Islamic Banking vs Conventional Banking: Understanding the Difference

Islamic and conventional banking are two different types. They share many similarities in their fundamental principles and practices but differ in ethics, history, instruments, and values. 

In this article, you’ll learn the key distinction between Islamic banking vs. conventional banking.

A Brief History of Islamic Banking & Conventional Banking

Banking can be traced back to ancient civilizations, such as the Babylonians, who used clay tablets as receipts for deposits and loans. During the Middle Ages, Italian merchants, such as the Medici family, began to use bills of exchange to transfer money over long distances.

Through this, the banking concept evolved and paved the way for modern banking today. Here is a brief history of Islamic Banking and Conventional Banking.

Islamic Banking and Its Roots

Islamic banking originated from Islam’s beliefs and has evolved alongside conventional systems. Its history is deeply rooted in religious beliefs and ethical values, making it a unique and important approach that continues to improve. Here are the roots of banking in Islam, Islamic banking after World War II, and their banking in the modern day.

Roots 

• 610 AD – Islam was founded by the Prophet Muhammad
• 610 AD- 632 AD – The Quran was widely disseminated and after Prophet Muhammad’s death Muslims developed financial transactions based on Islamic Principles
• 750 AD – The Abbasid caliphate took control of the Arabian peninsula and Islamic financial practices became more widespread
• 1100 AD – Islamic merchants developed the concept of sakk or financial certificates to act as certificate of deposits across long distances. 
• 1500 AD – The Ottomans developed a system based on Islamic principles and these included the modern murabahah financing system.

Post World War II

• 1963 – The Mit Ghamr Savings Bank in Egypt became the first modern Islamic bank that offers interest-fee financial services to its clients
• 1975 – The Islamic Development Bank was established and became the first multilateral financial institution based on Islamic Principles
• 1977: The Dubai Islamic Bank was founded, becoming the first modern commercial Islamic bank.

Modern Day

• 1980s: Islamic finance began to spread beyond the Middle East, with the establishment of Islamic financial institutions in Malaysia, Pakistan, and other countries.
• 2000s: Islamic finance continued to grow, with the establishment of new Islamic financial institutions and the development of new financial products, such as sukuk, or Islamic bonds.
• 2010s: Islamic finance became more integrated into the global financial system, with the participation of major international banks in Islamic finance and the development of Islamic finance regulations in countries such as the UK and Luxembourg.

Conventional Banking in Ancient and Modern Times

Banking has existed for centuries, with evidence of banking activities dating back to ancient times. With this, it continues to change, improve, and adapt to the needs of modern society. Here is a brief history of banking in ancient, late medieval, early modern, and modern-day eras.

Ancient Times

• 2000 BC: The first known banks in the world were the temples of ancient Babylon, where deposits were made of grain and other commodities.
• 1400 BC: The Ancient Egyptians began using gold and silver deposits for storage and safekeeping.
• 700 BC: The Greeks established a banking system based on the exchange of coins.
• 32 AD: The Roman Empire developed a complex banking system, which included the issuing of bills of exchange and the development of money lending practices.
• 1161 AD: The Knights Templar established a banking system throughout Europe, including the issuance of letters of credit.

Late Medieval Times

• 1400s: The Medici family of Florence, Italy, established one of the earliest modern banks, which became a model for other banks in Europe.
• 1694: The Bank of England was established, becoming the first modern central bank.

Early Modern Era

• 1861: The first national banking system was established in the United States.
• 1913: The Federal Reserve System was established in the United States, becoming the central banking system for the country.
• 1950s: The development of electronic banking began, including the introduction of credit cards and automatic teller machines (ATMs).

Modern Day

• 1990s: The widespread adoption of the internet led to the development of online banking services.
• 2000s: The global financial crisis of 2008 led to major changes in the banking industry, including increased regulation and oversight.
• 2010s: The growth of mobile technology led to the development of mobile banking, allowing customers to access their accounts and conduct transactions through their smartphones.

What Is Islamic Banking?

Islamic banking is based on the principles of the Quran and the Sunnah (the traditions of the Prophet Muhammad). It encourages Muslims to use their money in a way that aligns with their faith, so they can help others and avoid any immoral activity. Islamic banks must adhere to strict ethical guidelines set by their regulators to be considered Islamic banks.

Islamic Banking uses profit-sharing, loans with no interest, and other financial services based on Islamic Sharia law’s tenets. Islamic banks are designed to promote financial transactions, primarily focusing on charity and community development.

Islamic banks offer various financial services, including loans, investments, and insurance products. They also operate in many other countries worldwide where they are regulated differently than in Saudi Arabia or Egypt, where they were founded.

What Is Conventional Banking?

The conventional banking system is the type of banking that we know today. A bank is a financial institution that focuses on officialized distribution, collection of client deposits, making loans, accepting checking services, and offering various financial products for the client’s gain. Banks earn profit through interest from loans taken by other clients. 

There are different types of banks for different needs and services, such as commercial, retail, and investment banks. Each bank is regulated within the ruling of a country, state, or city. 

The Differences Between Islamic Banking & Conventional Banking

These are some differences between Islamic banking from conventional banking:

Points of Comparison	Islamic Bank	Conventional Banking
Interest	❌	✅
Risky Trade	❌	✅
Negotiable instruments	❌	✅
Sharia Laws	✅	❌

Interest

Islamic banks prohibit interest-bearing loans. Instead, it is paid by profit sharing or equity. Conventional banks earn profit by letting their borrowers pay interest on loans and fees such as late and bounced check fees.

Trade

Islamic banks do not engage in speculation (Gharar) or trade. They only invest in real estate, businesses, and other commodities that are considered halal (permissible). Conventional banks can engage in these activities since they do not receive any profit from them (or any other profitable activity).

Negotiable Instruments

Islamic banks do not issue negotiable instruments such as checks or money orders; instead, they accept payments via cash or check deposits made directly into accounts at the bank itself (rather than through third parties). Accepts and issues checks or money orders and check deposits from third-party banks.

Sharia Laws

Islamic banking uses principles of Islamic jurisprudence to regulate the relationship between lenders and borrowers and between borrowers themselves. Conventional banking doesn’t use Sharia law principles.

An Islamic bank’s goal is to promote economic development by providing financing for businesses that would otherwise be unable to access it through conventional banks due to their conservative approach toward financial products such as mortgages and personal loans.

A conventional bank aims to promote economic development through deposits, loans, and applying interest for its products.

What are the Financial Instruments Used in Both Types Of Banks?

There are many differences between Islamic Banking and Conventional Banking. Despite the two types focusing on saving money, earning money, and safeguarding investments, The main difference between Islamic banking and conventional banking is that Islamic banks are the financial instruments they use.

Points of Comparison	Islamic Banking	Conventional Banking
Mudarabah (Business Partnership)	✅	❌
Murabahah (Business Capital Financing).	✅	✅
Investments with Interest	❌	✅
Ijarah (Reant or Lease)	✅	✅
Musharakah (Joint Ventures)	✅	✅
Salam (Supplication of Goods)	✅	❌
Sukuk – securities	✅	✅
Istisna – Manufacturing, construction, and installations	✅	❌
Equity	✅	✅

Frequently Asked Questions

What is the advantage of Islamic Banking?

Islamic Banking ensures financial inclusions. Every client and business has access to affordable financial services and products.

What is the advantage of Conventional Banking?

More opportunities for investment and a wide variety of financial products with no limitations on the products or means used.

What are the risks involved in Islamic Banking?

Infrastructure, financial engineering, product offering, and Shari’ah audit.

What is the basis of Islamic Banking and Conventional Banking?

Islamic banking is based on the Quran and how they apply to business dealings. These regulations governing business dealings in Islamic banking are known as fiqh al-muamalat.

Conventional banking is based on the Agent of Trust, Agent of Development

Agent of Service by channeling capital exchange of money to loans and savings.

Conclusion: Recognizing Differences

Islamic Banking and conventional banking follow different philosophies. Islamic banking is founded on profit and loss sharing, risk sharing, financing, and loans without collateral or interest. It forbids investments that are not aligned with Shariah laws. Conversely, conventional banking relies on interest-based transactions, product or form assets, less risk, and collateral on loans.

Both banking systems benefit their clients, businesses, and customers. It aims to promote economic growth and stabilize economies by providing a safe space for clients. These principles, however different, help them grow individually.

Sources:

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• How Banking Works, Types of Banks, and How To Choose the Best Bank for You. (n.d.). Investopedia. Retrieved March 7, 2023, from https://www.investopedia.com/terms/b/bank.asp
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