75596250 Islamic Banking in India

7/28/2019 75596250 Islamic Banking in India

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Banking on faith: Islamic (sharia) banking and its prospects in IndiaPriyanka Lal and Sneha Snehal


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In this era where trends flourish around increasingaspirations to identify with social consciousinitiatives, it comes as no surprise that IslamicBanking is booming. The concept of interest isfundamental to the business of banking. With thisbackground it is very interesting thatsharia[1]banking is working without profits and isstill flourishing. They are not only profitable but arealso growing at an astonishing rate in sense ofcapital, assets and consumers. From Jakarta toJeddah to Jordan, 280 Islamic banks operate in over50 countries, with assets estimated between $ 250million and $ 300 billion.[2]ManagementConsultants Mckinsey and Co. say in their worldIslamic Competitiveness Report, 2007 that the valueof assets managed by Islamic Banks will grow by 33% by 2010.[3]

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Keeping all this as background this article explores Islamic Banking in totality: origin,principles, growths and future and the possibility of the same in India.

Historical Development

It seems that the history of Islamic banking could be divided into two parts. The earliestreferences to the organization of banking on the basis of profit sharing rather than interest(Fiqh al-Muamalat-the fundamental principal of Islamic Banking) can be traced to the lateforties.[4]However In the next two decades it attracted more attention, partly because of thepolitical interest that it created in Pakistan and partly because of the migration of muslims tothe western countries. The Islamic Development Bank, an inter-governmental bankestablished in 1975, was born of this process, being the first bank incorporating theprinciples of sharia banking.[5]The first private interest-free bank, the Dubai Islamic Bank,was also set up in 1975 by a group of Muslim businessmen from several countries. Twomore private banks were founded in 1977 under the name of Faisal Islamic Bank in Egyptand the Sudan. In the same year the Kuwaiti government set up the Kuwait Finance House.In the ten years since the establishment of the first private commercial bank in Dubai, more

than 50 interest-free banks have come into being. Though quite a few of them are in Muslimcountries, there are now spreading in other countries as well like in Denmark, Luxembourg,Switzerland and the UK.

In most countries the establishment of interest-free banking has been by private initiative(mostly by migrant muslims). In Iran and Pakistan, however, it was by government initiativeand covered all banks in the country.

Fundamentals of Islamic Banking

All interest-free banks agree on the same basic principles. However, individual banks differin their application. These differences can be because of several reasons including the lawsof the country, objectives of the different banks, individual banks circumstances andexperiences, the need to interact with other interest-based banks, etc.

Some of the essential principles which are followed by all the banks practicing shariabanking are:[6]

Deposit accounts

All the Islamic banks have three kinds of deposit accounts: current, savings and investment.

Current accounts

Current or demand deposit accounts are virtually the same as in all conventional banks.Deposit is guaranteed.

Savings accounts

Savings deposit accounts operate in different ways. In some banks, the depositors allow thebanks to use their money but they obtain a guarantee of getting the full amount back fromthe bank. Banks adopt several methods of inducing their clients to deposit with them, but noprofit is promised. In others, savings accounts are treated as investment accounts but withless stringent conditions as to withdrawals and minimum balance. Capital is not guaranteed

but the banks take care to invest money from such accounts in relatively risk-free short-termprojects. As such lower profit rates are expected and that too only on a portion of the

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average minimum balance on the ground that a high level of reserves needs to be kept at alltimes to meet withdrawal demands.

Investment account

Investment deposits are accepted for a fixed or unlimited period of time and the investorsagree in advance to share the profit (or loss) in a given proportion with the bank. Capital isnot guaranteed.

Modes of financing

Banks adopt several modes of acquiring assets or financing projects. But they can bebroadly categorised into three areas: investment, trade and lending.

Investment financing

This is done in three main ways:

a) Musharaka where a bank may join another entity to set up a joint venture, both partiesparticipating in the various aspects of the project in varying degrees. Profit and loss areshared in a pre-arranged fashion. This is not very different from the joint venture concept.The venture is an independent legal entity and the bank may withdraw gradually after aninitial period;

b) Mudarabha where the bank contributes the finance and the client provides the expertise,management and labour. Profits are shared by both the partners in a pre-arrangedproportion, but when a loss occurs the total loss is borne by the bank; and

c) Financing on the basis of an estimated rate of return. Under this scheme, the bankestimates the expected rate of return on the specific project it is asked to finance andprovides financing on the understanding that at least that rate is payable to the bank. If theproject ends up in a profit more than the estimated rate the excess goes to the client. If theprofit is less than the estimate the bank will accept the lower rate. In case a loss is sufferedthe bank will take a share in it.

Trade financing

This is also done in several ways. The main ones are:

a) Mark-up where the bank buys an item for a client and the client agrees to repay the bankthe price and an agreed profit later on;

b) Leasing where the bank buys an item for a client and leases it to him for an agreedperiod and at the end of that period the lessee pays the balance on the price agreed at thebeginning an becomes the owner of the item;

c) Hire-purchase where the bank buys an item for the client and hires it to him for an agreedrent and period, and at the end of that period the client automatically becomes the owner ofthe item;

d) Sell-and-buy-back where a client sells one of his properties to the bank for an agreed

price payable now on condition that he will buy the property back after certain time for anagreed price; and


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e) Letters of credit where the bank guarantees the import of an item using its own funds fora client, on the basis of sharing the profit from the sale of this item or on a mark-up basis.

Lending

Main forms of Lending are:

a) Loans with a service charge where the bank lends money without interest but they covertheir expenses by levying a service charge. This charge may be subject to a maximum setby the authorities.

b) No-cost loans where each bank is expected to set aside a part of their funds to grant no-cost loans to needy persons such as small farmers, entrepreneurs, producers, etc. and toneedy consumers.

c) Overdrafts also are to be provided, subject to a certain maximum, free of charge.

Services

Other banking services such as money transfers, bill collections, trade in foreign currenciesat spot rate etc. where the banks own money is not involved are provided on a commissionor charges basis.

Prohibited lending

Islamic Banking other than dealing with interest also prohibits any dealing in pork,pornography, and anything else which the sharia deems haram.

Feasibility of Islamic banking in India

Current status of Islamic Banking in India

Islamic banks in India do not function under banking regulations. They are licensed underNon Banking Finance Companies Reserve Bank Directives 1997 RBI (Amendment) Act1997, and operate on profit and loss based on Islamic principles. All the Islamic banks haveto be compulsorily registered with RBI.

Reasons for non implementation of Islamic Banking in India

In the straitjacket world of Indian banking, something as fascinating as Islamic banking is adistant dream. Nonetheless, countless advocates of Islamic banking have been trying theirbest over the years to propagate the concept. In furtherance of this propagation the ReserveBank of India (RBI) constituted a committee in 2007[7] to examine the issue but viewed thatIslamic banking cannot be offered by banks in India as well as the overseas branches oflocal banks under the present legal framework. Except a basic offering like current account,almost no other banking product in India can be modified to meet the conditions of Islamicbanking. As a genre of financial services, Islamic banking shuns the very idea of interestrates, and rests on profit-sharing principles. Based on the Sharia''''''''''''''''''''''''''''''''h law, itabhors the business of making money out of money, upholding the belief that wealth is

generated through actual trade and investment.[8] The RBI has not put the report in thepublic domain.[9]
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While the final form of the report is not known, from the newspaper reports it can becollected that the members had pointed out how Indian banking laws come in the way ofvarious Islamic banking principles. These are as follows:

1. n Al Wadiah (for saving bank account): Section 21 of the Banking Regulation Act (BR

Act) requires payment of interest on such deposits; thus, interest-free deposit and a simplecharging of premium or Hiba is not permissible.

2. Mudarabah (for term deposit or investment): Here again, Section 21 of the BR Actdisallows such products where the bank can invest the money in equity funds (in India,equity exposure is determined by a separate set of rules), and the client has completefreedom in the management.

3. Mudarabah, Musharakah (for project finance and SME credit): Sections 5, 6 of the BR Actindicate the forms of business a banking company can undertake, and does not allow anykind of profit-sharing and partnership contract the basis of Islamic banking.

4. Ijarah (for home finance) : As against Islamic banking where the banks owns the assetand hold the title, Section 9 of the BR Act prevents the bank from any sort of immovableproperty other than private use.

5. Istisna (leasing, buyback): Besides the usual curbs on acquiring immovable property,offering Islamic banking products many not are bankable due to stamp duty, central salestax and state tax laws that will apply depending on the nature of the transfer.

The BR Act even disallows an Indian bank from floating a subsidiary abroad to launch suchproducts, or offering these through a special window. Thus, the upshot of the findings is thatsuch banking experiment is impossible without a new law or multiple amendments to the BR

Act.

Another important consideration is the tax procedures. While interest is a passive income,profit is defiantly an earned income which is treated differently. If principles of Islamicbanking are incorporated then how does it comply with the tax procedure is the mootquestion. Furthermore RBI cannot act as the lender to such banks because suchaccommodation by the monetary authority is also interest based. Islamic banks cannotinteract with conventional banks based on principles of interest.

Conclusion

Though it can be concluded that as of now RBI has stopped all the possibility of Islamic

banking in India (other than NBFCs), there are certain questions which remain unanswered.The RBI report has not been made available on the public domain like other reports isdefinitely one question waiting to be answered. If the international banks[10] haveestablished Islamic merged it with their object of profit making why can the same be done inIndia also is not answered. Keeping in mind the flourishment of Islamic Banking all over theworld and the muslim population in India these are the questions which have to be answeredimmediately and with certainty.

(The authors are fourth year students of Hidayatullah National Law University, Raipur)
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75596250 Islamic Banking in India