMENT FROM THE NOMINATED REIMBURSEMENT BANK.SUBJECT TO 2 TIER INTEREST RATE
REIMBURSEMENT UPON RECEIPT OF COMPLIED DOCUMENT AT THE COUNTER OF THE ISSUING BANK.NOT SUBJECT TO 2 TIER INTEREST RATE
LENDER AND BORROWER SELLER & BUYER
THE RISK IN CONVENTIONAL BANKING vs THE RISK IN ISLAMIC
BANKING
Housing Loan vs
Housing financing
Housing Loan vs Housing financing
• In the conventional loan, the base-lending rate (BLR) stated above is subject to change depending of the interest rate market. BLR in is this country have reached over 10% during the financial crisis. But now for the last few years, the BLR has stayed around 6-7%. If the BLR goes up, the borrower has to pay more in interests. The user tends to gain, if the BLR goes down. If in the long term the interest rate remains low the user tends to gain.
Housing Loan vs Housing financing• In the Islamic banking model, the profit rates are fixed
for the entire tenure of the loan. It is based on Islamic principle that when we agree on a fixed loan and repayment, it should remain the same. If at the time that when the loan agreement is signed, the terms are say BLR + 1.5%. and assuming that the existing BLR is 6.0%, then the loan agreement is signed off as 8% flat for the entire tenure. Normally interest rates for Islamic rates are slightly higher if we were to look the rates now. The advantage is the user gains to benefit if the interest rates go up, as they are not affected by the increase. However they would tend to lose of if the rates go down and they would not benefit from the lower rates.
ISLAMIC H/F CONVENTIONAL H/L
BLR + FIXED RATE = BFR (BASE FINANCING RATE)
BLR IS SUBJECT TO CHANGE
THE USER GAINS TO BENEFIT IF THE INTEREST RATES GO UP, AS THEY ARE NOT AFFECTED BY THE INCREASE
IF THE BLR GOES UP, THE BORROWER HAS TO PAY MORE IN INTERESTS.
THEY WOULD TEND TO LOSE OF IF THE RATES GO DOWN AND THEY WOULD NOT BENEFIT FROM THE LOWER RATES.
THE USER TENDS TO GAIN, IF THE BLR GOES DOWN
CONCEPTS; THE BANK PURCHASE THE PROPERTY FROM THE SELLER ON CLIENT BEHALF, AND RESELL TO CLIENT WITH AN AGREED PROFIT RATE, SO THE PROFIT RATE IS TO BE PAID BY CLIENT TO THE BANK, WHEN CLIENT FULLY PAID THE INSTALMENT THEN THE PROPERTY WILL BE TRANSFERRED TO CLIENT.
CONCEPTS; CUSTOMER BORROW THE MONEY FROM BANK TO PURCHASE A PROPERTY.
Housing Loan vs Housing financing
ISLAMIC H/F CONVENTIONAL H/L
20% STAMP DUTY REDUCTION FOR PRINCIPAL DOCUMENT BASED ON SHARIAH PRINCIPLES OR WAIVER OF STAMP DUTY FOR THE CONVERSION OF CONVENTIONAL LOAN TO SHARIAH FINANCING
NO STAMP DUTY REDUCTION
BASED ON SYARIAH BASED ON HUMAN RULE
PROHIBITED RIBA, GHARAR, MAISIR & ZULM NOT RESRICTED
THE PURCHASER WILL PAY A PROFIT THE PURCHASER WILL PAY INTEREST
SELLER & BUYERLEASEE OR LEASOR
LENDER AND BORROWER
Housing Loan vs Housing financing
Islamic banks have changed the borrowing relationship to various concepts that are
acknowledged in Islam such as partnership (Musharakah or Mudharabah), or seller (bank) and
buyer/renter (customer). Changes in the relationship are not only with the ‘aqad or contract, even asset
ownership has changed and is accepted by Malaysian law. This means, from the legal point of view, the
trading or renting process does take place. However, many customers of Islamic banks do not recognise the efforts of Islamic banks in making changes as
they do not read the contracts they sign.
THE RISK IN CONVENTIONAL BANKING vs THE RISK IN ISLAMIC
BANKING
Hire Purchase vs
AITAB (Al Ijarah Thumma al Bai)
Hire Purchase vs AITAB (Al Ijarah Thumma al Bai)
Under common law, a hire-purchase transaction is a contract whereby one party (called “the owner”) leases goods on “hire” to “the hirer” and agrees that the hirer may (at his own option) either return the goods when he no longer needs them and terminate the lease, or elect to purchase the goods on completion of the necessary payments agreed in the contract. In simple terms, a hire-purchase transaction is hire, coupled with an option to buy, provided that all the conditions are fulfilled until the end of the hiring contract
The Islamic hire-purchase financing offered by local Islamic banks is AITAB. AITAB is applied as a modification of HPA with added emphasis upon two elements, namely the “letter of aqad” and without “overdue interest”. In the case of defaulted payments, a repossession order is executed without charge for overdue interest.
Hire Purchase vs AITAB (Al Ijarah Thumma al Bai)
Differences between conventional and Islamic hire purchase from a shari’ah
point of viewItem Conventional Hire
PurchaseIslamic Hire Purchase
Terms LoanInterest RateHiring ChargesLate payment interest
FinancingProfit rateMark-upLate payment charges
Eligible customer Good credit rating Not involved in immoral activities against shariah
Goods Limited to customer goods, motor vehicles and non-Act goods (corporate)
Applicable to all types of goods
Contract One standard contract 2 aqad (sighah)
Purchase Price or Installments
Cost price x interest rate month
Cost price + profit .Number of payments
Item Conventional Hire Purchase
Islamic Hire Purchase
Profit margin or Interest Rate
Floating based on the annual rate, decided up front
Determined based on market value
Responsibility Hirer or customer bears all costs of maintenance
Owner bears basic and structural maintenance
Differences between conventional and Islamic hire purchase from a shari’ah
point of view
THE RISK IN CONVENTIONAL BANKING vs THE RISK IN ISLAMIC
BANKING
Mortgage vs
Ar Rahnu
Mortgage vs Ar Rahnu
A mortgage loan is a loan secured by real property through the use of a mortgage
note which evidences the existence of the loan and the encumbrance of that realty
through the granting of a mortgage which secures the loan.
Mortgage vs Ar RahnuMORTGAGE AR RAHN
INTEREST PER MONTH BASED ON THE LOAN AMOUNT.
COST OF LOAN
MONTHLY SAFEKEEPING FEES BASED ON THE VALUE OF THE PAWNED GOLD (MARHUN VALUE).
6 MONTH LOAN PERIOD MAY BE EXTENDED FOR ANOTHER 6 MONTHS. A LOAN MAY BE EXTENDED INDEFINITELY.
LOANDURATION
THE FIRST PERIOD OF 6 MONTHS MAY BE EXTENDED FOR THREE MONTHS ANDFINALLY ANOTHER 2 MONTHS.
GOLD OF VARIOUS GRADES OF FINENESS, WHITE GOLD, GOLD WATCHES, GOLD BARS, GOLD COINS/DINARS, DIAMONDS, HOLLOW GOLD JEWELLERY AND GOLD JEWELLERY WITH STONES. GOLD ITEMS WHICH AREDAMAGED, BROKEN, TORN, OR CRUSHEDARE ALSO ACCEPTED.ANYTHING VALUABLE ARE ACCEPTED.
COLLATERAL 18K - 24K (750 – 999) GOLD .HIGH QUALITY SILVER.VALUABLE JEWELLERY.
MORTGAGE AR RAHN
MOST TRANSACTIONS WILL TAKE ONLY A FEW MINUTES. NO FORMS TO FILL OUT.
PROCESS CUSTOMERS MUST FILL OUT FORMS AND PROVIDE INFORMATION SUCH AS EMPLOYER’S NAME, WORK ADDRESS, OCCUPATION, GROSS INCOME AND OTHER PERSONAL DETAILS TO THE BANK. CUSTOMERS MUST ALSO OPEN A SAVINGS ACCOUNT WITH THE BANK.
NO CREDIT CHECKS. CUSTOMERS WHO ARE DECLARED BANKRUPT CAN GET A LOAN AT A PAWNSHOP.NO CUSTOMER DETAILS WILL BE ADDED TO THE CCRIS AND A CUSTOMER'S CREDIT HISTORY WILL NOT BE AFFECTED.
CREDIT CHECK AND
BANKRUPTCY STATUS
CUSTOMERS WHO ARE DECLARED BANKRUPT ARE NOT ELIGIBLE TO APPLY FOR LOANS UNDER THE AR-RAHNU SCHEME.LOAN DETAILS WILL BE ADDED TO THE CENTRAL CREDIT REFERENCE INFORMATION SYSTEM (CCRIS). A CUSTOMER'S CREDIT REPORT WILL BE AFFECTED IF THE LOAN WITH THE BANK IS NOT REPAID ON TIME.
Mortgage vs Ar Rahnu
MORTGAGE AR RAHN
SOLE PROPRIETOR BASEDINDIVIDUAL BASED
OPERATOR INSTITUTION BASED EG: BANKS, COOPERATIVES, YAPEIM, STATE GOVERNMENT AGENCIES, ETC
INTEREST IS CHARGEDMORE EXPENSIVE RATE
CHARGES MONTHLY SAFEKEEPING CHARGESNO INTEREST CHARGESCHEAPER
NOT COVEREDIF THE PLEDGED ITEMS ARE LOST, ONLY A 25% COMPENSATION IS OFFERED
INSURANCE TAKAFUL COVERAGE
NOT REQUIRED TO PROVIDE PROOF OF OWNERSHIP
OWNERSHIP MUST PROVIDE PROOF OF OWNERSHIP EITHER THROUGH THE LETTER OF PURCHASE / RECEIPT OR LETTER OF UNDERTAKING.IF IT BELONGS TO SOMEONE ELSE, A LETTER OF CONSENT / APPROVAL FROM THE OWNER IS REQUIRED
Mortgage vs Ar Rahnu
MORTGAGE AR RAHN
VALUATION IS MUCH LOWER THAN THE MARKET VALUEAVERAGE 30.5%
PAWNING VALUE UP TO 60 – 70% OF THE VALUE OF PAWNED GOLD.VALUATION BASED ON THE CURRENT MARKET VALUE.
NOT TRANSPARENT DEFAULT PLEDGED ITEMS WILL BE AUCTION PUBLICLY.TRANSPARENT AND NOTICE WILL BE SENT.
THE BALANCE AFTER THE AUCTION WILL NOT BE RETURNED BACK BY THE COMPANY TO THE PLEDGOR
BALANCE AFTER AUCTION
THE BALANCE AFTER THE AUCTION WILL BE RETURNED BACK BY THE COMPANY TO THE PLEDGOR
Mortgage vs Ar Rahnu
ADDITIONAL DIFFERENT BETWEEN ISLAMIC BANKING AND CONVENTIONAL BANKING
CONVENTIONAL BANKING ISLAMIC BANKING
ITS FUNCTIONS AND OPERATIONS ARE BASED FULLY ON MAN-MADE PRINCIPLES.
FUNCTIONS & OPERATIONS
ITS FUNCTIONS AND OPERATIONS FOLLOW THE QUR’AN AND THE SUNNAH AS MUCH AS POSSIBLE.
IN ITS INVESTMENT PRODUCT, THEINVESTOR IS PROMISED A FIXEDRATE. IN REALITY, IT IS A RIBA BASEDLOAN ACTIVITY.
INVESTMENT PRODUCTS
IN ITS INVESTMENT PRODUCT,AN ISLAMIC BANK PROMOTES THE SHARING OF RISK AND PROFIT BETWEEN INVESTOR AND INVESTMENT FUND MANAGER.THERE IS NO FIXED PROFIT PROMISED. DIVISION OF PROFIT IS BASED ON REAL PROFIT.
AIMING FOR PROFIT WITHOUTRELIGIOUS OR MORAL BOUNDARIES.
AIM AIMING FOR PROFIT THAT ADHERES TO ISLAMIC DISCIPLINE THAT IS LIMITED TO THAT WHICH BENEFIT SOCIETY.
CONVENTIONAL BANKING ISLAMIC BANKING
IGNORES ZAKAT. ZAKAT PAYS ZAKAT AS IT IS A SOCIAL RESPONSIBILITY FULFILLED BY ISLAMIC BANKS.
THE RETAIL LOAN PRODUCT APPLIES THE SYSTEM OF GIVING OUT LOANS WITH MULTIPLIED INTEREST.
RETAIL LOAN
ITS RETAIL PRODUCT UTILIZES THETRADING OR RENTING OF AN ASSET,AND NOT THE LOAN CONTRACT.
CHARGING A COMPOUNDING PENALTY ON A LOAN IF THERE IS LATE PAYMENT.
PENALTY CHARGES COMPENSATION FOR ANY LATE PAYMENT, BUT IT DOES NOT GO TOWARD THE BANK’S EARNINGS.INSTEAD, IT IS CHANNELED DIRECTLY TO CHARITY.
THE MAIN PRIORITY IS TO PROTECT THE BANK’S INTEREST; NO PRIORITYIS GIVEN TO ENSURE EQUITY DEVELOPMENT.
PRIORITY EMPHASIZE PROJECTS THAT BENEFIT SOCIETY. THE MAIN AIM IS TO ENSURE EQUITY DEVELOPMENT.
ADDITIONAL DIFFERENT BETWEEN ISLAMIC BANKING AND CONVENTIONAL BANKING
CONVENTIONAL BANKING ISLAMIC BANKING
LOANS GIVEN BY CONVENTIONAL BANKS ARE SIMPLE, NO ASSET REQUIRED. THEIR CONCEPT IS “MONEY BREEDS MONEY.”
REQUIREMENT OF ASSET
MONEY IS NOT GENERATED THROUGH LOANS. THUS, ANY LOAN SHOULD HAVE AN UNDERLYING ASSET.
EVALUATION STRESSES ON THE ABILITY OF THE BORROWER TO PAY OFF THE LOAN. NOT MUCH ATTENTION IS GIVEN TO THE PROGRESS OF THE CUSTOMER’S PROJECT.
EVALUATION EVALUATION ALSO STRESSES ON THE POTENTIAL OR VIABILITY, PERFORMANCE AND PROSPECT OF THE PROJECT THAT IS BEING FINANCED.
EARN REVENUE FROM FIXED INTEREST CHARGED TO THE CUSTOMER.
REVENUE EARNED
PROFIT ACCORDING TO THE CONCEPT OF SHARING PROFIT-LOSS; THE BANK GIVES MORE ATTENTION ON INVESTING IN PROJECT DEVELOPMENT.
THE BANK -CUSTOMER RELATIONSHIP: LOAN LENDER AND BORROWER.
RELATIONSHIP THE BANK-CUSTOMER RELATIONSHIP: SELLER, BUYER OR PARTNER.
ADDITIONAL DIFFERENT BETWEEN ISLAMIC BANKING AND CONVENTIONAL BANKING
CHALLENGES• Shariah interpretation versus the financing
commercial viability.• Legal jurisdictions and governing laws.• Transparency, accountability and governance
for public and private sectors.• Tax incentives, pervasive government
intervention and controls.• Supervisory and prudential regulatory
framework.• Lack in depth capital markets and liquidity
funding.• Accounting and auditing standards.
TEST 2 (CHAP 4-6)TUTORIAL EXERCISE 4 (CHAP 6)