Last week, we started to explore the differences between conventional banks and Islamic banks. This question is of growing interest to both investors and members of the public.

To recap: a conventional bank borrows funds from its depositors at a predetermined rate of interest, and lends the same to its customers, again at a pre-fixed rate. The interest rate paid by the bank to depositors is considerably lower than the interest rate it charges to its borrowers. This difference becomes the bank's profit.

Furthermore, while the conventional bank holds the sole authority to raise the interest rate on the funds lent by it to the borrowers at short or no notice, the depositors who lend their money to the bank are deprived of such discretion. They receive the rate fixed by the bank while accepting the deposit for an agreed period.

When it comes to Islamic banks, the first and foremost difference is this Islamic banks do not borrow funds from the customers (depositors). Neither do they lend the funds to entrepreneurs.

An Islamic bank accepts funds from individuals and institutions in the capacity of a fund manager, under a fund management contract. The provider of the funds is called the Rab Al Mal, the Islamic bank called the Mudareb and the transaction is referred to as a Mudaraba.

A Mudaraba contract is based on the following broad parameters in order to be Sharia-compliant:

  • The Mudareb will deploy the funds on behalf of the Rab Al Mal in a profitable manner, by utilising its expertise and skills;
  • The Mudareb cannot pre-advise the rate of return to the Rab Al Mal on its capital; it can, however, indicate a certain range based on its past performance;
  • The Mudareb has full discretion to manage the funds as it sees fit; funds will not, however, be deployed in activities or businesses repugnant to Sharia principles;
  • The Rab Al Mal will not interfere in the affairs of the Mudaraba;
  • The Mudareb will share the profit with the Rab Al Mal at a pre-agreed ratio;
  • The Mudareb will return the funds to the Rab Al Mal upon completion of the Mudaraba period, along with the share of profit for Rab Al Mal generated by the Mudaraba;
  • If the Mudareb has been negligent in deploying the funds prudently, resulting in a loss for the Rab Al Mal, it must bear the loss and return the entire amount originally provided to the Rab Al Mal;
  • Additionally, the Rab Al Mal will have the right to seek compensation from the Mudareb for any actual loss suffered by it due to the Mudareb's negligence;
  • A genuine loss not, however, caused by the Mudareb's negligence will be borne by the Rab Al Mal.

An Islamic bank receives funds from the customers through their current accounts, investment saving accounts and investment deposit accounts.

The current account funds do not attract any return, and hence are excluded from the Mudaraba. The Islamic bank guarantees the safe return of these funds.

The deposits received by an Islamic bank in investment savings and investment deposits accounts are part of the Mudaraba, and therefore receive a proportionate share of profit. These funds are put into a common pool the bank draws on for its day-to-day fund deployments.

Withdrawals from the investment saving accounts are allowed once a month, and the lowest balance during the month is considered part of the common pool. The investment deposit accounts are placed for different fixed periods such as one, three, six, nine and twelve months and beyond.

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