Islamic Banking

The term Islamic financial system or Islamic banking was relatively a new idea for the Muslim world before 1970s. All previous commercial activities and transaction were based on requirements of Islamic principles. According to Islamic Sharia principles, fixed return on capital or the fixed return on transaction made against the capital is prohibited. Only such transactions or investments can be made or allowed which is in contract of profit and loss sharing. Principles laid down in Islamic financial system are not only capable to provide a workable Islamic banking system, but also covers principles for all types of financial markets, instruments and other financial intermediaries. Islamic banks have showed rapid growth of 15%-20% per annum since 1970s to date and development of a complete Islamic banking system in comparison to their counterparts is a major success. Islamic banks are operating in approximately 75 countries of the world, serious efforts are under way to progress and implement the Islamic banking in every country at a comprehensive level. Islamic banking and financial institutions are working with the analogous position with the conventional banking system in the countries of Gulf, Bahrain and Malaysia. Islamic banking system depends upon profit and loss sharing, owning and transaction of physical goods, participation in trading process, and also Islamic modes of finance are used for leasing and construction contracts. As for purpose of income generation, Islamic banks deal with assets management. Gain on the capital is appreciated by the Islamic Shariah but the interest based transactions are prohibited. The interest is fixed amount that is charged over principal amount of loan or debt which is prohibited in Islamic Shariah. Islamic Shariah considers performance of capital when actual capital is rewarded. Islamic Shariah prohibit risk free return and trading, as in the Verse II: 275, of Holy Quran that financial activities and transactions in the Islamic Shariah principle are real asset-backed, with an ability of value addition. International Association of Islamic Banks (IAIB) defined the Islamic banking as the Islamic Bank basically implements a new banking concept in that it adheres strictly to the rules of Islamic Shariah inthe fields of finance and other dealings. Moreover bank functioning in this way must reflect Islamic principles in real life. Therefore, point is obviously clear that Islamic banking differentiate from conventional banking in terms and conditions of its mission and objectives along with social responsibility. Islamic bank take all these duties and responsibilities greater than conventional banks, (Hassan & Adnan, 1998, 1999). The doctrine of Islamic banking system is much more than the combination of production factors and economic activity (Nienhaus, 1994). While, conventional system primarily focuses on monitory aspects of transactions and economic activities. The Islamic systems equally emphasize on religious, moral, ethical and social aspects in order to increase equality and fairness for betterment of whole society (Akkas, 1996). The Islamic banking system, although dependant and regulated by rules of Islamic Shariah perform same functions as those of a conventional banking system; that is, they play role of financial intermediary and also economys payment system administrator (Ebrahim & Joo, 2001).

According to the work of (Haron, 2004) the Islamic and conventional banks differentiate with each other with some points but both have something in common. Islamic banks are totally against the investment of fixed return in other words money based transaction is not accepted (rent on money) and therefore do not charge interest, the banks innovate or developed some investment techniques such as Bai Murabahah, Musharakah, and Mudarabah for the purpose of investment to generate profit. Islamic banks use two monitory policy instruments that based on Islamic Shariah principles; Exchange of monitory value with monitory value is prohibited in the Islamic Shariah, a real based transaction process must be involved with the capital link. Second, Supplier of capital must be involved in risk sharing with user of capital and transactions must be based on the profit and loss sharing (Cornelisse, P. A. and Steffelaar, W. 1995).

The above two principles develop the Islamic framework of financial intermediation. As a result, in nature financial associations in Islamic point of view have been participatory and the interest based institutions converted according to the principle of profit and loss sharing, Chapra, (1985). The result is that the predetermined fixed rate of return is replaced by the rate that can vary on the return of real based economic activities, Mangla & Uppal, (1990). Conventional banking is fundamentally based on the debtor-creditor relationship between the depositors and the bank on the one hand and between the borrowers and the bank on the other, with interest as the price of credit, that reflect the opportunity cost of money. The creditor should not take advantage of the borrower (Al-Omar & Abdel-Haq, 1996). When money is lent on the base of Riba (interest), it often leads to the unfairness. The Islamic principle primarily does not allow such kind of transactions: Deal not unjustly, and you shall not be dealt with unjustly [2:279 Holy Quran]. The distinctive features that give clear picture of Islamic banking transformation from the traditional interest-based commercial banking system, these are: The profit and loss share base transaction is the principle of Islamic banking, which is not in conventional banking system. The investment in Islamic banking system must provide the benefit to the investor and economy as well.

In Egypt and Malaysia, in 1950 to 1960 a study was conducted regarding interest free banking system and the study could not add any value for Islamic banking system. In 1976, international Islamic bank was established and in Dubai the first Islamic bank started its operations in 1994. In present scenario Islamic banking is in practice and acceptable almost in all countries around the globe. Some institutions are working under Islamic financing in America even on smaller scale (Kahf, M. 2002). Comparison of Islamic and Conventional Banking Framework There are several points that explain the scenario of Islamic banking.

(1) Islamic banks focus on profit and loss sharing investment, so the banks neither provide the guarantee of capital value nor the return on investment deposits, and basically these banks are poor depositors funds to provide depositors with the supervision of professional investment management. This scenario of investment emphasizes on some interesting points between these activities of Islamic banking and the investment companies in the west. There is, however, a primary difference between the Islamic banks and investment companies that need to recognize. Fact is that the investment companies create a link with public and sell out their capital to them, but the Islamic banks find out the depositors from public to accept deposits. This criteria entails that the investment company shareholders own a part of the company equity capital in proportion and have the number of rights, which include Right to information on companys business development and at important matters they have right to exercise their voting rights. So they have the authority to check the companys performance, take part in investment decisions and also they have the power to affect the companys strategic decisions. (2) Islamic banking structure of balance sheet, procedure of profit and loss sharing, Islamic Banking operating system is much better than the conventional banks to absorb economic shocks. Conceptual difference between Islamic and conventional banks

Conventional Banks 1. Conventional banks functions and operating modes are based on self-developed principles. 2. Conventional banks provide fixed return. 3. Conventional banks focus only to generate profit without any restriction. 4. Conventional banks only deal with tax but do not deal for the collection and distribution of Zakat. 5. Conventional banks focus only on lending to get interest in shape of profit. 6. The defaulter of the bank pays extra charges as a penalty. 7. The bank has no concern with clients equity growth. 8. Conventional banks can easily borrow money from money market. 9. Conventional banks did not provide attention to develop expertise in project appraisal and evaluations. 10. Bank build relation with clients of creditor and debtors.

Islamic Banks 1. Islamic banks functions and operating modes are based on the Islamic Shariah principles. 2. The Islamic banking based on profit and loss sharing. 3. It also focuses to generate profit according to the Islamic Shariah principles. 4. Islamic banks are used to provide services of collection and distribution of Zakat. 5. Islamic banking promotes partnership business. 6. Islamic banks are multipurpose institution because of this their scope is wider. 7. Islamic banks highly appreciate equity growth for public interest. 8. Islamic Shariah principle of profit and loss sharing provides equal opportunity to the both. 9. Attention to developing projects appraisal and evaluation process is better due to profit and loss sharing principle. 10. Islamic bank create a relation with client as a partner, investor and trader.