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Feasibility of Islamic Banking in India
By: Dr. M I Bagsiraj bagsiraj@yahoo.com Cell: 91 9845144470
Today Islamic Banks are operating in most of the Muslim countries as well as some of the secular countries1. “ Islamic Finance is now a big industry that is truly world wide. There are over 90 Islamic Banks spread across 35 countries, excluding those in Pakistan, Iran and Sudan.”2 In India too public demand for Islamic Banking is growing. This paper deals with the ways and means of starting Islamic Banking in India. In section I we build the case for Islamic Banking. In section II we deal with the provisions that will facilitate Islamic Banking in India. In section III we take note of alternative institutional set-ups that can operate and promote Islamic Banking in India.
Section I
The Case For Islamic Banking:
Why Islamic Banking in India? Islamic Banking because almost 300 million Indians are still living below poverty line3. Another 300 million are living around poverty line. First social control later nationalization of banks, both have proved inadequate to eradicate poverty (remember Garibi Hataao! that remained a political slogan), bring about development with equality and render social justice. Further the direction in which our economic governance is headed, liberalization, privatization and globalisation in short extended capitalism, is an economic model that develops only the creamy layer at the top and leaves the vast majority at the mercy of trickle down effect to languish at the bottom. The 40% of lending to priority sector by our banks consistently over long period at differential interest rates has not been helpful either in poverty alleviation or balanced economic growth. It is time that our govt. and bankers take a look at the alternative banking model available in the form of Islamic Banking. Do we need to remind our planners that the mixed economic approach serves the interests of a multicultural society better. The value neutral capitalistic financial and banking model has led to 2% of world’s richest people owning over 50% of world’s wealth, and the bottom 50% of world’s people owning only 2% of wealth4. If this is the end product of capitalistic development we must tread this path very carefully. Our multilingual and multicultural society can neither absorb nor tolerate such economic injustice. Unless we introduce the value based economic and financial systems we cannot escape the fate of developed capitalistic countries, who are struggling to attain positive growth rates with the help of extended capitalism and enforced globalisation.
Islamic Banking provides value added finance like value added services. The values added by Islamic finance have universal demand e.g. interest free finance for poverty alleviation, profit sharing finance for growth with equality and PLS finance for economic justice. Islamic financial values also prohibit financing of those activities that are injurious to the social health of the people.
At a recent NDC meeting in his opening address our PM observed “growth to be real must bring about equity.” Growth that excludes disadvantaged and vulnerable sections of our society is no growth. Hence any economic growth that is brought about by Indian banks must address the problem of ‘financial exclusion’ as “markets by definition tend to exclude some as they include others” said Dr. Y S P Thorat, Chairman NABARD at the Banking Conclave 2006 in his presentation on “Indian Banking: Shaping an Economic Powerhouse.” The most recent report of Justice Rajendra Sachar on Socio-economic and Educational Backwardness of Indian Muslims has made it abundantly clear that the market forces have by and large excluded Muslims from financial services whether offered by banks or various govt. schemes. Thus exclusion of Muslims and other minorities as well as backwards and deprived including SCs and STs will have to be addressed to not only by the inadequate and ill administered PM’s 15 Point Programme, but also by a suitable banking policy including provisions for interest free Islamic Banking. Because Islamic Banking is very much for growth with equity and justice5.If Britain the mother of all secular societies can permit Islamic Banking for financial inclusion of 2 % Muslim minority why not India the home of 12 % Muslim minority and another 30 % of the deprived ones who are living below the poverty line? Thus the term Financial Inclusion needs to be broadened and redefined to include not only marginal farmers, oral lessees, share croppers, workers in unorganized sector etc. but also minorities with access to interest free financial services.
If Financial Inclusion is defined as the delivery of financial services at an affordable cost to vast sections of disadvantaged and low-income groups including minorities than provision of Islamic Banking services can yield the most desirable results. Dr. YSP Thorat rightly says that cultural and attitudinal constraints of Bank managers as well as commercial banking ethos of funding and profitability or lower NPAs is responsible for Financial Exclusion of weaker and disadvantaged sectors of society including minorities. Therefore too provision of interest free Islamic Banking is necessary for addressing market anomalies and facilitating equal and proper distribution of the fruits of globalization.
The facilitation of Islamic Banking leading to Financial Inclusion of Muslims is expected to boost Indian banking and economic operations by bringing in huge idle funds. According to Bindu Vasu6, “the assets controlled by Muslims are estimated to be $1.5 trillion and growing at 15 % annually. In kerla alone it is reported that this money could be above Rs. 40000 crore. Research reveals that a handsome bulk of money in India owned by the believers (Muslims) is lying idle, which if invested on profit sharing basis and utilized properly, can have a major impact on the Indian economy.” Besides the monetary assets of Indian Muslims, the introduction of Islamic Banking in India is also most likely to bring in huge amounts of petro-dollars from gulf that are awaiting permissible investment opportunities in nearby shores rather than risking them in increasingly insecure and unfriendly socio-political environment of USA and Europe. It will further boost our investments and growth rate, may be to the level of China’s growth rates of 12-15 %. Thus Islamic Banking has great potential to deliver growth with equity, justice.
We are not going in to the details of the virtues and USPs of Islamic Banking because that is not the subject matter of this paper. Suffice it to say that Islamic Banking is very much in tune with and complimentary to the Banking and socio-economic objectives of our govt. By promoting the value and asset based banking it establishes sound linkages between finance and real economic growth. It shuns dealing with speculative economic projections that lead the whole economy vulnerable to undesirable manipulations including supply bottlenecks and demand-pull inflation. To quote Bindu Vasu again “….banking without interest can take care of any kind of financing which the conventional banks are indulging in …..This may also serve thousands of needy people to come forward to borrow from banks without the fear of facing menace of high interest being charged by banks, especially the small borrowers. It can also free the banks from the clutches of rising Non-Performing Assets to a large extent….”
For Islamic Banks to become a reality in India its people at large as well as existing financial institutions will have to make out a strong case. The Islamic financial Institutions that are functioning in India, whether as Societies or NBFCs, will have to acquire financial prudence and write to central ministry of finance for provisions to undertake Islamic Banking operations. People at large including bankers, financial professionals, economists, entrepreneurs and activists will also have to be after the govt. for facilitating Islamic Banking in India. They can send requests, memorandums, and applications etc. to the ministry of finance as well as RBI.
Section II
Provisioning of Islamic Banking in India:
Islamic Banking in most of the Muslim countries has been introduced because of the Quranic injunctions against interest. However in most of the secular and non-muslim countries including USA, UK, and Australia etc., it has been introduced because of the demands of financial institutions and financial exigencies. Some of the MNC and International Banks or their branches have also started Islamic Banking Windows because of its higher growth rates and profitability7. Chase Manhattan, Citibank, ANZ Amro, Grindlays and HSBC, are offering Islamic financial products. In India too some Islamic Financial Institutions in the formats of Charitable and Co-operative Societies, NBFCs (Non Banking Financial Companies) etc. have been established8. However they have not been able to fulfill the interest free banking needs and aspirations of the people hence they have not been able to register satisfactory growth. In order to facilitate Islamic Banking the central Finance Ministry will have to initiate following measures:
1. Take a policy decision in favour of Islamic/ interest free banking.
2. Develop/select model/models of Islamic Banking and specify the same for the benefit of people and institutions.
3. Formulate necessary rules and issue guidelines for promotion of Islamic/interest-free Banking.
4. Develop a regulatory mechanism by making appropriate changes / additions / amendments in the Banking Regulation Act of 1949 and monitor growth of Islamic Banking through RBI.
5. Concerned tax laws that govern Company and Profit taxation that are more in favour of debt finance may have to be changed to provide a level playing field for Profit and Loss Sharing financial institutions including banks.
To facilitate Islamic Banking, following basic changes are required in the Banking Regulation Act of 1949 that governs the growth of banking in India and enables RBI to monitor and regulate their growth.
1. Interest wherever it occurs whether on the debt or investment instruments will have to be alternated with profit and loss sharing (PLS) ratios.
2. RBI will have to suitably adjust its monetary policy instruments of Bank Rate and SLR(Statuary Liquidity Ratio) whenever applied to Islamic Banks. May be it can use PLS ratios here too.
3. In addition to the existing provisions of Current Account, Savings Account and Fixed or Time Accounts: one more account viz. Equity Deposit Account may be permitted. The funds mobilized through Equity Account may be allowed to be invested in equities of small, medium and large industries/business ventures, subject to the guide lines and regulations of RBI.
4. Banks may be permitted to finance trading operations to enable them to undertake Leasing and Hire Purchase finance and Mark up Pricing i.e. Murabah.
5. The Govt./Treasury may have to develop PLS Bonds and Securities as well, so that Islamic Banks can buy and sell or hold them whenever required without violating their basic principle.
If Islamic Banking facility is to be provided along with the conventional banking system, a provision has to be made for replacing interest with Profit and Loss Sharing ratio that can be utilized for making payments to depositors as well as receiving income from users of funds of Islamic Banks. RBI not only regulates all banking activities of the country, it also implements the Monetary Policy of the Govt. It does so mainly through the instruments of Bank Rate, SLR and purchase and sale of govt. bonds and securities, all of which are interest based. Hence they too will have to be given the profit sharing base. RBI is also the lender of last resort to all the other banks. However it lends them at an interest. Either RBI can lend to Islamic Banks at the average rate of their profit and enhance their liquidity or give them interest free distress loans on reciprocal basis. The liquidity of Islamic Banks can be also increased or decreased by RBI by acquiring or returning the stocks of Islamic Banks as well as by selling and buying the PLS Govt. Bonds and Securities.
The introduction of Equity Deposit Account for those depositors who want to invest in stocks through their banks and earn profits or losses can be a revolutionary step for the banks as well as economic development. Even low and middle income groups who do not generally invest in stocks because they lack its knowledge, can get an opportunity to participate in economic progress of the country and also reap its fruits. The banks will have access to additional funds as well as income generating source. The higher risks of investment in stocks will be restricted to only Equity Deposit Accounts, who will bear the burden of losses if any. In this era of banking liberalisation the focus of bank activities has gradually shifted from financing commodity production to lubricating trade and financing personal consumption. For instance according to CP Chandrashekhar personal credit off take has increased from Rs.50000 crore in the year 2000 to Rs. 160000 crore in 20039. This growing imbalance can be corrected by promoting Equity Deposit Accounts that will also be helpful in strengthening the investment climate in the country as well as better spread of the gains of galloping stock values led by the globalisation of our economy. With the Universal Banking gaining momentum, acting as financial supermarkets they are offering a range of products including debt products, investment opportunities in equity, debt and commodity markets, and insurance products of different kinds. In this growing environment of virtual banking services provision of IBPs including Equity Deposit Accounts should not remain a dream for Indian banks and their depositors for long. So far leasing and hire purchase activities are allowed for only NBFCs. For the Islamic Banks world over it is an important source of earnings along with Murabaha. Hence Banks too need to be allowed to do so. Without the development of PLS public Bonds and Securities Islamic Banks can not invest in them as trading in interest bearing instruments is prohibited for them. Another special problem of Islamic Banks in India will be non- availability of an Islamic money market wherein they can invest their excess cash profitably over shorter periods. This problem can be taken care of to some extent by inter bank borrowing and lending between Islamic Banks on Profit Sharing basis. Islamic Banks can also have similar arrangements with Islamic NBFCs and Islamic Insurance (Takaful) companies, such as Bajaj Alliance Insurance Company that has recently started a health linked Takaful investment scheme especially for Muslims. Islamic Insurance or Takaful products that are already feasible in India as demonstrated by Bajaj Alliance needs to be further developed by Indian Muslims.
In order to make Islamic Banking acceptable to all political parties and the secular constitution and Govt. of India Muslims must consider adopting secular names like Interest Free Banking, Alternative Banking or PLS Banking. Let us remember that our objective is to persuade Govt. of India and the parliament to accept and permit Islamic Banking in India along with conventional Banking. Our objective is not the replacement of conventional Banking with Islamic Banking. Another related issue is that of constituting Shariah Boards for the guidance of Islamic Banks. Lot of Shaiah approved Islamic Banking Products (IBPs) have been developed and adopted by banks all over the world. The same can be adopted by Indian banking system as well. However wherever possible we can have Shariah Boards so as to develop new IBPs and practices. It is reported by an official of Foreign Bank in India drastic step may not be required to introduce Islamic Banking in India “a product can be introduced having similar features that Islamic Banking offers. Since it is a transaction between the client and the bank, there is little regulatory role required.”10 Further according to Mr.Jaspal S Bhindra, general manager South Asia and South East Asia Standard Chartered Bank “the concept (of Islamic Banking) is not restricted to a subject, but is a viable proposition for the rest of the population as well. We see this as a fast growing area.”11
Section III
Alternative Institutional Set-Ups for Islamic Banking:
Once the policy decision is taken by the Ministry of Finance and RBI to permit Islamic Banking in India there can be several options to set up Islamic Banking. Following are some of the important ones.
A. Only Nationalized Banks to operate Islamic Banking Windows (IBWs)
B. Only selected Foreign Banks to operate IBWs
C.Only private Indian Banks to operate IBWs
D.Private Banks in collaboration with Foreign Banks to operate IBWs or even full fledged branches of Islamic Banks.
E. Only Scheduled Urban Co-operative Banks to operate IBWs/ full fledged branches of Islamic Banks.
F.All Banks to operate IBWs/Islamic Bank branches.
Universally speaking there are 3 models of Islamic Finance including banking.12 In the first model there are banks, financial institutions, investment companies, leasing companies, mutual funds, etc. all in the private sector trying to operate without interest. Second model consists of the 3 Islamic countries that have decided to eliminate interest from the entire banking system. They are Pakistan, Iran and Sudan. However they are still in different stages of interest elimination. Third and final model consists of conventional Banks co-existing and competing with Islamic Banking. Malaysia and Britain are the main examples of this model, wherein an Islamic Bank, Islamic Financial Institutions and Islamic Banking windows are operating simultaneously along with conventional banks. In Malaysia for instance 14 conventional banks 10 local and 4 foreign have 1335 branches operating Islamic counters, compared to 122 branches of Islamic Banks. Thus It is the 3rd model that is most suitable for Indian conditions.
To begin with however there are several options as mentioned above from which we must carefully choose. Option A and F are but a distant possibility. As lot of preparation has to be made before Islamic Banking could be introduced on mass scale. Different accounting practices have to be developed, banking and supervisory staff has to be trained, regulatory norms and regime have to be in place and so on.
Option B is an immediate possibility, once the policy decision in favour of Islamic Banking is taken and its broad parameters are defined. Those MNC Banks that are operating Islamic Banking Windows elsewhere have the wherewithal to operate IBWs in India too. However why allow only MNC Banks to reap the harvest of huge Islamic Banking deposits and investments? Another problem of Foreign MNC Banks is that they may introduce only those IBPs that are most profitable for them leaving out other products of Islamic Banking that are socio-economically more relevant and desirable. Moreover Foreign MNC Banks do not have a broad based net work of banking in India. Hence it may not serve the purpose of facilitating Islamic Banking for all the people of India.
Option C is also feasible. Private Indian banks are recently registering faster growth than public sector banks. ICICI Bank has become the leading private sector bank. ICICI Bank along with State Bank of India are said to have received permission from the gulf monetary authorities to establish their branches in the region that will also provide Islamic Banking facilities13. Thus ICICI and other private banks like Jammu and Kashmir Bank can start either IBWs or even full-fledged Islamic Banks. However the reach of the private Indian banks is limited and restricted mostly to cosmopolitan Indians. Moreover apart from ICICI Bank other private banks of India may not be in a position to launch Islamic Banking operations at short notice as they have had no such exposure. Therefore Option D appears to be more realistic wherein private Indian banks in collaboration with those Foreign Banks that have had experience of operating IBWs or full fledged Islamic Banking operations can be given the responsibility of initiating Islamic Banking operations in India. It is learnt from the officials of Gulf Islamic Banks14 that they have already approached the RBI for permission to start branches in India. Perhaps they may do well to collaborate with an Indian private bank and apply to the Indian banking authorities for permission.
Option E is an interesting and viable option too. Ideologically Islamic Banking is much more closer to Co-operative Banking. In fact some Islamic Co-operative Societies are already functioning in India since pre-independence days15. But they do not enjoy the status or facilities of a bank. However there are several conventional Urban Co-operative Banks managed by Muslims. Some of them have even attained the status of Scheduled Bank. Given the permission they would very much like to operate IBWs. Given the opportunity some of them may even wish to convert fully to Islamic Banking. Subject to their financial prudence most of the Urban Scheduled Banks and some of the Urban Co-operative Banks can be given permission to operate IBWs. In such a case in addition to the central Ministry of finance and RBI, the Co-operative Department officials of respective state will have also to be approached for permission.
F is the ultimate and ideal option, whereby any bank that desires to operate IBWs or Islamic Bank branches in India is given the go ahead, subject off course to their financial prudence.
The way in which Islamic Banking has been developed elsewhere in the world and will be sooner than later adopted in India is for universal consumption. For Muslims it is only one part of Islamic finance. The other and more important part of Islamic Finance for Muslims is Zakah and Infaq that includes fitra, sadqah, qarde hassan, auqaf, etc. Without effective institutionalization and distribution mechanism of these Islamic financial instruments, Indian Muslims too cannot attain the desired well being and welfare, neither in this world nor hereafter.
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1 Encyclopedia of Islamic Banking and Insurance, 2000, Country wise List of Islamic Banks, Institute of Islamic Banking and Insurance, London.
2 Dr. Mohamed Arif, “Islamic finance Under Globalisation” a research paper presented at Delhi Seminar 18&19 Feb. 06.
3 Planning Commission Report, Hindustan Times, Mumbai Edition, 23-03-07, p 8.
4 UNO Report, Times of India Mumbai edition, 27-01-07
5 Refer International Seminar proceedings “Justice and Equity The Message of Islamic Banking 18-19 Feb 2006 Delhi”, Published by JIH,Jamia Nagar, New Delhi 25.
6 “Islamic Banking – Banking For A Change” by Bindu Vasu, Legal Officer RBI; RBI Legal News And Views – Journal Section, April-June 2005/vol.10 issue no.2.
7. Dr. Munawar Iqbal, “Islamic and Conventional Banking in the 1990s:A Comparative Study”, in “Islamic Banking and Finance: Current Developments in Theory and Practice”, Islamic Foundation, Uk 2001.
8 “Islamic Financial Institutions of India: Progress, Problems and Prospects Dr. M I Bagsiraj, King Abdulaziz University, Jeddah, .2002,
9 C P Chandrashekhar “Whatever is Happening to Indian Banking”, March 15, 2006.
10& 11 “Islamic Banking a non-starter in India”, A report by Priti Patnaik, Economic Times dated 22-05-06
12 Khurshid Ahmad, “Islamic Finance and Banking: The Challenges and Prospects” ,The Islamic Foundation, Leicester, UK,2000.
13 Javed Ahmad Khan, Research Paper, Academy of Third World Countries, Jamia Millia Islamia, Feb.2006.
14 Mohammad Talha, First Manager, International Banking Services, Qatar International Islamic Bank, 2006.
15 e,g.Patni Co- Operative Cedit Society Ltd. at Surat, Gujrat that was registered in 1942 & is still functioning successfully.