Islamic. vs. Conventional. Management

Islamic vs. Conventional Management By: Prof. Dr. Mohd. Ma’sum Billah masum2001@yahoo.com applied-islamicfinance@yahoo.com

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Introduction

The second part of Kalima, signifies that God has not left man without any guidance for the conduct of his life. He has revealed His Guidane through His prophets and Muhammad was the last Prophet. The test of acceptance of God and His prophet lies in conducting all human affairs in accord with the Law revealed by them. ‘ And those who do not make their decisions in accordance with that revealed by Allah, they (in fact) are the disbelievers.’ (al- Quran,5:44) Although both Al-Quran and hadith have given some basic principles in performing business transactions, these principles sometimes are not directly related to the modern banking system.

Therefore, it is a duty of contemporary Muslim scholars to establish the principles, which do not violate the Shariah and at the same time are applicable to the present banking system. Thus, what will be discuss here is it is essential for a Muslims to know and clearly understand about the principal of Islamic and conventional system as nowadays there are so many elements arise that can lead to the confusion, disorder and mistake in performing their activities life.

Comparison Between Islamic And Conventional Management

Basically, the conventional financial institution is based on the use of interest. Customers’ deposits are channeled into a variety of short and long-term loans and the rates of interest are dependents upon the period of time. The interest rates are pre-determined and are guaranteed. The borrower must pay the interest that applied to the loan and the lender will receive the interest promise in additional to the return of their initial deposit. The bank’s profitability depends greatly upon the margin between the borrowing and the lending rates.

The actual operation of a conventional bank is a complex one but there is a core of the banking principle. The essential feature of Islamic banking is that all operation is interest free. Riba’ or interest literally meaning “an excess” and interpreted as “any justifiable increase of capital whether in loans or sales” is the central tenet of the system. The general consensus among Islamic scholars is that riba covers not only usury but also the charging of interest as widely practice. The prohibition is based on arguments of social justice, equality, and property rights.

Islam encourages the earning of profit but forbids the charging of interest because profits, determined ex post, symbolize successful entrepreneurship and creation of additional wealth whereas interest determined ex ante, is a cost that is accrued irrespective of the outcome of business operation and may not create wealth if there are businesses losses.

Social justice demands that borrowers and lenders share rewards as well as losses in an equitable fashion and that the process of wealth accumulation and distribution in the economy be fair and representative of true productivity. The Quran forbids the collection of riba (something refereed to as “usuary” in surah 2:275. 2:276 & 30:39 and the following hadith (38) where Ibn Masud said. “The apostle of God cursed the one who collected usury, the one who paid it, the two witnesses to the transaction and the one who recorded it”.

In contrast to conventional banking, Islamic banking operates on a profit sharing basis. The bank invests depositors’ funds in the various types of businesses. A portion of profit earned is paid to depositors in a pre-determined profit and loss ratio. The profit is not and should not be determined ex ante. In the case of conventional banking, thee rates of interest is determined in advance regardless of the end result. Islam does not deny the capital deserves to be rewarded, however invested have no right to demand a fixed rate of return.

There are three major sources of funds for an Islamic bank. Besides the bank’s own capital and equity, the main sources of funds are likely to be two from of deposits, which are transaction deposits, and investment deposits. Transaction deposits are guaranteed the nominal value. The bank would pay no return on this type of liability. Generally speaking, funds mobilized through this source cannot be used for profitable in investment by bank. As such, banks are likely to levy a service charge on deposit holders to cover the cost of administrating this type of account.

Investment deposits constitute the principle sources of funds for Islamic bank and they more closely resemble share in a firm, rather than time and saving deposits of the customary sort. The bank offering investment deposits would provide no guarantee on their nominal value, and would not pay a fixed rate of return. Depositors, instead, would be treated as if they were shareholders and therefore entitled to a share of the profits or losses as made by the bank. The only contractual agreement between the depositors and the bank is the proportion in which profits and losses are to be distributed.

The profit or loss sharing ratio has to be agreed in advance of the transaction between the bank and the depositors and cannot be altered during the life of the contract except by mutual consent. As far as the lending operations of Islamic banks are concerned, the banks also are required by the Shariah to apply the principle of profit-or- loss sharing in their loan operation. Two methods that satisfy the requirements of the lending side are murabaha and mudaraba and arrangements. Murabaha, (cost-plus financing), here the Islamic bank purchased the goods (for example a house) from depositors accumulated funds, takes title of the asset and then the resells it to a member at a mark up price, as agreed by both parties.

Mudaraba (profit sharing), this is a business finance arrangement where the Islamic bank provides capital for an entrepreneur’s business venture from the depositor’s funds. The capital providers receive a percentage of the businesses profit according to a pre-determined ratio. In the case of loses, these are borne by the institution and the provi9der of the funds. In mudaraba contracts the agent receives a specified share of the profit arising from investing the fund provided.

On the other hand, the philosophical foundation of an Islamic financial system goes beyond the interaction of factors of production and economic behavior. Whereas the conventional financial system focuses primarily on the economics and financial aspects of transactions, the Islamic system places equal emphasis on the ethical, moral, social and religious dimensions, to enhance equality and fairness for the god of the society as a whole. The system can be fully appreciated only in the context of Islam’s teachings on the work ethic, wealth distribution, social and economic justice and the role of the state.

Moreover, Islamic banking fundamentally differs from conventional banking in its project-oriented focus on the investment as opposed to the specific return focus on each individual investor. Instead of each player setting his level of commitment to an investment according to his own risk or return threshold, each project is evaluated in term of its overall virtue, and all investor stands to gain or lose equally. Investment must steer clear of gambling and uncertainty and must confirm to the value pattern of Islam.

Any risk inherent is an investment project must be distributed fairly among all participants. No one is guaranteed a return. Financing arrangements in the Muslim world take the form of partnership working towards a common goal. They are not to be used as ends in themselves.

MISCONCEPTIONS ON THE DIFFERENCES BETWEEN ISLAMIC FINANCIAL SYSTEM AND THE CONVENTIONAL SYSTEM

The obvious benefits of the various principles of Islamic banking and financing as discussed indicate that they do not differ from conventional banking and financial system on the simple difference between an animal which is properly slaughtered in the Islamic way and one which is not. Some Muslims try to explain the differences in this way. The rational is more profound than a simple difference. It is therefore necessary to explain some of the misconceptions about the major differences between an Islamic financial system and the conventional system.

The most major misconception about Islamic banking and lending is that there is no difference between it and conventional banking in term of the premium to be paid on the principal. This is true as Islamic banking is not cheaper than conventional banking when there is no default on repayment. Muslim capital owners also need to earn a reasonable income from their capital. Otherwise there is no incentive for them to accumulate capital and lend it. By looking the difference in calculating the premium, in an Islamic consumer loan facility to purchase a property for example a house, the borrower will first sell the house to the lender at the price the borrower paid.

The lender will then resell the house to the borrower at an increased value, for example 50% higher. The percentage depends on the length of the repayment period. In such lending, the total loan to be repaid therefore remains fixed. In conventional banking, the total loan to be repaid will however fluctuate depending on the base lending rate (BLR). The Islamic loan therefore is fixed and contant while the conventional one is uncertain and subject to fluctuate since it is based on the floating interest rate.

When the BLR is very low, Islamic loan is therefore become expensive. Since the total loan (principal plus premium) is fixed and constant, the profit for the bank cannot be too low as it might discourage the justification for Islamic saving and lending. In such situation of low BLR, the ‘expensiveness’ of an Islamic loan is however immediate and short term. In the long term, when BLR increase to a high level, Islamic loan will be cheaper. In the current situation of the prolonged economic slowdown with a very low interest rates, Islamic banking is become unattractive.

However, a few bank have devised an attractive and practical solution by offering several set of fixed rates. The first set offers a low rate and the other increasingly higher in line with expected increase in interest rates. Islamic loan is much fairer in case of repayment default as it is not based on interest that is usually calculated on the daily basis. For a customer loan, the borrower has to keep a fixed deposit with the bank equivalent to three months payments. In case of default the deposit will be used to settle the monthly payment.

If the default continues and the borrower is considered unable to continue the payment, foreclosure measure on the property will be taken. In the meantime, the total loan will not increase, as there is no interest charged. In conventional banking, interest will be continue to accumulate until the loan is settled by foreclosure or other means, unless the bank agrees to suspend interest. Hence, in the case of conventional loan, payment over the long period of time may result in the cumulative interest exceeding the principal.

This will, of course impose serious financial problem to the borrower. Since an Islamic business loan is based on partnership and sharing of both loss and profit, the possibility of an earlier business recovery for the borrower is much better. The lender is more committed to the borrower’s recovery as he has a stake on it. Thus Islamic business financing reduces the possibility of business bankruptcies for borrower and bad loans for lender.

Conclusion

There are some similarities between Islamic and conventional finance, since both deal with a common set of operating business realities. In most cases, Islamic and conventional finance simply travel different paths toward the same. Most business needs long term financing. In conventional finance, this is accomplished through some mix of long term debt and owner’s capital. In one Islamic solution, passive partners contract for a certain share of the profits, with another share going to the entrepreneurs who manage the business.

This solution meets the concept of partnership required by doctrine and it similar to a dilute its ownership by bringing in partners, other options exist, such as leasing. A lease does not involve formal interest or a partnership stake, yet satisfies the business’s need for long term financing of plant and equipment and the investor’s need to earn a fair return. Inventory financing is a requirement common to both Islamic and conventional commerce. An Islamic business in need of short-term inventory for the business based on the business’s promise to buy the inventory later for cost plus a fair markup.

Consequently, that is way it is important to compare between Islamic management and conventional management in order to avoid misconception or misunderstanding between both.