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The Difference Between Conventional and Islamic Banking

Info: 2626 words (11 pages) Law Essay
Published: 6th Aug 2019

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Jurisdiction(s): Islamic Law

The difference between conventional which called western banking and Islamic banking are following:

Conventional Banking

Islamic Banking

The functions and working modes of conventional banks are based fully manmade principles.

The functions and operating modes of Islamic banks are based on the rule of Islamic Shariah.

The investor is assured of a fixed rate of interest.

It promotes risk sharing among provider of capital (investor) and the user of funds (entrepreneur).

It target at maximizing profit without any restriction.

It also aims at maximizing returns but subject to Shariah restrictions.

It does not deal with Zakat.

In the modern Islamic banking system, it has become one of the service-oriented functions of the Islamic banks to be a Zakat Collection Centre and they also pay out their Zakat.

Lending money and having it back with compounding interest is the essential function of the conventional bank.

Participants in partnership business are the fundamental functions of Islamic Banks. So we have to recognize our customer’s business very fine.

It can charge extra money (penalty and compounded interest) in case of defaulters.

The Islamic banks have no prerequisite to charge any additional money from the defaulters. Only little amount of compensation and these proceeds is given to donations. Rebates give for early settlement at the Bank’s discretion.

Conventional bank very frequently it results in the bank’s own interest becoming prominent. It makes no effort to ensure growth with equity.

It gives due importance to the community interest. Its ultimate aim is to ensure expansion with equity.

For interest-based commercial banks, borrowing from the money market is moderately easier.

For the Islamic banks, it must be based on a Shariah approved underlying business.

Since income from the advances is fixed, it gives less importance to developing expertise in project assessment and evaluations.

Since it shares profit and loss, the Islamic banks pay better attention to developing project appraisal and evaluations.

The conventional bank offer greater emphasis on credit-worthiness of the customers.

The Islamic bank, gives greater emphasis on the viability of the projects.

The status of a conventional bank, in relation to its clients, is that of creditor and debtors.

The status of Islamic bank in relation to its clients is that of partners, investors and buyer and seller.

A conventional bank has to guarantee all its deposits.

Islamic bank can only guarantee deposits for deposit account, which is based on the principle of al-wadiah, thus the depositors are guaranteed compensation of their funds, however if the account is based on the mudarabah concept, client have to share in a loss position.


Letter of guarantee is a letter from an Islamic bank to third party which states that a customer (who has made an order) does indeed have the underlying assets and the Islamic bank will promise delivery if the order is assigned. Thus the order can hand over covered. Not all third parties recognize letters of guarantee. Also: letters issued to Option Clearing Corporation by member firms covering a guarantee of any transaction made by one of its customers, (a trader or broker on the exchange floor).

Letter of Guarantee is a bank guarantee which is an indemnity letter which the Islamic bank commits itself to pay a sure sum if a third party fails to carry out or if any other form of default occurs. One use is when an Islamic bank wants a carrier to discharge a shipment which it has financed but the original bill lading are not yet available for surrender to the carrier. Letter of Guarantee issued according the kafalah principle.

The bank may offer the facility of a Letter of Guarantee to its clients for certain purposes under the principle of al-Kafalah. The Letter of Guarantee may be provided the performance of a task, the settlement of a loan, etc. The bank may require the customer to place a certain total of deposits for this facility which Bank accepts according to the principle of al-Wadiah Yad Dhamanah. The bank charges the client a fee for the services it supplies.

Feature and Mechanism

Bank acts as the supplier of guarantee on the fulfillment of client’s obligations toward the third party;

The guarantee have contract between Bank and the second party guaranteed by Bank and completed with the witnesses of the receiver of guarantee;

The object of guarantee should be:

the obligation of the party require guarantee;

clear in terms of value, sum and specification including the time of guarantee; and

in fulfillment with Shariah principles (permissible)

Bank is consent to receive fee that has been contracted in advance and defined on a fixed nominal value;

Bank is allowed to necessitate guarantee in the form of Cash Collateral or other forms of collateral based on the guarantee value; and

In the event where customer be unsuccessful to fulfill its obligation to third party, Bank will fulfill the said duty to the third party by providing bailout as financing based on Qardh contract to be complete by customer.

Objectives and benefits

For Bank

Bank treats Letter of Guarantee as the source of profits in the form of fee/ujroh.

For Customer

Customer use Letter of Guarantee to improve creditworthiness in order to be established in partnership.

Type of Letters of Guarantee

There are many types of Letters of Guarantee but underlying purpose is the same for all, that a being a guarantee of payment to a supplier.

Payment guarantee

Payment guarantee is a commitment (usually backed by collateralization of an asset) to pay a liability according to the terms of the debt contract.

A payment guarantee makes sure payment to the exporter if the importer does not execute its payment obligations. A payment guarantee can be issued in the form of an endorsement on a draft, also known as an “aval.”

Performance Bond

Performance bond is a written warranty from a third party guarantor (usually a bank or an insurance company) submitted to a principal (client or customer) by a contractor on win the bid. Performance bond make sure payment of a total (not exceeding a stated maximum) of money in case the contractor be unsuccessful in fulfill in full management of the contract. These bonds usually cover 100 percent of the contract price and replace the bid bonds on award of the agreement. Unlike a fidelity bond, a performance bond is not an insurance guiding principle and (if clashed by the principal) the payment sum is recovered by the guarantor from the contractor. It also called standby letter of credit.

A performance bond safeguards the importer be supposed to the exporter fail to meet its contractual duty. Performance bonds are usually issued for 10% to 20% of the contract amount but may be fixed by the local law of the importer’s country.

Advanced payment bond

Guarantee supplied by a party being paid an advance payment to payment to the party advance the payment. It provide that the advanced total will be return if the agreement under which the advanced was made fail be fulfilled. Also called advance payment bond.

An advanced payment bond ensure repayment to the importer of whichever advance payments they have made (usually an agreed percentage of the contract amount (typically 10%-30%) if the exporter does not fulfill its contractual obligations)

Retention bond

Type of performance bond that protect the customer after a job or mission is finished. It guarantees that the contractor will carry out all needed work to correct structural and/or other defect discovered straight away after completion of the contract, even if full payment has been made to the contractor.

With the provider of the factory plant, machinery and other capital goods, it is often agreed that the buyer may withhold 5%-10% of the contract amount for a period, for example 12 months after the plant or machine(s) are up and operation. The exporter may wish to be given the full contract amount before the end of the contract stage by issuing a retention bond that covers the quantity that would otherwise be withheld. The exporter will ask for its bank to issue a retention bond in act of kindness of the buyer. Once the buyer receives the retention bond he will transfer the amount of the bond value direct to the exporter by international money shift. A retention bond is issued usually for 5%-10% of the contact amount if the contract in not fulfilled the importer can make a request for the retention amount under the retention period.

Bid bond or tender bond

Bid bond is a written guarantee from third party guarantor (usually a bank or an insurance company) submits to a principal (customer) by a contractor (bidder) with a bid. Bid bond ensure that on acceptance of bid by client the contractor will carry on with the contract and will substitute the bid bond with a performance-bond. Otherwise, the guarantor will compensate the customer the difference between the contractor’s bid and next maximum bidder. This difference is called liquidated damages which cannot go over the total of the bid bond. Unlike a fidelity bond, a bid bond is not an insurance policy, and (if cashed by the principal) the compensation amount is recovered by the guarantor from the contractor. It also call bid guaranty or bid surety.

A bid bond is issued to sustain a customer’s tender for a particular contract and to guard the importer for any loss that might happen if the exporter fails to sign the agreement. Once the tender is accepted it will usually be needed to replace the bid or tender bond with a performance bond. Bid bonds are usually issued for 2%-5% of the tender quantity and are usually outstanding until the end of the tender procedure.

Fees and Charges of Letter of Guarantee

The bank can charge a fee that is based the actual services rendered to the client, such as the arrangement for a study to be done and for recommended services. The fee must keep up a correspondence to the normal fee that is charged for types of services. It is also permissible to charge fees for documentation services (can only be charged once). The below are the fees and charges that Bank Islam of Malaysia applied:




Upon issuance

Non-financial Guarantee

Financial Guarantee


0.6%-2.0% p.a. with min of RM 50.00

0.75%-2.25% p.a. with min of RM50.00


Deviation of Rate=follow L/O

Deviation of Min.Charges= follow this manual (RM50.00)

Commission formula:

= FV x r x t



FV = LG value

r = commission rate (as determine in LO)

Non-Standard Format

Handling Fee

RM150.00 flat rate

BG 1:1


As per above commission formula with commission rates as 1.5% p.a. of the LG amount (Performance Guarantee) and 1.75% p.a of the LG amount (Financial Guarantee) or RM300.00 whichever is higher


Extension of period

Increase in amount

Only changes in particular other than period and amount

Reduction in tenor and amount

Amount increase and extension of expiry date

Amount decrease and extension of expiry date


As per commission formula above


Commission will be charged for the extended contract period only with minimum of


As per commission formula above


Commission will be charged from the amendment date till the expiry date only with minimum of RM50.00

RM50.00 per request

RM50.00 per request

As per commission formula calculated based on new amount from the extension date until new expiry date with a minimum of RM50.00.

As per commission formula calculated based on new amount (decreased amount) from the extension date to the new expiry date with a minimum of RM50.00.








Actual cost or min RM10.00


Actual cost +20%







Others (MT799 etc.)


Local: RM50.00

Others: RM100.00


Foreign/Local: RM50.00

Local: RM25.00

Foreign: RM50.00

 Letter of Indemnity

Signed by applicant

Signed by applicant and third party as a guarantor (if signed on the same LI)

Stamp duty



Original copy Bank Guarantee

Stamp duty

RM10.00 (regardless of type of guarantee)

Replacement of Lost Guarantee

Other Charges (including out of pocket expenses)

RM50.00 flat

The difference between Letter of Guarantee and Memorandum of Understanding

Memorandum of Understanding (MOU) is certificate that expresses reciprocal accord on an issue between two or more parties. MOUs are generally recognized as binding, even if no lawful claim could be based on the rights and obligations laid down in them. To be legally effective, a MOU must (1) recognize the contracting parties, (2) spell out the subject matter of the contract and its purposes, (3) sum up the essential terms of the contract, and (4) must be signed by the contracting parties. It also called letter of intent.

Let say A wants to trade shares to B should B defaults, by using Letter of Guarantee bank will pay to the A on behalf of B where A does not lose from anything. But using Memorandum of Understanding which the default of B will weight in the court but A still lose in term of profit or benefits, which at this circumstances Letter of Guarantee act as a type of contract issued by a bank on behalf of a customer who entered to a contract to purchase goods from a supplier and promises to meet any financial obligations to the supplier in the event of default. It also can define as a document issued by a bank on behalf of a call writer guaranteeing than the writer owns the underlying asset and that the bank will deliver the underlying securities should the call be exercised. A MOU is legal document outlining the terms and detailed of an agreement between parties, including each party’s requirements and responsibilities.

The difference between Corporate Guarantee and letter Guarantee

Letter of guarantee is given by the bank on behalf of its customer (applicant) to the beneficiary of the bank, that incase of non happening of the particular event which is being by that particular guarantee, the bank (guarantor) will pay the beneficiary an amount, which is mentioned in the guarantee, provided the beneficiary submit the claim under the guarantee in the agreed format and within agreed time. The claim (compensation) under the bank guarantee will be financial in nature.

A corporate guarantee is a guarantee given by the corporate to cover their exposure or exposure of some other related entity, to the bank. It will also be financial in nature and banks derive an additional comfort from such guarantees when they do their lending to particular borrower.

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