Difference Between Commercial Banking and Islamic Banking
WHAT IS BANKING?
When we talk about banking, we are discussing the products and services offered by the financial industry including lending money, facilitating payments, and managing accounts. Banking services are available to individuals, companies, and governments. There are some key differences between commercial banking and Islamic banking.
Banks and financial institutions play an important role in the economy. Not only do they facilitate financial transactions, but they also act as intermediaries between businesses, between borrowers and savers, and between lenders and businesses.
Banks facilitate transactions and manage credit and debit accounts. The role in the economy goes beyond managing money. They are also responsible for ensuring the financial systems remain stable, and they are therefore subject to regulation and oversight by central banks.
The regulation of banks ensures that there is ongoing prudent financial management, and risk mitigation in addition to compliance with legal standards.
COMMERCIAL BANKING - HOW DOES IT WORK?
Commercial banking is a traditional form of banking used across the globe, especially in Western economies. In its very basic form, commercial banking relates to the services and activities that banks can provide to individuals, entrepreneurs, businesses and governmental organisations.
Commercial banks undertake various activities, including:
- Payments: commercial banks facilitate incoming and outgoing payments, transfers, cheques.
- Debit and credit cards: commercial banks provide customers with debit and credit cards
- Trading: banks also facilitate national and international trade by enabling international payments and foreign exchange transactions.
- Investment services: commercial banks offer brokerage services and accounts, advisory services, and information about investment options.
- Corporate banking: commercial banks offer the corporate world specialised corporate services to encourage and facilitate corporate trade and transactions.
Main Principles Of Commercial Banking
One of the main underlying principles of commercial banking is the payment and receipt of interest. A commercial bank makes money by earning interest on loans and financial instruments that it provides to businesses, individuals, and large corporations.
Commercial banks also make money from the fees they charge for their products. For example, when offering loans and mortgages, the bank will usually charge a fee for this service.
Commercial banking rests on the following main principles:
- Profitability - as with any commercial business, the banks main focus is on profitability.
- Liquidity - liquidity refers to the ability of assets to be quickly converted into cash/ money.
- Solvency - commercial banks need to be solvent at all times. What this means is that they have financial sufficiency and capability. This level of solvency enables banks to remain in competitive markets with enough capital.
ISLAMIC BANKING - HOW DOES IT WORK?
Islamic banking is very different to traditional commercial banking. Islamic banking is based on Islamic finance principles and guidelines. These guidelines follow Islamic Sharia law. Sharia law prohibits the receipt or payment of interest, as this is considered to be deeply unethical and exploitative.
Sharia compliant banking, underpinned by Islamic finance principles, does not charge or pay any form of interest. This does raise the question of how do Islamic banks make a profit if they do not charge interest to the customer.
The answer to this lies in the structure and the practices within Islamic finance institutions. Instead of making profit through interest, Islamic banks profit through equity sharing and partnership arrangements. These arrangements ensure that the profits and losses are shared between the parties.
Let's have a look at the way Islamic banks operate and how they make a profit:
- Profit and loss sharing - Islamic banks rely on Sharia concepts such as musharaka (cost-plus financing) and mudaraba (partnership based financing). The former requires both the customer and the bank to contribute capital and share in any profits arising from the investment. Mudaraba is a slightly different arrangement where the bank provides the capital and the individual manages the running of the business. Both these arrangements facilitate profit sharing in an equitable way.
- Asset-backed finance - Islamic banks rely on asset-based finance arrangements. Often, this means that the bank or financial institution will purchase an asset at the request of the customer and then sell it back to them. The sale back is at a higher price which is usually paid back in instalments.
- Investments - Islamic banks are permitted to engage in investment activities. However, the difference between Islamic banks and conventional banks is that Islamic banks retain control over the industries they invest in. They do not invest in industries that are deemed to be impermissible in Islam (ie, gambling, porn, alcohol). Additionally, any investment activity is not interest based and is not speculative or uncertain. This means the level of risk is often lower than the investment activities of commercial banks.
Key Principles Of Islamic Banking
As already mentioned above, the main principles relating to Islamic banking are derived from Sharia law. Sharia law guides Islamic finance and differentiates it from conventional commercial banking.
The key principles of Islamic banking are:
- No interest - there is a strict prohibition on interest (riba). This means that any deposit or payment does not accrue or attract interest in any form.
- Profits and losses - Islamic finance centres on the notion of equitable relationships and non-exploitative relationships. This means that there has to be equitable sharing of profits and losses between the parties.
- No uncertainty - excessive uncertainty is not permissible in Islamic banking. This means that any investor, entrepreneur, business, or leader looking to engage in activities needs to ensure that the trade or investment is not uncertain or ambiguous. Financial transactions should be transparent and solution based.
- Ethical and social responsibility - Islamic finance is underpinned by the key concepts of ethical behaviour and social responsibility. There is an onus on those with control to ensure that the parties engage in activity that does not adversely affect others and that benefits society as a whole.
- No speculation - it is important for Islamic banking to ensure that financial activities are based on real economic transactions, not hypothetical or speculative activities.
- No excessive debt - again, to ensure there is equity and transparency, Islamic finance requires that excessive debt is avoided. Islam promotes responsible borrowing and lending practices.
Commercial Banking Services Vs Islamic Banking Services
The main difference between commercial banking and Islamic banking are the main principles which guide the banking activities. As already discussed, Islamic banking does not rely on interest payments or interest based activities.
Whilst commercial banks rely on interest as a fundamental component when it comes to lending and borrowing, Islamic banks are more focused on a profit-loss sharing arrangement.
Whilst both commercial and Islamic banks offer a variety of financial products and services, Islamic banks have to ensure they are compliant with Sharia rules about financial activities. Islamic banks provide similar services to commercial banks (loans, mortgages, savings accounts etc) but the key difference is that they offer Sharia compliant alternatives to their clients.
Islamic banks actively avoid financial deals and transactions that are deemed to be risky and speculative such as derivatives and trading securities. The ethical and social responsibility element of finance is not something that features as heavily in commercial banking as it does in Islamic banking.
Commercial banks aim to generate and maximise profits through interest that is earned on lending and other banking services. For Islamic banks, interest is prohibited, so they look to Sharia compliant ways of generating profits.
It is important to remember that both Islamic and commercial banking aim to offer financial services to meet their clients needs. Islamic banking is favoured by Muslims because the principles of Islamic finance mean they remain compliant with their religious obligations. However, Islamic finance has a much wider appeal to customers across the Muslim and non-Muslim world.
The Regulatory Framework For Banking In The Uk
In the United Kingdom, the regulatory framework is managed by the Financial Conduct Authority.
As part of its supervisory and regulatory role, the Financial Conduct Authority aims to protect the customers of financial institutions that offer any form of financial product or service. The Financial Conduct Authority also ensures that it promotes healthy competition between financial service providers.
Risk Management In Commercial Banking
Risk management and mitigation are essential tasks for banks. Not only does risk management ensure that banks have a risk management strategy in place, but it also ensures banks remain compliant with the relevant regulatory regime in place.
Commercial banks assess risks on an ongoing basis to ensure that they can maintain their financial stability. Risk management also prevents unexpected losses that could occur and help the bank prepare for long-term viability and market fluctuations. Ultimately, commercial banking is arguably more volatile that Islamic banking as it places itself in a more fluctuating, interest and economy based market.
Islamic banking mitigates risk by avoiding interest based transactions, and discouraging speculative behaviour. The risk and reward is shared between the parties, this leads to shared responsibilities when it comes to risk.
Risk Management Is Islamic Banking
Risk management in Islamic banking is different from the risk management in conventional commercial banks.
Islamic finance promotes the forecasting of financial risks and ensures the necessary risk mitigation strategies are in place from the outset. Under Sharia rules and guidelines, Islamic banks manage risk via practices which actively mitigate risk. These practices include ensuring that is an equitable profit and loss sharing arrangements. Islamic finance also requires that parties to a transaction share the risk, so one party is not left dealing with huge losses.
Through intense screening and due diligence, Islamic banks assess feasibility in a more rigorous way than commercial banks. This helps them identify potential issues before they arise and mitigate risks early on.
Islamic banks will usually have Sharia compliant scholars and boards working with the bank and ensuring it is compliant and regulated. These boards provide Islamic guidance on complex transactions and reduce the risk exposure. Many Islamic banks will also ensure they have contingency funds and reserves to deal with unexpected events and losses.
Explore more news
WHAT IS ZAKAT?
Zakat is one of the five pillars of Islam. It is an obligatory act of worship and is also a mandatory form of charity for Muslims. It has always been seen as a means by which people can achieve social impact through the redistribution of their wealth. The five pillars of Islam are the absolute fundamentals of Islam and include the following:
- Faith (shahada)
- Prayer
- Zakat
- Fasting
- Hajj
Every Muslim is expected to fulfil these five pillars of Islam which serve as the very fundamental acts of worship prescribed by the Islamic faith.
Paying zakat, sometimes referred to as almsgiving, is an obligation for every Muslim who is able to and serves to bring economic equality, fairness, and to rebalance societal injustice.
The Obligations Of Zakat
Muslims who have the financial means and capability are required to pay zakat. They must donate 2.5% of their wealth (see our zakat calculator to work out how much you need to pay). The 2.5% is calculated on money and assets.
The aim of zakat funds is to ensure that they are used to provide the basic necessities for families and communities in need. These needs can include the provision of food, shelter, clothing, education and healthcare.
One of the most important elements of zakat is that payment of it is seen as a means of purifying your wealth whilst demonstrating empathy and compassion for others. In fact, the word zakat actually means 'cleansing' or 'purifying'.
The whole concept is based on the idea that once an individual donates a percentage of their wealth to charitable causes, they fulfil their moral obligation to serve others and build stronger communities and economies. Zakat is particularly important in times of crisis, as it can be used to alleviate hardship via the distribution of wealth.
Zakat is not the same as sadaqa which is encouraged but not obligatory. Zakat is an annual payment that is worked out in a specific way and spent in a specific way.
The Exemptions From Zakat
There are some important exemptions to be aware of when it comes to zakat.
Firstly, there are exemptions for those people who do not have to pay zakat and these include:
- children
- the mentally ill
- the infirm and elderly
- slaves
- Non-Muslims
- the very poor
WHO CAN RECEIVE ZAKAT?
Islamic finance principles set out clearly who can receive zakat. Those eligible to receive zakat include the following:
- Poor people
- The needy
- Debtors who cannot repay their debts
- Orphans
- Widows
- The stranded and destitute
- Travellers
- Slaves or captives
- New Muslims
- Those fighting a just cause
It is very important that when you pay zakat the recipients meet the eligibility criteria set out in Sharia law. Always make the intention of helping those who are in need and adhering to the principles of Islamic finance.
WHAT ROLE DOES SOCIAL JUSTICE PLAY IN ISLAM?
Social justice is one of the fundamental principles of Islam and Islamic finance. The Islamic framework is centred on social justice in all aspects from individual behaviour, to financial transactions, to how we behave in relationships with others.The teachings of Islam place great significance on ethical and moral behaviour. Islam promotes social justice by emphasizing the importance of the following concepts:
- Anti-discrimination: all humans are seen as equal in Islam and discrimination in any form is prohibited. In fact, the Prophet Mohammad's final sermon reiterated how important it was to treat everyone equally and fairly.
- Economic equity: Islam promotes economic justice by ensuring there are frameworks in place for wealth distribution. Zakat plays a key role in the distribution of wealth. Furthermore, the prohibition on interest further prevents exploitation and inequality.
- Charity: as already mentioned the concept of charitable giving is an essential element of Islam. Charitable giving takes place via zakat and sadaqa (amongst other forms of donation). Muslims are encouraged to consistently donate to the poor.
- Gender equality: as mentioned above, Islam believes that men and women are equal and it actively promotes gender rights (particularly those of women) and equality. The Quran consistently mentions treating people with respect and fairness.
- Legal justice: Sharia rules set out the legal framework within which Muslims operate and these rules focus on justice, fairness, and equity. The legal judicial system in Islam operates to ensure that justice and fairness are implemented.
- Ethical behaviour.
The Potential Of Zakat
The actual potential of zakat is large, and estimated to be valued in the region of $200 billion - $1 trillion (this is according to research from the Institute of Development Studies and the World Bank). It is difficult to estimate the exact amount paid each year, but it is clear that Muslims who pay zakat on an annual basis are some of the biggest and most consistent charity givers in countries across the world.
Whilst the Western world is still learning about the impact and potential of zakat, Muslim economies have harnessed the potential of zakat for many decades by establishing leadership institutions to manage and distribute zakat. In addition, Muslim countries have had discussion and debate with scholars relating to zakat and how best to use it, incorporating it into fiscal policy.
HOW DOES ZAKAT HAVE A SOCIAL IMPACT?
- Empowers individuals and communities
- Alleviates poverty
- Optimisation of social good
- Social cohesion building
- Wealth distribution
- Funding charitable projects (such as climate and environment change programmes, education, and healthcare initiatives and practices)
- Economic development
- Promote social justice
An underlying philosophy of Islamic finance and Zakat is the concept of mobilising finance for the greater good. Islamic finance embodies socially responsible actions whether from companies or individuals.
Zakat And Sustainable Development Goals
As zakat is applicable to all Muslims across the globe, it is one of the largest and most successful forms of philanthropy. It acts as one of the largest methods of wealth transfer from the rich to the poor that takes place consistently and with clear guidelines.
Inspired by the Islamic faith, zakat is taking on relevance in countries throughout the world including the UK, United States, Australia and beyond.
Alleviating poverty, inequality, and hunger are not only central tenets of Islam and Islamic finance, but they are also part of the UN's sustainable development goals. According to the Quran there are 8 categories eligible for zakat (see above) and these all align strongly with sustainable development goals.
Some countries such as Indonesia have started collaborating with zakat donors to achieve partnership working towards sustainable development goals. This is a win-win for Muslims as Islam and Sharia rules relating to financial transactions state that every person should seek to work collaboratively and fairly for the good of society.
Conclusion
The power of zakat to harness social impact through charity is undeniable. When you clearly understand what zakat is and its function in society it becomes clear that zakat has the power and potential to alter lives and bring equity.
As a business owner, you're always making plans for your future. You're planning ahead on a daily, weekly and monthly basis, looking ahead to anticipate challenges and opportunities. Whether your business is in its early days or it's become established in its market, you'll always be thinking about tomorrow and what comes after.
A vital part of that planning is around finance - how you're going to pay for the people, the stock and the infrastructure you need not just to keep going, but also to grow the business. You want to avoid running out of working capital - cash - because that's the lifeblood of commerce. It's cashflow that makes or breaks a business.
For many, finance planning isn't the most exciting part of running your own business. But it is perhaps the most important task, and certainly one of the most rewarding when you get it right. Investing time in finance planning can literally pay dividends in the form of better cashflow and improved profits.
If you're undertaking any major new project in your business, such as launching a new product range or expanding your geographical market, you expect to put together a business plan. This covers all aspects of the project, including the financial element - this is your finance plan.
Here are our suggested steps for putting together that business finance plan.
Step 1 Know what you need and why
Most planning starts with having the end in mind. You have a vision for where you are going - such as opening branches in new locations, increasing turnover by a specific amount or becoming a recognised brand in a new market.
In your business plan you'll set out the steps you need to reach that destination. You'll identify your current strengths and weaknesses, also the opportunities and the threats.
The business plan will detail the actions you need to take, along with their anticipated costs. These are likely to include:
- Purchase of stock or equipment
- Marketing costs
- Employment costs
Your planning will also factor in the impact of new revenue streams, when your investment in growth begins to generate new sales. This should lead into a cashflow plan, where you document projected income and costs over time. The cashflow plan will help you to see how much funding you need and over what period of time.
Step 2 Understand your current numbers
Having planned for the future, you also need to have a strong grasp of where your business is today. Without a realistic understanding of current income and costs and the cashflow associated with these, it's hard to plan for the future.
However, you also need to be aware of other numbers in your business, such as the value and type of assets that you have and the existing levels of debt and their associated repayments.
Most businesses carry some form of debt, such as an overdraft, a loan or credit cards. Alternatively, there could be an obligation to repay an external investor, such as a business angel. While the expectation of repayment may still be some way in the future, it should be factored into your numbers and planning.
If you're looking for funding for a major new initiative that will grow or transform your business significantly, this presents an opportunity to restructure your firm's finances. You could consolidate existing small debts, or even do away with them entirely by taking on funding in a different form.
Step 3 Research your options
When you're raising funds to grow your business there are a number of routes you can take. Your choice depends on factors that include:
- Your credit rating
- Your attitude to risk
- How much control you're willing to give away
You should consider taking professional advice about raising finance for business growth, drawing on the knowledge and experience of others. Be sure to take into account the impact of taxation on your decisions. Take a look at how similar businesses are financing their projects.
It's possible that some of the assets your business owns can be used as collateral for finance, or used in another arrangement to release capital, such as a sale and lease back.
Where appropriate, involve others with a role in the management of the business, such as directors and other senior staff.
One major decision will be whether you decide to raise debt finance or equity finance. You can read more about this in our article 'Choosing the right funding option for your business'.
The more information you can gather at this point, the better informed your decision will be.
Step 4 Create your finance plan
As you pull together all the information you can start to make a finance plan based on your preferred funding options.
At the heart of your plan will be a cashflow forecast, which sets out the incoming and outgoing cash movements over time. This can be built in a spreadsheet or in a dedicated finance modeling app. Building the plan in a spreadsheet or app should allow you to adjust it based on different scenarios, helping you to assess the impact of various changes.
You may want to create alternative plans, based on different approaches to raising the finance - such as taking out a loan over several years versus receiving investment from a business angel.
Step 5 Review your plan in detail
Share your financial plan with others to get their feedback. Encourage them to question your assumptions and to suggest alternative options. The larger the project, the more important it is that you have a finance review by a professional, such as your accountant. An objective opinion from someone outside your business can be hugely valuable, particularly when they have experience of finance planning for similar projects.
Step 6 Source funding providers
Having thoroughly researched, built and tested your finance plan, it's time to approach potential funders. This could be a bank, a venture capitalist or a business angel, or some other provider of business funds. Your planning will have helped you identify at least one, and possibly several, funding options.
Depending on the scale and basis of the funding you're looking for, potential providers will have different questions and require specific information from you. This can include:
- Your firm's past financial performance
- How your business is managed
- Projected future cash flows
This information, along with other details about your proposed project, will be easy to supply if you've done a thorough job of your finance planning.
Funding your business project with Qardus
We work with owners who are looking to grow their small or medium-sized business. Having already proven their product and their process in the market, they're now seeking funds for major growth initiatives.
The funding we provide is from £50k to £200k with terms of between 6 and 36 months.
We're different from banks and most other UK finance providers because we don't charge interest. Our funding arrangements are rooted in Islamic community principles and are certified as Sharia-compliant. This also means we don't work in business sectors considered damaging to society, such as alcohol, tobacco or gambling.
Because of our principles, our funding solution is proving a popular choice not only with Muslim business owners, but also with others committed to ethical and community values.
Talk to us about getting access to fast and flexible growth finance.
If your business is to grow, you need to invest in it. Whether the business is a start up, just getting going, or an established firm looking to expand, it needs cash to pay for recruitment, infrastructure, marketing, stock or whatever it is that you need for growth.
Choosing the way to fund your business growth can make a huge difference to your firm's future. While raising finance has one objective - to give you more working capital to invest in growth - the method you choose can have significant implications.
There are different routes for raising this finance. You can put money into the business yourself, take out a bank loan, receive capital from an external investor or take one of several other options. Factors that influence your choice include why you want the finance, the amount involved, your attitude to risk and business ownership, the assets available and your plan for repaying the funds.
How much and for how long
Before entering into a funding arrangement, it's important to be very clear on how much money the business needs and the plan for repaying it. You're investing in future growth, meaning potentially more sales and more profit, but how long will it take for these to come through? Preparing a detailed budget and cashflow gives you clearer visibility of how long it will be before you can repay. While you can't predict the outcome of your business growth activities, you can, using some reasonable assumptions, form a good idea of what's likely to happen.
Armed with this information, you're now in a better position to choose the right funding option for your business.
Debt finance
Raising money for your business can involve borrowing money from your family, a bank or other financial institution. Borrowing, or debt finance, can take the form of a loan, a credit card, invoice finance or some alternative mechanism, such as peer-to-peer borrowing. You're committing to make repayments over a period of time, usually paying interest on the amount borrowed.
Debt finance is either secured or unsecured. A secured debt is where the amount borrowed is linked with an asset, such as a building, and the lender has rights over that asset should you default on making the agreed repayments. You're giving the lender some security that they'll get their money back should your business become unable to repay.
An unsecured debt is not linked to an asset, making it harder for the lender to recover their money. As a result, the interest payments on an unsecured arrangement are often higher and the amount you can borrow is lower. Many financial institutions ask that a director signs a personal guarantee, making them personally responsible for ensuring that the debt is settled.
One risk of debt finance is that the business can become trapped in a debt cycle. You're continually borrowing and paying interest, which eats away at profits. Debt finance can be hugely useful, but its use should be planned and managed.
Equity finance
Equity finance means exchanging part of your business in return for a cash investment. This can be a popular approach for a startup company, particularly where high growth is anticipated, but it needs substantial investment to get going. Venture capitalists and angel investors are always looking out for investment opportunities like this - a business they can buy into that will give them a high return, years in the future.
Because equity capital means giving up ownership of part of your business, it can also mean handing over an element of control. The extent of this should be agreed in advance, in order to set clear expectations. Some investors are comfortable with leaving the founder to manage the business while others want some input into strategic decisions. This can be useful where the investment comes from someone with solid commercial knowledge and experience that they are able to share. Some angel investors want to provide mentorship as part of their investment.
Business angels and others willing to make an investment in equity will want some assurance as to how they will get their money back, and more besides. This could be in the form of dividends or as proceeds from the sale of the business.
The benefits of equity investments include access to larger sums of capital, and potentially, access to the expertise of their investor and their network of contacts. The downside can be loss of total control.
Asset finance
Your choice of funding is broader when your business has assets, such as property, equipment or non-tangible items such as intellectual property. An asset has intrinsic value and this value can be released by taking out finance that's secured on the asset. An example of this is a sale and leaseback arrangement, where the business effectively sells the asset, say a major piece of equipment, and then leases it back from the new owner. This ensures that you can still use the asset, but you also get a lump sum payment from the sale.
A related approach to raising money is invoice finance, also known as invoice factoring. This is often used to improve cash flow in a business that raises invoices on credit terms. The company gets paid almost as soon as it's raised an invoice, even though the customer may take 30 days or even longer to settle the bill. As with most such asset finance arrangements, the interest rate on the money borrowed will affect its cost and the impact on the bottom line.
Business finance can also be raised against the value of an asset in the possession of the business owner, typically a private property.
Crowdfunding finance
The sharing of the risks and rewards of doing business has been at the heart of commercial funding for hundreds of years. That's the principle behind the stock market. Today, crowdfunding is a popular solution to the problem of finding investment for your business growth plans. It comes in various forms, allowing you to raise either debt or equity finance. There are a number of crowdfunding platforms online, each of which offers a different approach to both risk and reward for their members.
The Qardus option for business funding
We provide finance to small and medium-sized enterprises with growth potential that the business owners want to unlock. The funding available is from £50k to £200k with terms of between 6 and 36 months.
Our funding process is rooted in Islamic community principles and is certified as Sharia-compliant. As a result, we don't charge interest and we don't work in business sectors considered damaging to society, such as alcohol, tobacco or gambling.
Because of our principles, our funding solution is an attractive option for Muslim business owners, but we also provide funding to business owners outside the Muslim community.
We offer fast, flexible and affordable business growth funding that's firmly grounded in ethical principles.
Stay informed on finance
