Some major differences between Islamic and conventional banking can be described as follows:

1-  In a conventional bank, a customer is given finances by a contract of loan where

the bank is creditor and the customer is debtor. On the other hand in Islamic

banking, finances are given to a customer by a contract of sale i-e a deferred sale

contract. In this contract, either bank itself buys goods or appoints the customer to

buy on its behalf and later sells them to the clients with a mark up (cost plus an

agreed profit margin). Payment is done in installments over a specific period of

time.

2-  Islamic banks earn their profit by trading and investment activities and this profit

can be said legitimate as it involves risk and efforts as compared to conventional

banks which earn their profit by financing the customers at a fixed interest rate.

3-  . Participation in partnership business is the fundamental function of the Islamic

banks. So they have to understand their customer's business very well. Whereas

lending money and getting it back with compounding interest is the fundamental

function of the conventional banks.

4-  The Islamic banks have no provision to charge any extra money from the

defaulters. Only small amount of compensation and these proceeds are given to

charity. On the contrary, conventional banks can charge additional money

(penalty and compounded interest) in case of defaulters.                                    

(Al-Omer & Abdul-Haq 1996)

5-  The nature of Islamic banking is not simply lending the money as experienced by

a conventional bank, but it is involved in selling and buying the commodity. Thus

the selling price which is a cost price plus the profit margin, which is the

contracted amount. In conventional banking practice, interest is regarded as the

price of loan. For example, if the worth of asset is $ 50,000 and interest rate is

15% per year, the price of the loan to be paid by the customer will be $57,500.

6-  Profit amount agreed once between the customer and an Islamic bank remains the

same, e.g., in murabahah or cost plus profit is fixed at the time of contract and

must be agreed upon by the customer. If customer is unable to pay on time, bank

cannot ask for a higher price due to delay in settlement of dues. While interest rate

is also prefixed at the time of contract would be either unchangeable or would

change according to the Base Lending Rate (BLR) which is monitored by the

central Bank.

7-  Islamic banks face more risk as compared to conventional banks. Although both

have to take credit risks, capital adequacy, liabilities and asset-matching risks,

currency fluctuation and liquidity risks, the risk for Islamic banks is higher.

Because Islamic banks have to face profit and loss in each deal in order to earn

profit but in conventional banks, the risk of loss is borne entirely by the client and

the lender (bank) safeguards itself against any possibility of loss. However

interest rate risk is faced by only conventional banks and not by Islamic banks as

interest is not permitted in their operations.

8-  Islamic banks cannot remain unconcerned about the nature of the activity for

which they are financing. They cannot finance any business which is against the

teachings of Islam. While conventional banks don’t have to follow any limitations

of religion and they may finance any profitable activity e.g., a gambling casino or

an alcoholic manufacturing industry etc.

Five Basic Islamic Financing Contracts

Murabaha: (Cost plus)

A Murabaha transaction is basically a cost plus profit financing transaction in which a

tangible asset is purchased by an Islamic bank at the request of its customer from a

supplier. The Islamic bank sells this asset to its customer on a deferred sales basis with a

mark up that is bank’s profit. The mark up on the asset cannot be altered during the life of

the contract. The Murabaha deals offer enough flexibility to be used in real estate and

project financing.

Ijara and Ijara wa-Iqtina: (leasing and lease purchase)

Ijara and Ijara wa-iqtina are Islamic leasing concepts similar to western operating and

finance leases. Ijara is similar to conventional operating lease, where in an Islamic bank

(lesser) leases the asset to the client (lessee) for agreed on lease payments for a specified

period of time, but with no option of ownership for the lessee. The maintenance and

insurance is the responsibility of the lesser.

On the other hand, in ijara wa iqtina, lessee has the option of owing the asset at the

termination of the lease. In both types of leasing, the lease payments must be agreed on in

advance to avoid any speculation. 

Istinsa: (leasing structured mode)

Istinsa is a leasing mode which is used to finance long term or large scale facilities

involving like construction of a sugar plant. In this mode, bank could either own the plant

and charge the lessee a fee based on profits or sell the plant to the company on a deffered

basis similarly like the Murabaha transaction. 

Mudaraba: (profit-sharing)

Mudaraba is a trust based financing agreement in which an investor e.g. Islamic bank

give capital to an agent for a project. Profits are based on prearranged and agreed ratio. In

case of loss earn no return and the agent receives no compensation for his effort.

Musharaka: (equity participation)

Musharaka is similar to a joint venture in which bank and agent jointly invest in some

project. They agreed on some prearranged profits and losses. 

(Zaher and Hassan 2001)

Islamic Banking

The prohibition of interest in Islam caused many writings to come forward with an idea

to establish banks that do not work on interest basis. So the basic difference between

Islamic banks and conventional banks is that Islamic banks are interest free banks

whereas conventional banks are interest based banks. (Kahf 2006) Although interest and

profit are very clear concepts but they are misunderstood by many people. Basic

difference between interest and profit is that interest is the reward to money and profit is

the reward to capital investment. In other words money produces interest and capital

investment produces profits. (Toutounchian 2004)

Islamic finance has gripped the world with a strong commitment and passion. It has been

depicted that interest in this segment has grown rapidly in almost 60 countries, not only

in Islamic countries but in the leading global financial centers. Even United Kingdom has

adopted an open door policy and provided a level playing field to Islamic finance and

now Singapore is following its lead.  (Dr.Shamshad 2007)

Islamic banking has shown tremendous growth in the past 20 years, with estimated

deposits surpassing $80 billion in more than 45 countries. Annual turnover is currently

estimated at $70 billion and is projected to pass $100 billion by 2000. (O’Sullivan 1994,

p. 7) For the last 60 years, the mode of banking in Pakistan was totally of interest based

but now there is a shift from western banking to Islamic banking in number of banks in

Pakistan and also there are some new banks like Meezan bank which is totally based on

Islamic banking. In 2007 Meezan Bank creates a significant milestone in the history of

Islamic Banking by opening its 100th branch in the city of Karachi. With 100 branches in

31 cities clearly positions the Bank as the leading Islamic Bank in Pakistan. Two new

dedicated Islamic Banks start operations in Pakistan, namely Emirates Islamic Bank and

Dawood Islamic Bank. (Meezan Bank 2007)