7 Differences between Islamic Finance and Conventional Finance

In modern times, Indonesia uses two different economic laws, which are state law and Islamic economic law. Both economic laws are implemented in almost every financial institution, including financing institutions. Both Islamic finance and conventional finance are based on state law, in which both aim to fulfill their customers’ financial needs. Despite their similar purpose, they are both different from each other.

The most obvious difference between Sharia-based finance and conventional finance is their legal basis. The difference in legal basis impacts every aspect or component of each finance institution. As a financing service provider, you must understand the differences between Islamic finance and conventional finance to properly conduct your business based on the existing law.

Let’s look at a complete explanation of the differences between islamic finance and conventional finance institutions in this article!

Definition

Before talking about the difference between each finance institution, let’s see the definition of each finance.

1. Islamic Finance

Islamic finance is a type of Sharia-based financing institution. Agreements in Islamic finance must be legal and suitable with the Sharia principles. Such principles are based on Islamic teaching that prohibits interest. For this reason, Sharia-based finance uses a profit-sharing system (mudharabah) to provide financing for customers.

Islamic finance uses the following systems to help customers:

• In the murabahah (repurchase) system, financing provided by Sharia-based financial institutions is charged to the borrower at a pre-agreed price.
• The qardhul hasan (interest-free loan) system requires loan payments to be made in the same amount as the amount borrowed.
• The ijarah system, where the borrower must pay rent for goods or services provided by Sharia-based financial institutions regularly by the borrower until the rental period ends.
• The musyarakah system, where financing system requires borrowers and sharia financial institutions to provide capital that will be used to make investments. The results of this investment will be shared according to the agreement agreed upon by both parties.

Conventional Finance

Conventional finance operates based on the existing state law. The principles of this finance are based on profit or interest from creditors to debtors. Conventional finance usually relies on loan or credit systems with interest when financing customers.

Conventional finance also uses several systems other than the credit system:

• Leasing is where payments are made regularly by the borrower until the lease period ends.
• A credit card that can be used by debtors to make purchases using limits determined by the financial institution.
• Overdraft system, where borrowers can withdraw funds from their accounts that exceed the existing balance.
• Margin credit system, where borrowers can use their assets as collateral for loans provided by conventional financial institutions.

Read also: Finance Company: Types and Schemes

Differences

Differences between Islamic finance and conventional finance are based on the following aspects.

1. Legal Basis and Financing Purpose

One of the most essential differences between Islamic finance and conventional finance is the legal basis. Islamic finance is based on Islamic law from the Quran or Hadith. The purpose of Islamic finance is not only to benefit the financing institutions but also to help society fulfill its financial needs in ways that are halal or compliant with Islamic teachings.

On the contrary, conventional finance is based on law regulations on banking. Financial credit to the customers is intended to make a profit for conventional financing institutions, while the customers have their financial needs satisfied.

2. Financing Service Provider

Conventional financing is channeled by conventional banks, Rural Bank (BPR), and pawnbroker institutions. On the other hand, Sharia-based financing is offered by Islamic banks, Sharia-based Rural Bank (BPRS), and other financing institutions based on the Islamic Sharia principles.

3. Relationship Between Customers and Service Providers

In conventional finance, financing institutions and customers are respectively referred to as creditors and debtors.

Conversely, there are three types of relationships between the financing institutions and customers in Islamic finance. These relationships are seller-buyer, partnership, and owner-tenant.

In murabahah, istishna, and salam agreements, the Islamic financing institution takes the role of a seller and customers as buyers. In musyarakah and mudharabah, both sides collaborate in a partnership. Lastly, Islamic financing institutions take the role of owners and customers as tenants in ijarah.

4. Supervisor of Financing Activities

Both Islamic finance and conventional finance are regulated under Law Number 10 of 1998 concerning Banking. Even so, the supervision process between both financial systems is different from each other.

A Board of Commissioners is responsible for supervising the activities of conventional financing institutions. Meanwhile, several supervisory agencies like the Islamic supervisory board, the national Sharia board, and a board of bank commissioners are tasked to supervise Islamic financing institutions.

5. Financing Operational System

In conventional finance, the system works by implementing interest and common agreements based on national law. Transactions between banks and customers are usually based on agreement on the applied interest rate.

It’s a different story with Islamic finance. As interest doesn’t exist in this financial system, Islamic finance instead uses profit-sharing (nisbah) agreements during its operations. Agreements between banks and customers are based on sharing profits from financial transactions.

6. Fines Imposition

Another difference between Islamic finance and conventional finance is the imposition of fines. If there is a late payment in conventional finance, fines will be imposed on the customers. The fines’ amount will increase as long as the customer still doesn’t pay the late payment.

In Islamic finance, customers with late payments will not be imposed with interest fines. As a replacement, Islamic financing institutions will negotiate with the customer until they reach an agreement. Even so, several Islamic financing institutions in Indonesia still impose fines as sanctions. The catch is the profit collected from these fines will be allocated for social development purposes.

7. Types of Risk

In conventional finance, debtors are fully responsible for risks from the failure of loan repayment. However, in Islamic finance, financing institutions must also bear the risk with the debtors based on a predetermined agreement.

For example, if a customer takes a loan of IDR 30 million from conventional financing institutions, the customer must repay the principal loan along with the risk of additional predetermined interest. It’s a different case with interest-free Islamic financing institutions, in which the impact of risk in the installment payment process is more manageable.

Read also: Credit Risk: Definition, Types, and How to Measure It

Potential customers must know the differences above between Islamic finance and conventional finance before relying on an institution of either financing system. The distinctive legal basis and principles of either financing system have greatly impacted the operations and policies regarding interest and fines.

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