The biggest problem with conventional banking is the very framework that it is built upon. Islam encourages a partnership in that both profit and loss are shared for both parties of any transaction. In conventional banking, there is an imbalance of risk, most of which is put on the borrower.
This ties into interest – one of the fundamental differences between Islamic and conventional banking. Banks make money through multiple avenues: charging interest via credit cards, investing its customers’ money from savings accounts, and interest on mortgage loans which are a few of what we will discuss.
Customers who are unable to pay off their credit card loans are required to pay interest to the bank. From an Islamic point of view, you are not allowed to benefit from lending money.
Conventional savings accounts are based on a creditor and debtor relationship. The bank borrows the customers’ money and invests or lends it to others (with no guarantee that these investments are Shariah-compliant).
The bank then returns the customers’ money with an agreed-upon interest and keeps the remaining profit for itself. There is no risk taken on by the customer as they are guaranteed the interest.
In a mortgage, the bank lends the customer money for the purchase of a house. The customer then pays back the money with interest periodically over a set timeframe.
Again, there is minimal risk from the bank’s point of view, and if the customer is unable to repay the loan, the bank will repossess the property and sell it to cover the cost of the loan.
Islamic banking is designed so that profit and loss are equally shared between both parties in a transaction. This eliminates the ability of the bank taking advantage of the customer.
Shariah-compliant savings accounts are typically based upon the Mudaraba Principle (Partnership). The customer acts as the financier and the bank acts as the fund manager. All investments made are Shariah-compliant.
The bank and the customer agree to a profit/loss sharing ratio and as the bank will have researched the investment, there is an expected profit, but that could potentially fluctuate. Hence, both parties are taking on risk. The bank then receives a portion of the profit (just like a fund manager would), and the customer receives the remaining profit.
For Islamic mortgages, there are several types. The most commonly used type is the Ijarah loan. The bank purchases the property outright from the seller and then agrees to lease the property to the customer over a set period.
Once the customer has made their final rental payment, the bank then transfers ownership of the property to the customer as a promissory gift. The customer did not borrow any money from the bank and is not paying back any interest.
Islamic banks and their customers are also not allowed to deal in any interest. The Islamic banking industry is continuously evolving and innovating to find better alternatives to make it easier for Muslims to grow and store their wealth.