Literature Review

Islamic Banking
Islamic banking describes the management of banking transactions in accordance with
the ethical ideas of Islam (Halal Banking). As such, it is a part of Islamic finance. Financial
instruments of Islamic banking include equity financing, Islamic bonds (Sukuk) or "Shari'a"
compliant investment funds, excluding investments in spaces that are rejected on religious
grounds by Muslims. The Islamic economic system is strongly linked to the principles and values
enshrined by religion. Sharia is Islamic law that forms the basis of Islamic legal system. The
legal sources of Sharia are the Quran, the Sunna, the Idjma and qiyas. With the first two, those
that come directly from the Prophet, and the last two, those that are created after solving the
loopholes of primary sources (Uppal, & Mangla, 2014). According Uppal, & Mangla,
(2014) the Koran is the sacred text of Islam and therefore representative of the most important
legal source. Moreover, the Sunna, is the collection of such facts or transmitted by the Prophet to
his disciples throughout his life as a "hadith".
In the 1970s, the first Islamic financial institutions emerged in its modern form. Adopted
in 1975, Islamic states to establish the Islamic Development Bank (IDB). They should promote
economic development and social progress of member states in accordance with the principles of
Islamic law. That same year, the Dubai Islamic Bank took on their business operations. There are
now around 270 Islamic banks in over 75 countries. Overall, they have a market capitalization of
around 13 billion US dollars, assets of 265 billion US dollars and make financial investments
totaling 400 billion US dollars. Some observers predict that in eight to ten years 40 to 50 percent
of the total savings of the Muslim population worldwide will be on account of Islamic
banking. The most important banking center for Islamic banking is still Kuala Lumpur, only then

followed by Bahrain, Dubai and Kuwait in tough competition (Dali et.al, 2013). The Singapore
government has meddled in 2006 by appropriate statutory funding in this competition.
Even Western banks have now discovered for themselves the Islamic regulated market;
the American Citibank has played a pioneering role. American Citibank straightened in 1996 an
Islamic line of business, and opened a branch in Bahrain. A global player is in second place, the
British "HSBC Amanah", which cooperates closely with the Abu Dhabi Islamic Bank's since of
2006. For several years, German banks offer Islamic financing instruments, especially from
2006, DWS Investments, the investment company of the German banking group. Credit Suisse
offers numerous funds and "sukuk" (Islamic-compliant equivalent to Bond) that are sponsored
either bank owned or managed together with partners such as the Ithmaar group in Bahrain.
Islamic Banks are universal banks, which usually, world, both private customers and
business customers offer their products. This occurrence is the most common among Islamic
financial institutions. Islamic Banks can be assigned in the central banking system of the country
concerned into four categories in terms of their business environment and their integrity:

Banks whose entire central banking system operates in countries on interest-free basis,

such as in Pakistan and Iran.

Banks that are active in Islamic countries are integrated into a conventional central bank

and compete with conventional banks, such as in Egypt and Turkey.

Banks operating in non-Islamic countries and their Islamic character is not recognized by
the central banks of these countries. Such as the Islamic Bank in South Africa.
Operating banks in non-Islamic countries, whose Islamic character is recognized and they

are registered as a licensed bank in the state banking supervision, such as the - Islamic Bank of
Britain in the UK.
Principles of Islamic Banking
Islam has its own paradigm of economic relations based on rules derived from the sharia.
The sharia specifies, among other things, the rules for the allocation of resources, property rights,

production and consumption, the functioning of markets and the distribution of wealth. Similarly,
it also specifies the requirements that define the framework in which the monetary and banking
system can operate. The core of this framework is that, as a mechanism for the allocation of
financial resources, the interest rate is replaced by a rate of return on the actual activities.
Although the absence of interest is a central feature in the Islamic financial system it is
by no means the only one with. Indeed, Islamic banking does not reject the profit, however, like
any other financial activity seeks to maximize as much as possible their capital. However, the
sharia specifies lawful ways to get it. Although some nuances according to the different
interpretations of the different legal schools, the fundamental principles on which Islamic finance
is based are as follows:
Content Halal: The term halal designates everything that is allowed by sharia. It is also
one of the distinctive features of Islamic banking which, unlike traditional finance in the Western
sense, factors of ethical and moral nature are involved. An activity can be economically viable,
but may not be permitted as it requires financial operations are consistent with the sharia. As a
consequence, it is prohibited to finance all those activities considered immoral and incompatible
with Islamic law and tradition. More broadly, the Sharia prohibits the financing of any activity
deemed harmful to society as a whole and those related to alcohol or drugs, gambling and betting
of any kind, the pork industry, pornography or manufacture and sale of weapons of mass
destruction.
Prohibition of Riba: The ban on receiving and payment of the interest is strictly based
on the principle of Islam that money is only a medium of exchange. It is the manner in which the
value of thing is defined; money itself does not have any value. In Islamic banking human effort,
initiative and risk invested in a productive enterprise are more important than the money used to
finance it. However, this prohibition should not be confused with the rates of return or capital
gains as income and the distribution of the benefits generated by real economic activity are

encouraged by Islam. But while profit symbolizes the creation of additional wealth through
successful entrepreneurship, interest, determined a priori, it is a cost that accrues irrespective of
the outcome of business operations and can create wealth even leaks in the business.
Ban Gharar: This fundamental principle in Islamic finance prohibits the presence of any
element of uncertainty or ambiguity in the chords commercial contracts to the sharia. An
example of gharar is gambling because in gambling the player does not know the final outcome
of the bet.
Ban Maysir: The term maysir literally means gambling or luck, totally prohibited by the
activity sharia as it is considered that this is achieved only effortless money and wealth is
transferred but not created new. As an extension is understood that also prohibited any form of
speculation to play with the concept of time to get benefits, including contracts conventional
finance market.
In addition, all financial activities must have a physical purpose and be related, directly or
indirectly, with real economic activity. Transactions must be backed by real assets such as real
estate, vehicles, or gold mines and other natural resources. Similarly, investments can be done
only through real and durable assets. With all this speculation and activities such as short selling
are totally prohibited is avoided.
Conventional Banking and Islamic Banking: Comparison and Contrast
Ever since its establishment in the 1970s, the Islamic finance has developed and offered
various financial products to the customers strictly based on the four basic principles that have
been discussed above. Therefore, the Islamic transaction are considered to be profit-loss sharing
(PLS) transactions, in which profits are shared among various parties, and the loss on the other
hand is shared by the parties depending on the proportion of their original contribution. These
limitations present in the Islamic banking systems are aimed towards maintaining equality
among Muslims and dispel exploitation and greed.

Yuksel, & Erturk, (2013) stated that in contrast to the conventional banking system,
Islamic banking is not dependent on the notion of a predetermined fixed return on capital. In
Islamic banking system the prohibition against risk does not imply that capital under any
circumstances is free of charge, or that its availability must be guaranteed no return on capital.
The Islamic banking systems allows a return on capital, provide that the capital play a major role
in improving the productive process, and is clearly visible towards the business risks associated
with it.
According to Wilson, (2015), the base of Islamic banking is associated with the principle
of mudarabah claims to be superior to interest-based commercial banking in terms of efficiency,
equity, growth, and stability. As compared to other financial systems, the Islamic banking system
is more Just, specifically because of the contract of mudarabah is based on the principles of
justice and equity. Along, with that the Islamic banking system also provide safeguards against
fluctuations in the business as it possess the potential of being strongly associated with the
productive capacity of the economy. Thus, in Islamic banking the cost of capital and amount
advanced for further investments are adjusted as per the changes in the business environment.
Furthermore, the Islamic banking system also promotes growth as it increases the supply of risk
capital for investment.
According to the study conducted by Beck et.al, (2013) the difference between the
conventional and the Islamic banking systems is far more nuanced then the definition, which is
often presented in the terse media accounts claiming that Islamic banking system forbids interest.
Another major difference lies in the business models of conventional and Islamic banking
system, the business models of Islamic banking are in the limitations imposed by the sharia ban
on interest and in the fact that a mere granting of money loans will not occur. The business
models of conventional credit institutions on the other hand connect the transfer of funds with

interest. In addition, Islamic banks do not engage in business or not invest in them, provided that
the "haram" (forbidden) fall. This includes all products, services and business transactions that
are declared as unlawful, unclean, immoral or illegal.
Contract models under Islamic law are largely designed so that they are targeted at profit
and loss participation. The customer is so far directly involved in the business risk, in that the
bank assesses the customer deposit as share capital. In contrast, conventional banks, customer
deposits are recorded as deposit-taking business. For example, a customer of a Islam compliant
product receives a previously agreed profit sharing for its deposits in the savings account instead
of interest rates, whereas the Bank is investing in the meantime, investment in halal projects or
bonds. From a qualitative point of view, the Islamic Bank is different from traditional bank
because it is the different its mission and its objectives. In fact, it should ensure economic
stability, financial and political community, referring to the dictates of Allah, while the
conventional bank is based on principles developed by man. Therefore, conventional bank is
more focused on the economic and financial transitions, with the sole end of the maximum
profit, while the Islamic bank, although aimed at a gain, gives, at the same time, the same
importance to the ethical, moral, social and religious. Not surprisingly, among the operations of
the Islamic bank, there is also to take care of zakat, while the other kind of organization does not
deal with taxes in solidarity.
Another important point highlighted by Islam, Alam, & Hossain, (2014) in the
comparison between Islamic Bank and conventional bank is the different way of seeing the
relationship between the customer and the lender, or between 'entrepreneur and the capital.
According to the capitalist economic system the capital and the entrepreneur are two different
and separate factors of production. Who provides the capital, taking fixed interest regardless of
how things will go, while the entrepreneur has the right to have the profit or loss based on the

outcome of her project. The Islam, however, considers any person who provides capital as a
factor of production, which has the right to share the profit based on the results of operations, but
at the same time bears the risk of loss. So the customer and the bank do not have the role of
creditor and debtor, as with traditional banks, but to employees.
Alone in the base of the two concepts is a big difference: the functioning of the Islamic
banking is based on the principles of Sharia, whereas the conventional banking system is
dominated by locally procured principles that can be further developed through the economy.
Investors are generally hedged over a set interest rate. In Islamic banking investor and investors
share the risk. Exist in the conventional banking no restrictions in terms of profit maximization,
so the Sharia of profit maximization sets on rules. Furthermore, in the conventional system no
alms tax ("zakat") available. The overriding function of conventional banks is in the borrowing
and lending of money amounts. In contrast, the Islamic banking emphasizes the partnership
relationship of those involved in transactions.
Venardos, (2012) defined Islamic Banks as a multipurpose institution. This compares to a
reduced time horizon of conventional banks. It may be subject to additional contributions in the
form of increased interest rates in case of default of a creditor. However, Islamic banking does
not hand opportunity to raise interest rates at elevated failure rates. Furthermore, Islamic banking
states, in contrast to conventional banking, that growth should be generated by equity. Islamic
Banks lend themselves money in the money market; they are confronted with difficulties in that
conventional systems based on different conditions. Conventional banks look at the
creditworthiness of their customers while Islamic Banks want to ensure the viability of the
projects.
One of the key principles of Islamic banking is that they operate their businesses using
PLS modes of financing like Murabaha and Muysharakah. Using these modes, banks rely
relatively more on their partners (borrowers) and there is a much greater chance of problems

with severe asymmetric information in that banks have little influence on the decision-making of
the funded business, and only limited access to its accounting information. In addition, as the
banks are obliged to absorb any loss in full (Mudarabaha) or part (Musharakah), a risky borrower
may tend to default. This increases the credit risk for Islamic banks, in sharp contrast to
conventional banking systems, where banks typically do not share in the operating losses of the
borrower. A few theoretical studies (Ryu et.al, 2012) have suggested that Islamic banks could in
fact have less credit risk than conventional banks. To start with, Islamic banks can share their
losses with the depositors through the PLS mode of finance on the liabilities side, an option not
available to conventional banks with their depositors. In addition, religiosity is one factor that
potentially lowers the credit risk of Islamic banks, in that because Islamic banks operate their
business according to Shariah, only the highly religiously motivated may be involved in Islamic
banking, and these may tend to default less. Moreover, Islamic banking is a relationship-type
banking system, which helps the banks to understand better the individual borrower and the level
of creditworthiness. Based on these theoretical arguments, it is clear that there is no simple
answer to the question of whether Islamic banks in principle have greater credit risk than their
conventional counterparts.
The literature on Islamic banking reveals that as compared to conventional banking
Islamic banking system tends to be more stables. Johnes et.al, (2014) conducted a study in which
they linked bank returns on deposits with bank returns on assets; they concluded that these two
serves in the form of a disciplinary device, as they increase the overall efficiency of the bank and
the financial system. Along, with that it also serves as the stabilization device which saves the
bank from the deposit runs under crisis. This stabilization takes place when the there is a decline
in the value of the bank assets, due to some sort of shock, resulting in decreasing banks liability
along with the profit-sharing nature of the deposit contracts. Thus, this results in the

perseverance of the net worth of the bank. This feature plays an essential role in adding to the
overall stability of the bank, and providing the bank the ability of avoiding the domino effect,
which in turn increases the stability of the bank as a whole.

Preferences of Customers toward Adoption of Islamic Banking

Numerous Islamic banking researchers have raised some serious concerns regarding the
awareness of the customers on Islamic banking, its products, customer patronage factors, and
customer banking behaviors, with a specific focus on the perception of customers towards
Islamic banking its products and services, as the essential factor towards the determination of the
adoption of the Islamic banking system. Thus, literature on the selection and adoption of Islamic
banking consists of various features as per different researches. In a study conducted by
Jamshidi, & Hussin, (2012), they used both conventional bank and the Islamic bank customer to
determine the factors associated with the customers preferences towards the selected banking
system. The results of the study revealed that the customer who patronized Islamic banks
perceived three factors as the essential factors that determines there adoption of the Islamic bank.
The factors were reputation and image of the bank, the efficiency and fast service provided by
the bank, and the high level of confidentiality. In another study conducted by Khan, & Asghar,
(2012), it was found that customer perceive Islamic principles as the crucial factor while the
selection of the bank, along with that they also considered rewards offered by the banks as an
essential factor for selecting the bank.

References
Beck, T., Demirg-Kunt, A., & Merrouche, O. (2013). Islamic vs. conventional banking:
Business model, efficiency and stability. Journal of Banking & Finance, 37(2), 433-447.
Dali, N. R. S. M., Yousafzai, S., & Hamid, H. (2013). The Development Of Islamic Banking &
Finance. Underpinning Theory Affecting Islamic Banking Consumers Post Purchase
Behavior. 2nd International On ASEAN Economics Development, Thailand, 1-15.
Islam, K. A., Alam, I., & Hossain, S. A. (2014). Examination of Profitability between Islamic
Banks and Conventional Banks in Bangladesh: A Comparative Study. Research in
Business and Management, 1(1), pp-78.
Jamshidi, D., & Hussin, N. (2012). A conceptual framework for adoption of Islamic Credit Card
in Malaysia. Kuwait Chapter of Arabian Journal of Business and Management
Review, 2(3), 102-110.
Johnes, J., Izzeldin, M., & Pappas, V. (2014). A comparison of performance of Islamic and
conventional banks 20042009. Journal of Economic Behavior & Organization, 103,
S93-S107.
Khan, H. N., & Asghar, N. (2012). Customer awareness and adoption of Islamic Banking in
Pakistan. Interdisciplinary Journal of Contemporary Research in Business, 3(9), 359-366.
Ryu, K. P., Piao, S. Z., & Nami, D. (2012). A Comparative study between the Islamic and
conventional banking systems and its implications. Scholarly Journal of Business
Administration, 2(5), 48-54.
Uppal, J. Y., & Mangla, I. U. (2014). Islamic Banking and Finance Revisited after Forty Years:
Some Global Challenges. Journal of Finance.
Venardos, A. M. (2012). Islamic Banking and Finance in South-East Asia: Its Development &
Future (Vol. 6). World Scientific.
Wilson, R. (2015). 10. The interface between Islamic and conventional banking.Islamic Banking
and Finance, 196.
Yuksel, S., & Erturk, M. (2013). Casual Link Between Islamic and Conventional Banking:
Evidence From Turkish Banking Sector (No. 06).