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CHALLENGES FOR ISLAMIC BANKING IN INDIA

By

Dr Shariq Nisar (Author, PhD in Economics, works with Idafa Investments Pvt. Ltd, Mumbai, India. He can be

contacted at shariqnisar@yahoo.com)

Introduction

Financial arrangements constitute an integral part of the process of

economic development. A growing economy requires a progressively rising

volume of savings and adequate institutional arrangements for the mobilisation

and allocation of savings. These arrangements must not only extend and expand

but also adapt to the growing and varying financial needs of the economy.

Perhaps it is due to these reasons that the Government of India has asked the

RBI to look into the matter of Islamic finance. A well-developed and efficient

capital market is an indispensable prerequisite for the effective allocation of

savings in an economy. A financial system consisting of financial institutions,

instruments and markets provides an effective payment and credit supply

network and thereby assists in making best use of a country’s financial

resources.

Imbued with a high level of concern for equity and justice, a consciousness

of differentiating the lawful (halal) from the prohibited (haram) and a sense of

responsibility towards the weaker sections of society, Islamic banking began its

modest operations in a small town in Egypt in the early sixties. Since then there

has been no looking back for it. In fact, with each passing day it grew stronger

and stronger. In certain quarters, it is believed that the oil boom in the mid-

seventies led to the starting of Islamic banking practices but the facts and history

do not support this hypothesis. Nevertheless, it cannot also be denied that the oil

boom did help Islamic financial institutions in the Arabian Gulf to flourish. The

seed of Islamic banking has however been sowed well before anybody could

think of the oil boom in the Gulf region. Moreover, the concept of Islamic

economics (a precursor of Islamic banking) had come not from the Arabian Gulf

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but from the Indian subcontinent. In fact a failed attempt to establish Islamic

banking in Pakistan during the mid-fifties also confirms this claim.

Islamic Finance in India

India’s endeavors in the field of Islamic banking and finance have been

beyond routine experimentation. Major attempts have been made in this direction

under the format of cooperatives or trusts. Under the latter the most popular legal

format adopted by Indian Muslims is that of the “Muslim Funds”. The first of these

was established in 1934. These Funds are mostly found in the belt of Muslim

concentration in the North of the country. According to the information provided

by the Federation of Interest Free Organization (FIFO), there are more than 130

Muslim Funds in the country. FIFO acts as their apex body in policy-making,

liquidity arrangements, staff training and making representation to the

Government.

These Muslim Funds, cooperative credits and welfare societies are non-

profit institutions and were began either out of the need to rescue people from the

usurious moneylenders or out of a concern for the economically backward and

downtrodden.

Much latter, from early 1980s, Muslims started venturing into profit-

oriented financing. This was made possible for three reasons; firstly, by that time,

they had gained some expertise through successful running of non-profit financial

businesses; secondly, the Islamic financial movement had gained momentum

throughout the Islamic world and; thirdly, the new economic policy initiated in

early 1990s focusing on liberalization, privatization, and globalization (LPG) had

opened new vistas of opportunities for them.

The decade of the 1990s saw proliferation of Islamic NBFCs. However, the

Government’s abrupt decision to introduce large-scale regulatory changes in the

non-banking financial sector did not augur well for the entire non-banking finance

sector. The Islamic NBFCs appeared to have been more affected because of the

distinct nature of their business and religious constraints in approaching

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conventional avenues of finance (interest based-financing) available to other

financial institutions. In that fast-changing regulatory environment, conventional

NBFCs preferred keeping their monies in commercial banks – an avenue that

was not available to Islamic financial institutions - than risk the same in business

ventures. On the other hand the small size of Islamic NBFCs, the absence of a

lender of the last resort besides their naive and complacent attitude towards the

regulation also contributed in fair measure to their doom.

The Prospects

Islamic financial institutions are now operating in over 75 countries.

Estimates suggest that the overall Islamic finance industry, which includes

Islamic banking, non-banking companies, mutual funds, leasing, real estate

investment and stock market investment as well as charitable financial

institutions, has grown 40-fold since the 1980s. Taking into account 15 percent

annual growth of the industry during the last two decades, even a conservative

estimate will put the Islamic finance sector size beyond $ 1000 billion.

Dow Jones Islamic Market Index, which tracks over a thousand companies

from all over the world has launched over forty Islamic indices catering to its

Muslim clientele. FTSE offers Islamic indices services in US, Europe, the Pacific

Basin and South Africa. Most of the large western financial institutions have their

own Islamic subsidiaries or Islamic "windows" or products aimed at their Muslim

clientele. Scores of western banks such as ANZ Grindlays, Chase, Citicorp,

HSBC, UBS and Morgan Stanley are offering shariah compliant products and

services. Statistics from the International Association of Islamic Banks suggest

that assets managed by Islamic banks have grown quite substantially during the

last few years.

Besides being the world’s second most populous country India is also the

world’s second most populous Muslim country. It is Asia’s third largest and one of

world’s fastest growing economies. Its Muslim population is estimated to be

between 160-200 million. There are several districts where Muslims constitute a

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majority and in a number of industries Muslims have traditionally maintained a

larger presence. Since the last two decades, India has continuously managed an

average saving rate of above 20 percent of the GDP. Considering their relative

economic backwardness even a 15 percent saving rate for Muslims would place

over Rs. 40 billion of investible resources with them annually. Besides, there are

properties worth billions under the control of Awqaf (Trusts). Zakat (2.5% tax

imposed on the wealth of rich people for distribution among the poor and

destitute) potential of the Indian Muslims still remains largely untapped and

underutilized. Indians working in Middle East and Middle Eastern companies

flush with petrodollars can also be a good source of financial resources for Indian

financial institutions offering Islamically permissible financial services.

The Problem

Indian banking laws do not explicitly prohibit Islamic banking but there are

provisions that make Islamic banking an almost unviable option. Banks in India

are governed under the Banking Regulation Act 1949, Reserve Bank of India Act

1934, Negotiable Instruments Act 1881, and the state and central Co-operatives

Acts. One of the most distinguishable features of these Acts is that they define

Banking in such a way that Banks can accept deposits from the public only for

further lending. A number of sections such as section 5 (b) and 5 (c) of the

Banking Regulation Act 1949 prohibit banks from investing on profit and loss

sharing (PLS) basis. Further, section 8 of the Banking Regulation Act 1949 reads,

“No banking company shall directly or indirectly deal in buying or selling or

bartering of goods …”

Besides India is among the countries which explicitly provide deposit

guarantee to banks’ depositors up to a value of Rs. 0.1 million through the

Deposit Insurance and Credit Guarantee Corporation (DICGC). Government also

interferes on the assets side by asking banks to provide concessional credit to

certain priority sectors.

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Some other factors that help in stealing the shine of Islamic banking are

the Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) requirements.

These together eat up about 30 percent of the banks’ total deposits. Adding to

this priority sector lending leaves banks with very little capital, which they can

invest in earning non-interest income.

The Solution

Besides banking, India’s financial system also comprises Non-banking

Financial Companies (NBFCs), Mutual Funds, Insurance Companies and

Developmental Institutions. NBFCs, Mutual Funds and Insurance are the sectors

where one can think of applying Islamic principles of finance without much ado.

However, considering the initial capital requirements, NBFCs look like the best

available option because of easier entry norms, lower capital requirements, lower

regulation and flexibility in registration and functioning.

On its own part, Government can allow some public sector banks to come

out with a scheme under which, instead of paying interest to its depositors, it will

agree to share profits earned out of actual investments in activities like trading in

equities, financing infrastructural projects and other core business activities.

Needless to mention, some filtering may be required in these sectors to keep out

segments like financial companies, vulgar entertainment, tobacco etc; but there

would still be a huge basket of investment opportunities left. Author’s own

research clearly shows that in any given quarter nearly fifty percent companies of

BSE 500 qualify on strict Islamic finance parameters. Banks can freely invest in

these securities and earn handsome profits. Simultaneously, Government can

also allow private mutual funds to launch schemes that meet the religious

requirements of Muslims. This will not only attract capital from within India but

also from the capital abundant region of the Middle East.