Differences Between Conventional Banks and Islamic Banks: A Complete Comparison Guide

You might be one of many people who are still confused about the differences between Islamic banks and conventional banks. In general, the banking system is divided into two main types: conventional banking and Islamic (Sharia) banking.

Although both function as financial institutions, they operate under very different principles, systems, and objectives. Below is a comprehensive explanation to help you better understand the key differences.

Definition: Conventional Bank vs Islamic Bank

The most fundamental difference can be seen from their definitions and underlying systems.

A conventional bank operates based on national and international financial agreements and follows the formal legal framework of the country where it operates. Its activities revolve around managing and circulating money for profit under established financial regulations.

Meanwhile, an Islamic bank (Sharia bank) operates based on Islamic law (Sharia principles). All its activities refer to Islamic legal sources, namely the Qur’an and Hadith, along with fatwas issued by Islamic scholars.

Purpose and Objectives of Establishment

Another major difference lies in their founding objectives.

• Conventional banks are primarily established to generate maximum profit, without limitations on profit margins, as long as they comply with legal regulations.
• Islamic banks are established not only to earn profit but also to implement and promote Islamic financial values. Their operations aim to balance worldly profit with ethical and religious considerations.

Operational Principles

The two systems apply very different operational principles:

• Conventional banks operate based on national and international financial laws and formal legal frameworks.
• Islamic banks operate based on Sharia law, referring to the Qur’an, Hadith, and rulings from Islamic scholars.

All financial activities in Islamic banks must comply with Islamic ethical guidelines and prohibitions, including the avoidance of interest (riba).

Operational System

One of the most visible differences is in the operational system.

Conventional Banks:

• Apply interest-based systems (interest rates).
• Agreements between banks and customers are based on loan contracts with predetermined interest rates.

Islamic Banks:

• Do not apply an interest system, as interest (riba) is prohibited in Islamic law.
• Use a profit-sharing system (nisbah).
• Contracts are based on profit-sharing, trade, leasing, or partnership agreements, without involving interest.

In Islamic banking, agreements are structured through contracts such as:

• Murabaha (cost-plus sale)
• Salam
• Istisna
• Mudharabah (profit-sharing partnership)
• Musyarakah (joint venture partnership)
• Ijarah (leasing agreement)

Relationship Between Customer and Bank

The relationship model between customers and banks is also different.

In Conventional Banks:

The relationship is strictly creditor and debtor.

• Customers may act as creditors (depositors).
• The bank acts as debtor or lender depending on the transaction.

In Islamic Banks:

The relationship can take several forms:

• Partnership
• Buyer–Seller
• Lessor–Lessee
• Business partners

For example:

• In Murabaha contracts, the bank acts as the seller and the customer as the buyer.
• In Mudharabah or Musyarakah contracts, the bank and customer act as business partners.
• In Ijarah contracts, the bank becomes the lessor and the customer the lessee.

Formal Agreements

Formal agreements between banks and customers also differ:

• In conventional banks, agreements are based on national civil law.
• In Islamic banks, agreements must comply with Sharia contractual principles, including specific pillars (rukun) and conditions required for the validity of the contract.

All Islamic banking contracts must fulfill Islamic legal requirements to be considered valid.

Supervisory Structure

Both conventional and Islamic banks in Indonesia are regulated under Law No. 10 of 1998 concerning Banking. However, their supervisory structures differ.

• Conventional banks are supervised by a board of commissioners overseeing financial activities.
• Islamic banks have multiple supervisory bodies, including:
  – Sharia Supervisory Board
  – National Sharia Council
  – Board of Commissioners

This ensures that all Islamic banking operations comply with Sharia principles.

Fund Management Process

The difference in operational systems significantly affects how funds are managed.

• Conventional banks manage funds across various business sectors, as long as they comply with applicable laws.
• Islamic banks can only invest funds in businesses permitted under Sharia law.

Islamic banks are prohibited from investing in industries considered non-compliant with Islamic principles, such as:

• Alcohol-related businesses
• Gambling
• Narcotics
• Tobacco (in certain interpretations)
• Other prohibited sectors

Interest System

One of the most obvious differences is the application of interest.

• Conventional banks apply an interest-based system, using benchmark interest rates as a source of revenue.
• Islamic banks do not use interest. Instead, they apply a profit-sharing (nisbah) system, where profits are shared between the bank and the customer based on agreed terms.

Profit Distribution

The way banks generate profit is also fundamentally different.

• Conventional banks generate profit from interest charged to customers.
• Islamic banks generate profit from trade, leasing, and partnership agreements, such as:
  – Buying and selling transactions
  – Leasing arrangements
  – Business partnerships

Understanding the differences between conventional and Islamic banks is important before choosing where to save or invest your money.

In summary:

• Conventional banks operate using an interest-based system under formal legal regulations.
• Islamic banks operate under Sharia principles, using profit-sharing and ethical investment systems.
• Islamic banking avoids interest (riba) and invests only in Sharia-compliant sectors.

By knowing these differences, you can make a more informed decision that aligns with your financial goals and personal values.

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