Islamic banking or Islamic finance deals with financing activities that complies with the Shariah law (Islamic law). This system prohibits Riba (interest paid on loans). Investment in goods and services which are contrary to Islamic principles such as alcohol is also considered as Haraam. But the question is, what makes it better than the conventional banking system where such investment, is not prohibited so far as banks can generate profit and also earn huge amount of income through the interest they charge on loans?
The following are some elements which give the interest free banking system a comparative advantage on the conventional form of banking;
- In the conventional banking system, the investor is assured of a predetermined rate of interest, which may push some borrowers to be very reluctant to loan taking. While, the Islamic banking system promotes risk sharing between providers of capital( investors) and the users of funds( entrepreneur), which tends to increase the ability of credit demanders to go out for more loans( e.g. commercial loans or business loans) and as a result, more development projects are been carried out.
- Also, lending money and getting it back with compounded interest is the fundamental function of conventional banks. Therefore, in the light of loan screening and monitoring they are more exposed to credit ricks as compare to the Islamic banking system where participation in partnership business is their fundamental function, which calls for more loan evaluation thereby, reducing bad debt. This low level of credit default increases the soundness and effectiveness of Islamic banks.
- Lastly, conventional banks use money as a commodity, since it can be sold at a price higher than its face value which leads to inflation. While, on the other hand Islamic banks tend to create links with real sectors of the economy system by using trade related activities. Since the money is linked with real assets, it therefore contributes directly in economic development.
The points above clearly demonstrate why Islamic banking is a more preferable banking system.