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Table of Content

EXECUTIVE SUMMARY

INTRODUCTION

OBJECTIVES OF THE STUDY


METHODOLOGY
LIMITATION OF THE STUDY

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3
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TRADITIONAL FINANCE

CHARACTERISTICS OF TRADITIONAL FINANCE


ROLE OF TRADITIONAL FINANCE IN THE DEVELOPMENT

OF

MODERN ECONOMIES

ISLAMIC FINANCE

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PINNING PRINCIPLES ON ISLAMIC BANKS


FEATURES OF ISLAMIC FINANCE
HOW ISLAMIC FINANCE CHALLENGES THE TRADITIONAL FINANCE
DIFFERENCES BETWEEN ISLAMIC FINANCE AND TRADITIONAL FINANCE
ISLAMIC FINANCE BUSINESS IN THE WORLD
ISLAMIC BANKING MOVEMENT IN THE WORLD
CONCLUSION
REFERENCES

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Introduction
Traditional and Islamic finance are all financial institute but having different system of
managements, aspects, history, products and even acceptance according to laws. The first
prototype banks of merchants of the ancient world and this began around 2000 BC
in Assyria and Babylonia. Later, in ancient Greece and during the Roman Empire, lenders based
in temples made loans and added two important innovations: they accepted deposits and changed
money. Many histories position the crucial historical development of a banking system to
medieval
and
Renaissance Italy and
particularly
the
affluent
cities
of Florence, Venice and Genoa. The oldest bank still in existence is Banca Monte dei Paschi di
Siena, headquartered in Siena, Italy, which has been operating continuously. The development of
banking spread from northern Italy throughout the Holy Roman Empire, and in the 15th and 16th
century to northern Europe. During the 20th century, developments in telecommunications and
computing caused major changes to banks' operations and let banks dramatically increase in size
and geographic spread.
While Islamic finance is a relatively small player in global terms, most commentators agree that
the current growth of between 15% and 20% in this niche market shows no sign of reducing in
the short to medium-term. It is estimated that assets in the industry will reach $1 trillion by the
end of 2010.

Objectives of the Study


This Research bases on the following objectives

To show, define and explain traditional banks and the role it play in economic
development.
The main purpose of the study is to analyze the Impact of mode of financing by Islamic
Bank and Traditional Bank.
To show similarities and differences between Islamic and Traditional banks.
To give people awareness that will make them choose the best banking system for their
development.
Showing Future of Islamic banks in World Economy.

Methodology
The nature of this study bases on descriptive and analytical method of covering the study. The
research project draws its information from published books, journals, reports, seminars, internet
and other research projects.

Limitation of the Study


The problems which I consider as the limitations are as followsDue to lack of knowledge in financial sector I faced difficulties in sort out
the data.
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Lack of primary data.

Traditional Finance
Traditional financing generally means a loan or line of credit secured through a financial
institution under conventional terms, usually based on the four Cs: character, collateral, capital,
and capacity. The process for securing such financing is fairly standardized, with lenders looking
at your credit history, and your assets when assessing your qualifications.
The most common source of traditional financing is loans from large or small banks. Large
banks can be the hardest to get loan approval from, with an application process that depends
heavily on rigid, numerical factors such as your credit score. Smaller banks may have higher
interest rates but are more likely to give your application detailed attention and work with you to
find a way to get you a loan.
Borrowers who are having trouble getting approval from a bank on their own can also turn to the
Small Business Administration to try to get an SBA-backed loan. Having the SBA guarantee the
loan essentially eliminates risk for the lender, making these loans very popular but also
competitive.
Similar to banks are credit unions, which also offer financing on generally favorable terms. The
difference between a bank and a credit union is that a credit union is a non-profit organization
owned by its members. Credit unions have restrictions on joining, generally limiting membership
to certain communities such as residents of a local area or associates of an educational
institution.
Because theyre non-profits, credit unions can sometimes offer lower interest rates than banks,
but this is not always the case, especially as larger banks often have access to tax advantages and
other benefits that the inherently small credit unions dont. Approval rates tend to be similar to
that of small banks and higher than for large banks; according to recent credit union approval
rates for small business loans are around 45%, versus 50% for small banks and 15% for large
banks.

Characteristics of Traditional Finance


Characteristics

Business Framework

Conventional
Banking
System (Interest based
system)
Not based on religious laws
or guidelines - only secular
banking laws

Islamic Banking System

Based on Shari'a laws Shari'a


scholars
ensure
adherence to Islamic laws and
provide guidance.
Balance Between Moral and Excessive use of credit and The requirement to finance
Material Requirement
debt financing can lead to physical assets which banks
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financial problems.

Equity financing with risk Not


generally
available
to capital
through commercial banks,
but through venture capital
companies and investment
banks which typically take
equity
stakes
and
management control of an
enterprise for providing startup finance.

Prohibition of Gharar

Trading and dealing in


derivatives of various forms
is allowed.

Profit and Loss Sharing

This principle is not applied.


Returns to depositors are
irrespective
of
bank
performance and profitability.
The customer as depositor is
like a lender and does not
share in the success of the
enterprise beyond receiving a
fixed rate of predetermined
interest. Unlike the Islamic
system the depositor cannot
theoretically gain subject to
improved bank performance.

usually take ownership of


before resale reduces over
extension of credit.
Available. Enables several
parties, including the Islamic
Bank to provide equity
capital to a project or venture.
Losses are shared on the basis
of equity participation while
profits are shared on a preagreed ratio. Management of
the enterprise can be in one of
several forms depending on
whether the financing is
through
Mudarabah,
Musharkah, etc.
Transactions deemed Gharar
are
prohibited.
Gharar
denotes varying degrees of
deception pertaining to the
price and quality of goods
received by a party at the
expense
of
the
other.
Derivatives
trading
e.g.
options are considered as
having elements of Gharar
All transactions are based on
this principle. Returns are
variable, dependent on bank
performance
and
not
guaranteed. But the risks are
managed to ensure better
returns than deposit accounts.
Consumers can participate in
the profit upside i.e. in a more
equitable way than receiving
a predetermined return.

Role of Traditional Finance in the development of Modern


Economies
One way the financial sectors impact on the overall economy has been measured in the past is
through its direct contribution to employment and GDP. For example, in 2006 there were 6.19
million people employed in the finance and insurance sector of the American economy,
representing 5.4 percent of total nonfarm private sector payrolls, according to data from the
Bureau of Labor Statistics. By 2010 employment in the financial sector had dropped to 5.76
million but total payroll employment was also down and so the share of employment in the
sector remained comparable. By 2012 employment in the sector had risen only marginally, to
5.83 million, and the sectors share of employment was down to 5.2 percent.
In this section, however, our purpose is not to talk about the direct employment or GDP impact
of the sector, but instead to emphasize the economic importance of the services the sector
provides. A modern financial system exists primarily to provide three types of services to the rest
of the economy:

Credit provision
Liquidity provision
Risk management services

Credit provision.
The total amount of debt gives an indication of the scale of financial intermediation that is
occurring. On top of the outstanding credit amounts, the banks have committed considerably
more through contingent arrangements such as lines of credit that allow companies and
individuals to know that funds would be available if needed. In addition to traditional lending,
commercial and investment banks also take credit risk in many other fashions, particularly
through derivatives exposures and the ownership of bonds and other financial instruments issued
by companies and governments.
The Consequences of Interruptions in the Flow of Credit
In Europe has now evolved into a sovereign debt crisis. Studies on financial conditions indices
also show that credit conditions affect economic growth even in more normal times. The
centrality of financial investors to the economy means that efficiently operating financial markets
are crucial to the provision of credit and equity investment for American businesses and families
Liquidity provision.
Many of the major debt and equity investors care significantly about the degree of liquidity of
their investments. Liquidity has two important and related aspects. First, there is the question of
how easily one can buy or sell a position of the relevant size without moving the market price

adversely. A large mutual fund, for example, will be less interested in owning thinly traded
shares whose price will move up during the process of their buying shares. This creates risk.
Thus, investors care about liquidity because it affects:

There direct transaction costs of getting into and out of a trade


The average price they pay or receive if their transaction is large enough to move the
market for that security.
The length of time it takes to execute a transaction, potentially forcing purchases or sales
to be spread over days or weeks.

Academic Literature on Banks and Liquidity


There is an extensive academic literature on the issue of liquidity with perhaps the most
frequently cited theoretical treatment being by Diamond and Dybvig (1983). There is a less
technical summary of this article in Diamond (2007), which also cites several important and
more recent contributions to the literature. 4 These authors lay out in a careful and rigorous
analysis the framework in which banks create liquidity and they also show the economic basis
for the demand for liquidity in the marketplace, both by consumers and businesses. Diamond
(2007) draws the following conclusions from this analysis:

Islamic Finance
Islamic finance is a term that reflects financial business that is not contradictory to the principles
of Shariah. Conventional finance, particularly conventional banking business, relies on taking
deposits from, and providing loans to, the public. Therefore, the banker-customer relationship is
always a debtor-creditor relationship. A key aspect of conventional banking is the giving or
receiving of interest, which is specifically prohibited by Shariah. For example a conventional
banks fixed deposit product is based on a promise by the borrower that is the bank to repay the
loan plus fixed interest to the lender that is the depositor. Essentially, money deposited will result
in more money which is the basic structure of an interest. In other non-banking businesses,
conventional products and services, such as insurance and capital markets could be based on
elements that are not approved by Shariah principles such as uncertainty (Gharar) in insurance
and interest in conventional bonds or securities. In the case of insurance, the protection provided
by the insurer in exchange for a premium is always uncertain as to its amount as well as its actual
time of happening. A conventional bond normally pays the holder of the bond the principal and
interest. Conventional practices could also involve selling or buying goods and services that are
not lawful from a Shariah perspective. These might be non-halal foods such as pork, nonslaughtered animals or animals not slaughtered according to Islamic principles, alcohol or
services related to gambling, pornography and entertainment. In short, conventional business
practices could be non-compliant from a contractual structure perspective (if they are based on
interest and uncertainty) and / or from a transactional perspective when they are involved in
producing, selling or distributing goods and services that are not lawful according to Shariah.
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Pinning principles on Islamic banks


Islamic banks must conform to Sharia law and, as a result, to the following six principles:
1. They must not allow predetermined loan repayments to become interest (riba) the
receipt and payment of interest is strictly prohibited.
2. The sharing of profits and losses must be at the heart of the Islamic banking system.
3. All financial transactions must be asset-backed. In other words, making money out of
money isnt acceptable in Islamic finance.
4. Speculative behavior is forbidden (and so options and futures are prohibited in Islamic
finance).
5. Only contracts approved by Sharia are acceptable.
6. An emphasis is placed on the holiness and sacredness of contracts.
7. Islamic laws strictly prohibit investments connected with gambling, liquor or tobacco, too

Features of Islamic Finance


As mentioned above, Islamic finance, especially Islamic banking, enjoys certain peculiar features
that are not found in conventional banking. These features are as follows:

Interest
free
Profit
and loss
sharing

Shariah
compliance

Characters
tics of
Islamic
Finance

The need
for
underlyi
ng assets

The
avoidance of
uncertainty
or gambling

Rights and
liabilities of
banks and
customers

Unlawful
goods or
services
Overriding
principles of
Islamic law

How Islamic Finance Challenges the Traditional Finance


Islamic finance does not, and should not, deal with money directly as money cannot earn more
money by itself. Money must be put into real business activities to earn extra money. This is the
whole basis of trading. In other words, IFIs facilitate the financing needs of customers by
becoming sellers, lessors or partners as the case may be. The function of money has been
transformed from a commodity into an enabler to facilitate trading, leasing and investment as
illustrated in the following diagram.

Differences between Islamic Finance and Traditional Finance


The principal difference between Islamic and conventional finance is in the approach and not
necessarily in the financial impact; otherwise there are many similarities between the two modes
of financing.
The key difference is that Islamic financing is asset-based in its approach, not currency-based. As
such, the rate of return is based on an underlying asset or investment as opposed to interest on
money loaned. If riba (i.e. interest or usury) is involved, then the transaction is considered to be
haram and not compliant with Islamic principles. The rationale behind this is that money is only
a means of exchange and should not have its own intrinsic time cost or value.
Another key difference is that Islamic finance is often said to promote a risk-reward approach to
certain aspects of a transaction. In other words in order to justify a return or reward an Islamic
investor must invest and assume certain risks inherent in that investment. However, these risks
tend to be heavily mitigated in practice (we discuss this further below).
Traditional Banking
Money is a commodity besides medium
of exchange and store of value.
Therefore, it can be sold at a price
higher than its face value and it can
also be rented out.
Time value is the basis for charging
interest on capital.
Interest is charged even in case the
organization suffers losses by using
bank funds. Therefore, it is not based
on profit and loss sharing.

Islamic Banking
Money is not a commodity though it is used as a
medium of exchange and store of value.
Therefore, it cannot be sold at a price higher than
its face value or rented out.

Profit on trade of goods or charging on providing


service is the basis for earning profit.
Islamic bank operates on the basis of profit and
loss sharing. In case, the businessman has suffered
losses, the bank will share these losses based on
the mode of finance used (Mudarabah,
Musharakah).
While disbursing cash finance, running The execution of agreements for the exchange of
finance or working capital finance, no goods & services is a must, while disbursing funds
agreement for exchange of goods & under Murabaha, Salam & Istisna contracts.
services is made.

Conventional banks use money as a Islamic banking tends to create link with the real
commodity which leads to inflation.
sectors of the economic system by using trade
related activities. Since, the money is linked with
the real assets therefore it contributes directly in
the economic development.

Islamic Finance Business in the World


Islamic finance is potentially a huge market. The ratings agency Standard & Poors has forecast
that the industry could potentially control up to US$4 trillion of assets. At DLA Piper, our team
can provide expert advice on a broad range of Islamic transactions including: bilateral and
syndicated Islamic financings, co-financings, project finance transactions (including complex
multi-sourced financings), the financing of real estate development, trade finance, asset finance,
debt restructurings and debt capital markets. Our Islamic finance practice also extends to
assisting our clients in relation to Islamic investment funds, private equity, takaful and Islamic
structured products. We have worked on some of the leading Islamic transactions in the Middle
East region, covering many different sectors.
Benefits of Islamic Financing over Conventional Financing
1. For an indefinite amount of time, there will be a 20% stamp duty discount for Islamic
Loan Agreement documents. Note: In conventional financing, there are only 2 legal
documents necessary - Facility Agreement and Charge documents. But for Islamic
financing, there are at least 3 (for some products 4), which brings up the total legal costs.
2. In cases of refinancing from Conventional to Islamic packages, there will be a 100%
stamp duty waiver on the existing refinance loan balance. This is not applicable to any
amount over and above the existing refinance loan balance.
Benefits of BBA Islamic Financing
1. For floating profit rates, profit rates are capped at a maximum. Conventional floating
interest rates have no such cap
2. Late settlement of loans can incur lower charges than Conventional loans as there is no
concept of compounding interest calculation. However, in practice, other fees and charges
may apply that could offset this benefit

ISLAMIC BANKING MOVEMENT IN THE WORLD


Islamic Banking, based on the Islamic economic system, is not restricted to Muslims only. The
objective of Islam injunction is welfare of the whole humanity. Islamic Banking is no longer
confined to concepts and ideas only. Until the first half of the 20th century, it was more or less an
abstract concept. Islamic Banking and finance started in 1963 when Mit Ghambr Savings Bank
began offering interest free banking in Egypt. This bank and its branches were forced to close
down in 1971 due to perceived threat by the administration. The Islamic Summit of Lahore,
Pakistan held in 1974 recommended the creation of Islamic Banks and Islamic Development
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Bank. Starting from 1980s various Islamic Banks and Islamic financial institutions have begun
their operations in different Islamic countries. While the countries of Iran and Pakistan have
implemented Islamic Banking in the whole banking sector, other countries have permitted
Islamic Banking institutions operate with the other traditional banks.
Malaysia is the first country to issue bonds on Islamic basis. Malaysian government allowed
conventional banks to offer Islamic instruments as well if they want. Examination of the progress
of these institutions in Iran and Pakistan reveals that in Pakistan this process is a gradual one. On
the other hand in Iran the process of conversion of traditional banks and financial institutions
into Islamic ones was very rapid. The government of Iran has nationalized all the banks during
the period of 1979-1982 after the Islamic revolution.
There are thirty-one Islamic Financial Institutions and interest-free mode of financing which
are practical and more than 48 countries as well as more than 300 Islamic Banks are working on
these non-interest modes and interest-free methods all over the globe.
The international Islamic Financial Institutions are providing a wide range of services in
accordance with the basic principles of Shariah. The products are Mudaraba, Murabaha,
Musharaka, Ijarah, Istisna and Salam. Conventional banks operate under the concept of lenderborrower relationship where interest is considered as the rental income on capital. The depositors
are assumed to be capital providers. Profits of the banks are distributed at the discretion of the
bank managements. But the Islamic Banks follow the concept of Mudaraba (profit sharing) based
on investor entrepreneur relationship. Here Islamic Banks consider depositors as entrepreneurs.
The profits generated through this relationship are divided between the two parties as per agreed
ratio. Further, researchers divide Islamic Bank customers into three broader categories
(a) Religiously motivated customers
(b) High profit motivated customers
(c) Customers who are religiously motivated but also expect returns at least similar to
conventional banks.
Instead of interest, it allows Islamic Banks to share surplus capital on profit-sharing basis.
Islamic and conventional money markets can be assumed to offer similar returns on investments.
Low returns in Islamic money markets may badly affect the overall profitability of Islamic Banks
in the initial stages of their development. Even if, Islamic money market offers returns higher
than conventional market, the Islamic Banks may still not enjoy an advantageous position.
According to the Institute of Islamic Banking and Insurance, there are more than 300 Islamic
Financial Institutions in the world. These institutions are working in the following countries:
Albania, Algeria, Australia, Bahamas, Bahrain, Bangladesh, Islamic Banking: Present and Future
Challenges Islands, Brunei, Canada, Cayman Islands, Cyprus, Djibouti, Egypt, France, Gambia,
Germany, Guinea, India, Indonesia, Iran, Iraq, Italy, Ivory Coast, Jordan, Kazakhstan, Kuwait,
Lebanon, Luxembourg, Malaysia, Mauritania, Morocco, The Netherlands, Niger, Nigeria ,
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Oman, Pakistan, Palestine, Philippines, Qatar, Russia, Saudi Arabia, Senegal, South Africa, Sri
Lanka, Sudan, Switzerland, Tunisia, Turkey, Trinidad and Tobago, United Arab Emirates, United
Kingdom, United States, Yemen. The positive realization of the Umahs responsibility towards
creating an Islamic framework of economic and financial system at state level owes itself to the
late King Faisal bin Abdul Aziz Al Saoud of Saudi Arabia on whose initiative the organization of
Islamic Conference was established.
Concrete steps were taken to initiative collective efforts towards uniting the Muslims for
common objectives. Malaysia, Bahrain and a few other countries of the Gulf no doubt are an
exception because they are running a parallel system of Islamic Banking and finance and money
market on a comprehensive scale. A number of other Islamic countries have taken legislative
measures to facilitate functioning of Islamic financial institutions. Sudan, Bahrain, Saudi Arabia,
Jordan, Turkey and some other countries are typical examples. In recent years, Bahrain
satisfactorily emerged as the hub of Islamic Banking activities.

Conclusion
In conclusion, encouraging developments and trends in Islamic finance lend confidence that this
industry has taken off. There are varying motivations and driving factors for the development of
this industry that range from religious fervor to the opportunities that exist in Islamic finance for
broadening and deepening the process of financial intermediation. These factors augur well for
financial innovation and engineering, enhanced financial services penetration in national
jurisdictions, and better cross-border capital flows. Though the size of the Islamic financial
industry is still quite small as a proportion of the worlds total financial assets, current growth
trends and infrastructure investments in the development of Islamic finance networks, and their
regulatory and supervisory systems, lend confidence that this industry has promising potential.
Islamic finance also has the potential to both blend economic and social objectives and to
address the ethical aspects of effective financing. As such, Islamic finance is generally more
acceptable in populations with moderate to strong inclinations toward managing their financial
relationships in line with their beliefs. This can thus help in poverty alleviation through including
a larger proportion of the population into the banking system, providing access to credit, and
effectively mobilizing savings.
Emerging solutions and the application of structured Islamic financial innovations have helped
cater to all types of markets and financing requirements, ranging from retail, project, and home
financing to equity funds, products, and insurance. Industry efforts both to benchmark pricing
and to apply legal and regulatory service standards on par with conventional products and
standards have also helped encourage confidence in the system.

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Meeting this challenge will require:


Deepening efforts to enhance the legal and regulatory framework of Islamic finance,
consistent with international practices
Continuing efforts to conform and align structures and products with sharia principles in
order to motivate Muslim populations to turn to this alternative financing mechanism,
while also attracting others to product and risk management, mitigation innovation, and
additional options being offered
Recognizing that Islamic finance has perpetuated and changed the dynamics of cross
border private capital flows, and that this industry has great potential to augment the
process of globalization and financial integration, but that this goal requires more
cooperation and vigilance on the part of home and host regulators
Launching aggressive efforts to implement evolving Islamic financial regulatory and
supervisory standards and to capture the different types of risks associated with Islamic
finance while launching consumer-protection frameworks
Promoting more financial diversification by encouraging financial innovation and Islamic
capital market development Measures such as these will both encourage and strengthen
the future development of the Islamic finance industry.

References
1. NBR analysis: Islamic Finance: Global Trends and Challenges, Shamshad Akhtar,
volume 18, number 4, march 2008.
2. Islamic Finance: Opportunities, Challenges, and Policy Options, Alfred Kammer,
Mohamed Norat, Marco Pin, Ananthakrishnan Prasad, Christopher Towe, Zeine
Zeidane, and an IMF Staff Team, I M F Staff Discussion Note , April 2015 SDN/15/05.
3. Why Traditional Financial Analysis Tools and Approaches are Not Suitable for
Municipalities and should be Re-Designed? (The Case of Municipalities in Czech
Republic) by Filip Hrza, International Journal of Social Science and Humanity, Vol. 3,
No. 1, January 2013.
4. Differences and Similarities in Islamic and Conventional Banking by Muhammad Hanif
Assistant Professor, National University of Computer & Emerging Sciences, Islamabad
PhD-Finance Scholar at International Islamic University, Islamabad, Pakistan, Published
on International Journal of Business and Social Science, Vol. 2 No. 2; February 2011.
5. Open to comparison: Islamic finance and IFRS6. Internationalization of Islamic Financial Institutions: Challenges and Paths to Solution by: Samy Nathan Garas Villa 5, Gate 789, Road 3217 Manama, Bu Ashirah 332 Kingdom
of Bahrain.
7. Islamic Banking: Present and Future Challenges by Noor Ahmed Memon , Department of
Economics, Institute of Business & Technology (BIZTEK), Journal of Management and
Social Sciences Vol. 3, No. 1, (Spring 2007) 01-10.

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8. Hopes for the Future of Islamic Finance by Dr. Abbas Mirakhor, Eminent Islamic Scholar
and Executive Director, International Monetary Fund (IMF), http://www.islamicbanking.com/iarticle_6.aspx
9. The Role of Finance in the Economy: Implications for Structural Reform of the Financial
Sector, Martin Neil Baily Douglas J. Elliott The Brookings Institution July 11, 2013.

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