Islamic Financing vs Conventional

Topics: Fractional-reserve banking, Islamic banking, Bank Pages: 5 (1622 words) Published: November 13, 2008
Risk Management – Differences Between Islamic and Conventional Banking

In evolving the Islamic financial system, important considerations include the development of a system that is able to meet the changing requirements of the consumer and business community, that is efficient and competitive, that is safe and sound and that is robust and resilient and able to withstand a more challenging and uncertain world environment. These considerations are vital to ensure the sustainability of the system not only as a form of financial intermediation in the domestic economy but also as an integral component of the international financial system. 1 However the features of Islamic banks and their intermediation models that they follow eg the Profit and Loss Sharing (PLS) method and the Non Profit and Loss Sharing(NPLS) method involves special risks that have to be recognized to assist in making risk management in Islamic banking more effective.

The Profit and Loss Sharing method:
This method of financing is very much different from the conventional as it uses the concept of profit and sharing for example when a corporate wants us to finance their project the bank uses the concept of Mudaraba where the bank act as investor and the corporate as the entrepreneur . As Islamic banking prohibits against repayment of a fixed or floating interest rate, this concept provides a risk to the bank as the entire financing will be provided by the bank and the customer (entrepreneur) merely provides his experience and labour, however any profit gained by this project will be shared between the bank (investor) and the customer (entrepreneur). If however should the the project have been mismanaged thus resulting in getting a lesser profit , the profit will be share among both parties as agreed in accordance to the agreed profit sharing ratio. However if in the even there is a failure with the project thus arising in a ed

Non Profit Sharing Method:
This concept of financing is used where the Profit and Loss Sharing method cannot be used eg for the financing of small traders or personal loans. Whilst it may be less risky than the Profit Sharing method NPLS also bears some risk such as in the financing using the concept of Bai Salam where the buyer pays the seller the full agreed price of a commodity or product where the seller will deliver at a future date. However there is the element of payment and commodity risk for the bank as the bank has pay the seller upfront and only obtain the goods at an agreed future date and what would happen if the price of the commodity drops such as the current palm oil commodity. In additional to the above two there are other factors of risk which makes Islamic banking more risky and less profitable as compared to conventional banking and there are:

Foreign Exchange Rates:
In terms of the above Islamic banks will find it more challenging in come out with innovative products to compete with the conventional banking as the Shariah does not permit the use of Riba or gharar for their risk hedging instruments. Thus entrepreneurs will find it less attractive and competitive for using their trade facilities where their goods will say arrive in 3 months but wishes to hedge forward their foreign currency . Interbank Money Market:

The difficulty in developing short term funding based on Profit and Loss Sharing method which is in compliance to Shariah hinders the Islamic banks in managing their liquidity thus increasing their exposure to liquidity shock such as in the case of the current financial credit crunch.

Lender of Last Resort:
As compare Conventional banking where banks can relay on the Central bank to come in as lender of last resort if there is a run in the bank or if the bank is in liquidity problem ,the LOLR from central bank instruments which are in compliance to Shariah is very limited thus hindering the access into this facility. However Bank Negara Malaysia have developed an innovative...
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