What is Islamic Banking?

Branch Manager, Islamic Banking Branch, National Bank of Pakistan
My friend asked me about the reality of Islamic Banking, whether it is truly Islamic or not and discussed the benefits of Islamic banking. I replied positively and said that the people are unaware of the Islamic financial system and they believe what they hear from others.
It looked that he wasn't satisfied from my reply and asked me to emphasise on how Islamic system is employed in Islamic Financial Institutes and banks. I discussed the difference between car Ijarah being offered by Islamic financial institution and car leasing being offered by conventional bank. One of the basic difference between the two is that when you are signing an agreement for purchase of car on lease from conventional bank, you are actually signing an agreement that involves money for payment of documentation charges, security deposit, monthly instalments from the day the price has been paid even if delivery is delayed, insurance, expense for running and maintaining the car and in the end settlement by paying additional for any delayed instalment paid during the lease period.
Whereas, taking car on Ijarah from Islamic financial institution is just like taking car on rent ie signing document only for the usufructs (benefit by use) of the car and not for anything else. All the expense related to the ownership of the car eg purchase, registration, insurance and any major maintenance necessary to keep the car in order is the responsibility of the Islamic financial institution being the owner of the car. While all the expenses related to the operations is the responsibility of the user. Suppose for any reason and without the negligence of the user the car is out of order, the user is entitle to stop the rental payment immediately and the owner (Islamic financial institution) will be responsible to provide him with the alternative car or get it repaired for usage.
In conventional lease, the ownership/title of the car is transferred in the name of the person who has taken it on lease against the security deposit. But in Islamic financial system the ownership of car remains with the Islamic financial institution as you have signed a promise that at the end of the Ijarah you will purchase the car from Islamic financial institution than of course the Islamic financial institution will offer you first to purchase the car against the security deposit. Otherwise you will get back your security deposit. Therefore the transfer of car at the end of Ijarah period is not included in the rental agreement as it is done in the conventional lease agreement. I hope it is now clear that all risk and reward of car is with the Islamic financial institution.
Islamic financial institution also charges late fees what is your opinion about that. I said of course my dear friend you are right, Islamic financial institutions charge late fee, but only for charity purpose and not for gaining profit like in conventional lease. And as far as payment of charity, it is not necessary that you have to pay it directly to the Islamic financial institution but you can pay it directly to the needy.
Ok! Tell me, why people say that Islamic finance is costlier than that of conventional banking? Well you see my friend Islamic financial institutions are in their early stages whereas the conventional banks rooted deeply in the current interest based system. The conventional banks have already gained the volume of business thus giving them edge over Islamic financial institution in terms economy of scale.
Whereas, Islamic financial institution along with the regular cost also have to maintain some additional documentation cost for its operations. So it may appear to be marginally costlier at development phase. Now coming back to your question of Islamic Banking, is it really Islamic? let me give you some more ground realities ;
The conventional banks ELIMINATES RISKS, Islamic financial institution BEAR RISKS.
The conventional bank when involve in transaction DO NOT TAKE LIABILITY rather takes only benefits in form of interest. Whereas Islamic financial institution BEARS ALL LIABILITIES involved in transaction.
Conventional Banks borrows FUNDS from its depositors at a predetermined rate of interest and lends the same to its customer again at a prefixed rate. The interest rate paid to the depositor is considerably lower than the interest rate charged to its borrower; difference becomes the bank's profit. The Islamic financial institution accepts FUNDS from individual/Institution in the capacity of Fund Manager under fund manager contract. The depositor is called Rab Al Mal (financer) and the Islamic financial institution is called Mudarib (fund manager) and the transaction is called Mudaraba. The profit received from the operations of Mudaraba is distributed at predetermined profit ratio.
Well my friend I have tried to explain the difference of conventional banking and Islamic financial institution in simple word without the use of Islamic jargon. That is why I said "only the perception is un-Islamic and the people are unaware of the inside and belief what they hear from others". In Islamic finance it is the documentation and the procedures which are followed to complete a financial transaction which makes a boundary one cannot cross. Whereas conventional banks do everything for the money & with the money and not much support to the economy in actual.
The Islamic financial institution when entering into a transaction is actually mobilising the economic resources ie land, labour and entrepreneurship. So my friend all we need to do is to build awareness of Islamic financial institution's operations and avoid comparing it with conventional banks as both are opposite pole of economy.
The writer is an executive in Islamic Banking Division of National Bank of Pakistan