Islamic Banking-An Emerging Trend (co authored by-Swati Mantri & Priya Dixit)

Islamic banking also known as “interest-free banking” plays a dominant role in working of the banks in Islamic countries.

Islamic banking refers to a system of banking or banking activity that is consistent with the principles of Islamic Law [Shariah].

Shariah prohibits the payment or acceptance of interest fee for the lending and accepting of money respectively, {Riba, usury} for specific terms, as well as investing in businesses that provide goods and services considered contrary to its principles [Haraam, forbidden.]

Say, a customer buying a home with bank funds, will not ‘borrow’ from the bank and service it through equal monthly instalments. Instead, the bank will purchase the property and then rent or lease it out to the customer. Once the bank recovers the investment, it will transfer the property to the customer at a reasonable rate.

The basic idea behind such practice is to treat all, rich or the poor equally and to bring about equal distribution of wealth among all classes of people.

History:

The first experiment with Islamic banking was undertaken in Egypt undercover, without projecting an Islamic image. This experiment lasted until 1967 by which time there were 9 such banks in the country. These banks which neither charged nor paid interest, invested mostly by engaging in trade and industry, directly or in partnership with others, and shared the profits with their depositors. In the 70’s changes took place in the political climate of many muslim countries so that there was no longer any strong need to establish Islamic financial institutions undercover.

A number of Islamic finance banks came into existence throughout the Middle East e.g., The Dubai Islamic Bank (1975), The Faisal Islamic Bank of Sudan (1977), The Bahrain Islamic Bank (1979), fostering trade and business activity. In Spain and the Mediterranean and Baltic states Islamic merchants became indispensible middle men for trading activity. It is claimed that many concepts, techniques, and instruments of Islamic finance were later adopted by European financers and businessmen.

The revival of Islamic banking coincided with the world wide celebration of the advent of the fifteenth century of the Islamic calendar [Hijra] in 1976. The boost received by the oil producing countries due to rationalization of oil prices led Muslims to strive to model their lives in accordance with the ethics and principles of Islam.

Principles:

The underlying financial principles in Islamic finance have remained unchanged historically since their development over 1,400 years ago. The basic principles underlying Islamic banking are profit and loss sharing and prohibition of interest (Riba).

• Prohibition of Interest:

The prohibition on paying or receiving of interest is based on the Islamic tenet that money is only a medium of exchange it has no value in itself and therefore should not be allowed to give rise to more money via fixed interest payments put in bank or lent to someone. Human effort, initiative and risk involved in a production venture are more important than the money put in it.

Interest can lead to injustice and exploitation in society. The Quran characterizes it as unfair as implied by the word ‘zulm’ (oppression, exploitation). Money is intended to be means of exchange, and interest represents an increase in money itself, hence of all ways of getting wealth this is the most contrary to nature. – Aristotle.

• Profit-and-loss-sharing :

While Islam employs various practices that do not involve charging or paying interest the Islamic financial system promoted the concept of participation in a transaction backed by real assets, utilizing the funds at risk on profit–and–loss–sharing basis. Such modes used by Islamic banks are known as Musharakah (Joint Venture) and Mudarabah (profit sharing)

The concept of profit and loss sharing is a progressive one as it distinguishes good performance from the bad and the mediocre. This concept therefore encourages better resource management.

• Rules of permissibility:

Muslims believe that all things have been provided by God and benefits derived from them are for man’s use and so they are permissible except those prohibited in Quran.

When guidance is not clearly given in Quran it can be sought from other sources of law like, ‘Fiqh’ which means understanding.

Prohibition includes a number of key principles like:

i. Transactions in unethical goods and services

ii. Earning returns from a loan contract (Riba/Interest)

iii. Compensation-based restructuring of debts

iv. Excessive uncertainty in contracts (Gharar)

v. Gambling and chance-based games (Qimar)

vi. Trading in debt contracts at discount.

vii. Forward foreign exchange transactions.

Scenario Worldwide:

The global market for Islamic financial services, as measured by Shariah compliant assets has estimated growth by over 10% a year from about $150billion in the mid-1990s.

Islamic commercial banks accounted for 75% of the assets and investment banks, 13%. The balance is made up by Sukuk issues.

Emerging centers of expertise :

Bahrain, Dubai/UAE and Kuala Lumpur have strong historical positions and future ambitions as centers for Islamic financial services. Riyadh, Qatar, and Singapore also have aspirations to become centers for Islamic finance. London is positioning itself as the gateway to Islamic finance in Western Europe. The market is currently most developed in Malaysia, Iran and the majority of countries that form the Gulf Co-operation Council (GCC). However, Islamic finance is moving beyond its historic boundaries in these countries into new territories both within and outside the Arab world. Initiatives are on to develop Islamic finance in the UK. The UK, in 9th place, is the leading Western country with $10billion of reported assets, largely based on HSBC Amanah.

Key future markets include:

• Arab countries such as Egypt, Turkey, Lebanon and Syria.
• Asian countries such as Indonesia, which has the largest indigenous Muslim population in the world, and China.
• Western countries in Europe and North America. Countries such as the US, France, Germany and the UK each have indigenous Muslim populations of between one and five million. Moreover, the customer base in Western countries is not necessarily restricted to Muslims, other customers may be attracted by the ethical and environmental basis of Islamic finance.
• Malaysia and Pakistan have over 15 banks supplying Islamic financial services; Kuwait, Bahrain each have 17; Iran, Saudi Arabia and Bangladesh each have around 10.
• Market share of Islamic banks in Malaysia and the Gulf Cooperation Council (GCC) is rising. Within the GCC, Kuwait and Saudi Arabia are the countries in which Islamic banks’ market share is highest and has grown the fastest.
• London has been providing Islamic financial services for 30 years, although only recently this service has begun to receive greater profile.

Success and difficulties in implementation:

• Islamic banks are evolving financial and investment instruments that are not only profitable but also ethically motivated. The boom in Islamic banking has several reasons, on one hand the industry is young so the growth is natural on the other hand it depends on credit crises.
• Volatile interest rates, high bank fees and foreclosure in payment defaults make people unhappy of traditional banking system.
• Islamic banks or banks that offer Islamic banking units, have a market that holds half of oil reserves and whose citizens have an estimated $ 1.5 trillion in private wealth.

• With great inclusion of muslim youths in the financial sector they can contribute in a better way and Islamic banking can help counter terrorism. One of the main reasons of terrorism is poverty and Islamic banking can alleviate the condition.
• Islamic banking, because of its value- oriented ethos enables it to draw finances from both Muslims and non-Muslims alike.

• Islamic banks are popular especially among young Muslims. Internationally Islamic banks appear more resilient to economic turndown and international financial crisis than conventional banks. Islamic finance involves regulatory framework that accommodates financial principles and clear willingness of the government to promote Islamic finance. It also generates employment opportunities at a large scale.

Challenges in development of Islamic Finance :

Despite all the progress Islamic banks have a long way to go. To keep a sustainable growth track, they must address some critical issues involved.

• One key challenge arises from the varying interpretations of Shariah across regions, countries and sometimes even within the same country. What constitutes an Islamic practice is determined by a bank’s Shariah Council, an independent bank-appointed panel of scholars. Therefore, what is considered Islamic in Malaysia maybe Haraam or prohibited in Saudi Arabia. These absences of uniform standards affect the bank’s ability to replicate and implement Islamic products across geographies, attract external investors and expand to near markets. The Council must approve all innovative products but, without a uniform interpretation, it is difficult for the banks to know whether the committee will give its nod for a particular region or country.
• Another challenge is of the regulatory frameworks governing these banks. These frameworks are often at variants leading to operational road-blocks. This is further compounded by absence of accounting, auditing, and credit analysis standards for Islamic banks. Not only must they satisfy the Shariah but also need to measure up to national policies.
• To operate in globalised economy these banks must also meet international requirements. Being part of International Banking Committee also means following corporate governance requirements which have not been designed for Islamic business model.
• Another cornerstone of global banking is financial risk management which is underdeveloped in Islamic banks since many such instruments are unacceptable under Shariah.
• The sector also faces IT related challenges due to systematic complexities of this market because core banking solutions are not perfectly tailored for Islamic markets.

Controversy related to Islamic Finance :

In Islamabad, Pakistan on June 16, 2004, members of leading Islamist political party in Pakistan, the Muttahida-Majlis-e-Amal (MMA) party, staged a protest walkout from the National Assembly of Pakistan against remarks by a minority member on interest banking. He was of the opinion that, without interest the country could not get foreign loans and could not achieve the desired progress. Later, the opposition members responded to the minority member’s remarks by saying that the Council of Islamic ideology had decreed that interest in all its forms was Haraam in an Islamic society. Hence, he said, no member had the right to negate this settled issue.

Current status in India:

India being one of the countries which has not accepted the law relating to Islamic Banking is now introducing proposition for establishing the first ever Islamic bank in Cochin, Kerala.

However, a year ago, the RBI was asked by the government to look into the matter. The members of the committee submitted their recommendations few months ago, but the regulator, perhaps held back by obvious sensitivities, has not yet put the findings in public domain.

While the final form of report is not known, sources said the members have pointed out how Indian banking laws come in the way of various Islamic banking principles.

These are as follows: Al Wadiah (for Saving Bank Account):

• Section 21 of the Banking Regulation Act requires payment of interest on such deposits; thus, interest-free deposit and simple charging of premium or Hiba is not permissible.
• Mudarabah (for term deposit or investment): Here again, Section 21 of the BR Act disallows 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 complete freedom in the management.
• Mudarabah, Musharakah (for project finance and SME credit): Sections 5, 6 of the BR Act indicate the forms of business a banking company can undertake and does not allow any kind of profit-sharing and partnership contract, the basis of Islamic Banking.
• Ijirar (for home finance) : as against Islamic Banking where the banks owns the asset and hold the title, Section 9 of the BR Act prevents the bank from any sort of immovable property other than private use.
• Istisna (leasing, buyback): Besides the usual curbs on acquiring immovable property offering Islamic banking products many not be bankable due to stamp duty, central sales tax and state tax laws that will apply depending on the nature of the transfer. In the markets like the UK there is separate law that makes it possible to launch Islamic banking products. The BR Act even disallows an Indian bank from floating a subsidiary abroad to launch such products, or offering these through a special window. Thus, the upshot of the findings is that such banking experiment is impossible without a new law and multiple amendments to the BR Act thereof.

Though the RBI study group had earlier rejected the concept of Islamic banking it was given a green signal by the Raghuram Rajan Committee on banking reforms. A report prepared by Ernst and Young was approved by the Kerala industries on August 12, 2009. Its likely that the registration formalities will be completed and the bank will be operational in 2010. Kerala State Industrial Development Corporation, which is the designated agency for the formation of the bank, will have 11% stake in the proposed banking company. According to the government officials it will be registered as a non banking finance company in the beginning and later get transformed into a full fledged Shariah-Compaliant bank. However the biggest challenge before the Kerala-based bank will be the formation of a Shariah Supervisory Board, including independent scholars on Shariah and banking business, in order to monitor the activities of the bank.

The islamically based system of finance has proven itself to be entirely feasible and sound. There are many benefits to the development of full-fledged Islamic banks in India which include a potential bettering of the condition of India’s largest minority and better integration of that minority into secular-democratic India. This would also enhance savings across the country and an increase in the national GDP growth rate. Reform, by opening to Islamic banks would be beneficial for all entrepreneurs who have profitable proposals but lack collateral. Increased political involvement, decreased inequality, business ownership and wealth will all serve towards the growth of our economy. All Indians will benefit from the increase in the GDP, the decrease in welfare expenditure, an increase in tax revenues, creation of new savings, employment opportunities and mobilization of savings. The increased growth would be the outcome of efficient investment allocation provided by Islamic banks.

Conclusion:

The benefits to India of opening itself to full-fledged Islamic banks are significant and numerous enough that the opportunity cannot be easily neglected. India’s banking sector should be reformed so as to allow and encourage Islamic banks to enter the market place. Islamic banks are on the thresh hold of historic opportunity. Oil prices are rising; banks are flush with funds and are driving growth on the back of strong recent performances.

The interpretation of fundamentals of Islamic financial principles and emergence of clear standard and a common framework will help bring about improved management practices at Islamic banks resulting in higher growth and profit margins.

The majorities of Islamic banking clients are found in the Gulf States and developed countries. With 60% of Muslims living in poverty, Islamic banking is of little benefit to the general population. The majority of financial institutions that offer Islamic banking services are owned by Non-Muslims. With Muslims working within these organizations, employed in the marketing of these services, having little input into the actual day to day management, the veracity of these institutions and their services are viewed with suspicion. One Malaysian Bank offering Islamic based investment funds was found to have the majority of these funds invested in the gaming industry; the managers administering these funds were non Muslim. These types of stories contribute to the general impression within the population that Islamic banking is simply another means for banks to increase profits through growth of deposits and that only the rich derive benefits from implementation of Islamic Banking principles. The sensitive secular fabric of India can hinder the full-fledged implementation of Islamic finance and can create a controversy on the term “Islamic Banking” itself. As the term refers to the form of banking as Islamic, a reserved impression is cast and not many non Muslims would prefer to opt for it. However if a rational approach is adopted by all without letting the secular aspect affect the banking scenario it will prove to be futile towards higher GDP and betterment of the entire economy.

With around 11% of the Indian population being Muslims, Islamic banking may find enough takers. But given the tedious route for new legislations, it may take a long time to happen. It can prove to be a conducive idea and the government of India can grow one step closer to development of the economy by way of making amendments in the current banking system and adopting Islamic banking.