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Global Business and Economics Research Journal
ISSN: 2302-4593
Vol. 3 (5): 15 - 29

A comparative study of Islamic financial system and
conventional financial system
Abdul Azeez Oluwanisola Abdul Wahab
Universiti Sains Islam Malaysia, Malaysia
[email protected]

Muhammad Ridhwan Ab. Aziz
Universiti Sains Islam Malaysia, Malaysia

Omar Ali Abuzraida
Universiti Sains Islam Malaysia, Malaysia

Ali Mahmoud Al Sanousi
Universiti Sains Islam Malaysia, Malaysia

Abdul Rahman Hamood Al Hinai
Universiti Sains Islam Malaysia, Malaysia

Abdurahem Ibrahim
Universiti Sains Islam Malaysia, Malaysia

Abstract
The recent global financial predicament has forced regulators and economists all over the world to query the existing financial system. The objective of this article is to explore an overview of Islamic finance, including its features and its importance in the world economy. The role of Islamic finance however which act as an alternative to the conventional financial system cannot be overemphasised. Islamic financing is working within the Shari’ah structure with certain restrictions. Islamic financial institution cannot provide finance for any activity which is prohibited by Shari’ah (Islamic law) irrespective of its profitability and economic viability for instance liquor business, pork and pornography. The methodology of this article is through qualitative method based on library research. The general finding of this article shows that there are significance differences between Islamic financial system and

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Keywords: conventional financial system; Islamic financial system

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conventional financial system.

Citation:
Abdul Wahab, A. O. et al. (2014). A comparative study of Islamic financial system and conventional financial system. Global Business and Economics Research Journal, 3(5): 15-29.

© Global Business and Economics Research Journal. Available online at http://www.journal.globejournal.org

Abdul Wahab et al.
Vol 3 (5): 15-29

Global Business and Economics Research Journal
ISSN: 2302-4593

1. INTRODUCTION
Islamic banks have grown for over four decades in number as well as in size globally and are being practiced on a demanding scale. Some countries (such as Sudan, Iran and Pakistan), have succeeded in converting their entire banking system to Islamic banking. In other countries (such as Malaysia, Indonesia, Bangladesh, and United Kingdom) where conventional banking are in dominance the Islamic Banking or Islamic window is operating alongside. The establishment of Islamic banking started with two financial institutions namely Mit-Ghamr in the Nile Delta a small town in Egypt and in Karachi from 1963-1967. The progress made from these two financial institutions led to the establishment of fullfledged Islamic bank under the name of Dubai Islamic Bank in 1965. By the end of 1996, the number of Islamic financial institutions have extended to 166 in at least 34 Muslim and nonMuslim countries. The popularity of Islamic banking was well noticeable in 1970s (Chapra, 2001). Currently, Islamic banks are providing Islamic financial products and services and operating in more than sixty countries of the world. (Rajesh et al., 2000). Also, there are more than 600 Islamic financial institutions throughout the world with surplus investment funds of $1Trillion (Dar, 2003). The annual growth rate of Islamic banking industry’s world-wide is more than 16%. Approval has also been gained by Islamic banking from international financial institutions (IFI), professional bankers and the academic. It is no doubt that Islamic banking has established its identity successfully and performed its operations diverse from its conventional banking counterparts. Largely, in the contemporary world the aims of Islamic banking is to encourage and advance the application of Islamic principles, law and traditions to transactions of financial, banking and related businesses. In this regards, Islamic banks will safeguard the Muslim communities and societies from activities that are prohibited in Islam (Tahir, 2003).

The comparative advantage of Islamic banking and finance encompasses three main areas: it preserves the financial sector in sync with the real sector, it is less susceptible to gambling such as speculation, and it is broad-based and universal. The first two features add to greater stability and the third makes Islamic banking and finance more suitable to the global village than the current conventional system, which has been alleged of being partial to the developed countries of the West (Siddiqi, 2000).

other financial assets cannot be allowed for the creation of debt. The sale or lease of real assets through lease-based financing schemes can only be used for debts creation. The debt © Global Business and Economics Research Journal. Available online at http://www.journal.globejournal.org

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distinctive feature of the Islamic finance is that direct lending and borrowing of money or

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The Islamic financial system is absolutely different from the conventional system. A

Abdul Wahab et al.
Vol 3 (5): 15-29

Global Business and Economics Research Journal
ISSN: 2302-4593

cannot be traded or shifted to someone else and the asset which is leased or sold must be real (building, property, or any other physical infrastructure) (Kyeong et al., 2012). Shari’ah (Islamic law) principle are the bedrock of Islamic finance which requires financial transactions to be accompanied by an underlying productive economic activity. This conditions minimised the possibility of superfluous exposure to risks associated with leverage and risk taking. Islamic finance involves profit and risk sharing which ensures that the profit is proportional with the risks. Therefore the prospects for the reliability and strength of Islamic finance is as a result of risk associated with the real investment activity is apparently incorporated into the financial transaction.

2. OVERVIEW OF ISLAMIC FINANCIAL SYSTEM
Islamic finance provides financial products, which comply with Islamic Law (Shari’ah), largely to Muslim investors and some Islamic products have even attracted conventional investors and borrowers (Hossein et al., 2011).

The conventional system can be considered unstable because it is dominantly a debt and interest-based system, and secondly it generates undue debt and leveraging through the credit multiplier. This resulted to susceptible periodic crises and necessitating massive bailouts. However, before the proliferation of debt financing in conventional system equity financing was well-known. Nonetheless a host of factors and developments has favoured debt-based contracts over risk-sharing contracts. These include Government deposit insurance schemes, rules and regulations of contract and tax treatments. Risk-transfer are been promoted under debt-based system and underutilizes the benefits of risk sharing. Hence, risk sharing is very much at a primary phase of development in most countries and it is regarded as a more modest international practice (Hossein et al., 2011).

Basically, Islamic finance is a financial system designed on risk sharing and prohibition of debt financing (leveraging). The major proposition of Islamic finance system is the proscription of any transactions that stipulate rent for a particular period as a proportion for the loaned principal without transferring the right claims of the property and at large transferring the total risk of the contract to the borrower. Thus, the mutual exchange have been seen as an alternative to debt-based financing which provide room for property rights to

smoothing, which is the basis of risk sharing as well as permitting parties to eliminate the risk of income instability (Hossein et al., 2011).
© Global Business and Economics Research Journal. Available online at http://www.journal.globejournal.org

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transportation, and marketing. This further increases welfare in exchange and consumption

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be exchanged, therefore, permitting the two parties to share the risk of production,

Abdul Wahab et al.
Vol 3 (5): 15-29

Global Business and Economics Research Journal
ISSN: 2302-4593

Islamic banking system is deeply rooted in Islamic principles which allows all activities to follow distinct morals which could be concluded that Islamic financial transactions are e...

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