1. INTERFACE BETWEEN TRADITIONAL AND ISLAMIC BANKING
AUSAF AHMAD
Meeting of the Board of Directors of Jan Seva: Interest free Cooperative Credit Society
Hyderabad, A.P.
16 July 2010

2. This Presentation covers
The definitions of certain concepts
The scope and working of traditional banking
The scope and working of Islamic banking
Similarities between traditional and Islamic banking
Dis-similarities between traditional and Islamic banking
Conclusions and suggestions

3. Definitions of certain concepts
Interface: A point where two things meet and interact (Oxford dictionary)
The term has been borrowed from PHYSICS
Physics: A surface forming a boundary between two portions of matter of space
2. BANK
A financial institution that accepts deposits and advances money as loans. The bank draws its name from moneylenders who used to conduct their business on the bank of a river in Florence (Italy) in late 14th and early 15th centuries.
3. Traditional Bank
A banking institution which conducts its business on the basis of an interest. It is also known as a standard commercial bank.
4. Islamic Bank
A bank which neither gives nor receives interest. It is also known as interest free bank, PLS bank, participatory bank, specialized financial institution etc. All expressions have been used in the literature interchangeably.

4. Is the use of expression “Bank” Justified?
Some scholars have reservations against the use of the word “ Bank” for Islamic financial institutions. Their main objection is against the power of credit creation and indiscriminate use of the power to grant loans. Being interest free financial institutions, Islamic banks are in a unique situation, un comparable with commercial banks.
These scholars suggested the use of the term Finance House or Beit at Tamwil.
Examples. Kuwait Finance House (K.F.H.) and Beit at Tamwil al Saudi al Tunisi (BEST)
Islam is not against loans. There is strong and irrefutable evidence that Prophet borrowed both for private and public purposes. Power of Banks to create credit is a social resource and must be used for the good of the society.

5. Power of “credit creation” and all that
Power of the commercial banking to “create” credit lies in the banking system and not in the individual banks.
Power of credit creation hinges upon the fact that a deposit never leaves the banking system and system of fractional reserves
Example of a monopoly bank
The power of Credit creation provides the reason detre for credit control.

6. Do Islamic banks “Create” Credit?
The Scholars are divided on the issue.
The group that argues that Islamic banks do not create credit compares them with equity companies.
The other group builds its argument on the existence of a fractional reserve system.
Fractional reserve system and credit creation is consistent with Mudarabah system.
In order to curtail the power of credit creation, some people argue for 100% reserve requirement. This will reduce the banks to safety valets .

7. Financial intermediation: non-islamic and islamic
Financial intermediation is required when savers and investors are two different classes. Savers save their own income but investors invest the savings of savers. Financial intermediaries are those institutions which make the saving available to investors for investment. Non Islamic financial intermediation involves payment of a fixed charge called interest for the services provided. Islamic financial intermediation shall be performed against a share of profits earned by the investors.

8. Direct financing
CAPITAL MARKKET money Equity
Savers
Business Firms

9. Financial Institutions
Indirect Financing I
Return on Investment
Return on Investment
Business
Households
Financial Institutions
Financial Resources
Financial Resources

10. Financial intermediation (indirect financing)
SURPLUS
HOUSEHOLDS
DEFICIT
HOUSEHOLDS
[Firms}
Financial Flow
FINANCIAL INTERMEDIARIES
Financial Flow

11. STRUCTURE OF FINANCIAL MARKETS
Supervisory Bodies
Indirect Finance
Direct Finance
Bonds
Equities
Depository
Institutions
Contractual
Savings
Institutions
Investment
Intermediaries
Secondary
Markets
Commercial
Banks
Insurance
Companies
Mutual
Funds
Primary
Markets
Saving & Loan
Associations
Pension
Funds
Finance
Companies
Investment
Banks
Dealers and
Brokers
Stock
Exchanges
Over-the-Counter
Exchange
Cooperatives

12. COMMON PARAMETERS BETWEEN ISLAMIC AND TRADITIONAL BANKS
Same purpose: Financial intermediation.
Same Objective: Profit
Successful Operation of Participatory banks has shown that financial intermediation is possible even without interest.

13. Similarities
Both are banks. They use saving of others
They perform the function of financial intermediation
Both operate in money market
Both are profit making institutions. One gets its income through payment of fixed interest and the other by a share of profit earned by investors
Both types of Banks use very similar kind of balance sheet i. Assets (money coming in ) and liabilities (money going out). A very famous dictum in the banking circles is:
Each loan/ investment is an asset, each deposit is a liability.

14. Dis-similarities Interest Vs Profit Sharing
The traditional banks operate on the basis of interest. The difference between interest received and interest given is profit of the bank. It is aggregated over all operations of the bank. For Islamic bank total profit is the sum total of profit earned from each operations stated as a share of profits earned by the entrepreneurs.
Fixed Deposit Vs Investment Accouny
The traditional bank run fixed deposit or time deposits. Islamic banks do not have this account. They have investment account.
Asset Management
Main difference between traditional and Islamic banking is in asset management. In the former, it is simple, in the latter it is a complex
Process.

15. Conclusions and suggestions
It is necessary to understand and appreciate the limitations of various models. This may prevent raising false hopes and aspirations.
The interest free cooperative societies are non-banking financial institutions. They do not create credit. They only recycle the funds of their members..
The non-banking financial institutions have to operate within the legel framework provided to them.
The interest free cooperative societies may use the instruments of Islamic banking, but they are not Islamic banks. They may carry out financial intermediation as they function between savers and investors as intermediaries. But they are not Islamic Banks.
This may be kept into consideration while formulating operational policies.

16. Thank you for your patience !