Differences between Conventional and Shariah Financing

Differences between Conventional and Shariah Financing

Finance has grown tremendously over the recent decades. Conventional finance saw an evolution since the rise of mercantile States in the Middle Ages. A newer mode of finance gained traction in the 1970s: Islamic finance. Islamic financial institutions were established in the Middle East and Asia. Malaysian banks like Bank Islam Malaysia Berhad (BIMB) and Bank Muamalat Malaysia Berhad (BMMB) were established following the enactment of the Islamic Bank 1983. This statute was later repealed and replaced by the Islamic Financial Services Act 2013. Innovative Shariah financing products have been introduced since then.

While both conventional and Shariah financing (or Islamic financing) share similar outcomes, how the financial risks are treated differs between the two. Conventional financing is a system based on interest payment determined by the overnight policy rate (OPR). This model is adopted by many financial institutions across the globe. These financial institutions generate their profit from the interests imposed for the loans or credit facilities received by both individual and business customers.

Islamic financing, on the other hand, incorporates Shariah principles into its business model. These principles include the prohibition of riba (usurious interests). Principles underlying the returns adhere to Musharakah (joint venture), Mudarabah (passive partnership), or other recognised mu’amalah arrangements. Since more than 80% of 1.6 billion Muslims worldwide don’t use banks due to religious reasons. Islamic financing broadens financial inclusion to these communities.

Considered one of the fastest-growing segments in the global financial system, Islamic finance has had a compound annual growth rate (CAGR) of around 17% since 2009. In several Southeast Asian countries with predominantly Muslim populations, it has become a significant growth industry. But how exactly do these two methods differ from each other?

Islamic vs Conventional contract

Under Shariah law, financing is only allowed under a structure named Qard. In the structure, the lender is not allowed to charge any additional amount and can only reclaim what they lend out.

As mentioned before, conventional financing is based on the payment of interest  (i.e., money charged on top of money), while Shariah financing, most of the existing facilities are based on the principle of trading or profit sharing depending on the types of Shariah contract adopted.

In Islamic financing, the financier and customer enter into a contract of trading or partnership. Any generated profit is shared between them, while any losses are shared. As such, the financier’s profit is not guaranteed or even negative compared to people who are using conventional financing.

Asset-Backed vs Collateral-Based Financing

Shariah-compliant financing, particularly in equity-based contracts such as mudarabah and musyarakah, requires an underlying asset, where the financier provides financing against a specific asset or project. The asset is then jointly owned by the financier and customer, with the customer managing the asset.

In contrast, the customer offers collateral of security to the financier, such as property or assets, to secure the funds in conventional financing. The financier will seize the asset if a customer fails to pay their financing facility.

Risks of Non-Compliance with Hukum Syarak

Apart from the usual risks that need to be managed by financial institutions, Shariah risk is a unique risk faced by Islamic financing institutions and refers to the risk of non-compliance with Islamic law or Shariah principles. In Islamic finance, all financial transactions must comply with Shariah principles, which prohibit the payment or receipt of interest (riba), investments in prohibited industries such as gambling and alcohol, and speculative activities. Any violation of these principles can lead to financial and reputational damage for the institution. To mitigate this risk, Islamic financial institutions employ Shariah scholars to provide guidance and ensure compliance with Shariah principles. Additionally, regulatory bodies have been established to oversee compliance in the industry.

Transparency and Disclosure

Transparency and disclosure are required in Shariah financing. In a Shariah compliant facility, both financier and customer need mutual understanding and consent. They must know the terms and conditions, the risks and the rewards of the financing.

On the contrary, conventional financing is often said to have complex financial products that are hard to understand by the average person. This could lead to potential conflicts in the future.

Social Responsibility and Ethical Considerations

Lastly, conventional financing is mostly profit-focused, which can lead to unethical practices and social and environmental harm. In contrast, Shariah financing promotes sustainable financing solutions that conform to the principles of Islamic law, such as gambling, alcohol, and tobacco are prohibited.

This system is often called ‘ethical’ or ‘people-friendly’ financing. No wonder Islamic deposits have increased to 11.7% in Malaysia, and outstanding financing has risen to 12.1% of the industry’s total.

In conclusion, conventional financing is characterised by interest-based lending, collateral-based financing, and the allocation of risk to the customer. On the other hand, Shariah financing is a system where mutual agreement is required from all contracting parties and any charges on financing activities should not be without acceptable cause.

With how vast and diverse our world is, some of our ways of living are determined by a society’s cultural, religious, and social beliefs. Even though financing has been an essential aspect of economic activity in communities worldwide, knowing the differences between conventional financing and Shariah financing will help individuals select the financing model best suited to their needs.