By: Riaz Akhtar,Senior Consultant, Infosys & Babita Talreja,Principal Consultant, Infosys
Islamic banking seems an alien concept in India’s conventional banking world. Despite its impressive growth in other parts of world such as the Middle East, South East Asia (which primarily include Malaysia and Indonesia) and Europe, it is yet to find favor with the Indian authorities.
The search for alternatives to conventional banking in the aftermath of the global financial crisis trained the spotlights on Islamic banking in many parts of the world.
The purpose of this thought paper is to provide a quick roundup of the world Islamic banking scenario and highlight its potential and need in India as well as the accompanying challenges.
Islamic banking, also known as interest free banking or finance, is a banking system, which promotes profit sharing, but prohibits the charging and paying of interest. This system is based on the principles of Sharia Islamic Law, which are derived from the Holy Quran and the “Hadeeth”, a compilation of the noted sayings of Prophet Mohammad. Islamic Banks everywhere follow these principles in their business.
In Islamic banking, productive activities which promote entrepreneurship, trade, commerce and societal development are supported, while those which earn income sans risk – such as interest (Riba) bearing transactions – and unproductive activities like speculation or gambling are prohibited.
Basic tenets of Islamic banking
• Payment and receipt of interest (known as Riba) is strictly prohibited (haram).
• The business is based on profit and loss sharing.
• Certain industries, such as adult entertainment, alcohol, and gambling are “haram” (disallowed by Sharia) and prohibited for investment.
This is why Islamic Banking is also referred to as Ethical banking.
• Banks may not lease or lend any product that they do not wholly own.
• Trading in debt is also not allowed, which is why Banks do not deal in traditional bonds; rather they have their own version of such instruments called Sukuk (Islamic Bond).
• Interest free loans (Qard Hasan) are encouraged to spread financial inclusion.
Islamic banking presence in world economy
During the past decade, the assets of Islamic banks have grown at an average rate of 15%
(1). Many developed countries of the world, such as Germany, UK, USA, France and Singapore have embraced Islamic Banking to take the tally of countries where this form of banking is already operational as an alternative system(2) to over 75. The robut performance of the Islamic Banking and Finance sector during the recent financial downturn has attracted the attention of several other nations. Major multinational banks including HSBC Amanah, Standard Chartered Saadiq, Lloyds TSB Bank and Citigroup offer products in accordance with Islamic Banking principles.
Western nations like the UK are promoting Islamic Finance following the principle of “no favor, but no discrimination”. Former Prime Minister Gordon Brown, who was Finance Minister when Islamic Banking was introduced in the UK, was so confident of the system that he predicted London would become its future gateway. The results today vindicate his predictions. This is why, at a time when other banks are facing closure, the Islamic Bank of Britain is expanding its network in the UK and being asked to do the same in Europe.
Islamic banking growth in a nutshell
• Islamic banking is operational in more than 75 countries in the world.
• During the past decade, the assets of Islamic Banks have grown at an average rate of 15%.
• According to estimates, global Islamic Banking assets have touched $ 1.1 trillion in 2012 as against $ 826 bn in 2010.
• The market share of Islamic Banking by assets is 14% in the Middle East and North African region and 25% in the Gulf.
• For 2006-10(5), the Compound Annual Growth Rate of the top 20 Islamic Banks in the Gulf is 20% as compared to 9% for the region’s conventional banks.
• In the Gulf region alone, Islamic Banking assets are expected to grow to $990 bn in 2015 from $ 416 bn in 2010.
Islamic banking and finance story in India so far
Recently, the RBI Governor D Subbarao recommended introducing Islamic banking in India and wrote to the Government about amending the law to facilitate the same(6). In 2008, a high level Committee on Financial Sector Reform (CFSR) of the Planning Commission of India (2008) headed by Dr. Raghuram Rajan had recommended the introduction of interest-free finance and banking as part of mainstream banking in the interest of inclusive, innovative growth.
Aligarh Muslim University has started a postgraduate program in Islamic banking and Finance under the stewardship of Professor Nejat Ullah Siddiqui, one of the pioneers of the Islamic banking model.
Today, Islamic banking has a presence in India in the form of NBFCs and Baitul Mal (Islamic Treasury), but the business is small. These institutions mostly work at the regional level, catering to a niche segment. Many Indian institutions, including some government-owned ones, have shown interest in this growing niche opportunity. For example, Kerala government-owned KSIDC has started Al-Barakah Financial Services Ltd; GIC of India runs an Islamic re-assurance scheme; and several mutual fund schemes invest explicitly in compliance with Islamic rules. TASIS, an index on the Bombay Stock Exchange representing only Sharia-compliant stocks, is the first of its kind in India.
Why India needs an Islamic banking model
While Islamic finance originates from religious principles, it is also a workable model of investment, based on risk sharing. The nations, which have adopted Islamic finance, have done so because it makes business sense. Islamic finance is all about encouraging and facilitating investment in real economic activity and societal welfare, while prohibiting investment in reckless businesses such as gaming, alcohol and adult entertainment or risky financial products like derivative contracts of the kind which led to the 2008 sub-prime crisis.
Apart from being a viable alternative to capitalist financial systems prone to extreme risks, the interest-free solutions of Islamic Banking could restore equilibrium in Indian society by providing succour to debt-ridden farmers, labourers and other marginalized groups. Hence, Islamic Banking has potential as a tool of financial inclusion.
As per the Pew Research Centre, India was home to nearly 177 million Muslims in 2010, making it the country with the third largest Muslim population in the world. A considerable number of Indian Muslims either invest in non-interest bearing accounts or donate the interest from interest-bearing accounts to charity. There is an opportunity for Islamic banks to attract funds that interest paying conventional banks can not Traditionally, Indians practised participatory banking by creating cooperative banks, non banking financial institutions and micro credit programmes; the same platform can be used to introduce Islamic Banking.
According to the Planning Commission, Indiais facing a funding gap of US$ 300 billion – or30% – in meeting its infrastructure funding requirement until 2017. Following the example of countries such as Malaysia, Indonesia, UK, France and Germany, India could use Islamic financial products such as Sukuk (long term bond) to fund infrastructure and other sectors.
Specifically, India could attract the Middle East’s high investible surplus through Islamic banking and finance.
Challenges for Islamic banking in India
• Indian banking is governed by the following:
Banking Regulation Act 1949, RBI Act 1934,and Cooperative Societies Act and Negotiable Instruments Act 1961.Many sections of the said acts are in opposition to the basic tenets of Islamic banking. For instance, payment of interest on deposits is mandatory as per section 21 of the Banking Regulation Act; sections 5(b) and 5(c); specifically prohibit investments based on profit and loss sharing; and section 8 of the Banking Regulation Act1949, which reads “No banking company shall directly or indirectly deal in buying or selling or bartering of goods.” Directly contradicts the Murabaha concept of Islamic banking which allows banks to enter into sale and purchase agreements.
• The interest earned on fixed deposits is subject to TDS as per the Income Tax Act1961, whereas the profit on Islamic banking deposits is treated differently.
• Commercial banks borrow from other banks or the RBI to meet their short term funding requirements, but Islamic banks can’t do so because it involves interest.
• Islamic banks are required to closely monitor their investments in various businesses, as well as ensure that the investee firms are managed properly. This calls for expensive supervisory infrastructure.
Dearth of Islamic banking professionals:
There is a serious dearth of Islamic banking experts and trained personnel in India. Although there are a few training institutes, they are unable to compensate for the shortage of experienced Islamic banking professionals.
Lack of awareness:
• There is a lack of awareness about Islamic Banking. Most people mistakenly believe04 Thought Paper derivative contracts of the kind which led to the2008 sub-prime crisis.
Apart from being a viable alternative to capitalist financial systems prone to extreme risks, the interest-free solutions of Islamic Banking couldrestore equilibrium in Indian society by providingsuccour to debt-ridden farmers, labourers and other marginalized groups. Hence, Islamic Banking has potential as a tool of financial inclusion.
As per the Pew Research Centre, India was home to nearly 177 million Muslims in 2010, making it the country with the third largest Muslim population in the world. A considerable number of Indian Muslims either invest in non-interest bearing accounts or donate the interest from interest-bearing accounts to charity. There is an opportunity for Islamic banks to attract funds that interest paying conventional banks cannot.
Traditionally, Indians practised participatory banking by creating cooperative banks, nonbanking financial institutions and micro credit programmes; the same platform can be used to introduce Islamic Banking. According to the Planning Commission, Indiais facing a funding gap of US$ 300 billion – or30% – in meeting its infrastructure funding requirement until 2017. Following the example of countries such as Malaysia, Indonesia, UK, France and Germany, India could use Islamic financial products such as Sukuk (long term bond) to fund infrastructure and other sectors.
Specifically, India could attract the Middle East’s high investible surplus through Islamicbanking and finance that it is only meant for Muslims, where asin Malaysia, UK and elsewhere, 40% of the customers of Islamic Banks are Non Muslims.
• Banks should educate customers regarding the benefits of Islamic Banking. Admittedly, this is a herculean task, given that Islamic Deposits like Mudarabah Deposit, do not guarantee principal, nor pay a fixed return.
• The latest RBI directive is clear that Islamic banking can’t be adopted in India under the current legal framework. India needs to follow the UK example and introduce new laws to govern the Islamic Banking business.
• More effort is required in the area of training and education; the State can play a pivotal role in promoting this subject by including it in the curriculum of professional courses.
• The myth that Islamic banking is only for Muslims must be dispelled, and awareness of Islamic Banking as an alternative, ethical form of banking should be created. Public seminars and discussions are a good way to do this.
Growth of Islamic finance depends on two important factors: domestic demand and India’s role in the globalization of the financial sector.
By not introducing Islamic finance, India is losing the opportunity of garnering capital from a large section of the Muslim population as well as from Islamic nations in the Middle East and elsewhere.
Islamic finance is an idea whose time has come. It is time the Indian Government recognized this significant opportunity.