What is Islamic banking and how will it impact India’s financial System?

Islamic banking system is founded upon the principles of Islamic law, also referred as Shariah law. Islamic banking is based on two basic principles- sharing of profit and loss and the prevention of the collection and payment of interest by investors and lenders.

Islamic Banking in IndiaThe Reserve Bank of India (RBI) has suggested an idea to open “Islamic window” in traditional banks for gradual initiation of Islamic banking or Sharia Banking or interest-free banking in the country. Both the Centre and the RBI are trying to explore the possibility to introduce Islamic banking system in the country.

It is being proposed to ensure the financial inclusion of those sections of the society that remain marginalized due to religious reasons.

This proposal of the central bank is based on the examination of technical, legal, and regulatory issues related to the practicability of introducing Islamic banking in India on the basis of suggestions of the Inter-Departmental Group (IDG). In order to have a comprehensive understanding of this whole issue let us discuss it thoroughly. First of we need to know about Islamic Banking.

What is Islamic Banking?

Islamic banking system is founded upon the principles of Islamic law, also referred as Shariah law. In Islamic banking, the banking system is guided by Islamic economics. Islamic banking has two basic principles- sharing of profit and loss and the prevention of the collection and payment of interest by investors and lenders. The model of Islamic banking follows the Islamic morals and principles. Therefore, the financial transactions within Islamic banking are a culturally different form of ethical investing. For example, investments entailing gambling, alcohol, pork, etc. are prohibited.

The principles of Islamic Banking follow Shariah laws, which are based on the Hadith and the Quran, the recorded actions and sayings of the Prophet Muhammad. Whenever more guidance or information is needed, Islamic bankers turn to learned scholars or apply independent reasoning based on scholarship and customs. While doing this they also ensure that their ideas do not divert from the fundamental principles of the Quran. 

It is interesting to know that how Islamic banks earn money without charging any interest. It has developed a mechanism which does not charge interest but still earns the profit. Islamic banks use equity-participation systems. In this method, if a bank gives the loan to a business, the business pays back the loan without interest, but it pays its share of profit to the bank. If the business fails on the loan or does not earn any profits, the bank does not get any profit either.

There is a different method for saving accounts. There are two kinds of deposits for saving accounts. In one, customers deposit their savings in the bank and allows the bank to use their money, with the promise that they would get the full amount back. The bank is not accountable to pay interest to the savers. Some banks do return certain sum to the account holder as profit accumulated from their operations.

In the other kind, the holder allows the bank to invest his money in specific projects and gets returns after a stipulated term based on how the business performs.

The Islamic bank was established in 1963 by Egyptians in Mit Ghmar. This bank was established on profit sharing model. It loaned money to businesses and shared their profits. In order to reduce risk, the bank only granted loans to about 40% of its business loan applications. Its default ratio was zero.

Islamic Banking Terminology:

Riba: It is a concept in Islamic banking that refers to charged interest. It is prohibited under Sharia because it is considered exploitive. There can be a different interpretation of Riba but ultimately it refers to interest that is why it is unlawful in Islamic banking.

Haram/Halal: It is a rigid code of ‘ethical investments’. The operation of this code is meant for interest-free financial activities. It helps in deciding the priority in the investments e.g. investing in essential goods that fulfil the needs of the population, such as food, clothing, health, shelter, and education.

Gharar: It is an Arabic word that is related to uncertainty, deception, and risk. It can also be said that this concept is related to gambling which prohibited in all forms. But Ghrarar is an important concept in Islamic finance and is used to measure the legitimacy of a harmful sale or risky investment related to the selling of goods, short selling, or contracts that are not drawn out in clear terms or assets of uncertain quality or delivery.

Zakat: In Islamic banking, this is the very important instrument for the redistribution of wealth in the form of a compulsory levy.

Takaful: It is a kind of Islamic insurance, where members contribute money into a pooling system in order to guarantee each other against loss or damage. Takaful-branded insurance is based on Sharia. It explains that how it is the responsibility of individuals to cooperate and protect each other.

Shirkah: In the Sharia law, Shrikah is divided into two categories:
1.Shirkat-ul-milk: It is a joint ownership between the parties involved, where each party has given capital in order to buy a particular property.
2. Shirkat-ul-'aqd: It is a partnership formed through a contract. This can also be termed as a type of joint commercial enterprise.

Maisir: Maisir is the prohibition of certain explicit haram activities such as alcohol, prostitution and the like. And Islamic Banks are prohibited to have any connections with such business.

Musharaka: It is a joint investment by the bank and the client, in which both contribute to funding an investment or purchase, and agree to share the profit or loss in agreed-upon proportions.

Ijara: In Ijara, the bank buys the asset on behalf of the client and grants its usage for a fixed rental. The ownership of the asset is transferred to the client after a mutually agreed time.

This instrument is made for those clients who want to get credit from a Sharia-compliant bank.

How is it working globally?

World Bank released a report in 2015 which said the estimate of Sharia-compliant financial assets was in the range of US $2 trillion, including capital markets, bank and non-bank financial institutions, insurance and money markets. The growth rate of Islamic Finance Industry has been of 10%-12% annually. According to this report of World Bank, in many Muslim countries, the growth rate of Islamic banking assets has been faster than conventional banking assets. The Islamic finance has also been increased in non-Muslim countries such as the Luxembourg, UK, Hong Kong and South Africa.

It has been witnessed worldwide that Islamic finance has emerged as an effective instrument for financial development. Major financial markets are exploring solid evidence that Islamic finance has already been mainstreamed within the global financial system.

Concept of Islamic Banking in India

A committee headed by Raghuram Rajan submitted a report to the government in 2008, in which the committee, without naming Sharia banking, suggested the need to have interest-free banking in India. The report said that the non-availability of interest-free banking products in India eventually results in some Indians, including those in the economically disadvantaged strata of society, not being in a position to reach the banking products and services due to reasons of faith. This non-availability also forbids access of many Indians to substantial sources of savings from other countries in the region. As a consequence, the Kerala government had tried to co-promote an Islamic finance institution, but this move was challenged in the High Court.

The concept of Islamic Bank got further push with the recommendation from the committee named as “Medium-Term Path for Financial Inclusion”, headed by Deepak Mohanty. This committee has advocated “interest-free windows” in existing conventional banks. On the other hand, the government also appears to be inclined towards implementing the Islamic banking.
The government has advised the RBI that before taking a decision about Islamic Window, the legal, regulatory, technical, issues need to be clarified by the RBI. After this, an inter-departmental group on Islamic /Alternative Banking was formed within the RBI to evaluate the issues for introducing Islamic banking.
The State Bank of India (SBI) had launched a Shariah-compliant mutual fund in 2014. It was the first time a state-owned bank rolled out an Islamic financial instrument for the country’s estimated 170-million Muslim populations.

Why Islamic Banking in India?

India has a substantial Muslim population, this not only showcases a huge potential for the growth of Islamic Finance but also an inherent necessity for it. In 2011, there were approximately 180 million Muslims living in India, and this is estimated to rise to 310 million by 2050. This will make India home to the largest Muslim population in the world. In India, at the same time, most Muslims are self-employed and most of their investments are not adequately supported by banks.

Presently, there is a need to increase financial inclusion of Muslims in India, which has not happenedsubstantially because the Indian Banking and Financial system has failed to take note of Islamic Financial principles. And as a result, it failed to develop financial products like the Middle East and Europe.

A report released by Sachar Committee back in 2006 points out the necessity of Islamic Finance in India. The report said Muslims hold 12 per cent of accounts in public sector banks and 11.3 per cent in private sector banks which are less than their share of 13.4 percent of the overall population. So the Muslim population is in need of financial Inclusion and Islamic banking is a prominent idea to satisfy this need.

Problems for Islamic Banking in India

India is a secular country by Constitution. So opening any financial institution with the name of a religion can raise questions among other religious groups. Apart from this, some political parties have said they will oppose the introduction of Islamic banking in India. Another reason that has withheld growth of Islamic Banking in India, is the lack of adequate work force trained in Sharia banking.

And Islamic banking is based on strict Sharia laws of not paying or taking the interest, so the application of Islamic banking will call for a complete change in the banking regulatory system.

The foremost concern for the development of Islamic banking in India is the development of comprehensive legislation, regulations and rules governing the same. Former RBI Governor D. Subbarao objected that present rules and regulations do not allow the operation of Islamic Finance in India, and this creates a major hurdle to achieving complete financial inclusion, given India’s growing and prominent Muslim population. 

The banking in India is governed by the laws made in the archaic Negotiable Instruments Act of 1881, Reserve Bank of India Act, 1934, and Banking Regulation Act of 1949.
The core principles of all of these legislations stand in direct conflict with the principles of Islamic Finance. For example, the payment of interest on deposits is mandatory under the Section 21 of the Banking Regulation Act, but it is clearly prohibited under the Riba principle.

Section 8 of Banking Regulation Act, mandates that a banking company cannot deal in the selling or buying or bartering of goods. This shows the impossibility to have Shariah-compliant structures such as Murabaha in India.

One of the criticisms of the introduction of Islamic banking in India is Subramanian Swamy’s suspicion about it. He objected to the launch of Islamic Banking in India by saying Islamic banking will pave the way for the entry the dubious funds of the Middle East into India through legally baptized channels of Sharia compliant financial institutions. And he highlighted that these dubious funds hold the volatility to be used for terrorist funding. He also claimed that it can raise the rate of Islamic conversions in India.

So, what now?

The criticism that introducing Islamic banking in India will raise Islamic conversions in India is avoidable because in countries like Singapore and Malaysia there have not been any such incidences. And the scepticism that Islamic banking will enhance funding to the terrorist organizations seems flawed because all the money circulation in the Banking sector in India is under the regulation of the RBI. So, it is very unlikely that any RBI affiliated bank can send money to any banned terrorist organization.

Another doubt about Islamic banking which says it will harm the secular fabric of the country can be questioned. Because Islamic banking will serve the need of many people who have been marginalized and it will bring them into mainstream banking. So, it is an inclusive step and our secularism is meant to promote inclusive values. Thus it can be said it will not harm the social fabric of the India.

So, we have discussed the reasons which are in favour of Islamic Banking in India and also the reasons which are against it. By viewing both perspectives, it seems reasonable to say that a gradual introduction of Islamic Banking should be a welcome step in India. The Indian government also strongly emphasizes and supports the idea of finance inclusion. A noticeable part of Indian population still needs to be a part of Financial Inclusion program of the government. So initiatives about Islamic Banking should be taken in future.

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