Conventional financial organizations such as banks focus on creating a profit by diverting surplus funds from savings accounts and offering them to borrowers as a loan. Income is earned by offering higher interest rates to borrowers than dividends paid to depositors. Additional income is brought in through fees (Abdullah, 2018). Meanwhile, Islamic finance institutions are guided by a set of religious guidelines and ethical principles. Zakat is an obligatory donation to a charity that is paid annually, usually consisting of 2.5% from the available balance. The money goes towards the philanthropic activity. Furthermore, Islamic finance adheres to specific regulations on loans. It is prohibited to collect interest on any loans. In the Islamic economy, a loan is considered a non-profit activity that can only benefit the borrower (Al-Suwailem, n.d.).
The primary difference between Islamic and conventional institutions can be characterized by the approach to risk-sharing and the collection of interest. In conventional banking, interest serves as insurance for loan repayments and protects the financial institution. All risk is transferred to the debtor. In Islamic banking, deposits are safer because profit is created through successful investment. There are no investments in projects where the return is not guaranteed, and banks have a significant concern for their clients’ success (Cerović, Nikolaj, & Maradin, 2017). Islamic banks are not as cost-effective but have better capitalization and stability during crises due to better asset quality and intermediation ratio (Beck, Demirgüç-Kunt, Merrouche, 2013).
Overall, Islamic finance is guided by a moral code with social considerations. Financial and investment decisions must always create social value and follow ethical considerations. This includes ensuring social responsibility and environmental protection (Ayaydin, Bejaoui, Dorsman, & Shahzad, 2016). Islamic and conventional finance can co-exist with a certain flexibility, thus allowing to serve a wider variety of populations and financial needs. It would require overcoming challenges in legal frameworks and market practices. However, it shows promise since Islamic and conventional finance do offer comparable products regarding suitability and pricing (Ahmad, 2015).
References
Abdullah, A. K. (2018). Finance: Islamic and conventional. Web.
Ahmad, A. (2015). Can Islamic and conventional financing co-exist? Web.
Al-Suwailem, S. (n.d.). Essence of Islamic finance. Web.
Arslan-Ayaydin, Ă–., Bejaoui, M., Dorsman, A.B., Shahzad, K. (2016). Islamic finance versus conventional finance. In: A. Dorsman, Ă–. Arslan-Ayaydin, & M. Karan (Eds.), Energy and finance. Cham, Switzerland: Springer
Beck, T., Demirgüç-Kunt, A., Merrouche, O. (2013). Islamic vs. conventional banking: Business model, efficiency and stability. Journal of Banking and Finance, 37(2), 433-447. Web.
Cerović, L., Nikolaj, S. S., & Maradin, D. (2017). Comparative analysis of conventional and Islamic banking: Importance of market regulation. Web.