Banks form an integral part of human life, though the choice of banks depend upon a number of factors varying between customers' preference for safety of their deposits, size and strength of the bank, accuracy, speed and general quality of service, proximity to the location of the customer, behaviour of the bank staff, environment, etc. (Seshaiah & Narender, 2007). The vitality of retail banking in the daily sphere of life gives rise to the question about the choice of banks. Broadly speaking there are two kinds of banks prevailing in society today, viz., Islamic banks and traditional ones which believe in conventional methods of banking. The following sections deal with the evolution and the characteristic features of either of them.
2.1.1 Islamic banks
The evolution of Islamic banks had existed during the medieval time period when the traders in the Middle East used to quote the Shari'ah norms included in the holy Quran while financially dealing with each other. The primary features of such transactions had been devoid of any interest payments, which were treated as usury and omitted any means which could raise a possibility of generating profits and losses. One important event in the history of Islamic banks had been the initiation of the Mit Ghamr savings project set up in 1963. This was a financial cooperative firm which allowed people to borrow small sums of money given that they had deposited their funds with the bank. It gained immense success among the Islamic population based in the Middle East and was later incorporated in the Nasser Social Bank in 1971. Around the same time financial services to propel savings among the population was initiated in Malaysia to assist the pilgrims going for hajj (Schoon, 2009, p. 9).
The formalised version of Islamic banks entered the financial scenario approximately thirty years ago, following the First International Conference on Islamic Economics arranged in Saudi Arabia under the supervision of King Abdul Aziz University. The conference became the inspiration behind the establishment of Dubai Islamic Bank (DIB), the first of its kind in the world in the year 1975. It was succeeded by the launching of the multilateral development bank, Islamic Development Bank (IDB) in Jeddah, which primarily tackled issues related to investment of assets and hence that of redistribution of wealth, that also happened to be one of the norms being followed by the Islamic banks (Schoon, 2009, p. 9). Since then the Islamic banking sector expanded around various parts of Africa and South Western Asia, which are often regarded to be densely populated by an Islamic population (Chachi, 2006, p. 37).
Islamic banks mainly abide by the traditional norms defined in the sacred Quran, and commonly termed as the Shari'ah laws. These laws demand the fulfilment of some vital social and economic aspects prior to entering into any financial dealings with their customers. Islamic laws ensure that its customers and officials are generous enough towards society and fair enough in their transactions and obligations towards others. The purpose behind the inclusion of these elements in their norms is to infuse values and virtues within the society. Shari'ah laws hence could be considered as neither favouring capitalism nor socialism, ensuring a fewer number of economic disagreements. In simple words, the Islamic laws emphasise upon any activity which comes with a promise of the development of human society (Ahmad, n.d., p. 3). Popularity of Islamic banks has reached its epitome despite the fact that the history of their evolution dates back to just thirty years. Today branches of Islamic banks are spread in more than 60 countries globally with their gross assets over US$ 23 billion. Their assets had been growing at the rate of approximately 19 percent throughout the decade of 1980s and had sustained a double digit number throughout the 1990s as well. Rates of growth of these banks have drawn the attention of many investors around the world instigating them to purchase shares of these banks and helping them to finance their expansion process (Kuran, 1995, p. 160).
2.1.2 Conventional banks
The history of conventional banks date back to as early as the eleventh century in the nation of England, though the primitive form of banks had existed back in 2000 B.C. The earliest forms of financial transactions had depended upon the Jews who were responsible for accepting deposits of money from the richer strata of the society and lending them to the warriors during crusades. They earned hefty profits out of these loan advances through charging high rates of interest. However, the Jews were extradited from the society due to the unjustified ways they implemented for generating profits, back in the year 1290. They were succeeded by Italian migrants from USA who initially were traders but settled down as bankers in UK during the sixteenth century. These new bankers were responsible for looking after the accumulated gold of rich people and forwarded receipts to the depositors against those deposits. Receipts were actually, far better and easier mode of carrying around sums of money due to the heavy weight of the gold coins. These receipts later were popularised as bank notes and were eventually being used as instruments for making transactions in the market (Pond, 2007, p. 32). This was how paper money came into existence in the English society.
But the invention of paper money was also associated with serious drawbacks like the scope that they provided to the unfair moneylenders, who soon discovered the immoral benefits they could enjoy out of the scheme. The money lenders started issuing notes bearing the denomination of sums advanced as credits, even though they were not backed by gold. Hence, the economic situation of the nation was at the mercy of the moneylenders who actually created money out of nowhere and triggered inflation at the same time. Hence, the modern method of creating money out of seigniorage was established that established the people with the highest sums of bank notes, as the wealthiest people in the nation. This system was approved as the mode of financial transaction in the year 1694 in England. The Bank of England was established in the latter parts of eighteenth century as the public exchequer. Its role was modified during the nineteenth century when the Bank undertook the role of lender of last resort to the economy so as to prop it up at times of financial instability. In USA too, a transformation originated during the same phase when silver money was replaced by pennies made out of cheaper materials. USA used to import bullions of silver from England and India while exporting gold to them in exchange. There was an arbitrage profit involved in such transactions due to the difference in the values of those metals among the nations (Ashton, 2006). The First World War saw the world in the midst of a huge financial crisis owing to the use of gold standard. Hence, the standard was abolished and the national treasuries took charge of the circulation of money in their respective nations. This was when the initiation of the new form of banking structure took place in the world (Bank of England, n.d.).
2.1.3 Conclusion of definitions and history
Conventional banks date back to as early as the eleventh century, while the Islamic banking sector was formally established about three decades ago in Dubai. Though primitive forms of both the systems had prevailed during the medieval era, their formalised versions came into later. Islamic banks were established nearly thirty years ago in Dubai following a conference on Islamic economics in the region. On the other hand, conventional or the non-Islamic banking system was popularised following the First World War. The primary motive of Islamic banks was to establish peace and order in the society through the implementation of social virtues in their operations and taking care of human values as much as possible. They were completely against capitalism and socialism which empowered a certain section of the society and couldn't correct the existing malice. Instead the Islamic banks believed in redistribution of the excess wealth among the poor through taxing the richer population. On the other hand conventional banks believed in simple lending and borrowing principle rather than in reforming the society. The latter maintain a profit motive while making financial transactions in contrast to the former.
2.2 Comparison between Islamic and conventional banks
Islamic and non-Islamic conventional methods of banking are the two major types of retail banking which exist in the world today.
2.2.1 Islamic Banks
The main features which define a typical Islamic bank are -
Prevention upon charging interests
One of the defining and distinguishing characteristics of Islamic banking sector is the ban that they impose upon the payment of interests on loans and deposits. According to Shari'ah laws the practice of charging riba is an offense since it often shoved the defaulters towards enslavement in the older days when the merchants agreed upon lending the principal only if the borrower pledged to return back double the amount, with the additional amount often termed as the accumulated rate of interest and being justified as an opportunity cost to the merchant.
Though there rarely are instances where any bank, irrespective of being Islamic or non-Islamic, has prevented the imposition of rates of interest on loans, the Islamic economists claim it to be a rather unjust method of income generation. If the investor who borrows the sum pours it in a risky venture and faces a loss, his obligation to the bank might be burdensome on him especially with the added rate of interest. In the meantime, the bank faces almost no risk of losing its money, which is terribly unfair, given the fact that the creditors too are responsible to the investment to some extent (Kuran, 1995, p. 156-158).
Islamic banks promote the redistribution of wealth
An important aspect of the Islamic banking system, defined by the Shari'ah laws is that it gives an immense effort upon a proper redeployment of wealth among its customers. The system, locally known as zakat, imposes taxes upon financially affluent Muslims to serve various purposes, such as fund raising for the needy, assistance to the preachers and saviours of Islam as well as liberation of slaves. This system is often claimed to be a potential remedy against the prevailing social vices like income inequality and poverty. Zakat is often preferred to be paid by the Muslims over taxes they owe to their governments, since the former has a religious interest associated with it (Kuran, 1995, p. 159).
Islamic banks are against speculative activities
The Islamic banking sector is completely against the promotion of speculative activities for the purpose of income generation. The Shari'ah laws consider such activities to be highly risky and hence bar the banks from getting involved in them.
2.2.2 Conventional banks
The conventional methods of banking are solely inspired by profit motives with profit margins generated from the interests that the banks charge to borrowers. These rates of interest which they charge from the debtors are higher than what they pay to the depositors. The primary features which define the characteristics of the non-Islamic or the traditional banking sector and distinguishes it from the Islamic banking sector have been elaborated underneath. (where is the reference )
Rates of Interest
The conventional methods of banking charge rates of interest from their debtors and at the same time also pay their depositors with a certain amount of interest. However the rates of interest that the banks charge from their debtors depend upon the credit worthiness of the borrowers. The lower the credit worthiness is, higher will be the rate of interest that the banks charge from them and vice-versa. Their credit worthiness depends upon the amount of collaterals or mortgages that the borrowers are capable of keeping with the banks in exchange of the amounts that they appeal for debts. These variable rates of interest which the banks charge are actually methods of earning hefty profit margins. Hence, the banks sworn under the conventional methods of banking do not treat the charging of rates of interest upon loans as unjust and rather consider them as potential methods to earn profits. In fact, the rates of interest that the banks charge are determined from market behaviour and are actually subjects of high economic interest. Thus, the conventional banks also participate in speculative activities simultaneously, since their rates of interest depend upon the credit worthiness of the borrowers. If the borrowers fail to repay back the amounts that they owe to the banks, the banks stand a chance of losing its money. Moreover, unlike the Islamic banks, in the conventional system, the obligations that the debtors have towards their banks are independent of the status of their ventures, so that in terms of the Islamic Shari'ah laws, the method of earning profit could as well be treated as unfair or unjust. (need reference)
Social Responsibility of the conventional banks
As far as the case about the social responsibility of the banks are concerned, it is limited to the extent of taking care of the economy and help it stay afloat during times of financial distress or instabilities. However, as far as the matters of redistribution of wealth are concerned, the conventional banks do not consider themselves responsible for the same. The only measure which they undertake is to charge lower rates of interest on loans advanced to the poor and the needy; but even in such cases the trends in the monetary policies have an immense role to play. (Need reference)
2.2.3 Conclusion of comparison
After elaborating upon the integral characteristics of either methods of banking, it could be clearly concluded that the policies which they depend in are almost in contrast of each other. While the Islamic banks believe in protecting the human and social values while deciding the distribution of wealth or rather the allocation of resources in the economy, the non-Islamic banks play their role after keeping room for profit margins to some extent. On the other hand, the Islamic banks are dead against participation in speculative activities while the conventional banks treat such activities as potential areas of earning profits. Hence, speaking in general the Islamic banks are far better and socially beneficial but the role of conventional banks are more related to economic and financial matters.
References
Ahmad, Z. (No Date) 'Islamic banking: State of the Art' [Pdf]. Available at <http://www.irti.org/irj/go/km/docs/documents/IDBDevelopments/Internet/English/IRTI/CM/dowdownlo/IES_Articles/Vol%202-1..Ziauddin..ISLAMIC%20BANKING.pdf> (Accessed: July 12, 2010).
Ashton, T. S. (2006) An Economic History of England: The Eighteenth Century. London, UK: Routledge.
Bank of England (No Date). 'Key moments in the Bank;s history - A brief guide' [Online]. Available at http://www.bankofengland.co.uk/about/history/index.htm#3 (Accessed: July 12, 2010).
Iqbal, M. & Molyneux, P. (1975) 'Thirty Years of Islamic Banking: History, Performance and Prospects'. JKAU: Islamic Economics Research Centre, Vol. 19 (1): 37-39. (I can't see it in the research)
Kuran, T. (1995) 'Islamic Economics and the Islamic Subeconomy'. Journal of Economic Perspectives, Vol. 9 (4): 155-173.
Pond, K. (2007) Retail Banking. London, UK: Global Professional Publishing.
Schoon, N. (2009) Islamic Banking and Finance. London, UK: Spiramus Press.
Seshaiah, S. V. & Narender, V. (2007) 'Factors Affecting Customers' Choice of Retail Banking'. The IUP Journal of Bank Management, Vol. VI (2007): 34-46.
