Introduction
The banking system is very essential for the economy of a country since it offers financial advice to business people besides taking custody of the money which will otherwise be risked at homes. Nevertheless, religion has found its way into the economic well being of the society and to a larger extent determines the financial and other services that people require, because of the difference in belief and teaching of various religious groups.
It is because of this reason that Muslims whose Sharia law is a bit restrictive, and were therefore unable to receive their services from the conventional banks, decided to form the Sharia compliant Islamic banks. However, the Islamic and conventional banks exhibit differences in terms of their operations and disclosure in their financial statements.
Overview
Islamic banks observe the Islamic law which prohibits the acceptance or imposition of interests, because according to the sharia law profits should be earned from goods and services only and money does not fall to any of these categories (Kettell 2011). On the same note, not all goods and services are consistent with the Islamic laws and income from those that are not right in the sharia law is forbidden.
The sharia law is put into exercise through the Islamic economics which is the practical application of the sharia and is implemented by many of the nations that observe the Islamic law. Islamic banks are guided by Islamic moral code which restricts the kind of investment that one may undertake and the methods of generating income that the Muslims may be involved in (Greuning & Iqbal 2008).
In the recent years, especially the late years of 20th century, Islamic banks have been growing at high rate spreading all over the globe including in countries which do not observe the Islamic laws. Islamic banks are mostly concerned with the issues of public interest and they belief in profit and loss sharing principle of investment.
On the other hand, conventional banks belief in the rule of maximization of profit, and the main source of income is the interest that they get from loans advanced to their clients. Conventional banks take money to be their core business and they are not under any religion’s moral code on how to make profits.
They consider that the process of handling money for their clients is a service that attracts charges therefore they allocate differing fees on every transaction (Greuning & Iqbal 2008).
Additionally, these banks take granting a loan as one among the many options that the same money could have been used, and therefore attach an interest rate equal to the opportunity cost incurred. On the same note, the conventional banks operate on the rule of free market thus the fee that is charged and the interest rates are determined by the forces of demand and supply.
Differences
While the conventional banks provide guarantee to their clients for their deposits, Islamic banks do not. This means that, conventional banks ensure that their clients will always get their actual deposits in case of any catastrophe, for example fire or theft, by insuring the deposits (Kettell 2011).
On the contrary, Islamic banks only guarantee the profits of their clients but not the actual deposits therefore probability is high that customers can lose all the money the have deposited in case of any eventuality. On top of that, conventional banks are established to lend money or receive deposits from the clients making the relationship between the bank and clients to be that of a creditor and a debtor (Kettell 2011).
Islamic banks on the other hand, involve themselves in the projects that their clients are having because the sharia law demands that the client’s source of income should be compliant to the Islamic requirements. This makes the banks and their clients have the relationship of a partner in business and at the same time trader and an investor.
Additionally, the Islamic banks focus on the principle of profit and loss sharing between the bank and the clients therefore providing equal opportunities for both parties, besides generating profits according to the sharia law for the customer and the bank. In conjunction with that, the principle of profit and loss sharing compels the bank to be concerned with the kind of business a client is involved in.
Conventional banks on the contrary make their profits from the interest on loans and are usually less concerned about the profits made by the clients, while the client is also not included in the affairs of the bank as far as the profits are concerned.
Similarly, conventional banks have a fixed interest rate on the loans that they advance to customers therefore; they expect to generate a fixed return at the end of any given trading period. On top of that, the conventional banks carry out their operations in a more or less free market and they make their profits or income without restrictions (Greuning & Iqbal 2008).
However, Islamic banks are not guaranteed of the specific amount of income or profits that they will make since this depends on the outcomes of the market in which the investments have been made. Accordingly, the Islamic banks are also restricted by the sharia law on where they can invest and the kind of income they can accept.
Islamic banks are usually involved in the business that their clients carry out especially if they get loans from the bank since the profits from these investment is shared between the banks and the clients, given that they do not accept any interest.
Consequently, the Islamic banks are often compelled to appraise and evaluate the projects forwarded by the customers to ascertain their feasibility before advancing any loan (Greuning & Iqbal 2008).
While the conventional banks are not concerned with the area of investment of the customer since their profits are generated from the interest rates and they have no share in the incomes from the investments of their customers.
This coupled with the fact that mostly customers provide security for the loans they take makes the conventional banks assured of their money and they therefore, do not provide the professional services to appraise the projects of customers.
Conventional banks easily get money from the money market since they are ready to pay the interest that is charged by the money market lenders.
On the contrary, the Islamic banks are restricted from accepting or paying interest and this limits their ability to get money from the money market where interest is the rule of the game (Kettell 2011). On top of that, conventional banks have to take care of taxes to the government at the end of any given trading period while the Islamic banks have to collect the religious offerings besides the taxes.
The Balance Sheet Comparison
To begin with, the items on the balance sheet of the two types of banks are somehow different given the difference in the operations that are carried out by these banks. Conventional banks, due to the fact that they depend on interest they charge on loans for their day to day functions have to include it in their balance sheet.
On top of that, the conventional banks are able to access finances from the money market which includes other banks and the central bank, while the Islamic banks can not, and they disclose the same on their balance sheets (Kettell 2011).
Additionally, conventional banks categorize money in the group of goods and services which can be used to get income and therefore they hold financial assets for trading. The financial securities have to be disclosed in the balance sheet as per the requirements of the international accounting standards.
On the other hand, the Islamic banks also have other items which are not present in the case of conventional banks. Firstly, the investment accounts are present in the Islamic banks’ liability side because these banks are direct involved in the investment activities that customers are carrying out.
In the asset side of the Islamic banks, investment assets are disclosed which are assets that the bank owns for the purpose of financing its liabilities (Greuning & Iqbal 2008). On the same note, the Islamic banks have some other services on which fees are charged in accordance with the Islamic law and these form a source of income which is also disclosed.
Conventional banks are compelled to finance their long term or medium term assets using short term liabilities that keep on streaming in, especially from deposits, which in the end limits the banks from investing in long term non liquid ventures.
These banks are at the risk of having a maturity variance therefore making the bank to have a problem of liquidity management, since the finances which are mainly from the deposits are not guaranteed in terms of duration and clients can withdraw them anytime (Greuning & Iqbal 2008).
On the same note, deposits form a liability to the bank which is supposed to be used efficiently and no matter what the end result might be, as far as the assets of the banks are concerned, the deposits must be paid back.
However, the Islamic banks acts more as an intermediary through which money is channeled from savers to investors and therefore, the ratio of capital to liabilities is very low to sustain any business outside the banking sector thus decreasing the risk profile of the Islamic banks.
On top of that, the return to capital of the depositors is matched to the return of the banks in Islamic banking, because the bank acts as a partner therefore eliminating the asset-liability variance that is present in the conventional banks.
On the same note, Islamic banks have most of their assets in investment based assets which though they have a credit risk, they are supported with real assets that determine the lending ability of the banks, thus eliminating speculated credit creation.
Islamic banks can not issue loans to finance assets which helps in eliminating speculation investment that have been the source of financial crisis, thus putting the Islamic banks at a better position to avoid risks during financial crisis. Additionally, the Islamic banks have a more direct relationship between assets and their function as a financial intermediary thus easing the processes of asset monitoring.
Islamic banks trade in physical commodities and services which form the financing assets therefore, exposing the banks to credit risks by combining the assets and their financing together (Kettell 2011). Similarly, this habit can expose the bank to the additional risks as a result of involvement in material commodities.
Furthermore, Islamic banks lack liquid securities in the asset side of the balance sheet exposing the banks to liquidity risks in case a situation that requires a lot of liquid cash comes up, and the period is not enough to transform the non-liquid assets to cash.
It is therefore paramount for the risk managers to incorporate the non financial risks of the Islamic banks’ liability side as well as the competition from the conventional banks in their plans.
Income Statements
The Islamic banks have different disclosure method of their income statement from the conventional banks, due to the fact that they are supposed to report on some items which are not reported by the conventional banks. On top of that, the operations of the Islamic banks are quite different from those of the conventional banks necessitating the unique reporting style.
From the balance sheet, there are investment accounts in the case of Islamic banks and the people involved will need disclosure of the information that affects their welfare (Greuning & Iqbal 2008). In addition to that, Islam banks have an extra task of collecting the zakat, which is a religious offering as by the Muslim laws, and therefore the zakat agencies have to be taken into consideration when preparing the income statement.
Perhaps the most significant difference in the two income statements is the fact that Islamic bank and the conventional banks have different income generating activities.
Conventional banks mostly concentrate on interest generating activities as the main source of income, while Islamic banks can not accept interest from any activity and they get their income from sharing profits with the clients (Kettell 2011). Therefore, in the income statement of the conventional banks the income side has interest income while in the case of Islamic banks this is not the case.
Conclusion
The Islamic and conventional banks both aim at providing the much needed financial services to their customers through extending loans to support investments, and assisting the clients in keeping custody of their money. However, the difference in the regulation and the expectations from the concerned groups prompts the difference in operations and disclosure in the income statement and the balance sheet.
It should be noted that, the Islamic banking does not completely defy the international accounts reporting standards, but has to include some items which are not present in the case of conventional banks. On the same note, due to difference in the operating systems of Islamic banking, the Islamic banks are faced with a completely different set of risks both financial and operational as compared to conventional banks.
Therefore, as far as risk management is concerned, a risk manager will need to understand the Islamic banking before coming up with models that will be used to manage the risks, since the conventional models might not be applicable.
Furthermore, though in the past years the Islamic banks were not very pronounced, they have been increasing at a very high rate in the recent years and must therefore be studied properly for proper actions to be taken.
References
Greuning, H. V. & Iqbal, Z. (2008). Risk Analysis for Islamic Banks. Washington: World Bank Publications
Kettell, B. (2011). Case Studies in Islamic Banking and Finance. Hoboken: John Wiley & Sons.