Islamic Finance: Learning more about the differences between banks

This week's column on Islamic banks versus their conventional counterparts begins with a recap of last week's discussion. Readers will recall how an Islamic financial institution in contrast to its conventional cousin does not borrow funds at interest. Neither does it lend funds at interest.

Instead, an Islamic bank enters into a Mudaraba (or agreement) with its fund-providing customers (known as Rab Al Mal). Under the terms of the Mudaraba, the Islamic bank acts as a fund manager (or Mudareb) for the customers, using its expertise to find profitable opportunities to use the funds.

Profits flowing from these deployments are divided at a pre-determined profit-distribution ratio.

The Islamic bank's funds are received through investment saving accounts and investment deposit accounts. No fixed rate is agreed or indicated at the time of receiving the funds. The current account funds are excluded from the Mudaraba, because the Islamic bank does not pay any return on them.

The fund-providing customers and not the Islamic bank remain the owners of their respective funds at all times. As such, any genuine loss incurred in the course of fund deployments by the Islamic bank is borne by the customers.

The Islamic bank will be responsible, however, for losses incurred due to its misconduct or negligence.

After recalling these differences between Islamic and conventional banks, it is time to move on to a new question. How can an Islamic bank earn enough income to be able to meet its operating expenses, as well as distribute returns to its depositors and pay dividends to its shareholders?

Transaction

Before answering this question, however, there is another dimension of the difference between the two banks to explore the matter of licences.

Conventional banks all over the world are licensed by their respective regulatory authorities (central banks, financial services authorities, ministries of finance, etc).

The licences permit the banks to accept deposits from members of the public on a pre-fixed rate of interest, and to lend these funds at pre-agreed rates of interest (which are subject to change at the bank's discretion).

Conventional banks are strictly barred from utilising these funds for any other purposes. These purposes could include: trading in goods or assets, or equity investments, etc. The banks can carry out such transactions, however, but only by utilising shareholders' funds, in such forms including equity, general reserves, residual income, etc.

Good analogy

If a conventional bank uses depositors' funds for trading and investment purposes, it will have violated the terms and conditions of the licence. Such action puts the licence at risk.

The key thing to remember here a conventional bank is not permitted to use depositors' funds in any other manner, except to lend them at pre-determined rates of interest.

In contrast, the Islamic bank is permitted by licensing authorities to utilise customers' funds for the purpose of trading in goods and assets, leasing, investment and any other commercial activities, provided these activities are Sharia compliant.

An Islamic bank is prohibited from borrowing funds from individuals and institutions at a fixed interest rate and then lending them at a pre-agreed interest rate. Any Islamic financial institution caught doing this would lose its licence.

As readers can see, it is not for nothing that the chairman of the Sharia board of the Islamic bank where I work has observed the only thing conventional banks and Islamic banks share is the word "bank."

An Islamic bank, technically, does not operate on the lines of the recognised definition of the word "bank", which is defined as "a licensed deposit taker and money lender". How should an Islamic bank be classified, functionally speaking? Scholars say a good analogy is to compare it to that of a trader.

The writer is the vice-president, Sharia structuring, documentation and product development, Dubai Islamic Bank.