COMPARATIVE CONVENTIONAL AND ISLAMIC BANKING - PS601 RISK MANAGEMENT IN ISLAMIC BANKING CHAPTER 06

1. CHAPTER
SIX
THE RISK IN CONVENTIONAL BANKING vs
THE RISK IN ISLAMIC BANKING(06 : 02) –
CLO1 & CLO3
TEST 2 (CHAP 4-6)
TUTORIAL EXERCISE 4 (CHAP 6)

2. Risk in conventional
and Islamic banking
on management
and the financial
products

3. THE RISK IN CONVENTIONAL
BANKING vs THE RISK IN ISLAMIC
BANKING
6.1 ;
Distinguish between the risk
management in conventional
banking and Islamic banking

4. THE RISK IN CONVENTIONAL
BANKING vs THE RISK IN ISLAMIC
BANKING
6.1.1
Differentiate between the risk management in
conventional banking and Islamic banking

5. FUNDAMENTALS
• Shariah laws are the tenets of Islamic Banking. As such,
the comparison with that of the conventional are not
exactly like-to-like.
• Conventional banking was build upon the fundamentals
of debtor-creditor relationship with interest being the
price of credit and reflecting the opportunity cost of
money. Hence, money is a commodity somewhat.
• Financial relationship in Islam is generally participatory in
nature. E.g. the Financial relationship in Islam is generally
participatory in nature. E.g. the principles of Musharakah
and Mudharabah, or contractual transaction.
• In addition, risk and reward relationship is guided by the
socio-economic principles.

6. There are two major difference
between Islamic Banking and
Conventional Banking
• Conventional banking practices are concerned
with "elimination of risk" where as Islamic
banks "bear the risk" when involve in any
transaction.

7. • When Conventional banks involve in
transaction with consumer they do not take
the liability only get the benefit from
consumer in form of interest whereas Islamic
banks bear all the liability when involve in
transaction with consumer. Getting out any
benefit without bearing its liability is declared
Haram in Islam.
There are two major difference
between Islamic Banking and
Conventional Banking

8. Conventional Banking System Islamic Banking System
Depositors are paid interest Depositors are entitled to profit sharing
The customer has no say where banker
invest money
Under special investment account, the
customer can decide where banker invest
the money
Borrowers are charged interest Financing is done through purchase and
resale to the customer, thus earning
profit. If a loss is incurred under
Mudharabah, the capital provider will
bear the loss, whereas under
Musharakah, the loss will be shared
according to the financing ratio
Except for financing under leasing, margin
of financing will be less than 100%
Under Mudharabah or BBA concept,
100% financing can be availed
Repayment is not fixed Repayment price is fixed
Conventional Banking system vs
Islamic Banking system

9. Conventional Banking system vs
Islamic Banking system
Conventional Banking System Islamic Banking System
Legal relationship:
•Debtor and Creditor
Legal relationship:
•Seller and buyer
•Lessor and lessee
•Partner and partner
Commodity, e.g. example house, become
the security
Commodity, e.g. house is the subject
matter and major element.

10. A COMPARISON
BETWEEN ISLAMIC
AND CONVENTIONAL
BANKING
OVERALL

11. ISLAMIC BANKING CONVENTIONAL BANKING
The functions and operating modes of
Islamic banks are based on the principles
of Islamic Shariah.
The functions and operating modes of
conventional banks are based on fully
manmade principles (largely capitalism
theory).
It promotes risk sharing between provider
of capital (investor) and the user of funds
(entrepreneur).
The investor/lender is guaranteed of a
predetermined rate of interest or returns.
It also aims at maximizing profit but
subject to Shariah restrictions.
Unrestricted profit maximisation
illustrated by derivatives trading.
In the modern Islamic banking system, it
has become one of the service-oriented
functions of the Islamic banks to be a
Zakat Collection Centre and them also pay
out their Zakat
It does not deal with Zakat.

12. ISLAMIC BANKING CONVENTIONAL BANKING
Participation in partnership business is
the fundamental function of the Islamic
banks. Understanding the venture is
therefore essential. Embedded know-
your-customer orientation.
Lending money and getting it back with
compounding interest is the fundamental
function of the conventional banks.
Money is a commodity and the
motivation.
Islamic banks have no provision to charge
any extra money from the defaulters
except for compensation (typically such
proceeds are given to charity). Rebates
early settlement at the Bank's discretion.
It can charge additional money (penalty
and compounded interest) in case of
defaulters
Due importance to the public interest/
maslahah. Its ultimate aim is to ensure
growth with equity.
Often, lenders/banks interest becoming
forefront. It makes no effort to ensure
growth with equity
For the Islamic banks, it must be based on
a Shariah approved underlying
transaction.
For interest-based commercial banks,
borrowing from the money market is
relatively easier.

13. ISLAMIC BANKING CONVENTIONAL BANKING
Since it shares profit and loss, the Islamic
banks pay greater attention to developing
project appraisal and evaluations.
Since income from the advances/loans is
fixed, it gives little importance to developing
expertise in project appraisal and
evaluations. Risks are transferable at a price
(and sometimes incremental).
Greater emphasis on the viability of the
projects.
The conventional banks give greater
emphasis on creditworthiness of the clients
where credit equals to ‘commodity pricing’.
The status of Islamic bank in relation to its
clients is that of partners, investors and
trader, buyer and seller.
Relationship is often defined as that of
creditor-debtor.
Islamic bank can only guarantee deposits for
deposit account, which is based on the
principle of al-wadiah, thus the depositors
are guaranteed repayment of their funds,
however if the account is based on the
mudharabah concept, client have to share in
a loss position.
A conventional bank has to guarantee all its
deposits.

14. THE RISK IN CONVENTIONAL
BANKING vs THE RISK IN ISLAMIC
BANKING6.1.2 Compare the conventional risk of Financial Products
such as:
a. Personal Loan
b. Housing Loan
c. Hire Purchase
d. Mortgage
6.1.3 Compare the risk of Financial Products in Islamic
banking such as:
a. Personal financing
b. Housing financing
c. AITAB (Al Ijarah Thumma al Bai)
d. Ar Rahnu

16. THE RISK IN CONVENTIONAL
BANKING vs THE RISK IN ISLAMIC
BANKING
Personal Loan
vs
Personal financing

17. Personal Loan vs Personal financing
• The main difference between Islamic
Banking and Conventional Banking arises on
the charging of interest on loans without the
lender taking a share of the risk involved in
the investment of the loan; something
traditionally known as usury.
• Usury is making money by lending money;
put in other words, it is making money from
absolutely nothing, and is exactly what is
happening around the globe today on an
absolutely massive scale.

18. CONVENTIONAL SIDE
• The charging of interest discourages people from
working to earn money, and the value of work is
undermined. Therefore money lies idle in banks
as people are earning money over their bank
deposits. This discourages investment, and risking
money in business. It also discourages the
borrower from borrowing money for investment,
because the risks involved in borrowing are not
shared by the bank so the borrower has to return
his loan to the bank with the interest whether his
business results in failure or success.

19. ISLAMIC SIDE
• Islamic banking on the other hand, is based on the
concept of risk sharing. The bank enjoys a share in
the profit of the company if it thrives, but also
provides extensions for loan repayment if
required, and shares the loss if the business fails,
and in extreme cases, it may forgive the loan
altogether.

20. Personal Loan vs Personal
financing
CONVENTIONAL P/L ISLAMIC P/F
USURY RETURN ; PROFIT / LOSS
LAW; MAN MADE LAW LAW; USUL FIQH AND QAWAID FIQH
CUSTOMER SUFFER THE RISK RISK SHARING CONCEPT
INVOLVE RIBA, GHARAR & MAISIR PROHIBITED RIBA, GHARAR & MAISIR
BASED ON LENDING/BORROWING
CONTRACT
NORMALLY BASED ON SALE AND
TRANSACTION
REIMBURSEMENT FROM THE NOMINATED
REIMBURSEMENT BANK.
SUBJECT TO 2 TIER INTEREST RATE
REIMBURSEMENT UPON RECEIPT OF
COMPLIED DOCUMENT AT THE COUNTER
OF THE ISSUING BANK.
NOT SUBJECT TO 2 TIER INTEREST RATE
LENDER AND BORROWER SELLER & BUYER

22. THE RISK IN CONVENTIONAL
BANKING vs THE RISK IN ISLAMIC
BANKING
Housing Loan
vs
Housing financing

23. Housing Loan vs Housing financing
• In the conventional loan, the base-lending
rate (BLR) stated above is subject to change
depending of the interest rate market. BLR in
is this country have reached over 10% during
the financial crisis. But now for the last few
years, the BLR has stayed around 6-7%. If the
BLR goes up, the borrower has to pay more
in interests. The user tends to gain, if the BLR
goes down. If in the long term the interest
rate remains low the user tends to gain.

24. Housing Loan vs Housing financing
• In the Islamic banking model, the profit rates are fixed
for the entire tenure of the loan. It is based on Islamic
principle that when we agree on a fixed loan and
repayment, it should remain the same. If at the time that
when the loan agreement is signed, the terms are say
BLR + 1.5%. and assuming that the existing BLR is 6.0%,
then the loan agreement is signed off as 8% flat for the
entire tenure. Normally interest rates for Islamic rates
are slightly higher if we were to look the rates now. The
advantage is the user gains to benefit if the interest rates
go up, as they are not affected by the increase. However
they would tend to lose of if the rates go down and they
would not benefit from the lower rates.

25. ISLAMIC H/F CONVENTIONAL H/L
BLR + FIXED RATE = BFR (BASE FINANCING
RATE)
BLR IS SUBJECT TO CHANGE
THE USER GAINS TO BENEFIT IF THE INTEREST
RATES GO UP, AS THEY ARE NOT AFFECTED
BY THE INCREASE
IF THE BLR GOES UP, THE BORROWER HAS TO
PAY MORE IN INTERESTS.
THEY WOULD TEND TO LOSE OF IF THE RATES
GO DOWN AND THEY WOULD NOT BENEFIT
FROM THE LOWER RATES.
THE USER TENDS TO GAIN, IF THE BLR GOES
DOWN
CONCEPTS; THE BANK PURCHASE THE
PROPERTY FROM THE SELLER ON CLIENT
BEHALF, AND RESELL TO CLIENT WITH AN
AGREED PROFIT RATE, SO THE PROFIT RATE
IS TO BE PAID BY CLIENT TO THE BANK,
WHEN CLIENT FULLY PAID THE INSTALMENT
THEN THE PROPERTY WILL BE TRANSFERRED
TO CLIENT.
CONCEPTS; CUSTOMER BORROW THE
MONEY FROM BANK TO PURCHASE A
PROPERTY.
Housing Loan vs Housing financing

26. ISLAMIC H/F CONVENTIONAL H/L
20% STAMP DUTY REDUCTION FOR
PRINCIPAL DOCUMENT BASED ON SHARIAH
PRINCIPLES OR WAIVER OF STAMP DUTY
FOR THE CONVERSION OF CONVENTIONAL
LOAN TO SHARIAH FINANCING
NO STAMP DUTY REDUCTION
BASED ON SYARIAH BASED ON HUMAN RULE
PROHIBITED RIBA, GHARAR, MAISIR & ZULM NOT RESRICTED
THE PURCHASER WILL PAY A PROFIT THE PURCHASER WILL PAY INTEREST
SELLER & BUYER
LEASEE OR LEASOR
LENDER AND BORROWER
Housing Loan vs Housing financing

27. Islamic banks have changed the borrowing
relationship to various concepts that are
acknowledged in Islam such as partnership
(Musharakah or Mudharabah), or seller (bank) and
buyer/renter (customer). Changes in the relationship
are not only with the ‘aqad or contract, even asset
ownership has changed and is accepted by Malaysian
law. This means, from the legal point of view, the
trading or renting process does take place. However,
many customers of Islamic banks do not recognise
the efforts of Islamic banks in making changes as
they do not read the contracts they sign.

29. THE RISK IN CONVENTIONAL
BANKING vs THE RISK IN ISLAMIC
BANKING
Hire Purchase
vs
AITAB (Al Ijarah Thumma
al Bai)

30. Hire Purchase vs AITAB (Al Ijarah Thumma al
Bai)
Under common law, a hire-purchase transaction is a
contract whereby one party (called “the owner”)
leases goods on “hire” to “the hirer” and agrees
that the hirer may (at his own option) either return
the goods when he no longer needs them and
terminate the lease, or elect to purchase the goods
on completion of the necessary payments agreed in
the contract. In simple terms, a hire-purchase
transaction is hire, coupled with an option to buy,
provided that all the conditions are fulfilled until the
end of the hiring contract

31. The Islamic hire-purchase financing offered by
local Islamic banks is AITAB. AITAB is applied as
a modification of HPA with added emphasis
upon two elements, namely the “letter of aqad”
and without “overdue interest”. In the case of
defaulted payments, a repossession order is
executed without charge for overdue interest.
Hire Purchase vs AITAB (Al Ijarah Thumma al
Bai)

32. Differences between conventional and Islamic
hire purchase from a shari’ah
point of view
Item Conventional Hire
Purchase
Islamic Hire Purchase
Terms Loan
Interest Rate
Hiring Charges
Late payment interest
Financing
Profit rate
Mark-up
Late payment charges
Eligible customer Good credit rating Not involved in immoral
activities against shariah
Goods Limited to customer goods,
motor vehicles and non-Act
goods (corporate)
Applicable to all types of
goods
Contract One standard contract 2 aqad (sighah)
Purchase Price or
Installments
Cost price x interest rate
month
Cost price + profit .
Number of payments

33. Item Conventional Hire
Purchase
Islamic Hire Purchase
Profit margin or Interest
Rate
Floating based on the
annual rate, decided up
front
Determined based on
market value
Responsibility Hirer or customer bears all
costs of maintenance
Owner bears basic and
structural maintenance
Differences between conventional and Islamic
hire purchase from a shari’ah
point of view

35. THE RISK IN CONVENTIONAL
BANKING vs THE RISK IN ISLAMIC
BANKING
Mortgage
vs
Ar Rahnu

36. Mortgage vs Ar Rahnu
A mortgage loan is a loan secured by real
property through the use of a mortgage
note which evidences the existence of the
loan and the encumbrance of that realty
through the granting of a
mortgage which secures the loan.

37. Mortgage vs Ar Rahnu
MORTGAGE AR RAHN
INTEREST PER MONTH BASED ON THE
LOAN AMOUNT.
COST OF
LOAN
MONTHLY SAFEKEEPING FEES BASED
ON THE VALUE OF THE PAWNED
GOLD (MARHUN VALUE).
6 MONTH LOAN PERIOD MAY BE
EXTENDED FOR ANOTHER 6 MONTHS.
A LOAN MAY BE EXTENDED
INDEFINITELY.
LOAN
DURATION
THE FIRST PERIOD OF 6
MONTHS MAY BE
EXTENDED FOR THREE MONTHS AND
FINALLY ANOTHER 2 MONTHS.
GOLD OF VARIOUS GRADES OF
FINENESS, WHITE GOLD, GOLD
WATCHES, GOLD BARS, GOLD
COINS/DINARS, DIAMONDS, HOLLOW
GOLD JEWELLERY AND GOLD JEWELLERY
WITH STONES. GOLD ITEMS WHICH
AREDAMAGED, BROKEN, TORN, OR CRU
SHEDARE ALSO ACCEPTED.
ANYTHING VALUABLE ARE ACCEPTED.
COLLATERAL 18K - 24K (750 – 999) GOLD .
HIGH QUALITY SILVER.
VALUABLE JEWELLERY.

38. MORTGAGE AR RAHN
MOST TRANSACTIONS WILL TAKE
ONLY A FEW MINUTES. NO
FORMS TO FILL OUT.
PROCESS CUSTOMERS MUST FILL OUT FORMS
AND PROVIDE INFORMATION SUCH AS
EMPLOYER’S NAME, WORK ADDRESS,
OCCUPATION, GROSS INCOME AND OT
HER PERSONAL DETAILS TO THE BANK.
CUSTOMERS MUST ALSO OPEN A
SAVINGS ACCOUNT WITH THE BANK.
NO CREDIT CHECKS. CUSTOMERS
WHO ARE DECLARED BANKRUPT
CAN GET A LOAN AT A
PAWNSHOP.
NO CUSTOMER DETAILS WILL BE
ADDED TO THE CCRIS AND A
CUSTOMER'S CREDIT HISTORY
WILL NOT BE AFFECTED.
CREDIT
CHECK AND
BANKRUPTCY
STATUS
CUSTOMERS WHO ARE DECLARED
BANKRUPT ARE NOT ELIGIBLE TO APPLY
FOR LOANS UNDER THE AR-
RAHNU SCHEME.
LOAN DETAILS WILL BE ADDED TO THE
CENTRAL CREDIT REFERENCE
INFORMATION SYSTEM (CCRIS). A
CUSTOMER'S CREDIT REPORT WILL BE
AFFECTED IF THE LOAN WITH THE BANK
IS NOT REPAID ON TIME.
Mortgage vs Ar Rahnu

39. MORTGAGE AR RAHN
SOLE PROPRIETOR BASED
INDIVIDUAL BASED
OPERATOR INSTITUTION BASED EG: BANKS,
COOPERATIVES, YAPEIM, STATE
GOVERNMENT AGENCIES, ETC
INTEREST IS CHARGED
MORE EXPENSIVE RATE
CHARGES MONTHLY SAFEKEEPING CHARGES
NO INTEREST CHARGES
CHEAPER
NOT COVERED
IF THE PLEDGED ITEMS ARE LOST,
ONLY A 25% COMPENSATION IS
OFFERED
INSURANCE TAKAFUL COVERAGE
NOT REQUIRED TO PROVIDE PROOF
OF OWNERSHIP
OWNERSHIP MUST PROVIDE PROOF OF
OWNERSHIP EITHER THROUGH THE
LETTER OF PURCHASE / RECEIPT OR
LETTER OF UNDERTAKING.
IF IT BELONGS TO SOMEONE ELSE, A
LETTER OF CONSENT / APPROVAL
FROM THE OWNER IS REQUIRED
Mortgage vs Ar Rahnu

40. MORTGAGE AR RAHN
VALUATION IS MUCH LOWER
THAN THE MARKET VALUE
AVERAGE 30.5%
PAWNING VALUE UP TO 60 – 70% OF THE VALUE
OF PAWNED GOLD.
VALUATION BASED ON THE
CURRENT MARKET VALUE.
NOT TRANSPARENT DEFAULT PLEDGED ITEMS WILL BE
AUCTION PUBLICLY.
TRANSPARENT AND NOTICE
WILL BE SENT.
THE BALANCE AFTER THE
AUCTION WILL NOT BE
RETURNED BACK BY THE
COMPANY TO THE PLEDGOR
BALANCE AFTER
AUCTION
THE BALANCE AFTER THE
AUCTION WILL BE
RETURNED BACK BY THE
COMPANY TO THE PLEDGOR
Mortgage vs Ar Rahnu

42. ADDITIONAL DIFFERENT BETWEEN ISLAMIC BANKING
AND CONVENTIONAL BANKING
CONVENTIONAL BANKING ISLAMIC BANKING
ITS FUNCTIONS AND OPERATIONS
ARE BASED FULLY ON MAN-MADE
PRINCIPLES.
FUNCTIONS &
OPERATIONS
ITS FUNCTIONS AND OPERATIONS
FOLLOW THE QUR’AN AND THE
SUNNAH AS MUCH AS POSSIBLE.
IN ITS INVESTMENT PRODUCT, THE
INVESTOR IS PROMISED A FIXED
RATE. IN REALITY, IT IS A RIBA
BASED
LOAN ACTIVITY.
INVESTMENT
PRODUCTS
IN ITS INVESTMENT PRODUCT,AN
ISLAMIC BANK PROMOTES THE
SHARING OF RISK AND PROFIT
BETWEEN INVESTOR AND
INVESTMENT FUND
MANAGER.THERE IS NO FIXED
PROFIT PROMISED. DIVISION OF
PROFIT IS BASED ON REAL PROFIT.
AIMING FOR PROFIT WITHOUT
RELIGIOUS OR MORAL BOUNDARIES.
AIM AIMING FOR PROFIT THAT ADHERES
TO ISLAMIC DISCIPLINE THAT IS
LIMITED TO THAT WHICH BENEFIT
SOCIETY.

43. CONVENTIONAL BANKING ISLAMIC BANKING
IGNORES ZAKAT. ZAKAT PAYS ZAKAT AS IT IS A SOCIAL
RESPONSIBILITY FULFILLED BY
ISLAMIC BANKS.
THE RETAIL LOAN PRODUCT
APPLIES THE SYSTEM OF GIVING OUT
LOANS WITH MULTIPLIED INTEREST.
RETAIL
LOAN
ITS RETAIL PRODUCT UTILIZES
THETRADING OR RENTING OF AN
ASSET,AND NOT THE LOAN
CONTRACT.
CHARGING A COMPOUNDING
PENALTY ON A LOAN IF THERE IS LATE
PAYMENT.
PENALTY CHARGES COMPENSATION FOR ANY
LATE PAYMENT, BUT IT DOES NOT GO
TOWARD THE BANK’S
EARNINGS.INSTEAD, IT IS
CHANNELED DIRECTLY TO CHARITY.
THE MAIN PRIORITY IS TO PROTECT
THE BANK’S INTEREST; NO PRIORITYIS
GIVEN TO ENSURE
EQUITY DEVELOPMENT.
PRIORITY EMPHASIZE PROJECTS THAT BENEFIT
SOCIETY. THE MAIN AIM IS TO
ENSURE EQUITY DEVELOPMENT.
ADDITIONAL DIFFERENT BETWEEN ISLAMIC BANKING
AND CONVENTIONAL BANKING

44. CONVENTIONAL BANKING ISLAMIC BANKING
LOANS GIVEN BY
CONVENTIONAL BANKS ARE
SIMPLE, NO ASSET REQUIRED.
THEIR CONCEPT IS “MONEY
BREEDS MONEY.”
REQUIREMENT
OF ASSET
MONEY IS NOT
GENERATED THROUGH LOANS. THUS,
ANY LOAN SHOULD HAVE AN
UNDERLYING ASSET.
EVALUATION STRESSES ON
THE ABILITY OF THE BORROWER
TO PAY OFF THE LOAN. NOT
MUCH ATTENTION IS GIVEN TO
THE PROGRESS OF THE
CUSTOMER’S PROJECT.
EVALUATION EVALUATION ALSO STRESSES ON THE
POTENTIAL OR
VIABILITY, PERFORMANCE AND
PROSPECT OF THE PROJECT THAT IS
BEING FINANCED.
EARN REVENUE FROM
FIXED INTEREST CHARGED TO
THE CUSTOMER.
REVENUE
EARNED
PROFIT ACCORDING TO THE
CONCEPT OF SHARING PROFIT-LOSS;
THE BANK GIVES MORE
ATTENTION ON INVESTING IN
PROJECT DEVELOPMENT.
THE BANK
-CUSTOMER RELATIONSHIP: LOAN
LENDER AND BORROWER.
RELATIONSHIP THE BANK-CUSTOMER RELATIONSHIP:
SELLER, BUYER OR PARTNER.
ADDITIONAL DIFFERENT BETWEEN ISLAMIC BANKING AND
CONVENTIONAL BANKING

45. CHALLENGES
• Shariah interpretation versus the financing
commercial viability.
• Legal jurisdictions and governing laws.
• Transparency, accountability and governance
for public and private sectors.
• Tax incentives, pervasive government
intervention and controls.
• Supervisory and prudential regulatory
framework.
• Lack in depth capital markets and liquidity
funding.

47. TEST 2 (CHAP 4-6)
TUTORIAL EXERCISE 4 (CHAP 6)