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National Seminar on Future of Financial Markets in Centre of management Studies Jamia Millia Islamia, New Delhi Date: 5th

September 2011

Conventional Banking Vs Islamic BankingComparative Analysis of the Dynamics of Operations

MatloobUllah Khan Research Scholar Department of Management JamiaHamdard, New Delhi, India
Email: matloobullah.khan@gmail.com

Dr. ReshmaNasreen and Dr.SadafSiraj Assistant Professor Department of Management JamiaHamdard , New Delhi, India Email: drreshmanasreen@yahoo.com,sirajsadaf@gmail.com

Abstract: Main objective of this paper is to study the basic concepts of Islamic banking and analyze the working mechanism of both types of structures (Islamic and Interest based) along with the possibility of Risk factors in both model. This paper also shows the basic differences between Interest and Islamic based banking system in terms of profit earning function.

Keywords: Islamic Banking and Interest based banking

ISBN: 978-81-922331-0-9, Page no. 609-602 in Seminar Proceeding

National Seminar on Future of Financial Markets in Centre of management Studies Jamia Millia Islamia, New Delhi Date: 5th September 2011

Conventional Banking Vs Islamic BankingComparative Analysis of the Dynamics of Operations

Introduction The financial market in general is a highly leveraged market. History of Wall Street Crashes and the most recent Lehman Brothers is witness to the follies of over speculation. Most of the banking and financial activities are based on Interest rate structure, under such complicated condition. The concept of Islamic banking generates new innovation in the field of financial activity for those people who are not interested in receiving interest, or not interested to put their money in interest based organization. Basically the concepts of Islamic Banking focus on the community of those people who believe in Islamic Law (Shariah). According to the Islamic Law, Interest (Riba) receiving and giving both are prohibited or in Islamic language it is coded as Haram. This poses a question from people who are skeptical of the concept of Islamic banking and they ask how can a bank survive without interest. But when you see the Islamic rules and regulations which are given in Quran related to trade and business; Islam only allows those business and trade in which both Profit and loss go hand in hand. If an investor or the owner of business only gets profit instead of loss, it is prohibited (Haram) in Islamic law, if they get profit as well as losses, it is acceptable (Halal). If the level of risk factor is minimum, it is also acceptable. It means risk factor should always carry with the business according to Islamic law otherwise that business is prohibited (Haram).

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National Seminar on Future of Financial Markets in Centre of management Studies Jamia Millia Islamia, New Delhi Date: 5th September 2011

Concept of Islamic banking Definition Islamic banking is a system which follows the rules and regulation depend on the principles of Islamic law (Sharia), which is called fiqh al-

mumalat1(Islamic rules on transaction) which are given in Quran and different Hadies2. Some of the basic concepts of Islamic banking are given blow with explanation Wadiahor Amanah (Safe keeping): This is an agreement between bank and a customer, in which customers deposit their money &tangible assets (gold, silver and Diamond, etc.) in a bank for the purpose of safety and if any time, a customer wants to receive their amount and assets, the bank returns their assets. On such kind of services bank charge some amount of fees from the customer according to the predetermined agreement. On Amanah agreement Islamic bank also provide other kinds of services such asclearance of cheque, M-Banking, E-Banking, Deposits of fund, Foreign exchange service and Cash withdrawal service. On that deposit balance, when customer give permission to the bank to invest that amount in any feasible project, the bank gives profit to customer in the form of Hibah3 (gift). Its applicable; when project is in profit, otherwise they share losses also. Mudharabah (Profit sharing): This is an agreement between two persons one is the investor who invests money in the project and other is the entrepreneur or manager of a particular business or project, one person gives his fund to another person for the purpose of diversification of existing business or to start a new business and share
1- See Hassan k. and Mahlknecht M. (2011), P: 311-314 2-In Islamic terminology, the term hadies refers to reports of statements or actions of Muhammad, or of his tacit Approval of something said or done in his presence. 3- Hibah (gift) is the gratuitous transfer of a property to another party without any material consideration.

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National Seminar on Future of Financial Markets in Centre of management Studies Jamia Millia Islamia, New Delhi Date: 5th September 2011

profit and loss on the basis of agreement. Islamic banking uses this concept in the form, of putting itself between two parties. Under such kind of working concept bank creates two deals one with the capital investor (owner of the fund) and other with the capital receiver (Entrepreneur or manager of project). If investor is also interested to Know where his money will be invested, the bank will give information related to business, where the money is to be invested. Murabahah (Sale of goods at a price which include profit margin): In that concept bank purchases goods from one party in large number of quantity and sells those goods to another party by adding some profit margin which will be paid by the purchaser either fully or in proper installment which is specified in written agreement. Musyarakah (Joint venture between bank and entrepreneur): In that concept both the party Bank and Entrepreneur contribute capital and share profit and loss on the bases of contributed capital. In that case entrepreneur should contribute at least 30% equity capital and bank contributes the remaining 70% equity capital. Such kinds of concepts are used in financing the specific project. When project is completed, they share profit or loss according to the capital investment ratio, with their actual investment amount. Istisna (Intermediary): In this concept bank act as a mediator between manufacturer and purchaser. Bank orders the goods to purchase on behalf of the purchaser, gives full payment to manufacture and sells same goods to the purchaser or customer along with profit margin (cost plus price) which should be paid by the customer in lump sum or in installment to the bank, accordingly to written agreement. Salam (Advance payment): Salam process includes advance payment for goods before its delivery, it means delivery of goods will be in near future after two or three month which are given in contract but the payment should be made in advance. This concept is used to promote forward and future market for purchase and sell of
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National Seminar on Future of Financial Markets in Centre of management Studies Jamia Millia Islamia, New Delhi Date: 5th September 2011

commodities, Salam process involves two different agreements- one between purchaser of commodity and the bank another with the seller of commodity and the bank. IjarahThumma Bal (Hire Purchase):Ijarah Thumma are used to purchase high price assets with the help of Bank, specially motor cars and other heavy equipments. This concept works in such a way, that if a person wants to purchase car, he goes to a bank for finance and the bank agrees to purchase that product on behalf of customer. The bank makes an agreement with the customer that after some time they will purchase the same product with some cost plus price or pay rent in the form of installment. When the final installment along with some agreed profit (as per the agreement clause) has been paid to the bank, the ownership of the car or heavy equipment is transferred to the customer. During that period bank makes two agreements one at the time of purchase of assets and another at the time of sale of the same assets. Rahn (Mortgage and Pledge): Rahn means mortgage something in the Bank against of finance which is provided by the Bank. The person who takes finance from the bank for a particular project, the same person mortgages something in the bank in against of that finance, so such kind of activity reduces the risk factor of bank related to financing. If client is not able to pay the financed amount due to some default this amount may be recovered from these mortgages. For example- if a particular person wants funds to construct or purchase house, he/she mortgages the paper of land/house to the bank up to the given period of installment which are given in agreement. Kafalah (Guarantee): In Kafalahguarantee is given by the bank to pay amount to another party on behalf of other party. For example there are three party A, B and C.

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National Seminar on Future of Financial Markets in Centre of management Studies Jamia Millia Islamia, New Delhi Date: 5th September 2011

In which B act as Bank, and A & C act as party, if A uses the service of B (Bank), A issues written document to B (Bank) to pay certain amount to C, B (Bank) acts as first party and pays amount to C on behalf of A and B (Bank) fulfill the obligation of A and gives guarantee to C. Hawalah (Transfer of payment responsibility): In Hawalah Bank takes the responsibility of payment from one point to another point, means transfer the responsibility of payment from one party to another party with the condition that debtor is supplanted by another debtor. For example this concept is used in discounted bill of exchange or basically the return for a post datedcheque. Wakalah (Agent): In this concept a particular person appoints Bank on behalf of himself for a particular task according to the written agreement and Bank works for that person as an agent and in against of that bank charges some consultant fees. Quard (Interest free loan): In this concept bank gives loan to its loyal customer or gives to such kind of people who require financial support to start new business or for the expansion of existing business on the basis of goodwill. In Quard clients are not bound to pay any fixed profit but liable to pay actual amount which he/she receives from the bank. If customer feels to pay some extra amount to bank in respect of that financial support which he receives, then he/she can give that amount to the bank in the form of Gift (Hibha) not in the form of interest. Analysis Model of Interest Based Banking structure: Model of Interest Based Banking Structure is a combination of different kind of credit and loan activity, from which bank generate huge amount of profit. Banks also follow different interest rate structure, which varies from customer to customer (see Model 1).
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National Seminar on Future of Financial Markets in Centre of management Studies Jamia Millia Islamia, New Delhi Date: 5th September 2011

Model: 1 Normal Structure of Interest base banking In India


/
=1

/
=

NA
=

/ +
=

/
= 9.75% to 9.95%

/ +
=

3.5%

4% to 9%

8.5%

BANK

S/A Dept.

C/A Dept.

FD & RD Dept.
=

12% to 13.5%
=

Generate Funds Loan Dept. /

//
=

9.75% to 10%

/
=

12.5% to 13.% 14.75%

11.% to 16.5%

12.75%

13.5% to 13.75%

16.50% 15.% to16.75%

////.
=

Source: Interest rates taken from SBI (State Bank of India) website, Dated 14 February 2011

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National Seminar on Future of Financial Markets in Centre of management Studies Jamia Millia Islamia, New Delhi Date: 5th September 2011

Product/service offerings of conventional banks Now a days definition of banking is changed, bank has become a function of multidimensional services. It follows the concept of commercial bank, means all kind of services provided under one roof, so on that basis profit of bank also increases but still most of their profits are generated from loan department. Function of Modern Banking (MB) includes various kinds of activities some of its important function are:
= (, , , / , /, , , , , , , , , , , , ) Where: ..(1)

MB=Modern banking, L=loan, FD=Fix Deposit,Iinsu=Insurance, CA/c=Current Account,SA/C=Saving Account,BEX=bill of exchange, DDR=Demand Draft,CEX=Currency Exchange,MF=Mutual fund, LF=Locker facility,FDbu=Form Distribution, Ssal= Share sale(IPO/NEW Issue), DMserv=Dematerialized service, Ccard=Credit card, DCard=Debit Card, and Tch=Travel Cheque. From the above function bank generate profit, Then profit of the Bank (PBank) are: = + ( ) Where:
=Difference in Interest Receive and paid, Scharge= Service charge, Bexp=Bank expanses.

(2)

Service charges include all those function of bank in which bank charges its fees. For example on loan approval bank charges one percent to two percent as a file processing fees. Bank expenses include all kinds of expenses such as tax, Employ salary, maintenance charges, building charges, and rent of assets etc. But our study is only related to interest rate structure of normal banking. So, the function of Bank profit from interest given by relation: =
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.. (3)

National Seminar on Future of Financial Markets in Centre of management Studies Jamia Millia Islamia, New Delhi Date: 5th September 2011

Or Where

= 2 1 I1=Interest paid by bank, and I2= Interest receive by bank


, 2 = 1 , = 0, , = , 2 < 1 , = , . . , 2 > 1 , = , . . .

..(4)

Or = 2 1

(5)

In above three cases, interest base banking always tries to maintain I2>I1in eachand every condition or at any cost, otherwise it cant able to survive in conventional banking system. Or 2 = 2 (1 )

(6)

= 13.75% and 1

= 7.21%

= 13.75% 7.21% = 6.54% From 6.54% average difference in interest, bank generate huge amount of profit (See Table 1.1) Table 1.1
Profit & Loss account of State Bank of India Mar '07 12 mths Income Interest Earned Other Income Total Income Expenditure Interest expended Employee Cost Selling and Admin Expenses Depreciation Miscellaneous Expenses Preoperative ExpCapitalised Operating Expenses Provisions & Contingencies Total Expenses ------------------- in Rs. Cr. ------------------Mar '08 12 mths Mar '09 12 mths Mar '10 12 mths

39,491.03 7,446.76 46,937.79 23,436.82 7,932.58 3,251.14 602.39 7,173.55 0.00 13,251.78 5,707.88 42,396.48 Mar '07 12 mths

48,950.31 9,398.43 58,348.74 31,929.08 7,785.87 4,165.94 679.98 7,058.75 0.00 14,609.55 5,080.99 51,619.62 Mar '08 12 mths 6,729.12

63,788.43 12,691.35 76,479.78 42,915.29 9,747.31 5,122.06 763.14 8,810.75 0.00 18,123.66 6,319.60 67,358.55 Mar '09 12 mths 9,121.23

70,993.92 14,968.15 85,962.07 47,322.48 12,754.65 7,898.23 932.66 7,888.00 0.00 24,941.01 4,532.53 76,796.02 Mar '10 12 mths 9,166.05

Net Profit for the Year

4,541.31

Source:http://www.moneycontrol.com/financials/statebankindia/profit-loss/SBI, 10 April 2011


4- Average Interest receives by SBI (Source: www.statebankofindia.com); 5- Average Interest paid by SBI (Source: www.statebankofindia.com);

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National Seminar on Future of Financial Markets in Centre of management Studies Jamia Millia Islamia, New Delhi Date: 5th September 2011

Analysis Model of Non- Interest Based Banking Structure: Model of non-interest based banking structure was generated by Islamic Banking, which runs on the principle of Islamic Rules and Regulation, which are given in Quran. In this structure Islamic Banks generate profit without using interest rate concept. (See model: 2). (Refer concepts of Islamic banking) Basically Islamic Banks operates mainly three categories of accounts; these are Saving, Current and Investment account. In saving account Islamic banks provide all kind of services similar to an interest based banking system but only difference is that instead of interest, it gives Hibah to their saving bank account holder. Hibah is a kind of gift which is given by Islamic Banks to their saving bank account customer in the form of money. Hibah is not a fixed rate of profit; it goes up and down on the bases of Islamic Banks performance. Some time Islamic banks give high rate of return on the basis of their profit, some time they give low or zero rate of return on the basis of their profit. On current account, Islamic banks dont give any type of Hibah, because on current account banks generate profit with the help of current account credit policy, such as purchase raw material for current account holder business. Investment account is a type of term deposit account, in which money should be blocked up to the completion of project or tenure of project, but in investment account customer share both profit and loss according to project performance, which is the basic requirement of Islamic finance, because Islamic law only accept those investment which involve risk factor otherwise it is not accepted by Islamic law. Fixed or variable interest rate investment is the part of one sided profit oriented investment, so it is not acceptable by Islamic laws, which are given in Quran.

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National Seminar on Future of Financial Markets in Centre of management Studies Jamia Millia Islamia, New Delhi Date: 5th September 2011

Model: 2 Normal structure of Islamic Bank


/
= =

/
=

Share Profit and loss

Receive Hibhaif Bank generated profit

1 5 2
1. Bank charges fees -Wadiha -Kafalah -Hawalah Islamic Bank

NA for any type of Hibha

1 4 3
6. Higher purchase -IjarahThummaBal 5. Agent -Wakalah 4. Interest free loan -Quard

Paid Hibah if interested

2. P/L sharing -Mudharabah -Musyarakah

6
Charge Extra price

3. Cost plus price -Murabahah -Istisna -Salam

4
=

Share Profit and loss

3
Paid Hibah if interested Paid cost plus price


= =

Rahn (Mortgage)

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National Seminar on Future of Financial Markets in Centre of management Studies Jamia Millia Islamia, New Delhi Date: 5th September 2011

Product/service Offerings of Islamic Banks Function of Islamic Bank (IB) includes various kind of activity some of their important functions are: = ( , , , , , / , / , / , , , , )..(7) Where: IB = Islamic Bank, PLs = Profit and loss sharing,CPp = Cost plus price, Hpur = Higher purchase,IFL = Interest free loan, HbR = HibahReceive and paid, SA/C = Saving account, CA/C = Current account, IA/C = Investment account, CEX = Currency exchange, DDR =Demand draft, BEX = Bill of Exchange, and Tch = Travel cheque. From the above function Islamic bank generate profit. Then profit of Islamic bank (PIB) has shown by the relation: = + + ( ) ( ) Where: = Difference in Hibah received and paid, = profit received and paid, Scharge = Service charges,BExp = Bank expenses, and Ls = Loss sharing. In conventional banking system, bank receives and pays interest but in Islamic banking system, bank receives and pays Hibah, and shares profit or loss on project and on business finance. Profit of Islamic bank by Hibah and profit sharing given by function: & Or Where: 2 = , 1 = , 2 = , 1 = .
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. ..(8)

= + ().(9)

&

= 2 1 + 2 1

10

National Seminar on Future of Financial Markets in Centre of management Studies Jamia Millia Islamia, New Delhi Date: 5th September 2011

If, 2 increasesby good performance of bank,1 will also increase. Similarly if P2 increases by good performance of project or business, P1 will also increase. If 2 decreases then1 will also decrease, likewise P2 decreases, P1will also decrease. Its applied that: and (11) > > ...(12) From above equations(12) we find that Bank generates profit from Hibah and profit sharing, because Islamic bank always try to maintain the situation of equation (12). Above relation of Hibah and Profit Sharing concludes that customer from both side feels comfortable, while using the services of Islamic bank. Loan Customers are not bound to pay interest but it depends upon the performance of their business and they have to pay principle amount. Saving and investment account holders also have a possibility to get high rate of Profit and Hibah on the bases of performance of bank and its projects. (See table 1.2 and 1.3) Table 1.2 Profit Rates for the month of February 2011 Percentage per Annum Profit rate at Quarterly Rate Monthly Rate Maturity 7.14% ----------------------------7.41% -----------------------------9.41% 8.34% 8.08% 9.54% 8.41% 8.14% 10.14% 8.88% 8.28% 11.88% 10.14% 9.28%

Tenure Three month Six month One year Two year Three year Five year

Source: Meezan Bank (www.meezanbank.com), 5 March 2011

Table 1.3, is related to profit and loss account of Meezan Bank which runs on the principle of Islam laws. The profit earning process of Meezan Bank doesnt contain any item of interest based program.
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National Seminar on Future of Financial Markets in Centre of management Studies Jamia Millia Islamia, New Delhi Date: 5th September 2011

Table 1.3 Meezan Bank profit and loss Account (year ended 31 December 2010

Source: www.meezanbank.com (Financial statement)

Possibility of Risk Factor( ) in both models: While analyzing the working mechanism of Islamic banking and conventional banking comparatively, Risk factor is almost same. Both types of banking have a concept of Non-performing Assets6, but only difference is that in conventional banking system Non-performing Assets means installments of loan unpaid along with
6- See Venardoas A.M. (2005) , P: 157-160, For Non-performing Assets in Islamic bank, and see Jalan P.K. (2005), P:196-200, For Non-performing Assets in SBI.

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National Seminar on Future of Financial Markets in Centre of management Studies Jamia Millia Islamia, New Delhi Date: 5th September 2011

interest and bank bears losses. In Islamic banking system installment of principle amount unpaid and investors share losses with bank in case of Investment account, and in case of saving account bank dont give Hibah. (See figure 1.1) Figure 1.1 In Conventional Banking System
Customer paid loan amount along with interest

Customer received interest

Interest based Bank

Risk factor ( ) lies on Bank only In Islamic Banking system


Customer received Hibah and profit Customer paid principle amount along with Hibah and profit

Islamic Banking

Risk factor ( ) lies on customer and bank both

In both type of system level of Risk factor ( ) depend upon size of loan or credit. The level of Risk factor should be maintain by using the concept of Mortgage Its applied that:

(13)

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National Seminar on Future of Financial Markets in Centre of management Studies Jamia Millia Islamia, New Delhi Date: 5th September 2011

Where: SL = Size of loan; and MV = Mortgage value; > , = , < , 0

In above three conditions most of the banks follows second and third condition including Islamic banks, but in case of goodwill (Related to loan customer) banks also follow first condition. Conclusion Structure of Islamic banking is different from Interest based banking structure in respect to the return point of view. Technically Interest based banking structure is more risky than Islamic banking structure. The interest based system bank bears all types of losses, but Islamic based system banks share their losses with their customers. Therefore, the level of risk in the case of Islamic banking system is minimum, as the result of the effect, survival chances of Islamic banking is more positive than that of Interest based banking system. Books reference: 1. Akgunduz A. 2009. Studies in Islamic economics (Islamic Banking and Development). Turkey; IUR press publication. 2. Ahmad U.F. 2010. Theory and practice of modern Islamic finance: the case analysis from Australia. Florida USA; Walker press publication. 3. Bhatia R.C. 1982. Banking structure and performance a case study of India. National Institute of Banking Management publication.
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National Seminar on Future of Financial Markets in Centre of management Studies Jamia Millia Islamia, New Delhi Date: 5th September 2011

4. Fealy G. and White S. 2008. Expressing Islam: Religious life and politics in Indonesia. Singapore; ISEAS publication. 5. Hassan K. and Lewis M.K. 2007. Hand book of Islamic Banking. USA; Edward Elgar publication. 6. Mahmoud A. and Gamal E.L. Islamic finance: law, economics and practice. USA; Cambridge University press publication. 7. Murthy D.K. and Venugopal K.R. 2006. Indian financial system. New Delhi; International publication House. 8. Schoon N. 2009. Islamic banking and Finance. London; Spiramus press publication. 9. Usmani M.T. 2002. An Introduction to Islamic finance. Netherlands; Klumer Law International publication. Journals reference: 1. Abdul-Rahman, Yahia. 1999. Islamic instrument for management liquidity. International journal of Islamic finance service. Vol-1 No. 1. 2. Aggarwal, Rajesh k, Yousef and Trick. 2000. Islamic banking and investment finance. Journal of Money, credit and banking. Vol-32, No.1, February, pp 93-120. 3. Al dehanniTalla, Karim A, Ahnad R and Vector H. 1999. The capital structure of Islamic bank under the contractual obligation of profit sharing. International journal of theoretical and applied finance. Vol-2, No.3, pp 243283.

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National Seminar on Future of Financial Markets in Centre of management Studies Jamia Millia Islamia, New Delhi Date: 5th September 2011

4. Ali A. Al-Salous 1988, AI- Murabaha to He who order to purchase: View in practical work in Arabia, Paper presented to the 5th conference of Islamic Figh Academy Kuwait, p 14. 5. Dar, Humagon A, Presleg and John R. 2000, Lack of profit loss sharing in Islamic banking: Management and control imbalance. Economic research paper. No 00/24, Lough brough university. 6. Dar H.A and Harney D and Presley J.R. 1999, Size profitability and agency problem in profit and loss sharing in Islamic Finance. Proceeding of the second Annual Harvard University Forum on Islamic Finance, Cambridge MA: Center for Middle Eastern studies, Harvard university Press, pp 51-62. 7. EL-Gamal M. 1999, The survival of Islamic Banking: A Micro-evolutionary perspective, Proceeding of second annual Harvard University forum on Islamic finance, Cambridge MA: Center for Middle Eastern Studies Harvard University Press, pp 63-76. 8. Iqbal M. 1999, Challenges Facing Islamic Banking. Paper presented at the 6th orientation course in Islamic Economics, Banking and Finance. The Islamic foundation U.K, pp 17-21 September. Abbreviations: / =Customer current Account / = Customer Saving Account = Customer Fix Deposit = Customer Bank Bond = Public of city
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National Seminar on Future of Financial Markets in Centre of management Studies Jamia Millia Islamia, New Delhi Date: 5th September 2011

= Customer Recurring Deposit = Customer Education loan = Customer Home loan / = Customer Car loan or Bike loan = Customer loan against Mortgage Property / /// =Customer loan against NSC/KVPs/RBI-Retail Bond/ LIC/Mutual Funds etc. = Customer Personal loan Schemes / = Customer Over Draft and Working Capital loan // = Customer loan against Shares, Debentures and bonds = Customer Loan against Gold Ornament P/L = Profit and loss NA = Not Applicable *******************************************************************

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