Post by Sapphire Capital on Sept 15, 2008 0:30:39 GMT 4
Banking on Faith: Islamic (Sharia) Banking and its Prospects in India
Source: Priyanka Lal and Sneha Snehal
In this era where trends flourish around increasing aspirations to identify with social conscious initiatives, it comes as no surprise that Islamic Banking is booming. The concept of interest is fundamental to the business of banking. With this background it is very interesting that sharia[1] banking is working without profits and is still flourishing. They are not only profitable but are also growing at an astonishing rate in sense of capital, assets and consumers. From Jakarta to Jeddah to Jordan, 280 Islamic banks operate in over 50 countries, with assets estimated between $ 250 million and $ 300 billion.[2] Management Consultants Mckinsey and Co. say in their world Islamic Competitiveness Report, 2007 that the value of assets managed by Islamic Banks will grow by 33 % by 2010.[3]
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 earliest references 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 late forties.[4] However In the next two decades it attracted more attention, partly because of the political interest that it created in Pakistan and partly because of the migration of muslims to the western countries. The Islamic Development Bank, an inter-governmental bank established in 1975, was born of this process, being the first bank incorporating the principles 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. Two more private banks were founded in 1977 under the name of Faisal Islamic Bank in Egypt and 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 Muslim countries, 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 initiative and covered all banks in the country.
Fundamentals of Islamic Banking
All interest-free banks agree on the same basic principles. However, individual banks differ in their application. These differences can be because of several reasons including the laws of the country, objectives of the different banks, individual banks circumstances and experiences, the need to interact with other interest-based banks, etc.
Some of the essential principles which are followed by all the banks practicing sharia banking 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 the banks to use their money but they obtain a guarantee of getting the full amount back from the bank. Banks adopt several methods of inducing their clients to deposit with them, but no profit is promised. In others, savings accounts are treated as investment accounts but with less 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-term projects. As such lower profit rates are expected and that too only on a portion of the average minimum balance on the ground that a high level of reserves needs to be kept at all times to meet withdrawal demands.
Investment account
Investment deposits are accepted for a fixed or unlimited period of time and the investors agree in advance to share the profit (or loss) in a given proportion with the bank. Capital is not guaranteed.
Modes of financing
Banks adopt several modes of acquiring assets or financing projects. But they can be broadly 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 parties participating in the various aspects of the project in varying degrees. Profit and loss are shared 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 an initial 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-arranged proportion, 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 bank estimates the expected rate of return on the specific project it is asked to finance and provides financing on the understanding that at least that rate is payable to the bank. If the project ends up in a profit more than the estimated rate the excess goes to the client. If the profit is less than the estimate the bank will accept the lower rate. In case a loss is suffered the 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 bank the 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 agreed period and at the end of that period the lessee pays the balance on the price agreed at the beginning 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 agreed rent and period, and at the end of that period the client automatically becomes the owner of the 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 an agreed price; and
e) Letters of credit where the bank guarantees the import of an item using its own funds for a 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 cover their expenses by levying a service charge. This charge may be subject to a maximum set by 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 to needy 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 currencies at spot rate etc. where the banks own money is not involved are provided on a commission or charges basis.
Prohibited lending
Islamic Banking other than dealing with interest also prohibits any dealing in pork, ography, 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 under Non Banking Finance Companies Reserve Bank Directives 1997 RBI (Amendment) Act 1997, and operate on profit and loss based on Islamic principles. All the Islamic banks have to 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 a distant dream. Nonetheless, countless advocates of Islamic banking have been trying their best over the years to propagate the concept. In furtherance of this propagation the Reserve Bank of India (RBI) constituted a committee in 2007[7] to examine the issue but viewed that Islamic banking cannot be offered by banks in India as well as the overseas branches of local 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 Islamic banking. As a genre of financial services, Islamic banking shuns the very idea of interest rates, and rests on profit-sharing principles. Based on the Sharia''h law, it abhors 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 the public domain.[9]
While the final form of the report is not known, from the newspaper reports it can be collected that the members had pointed out how Indian banking laws come in the way of various 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 simple charging of premium or Hiba is not permissible.
2. 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.
3. 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.
4. Ijarah (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.
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 sales tax 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 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 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 Islamic banking are incorporated then how does it comply with the tax procedure is the moot question. Furthermore RBI cannot act as the lender to such banks because such accommodation by the monetary authority is also interest based. Islamic banks cannot interact 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 is definitely one question waiting to be answered. If the international banks[10] have established Islamic merged it with their object of profit making why can the same be done in India also is not answered. Keeping in mind the flourishment of Islamic Banking all over the world and the muslim population in India these are the questions which have to be answered immediately and with certainty.
------------------------------
[1] Both Islamic and sharia banking mean the same and would be used interchangeably throughout this article
[2] www.islamic-banking.com/
[3] www.megaevents.net/wibc2007/main.php?p=11
[4] One in Malaysia in the mid-forties and another in Pakistan in the late-fifties. Both did not survive
[5] www.isdb.org/irj/portal/anonymous?NavigationTarget=navurl://4af56c7f8e33ae3bdeb62cc164638e52
[6] Supra note 2 and also see www.islamic-banking.com/
[7] Reserve Bank of India to set up a committee headed by Mr Anand Sinha, chief general Manager in-charge, department of banking operations & development to look into the matter and the committee submitted the report.
[8] www.economictimes.indiatimes.com/articleshow/2172818.cms
[9] The newspapers state that it might be because of the sensitive issues it was dealing with.
[10] Giant Western banks or, rather, their Islamic subsidiaries are leading the market for financing that complies with Qur''anic laws forbidding lending money for profit, or sponsoring un-Islamic activities such as gambling or smoking. Citigroup''s Bahrain-based Citi Islamic subsidiary was first into the market in 1996, and now leads the pack with deposits of more than $6 billion. Citi and at least 10 other Western majors dwarf the biggest locally owned rival, Al Baraka of Bahrain, worth a little more than half a billion
Source: Priyanka Lal and Sneha Snehal
In this era where trends flourish around increasing aspirations to identify with social conscious initiatives, it comes as no surprise that Islamic Banking is booming. The concept of interest is fundamental to the business of banking. With this background it is very interesting that sharia[1] banking is working without profits and is still flourishing. They are not only profitable but are also growing at an astonishing rate in sense of capital, assets and consumers. From Jakarta to Jeddah to Jordan, 280 Islamic banks operate in over 50 countries, with assets estimated between $ 250 million and $ 300 billion.[2] Management Consultants Mckinsey and Co. say in their world Islamic Competitiveness Report, 2007 that the value of assets managed by Islamic Banks will grow by 33 % by 2010.[3]
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 earliest references 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 late forties.[4] However In the next two decades it attracted more attention, partly because of the political interest that it created in Pakistan and partly because of the migration of muslims to the western countries. The Islamic Development Bank, an inter-governmental bank established in 1975, was born of this process, being the first bank incorporating the principles 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. Two more private banks were founded in 1977 under the name of Faisal Islamic Bank in Egypt and 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 Muslim countries, 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 initiative and covered all banks in the country.
Fundamentals of Islamic Banking
All interest-free banks agree on the same basic principles. However, individual banks differ in their application. These differences can be because of several reasons including the laws of the country, objectives of the different banks, individual banks circumstances and experiences, the need to interact with other interest-based banks, etc.
Some of the essential principles which are followed by all the banks practicing sharia banking 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 the banks to use their money but they obtain a guarantee of getting the full amount back from the bank. Banks adopt several methods of inducing their clients to deposit with them, but no profit is promised. In others, savings accounts are treated as investment accounts but with less 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-term projects. As such lower profit rates are expected and that too only on a portion of the average minimum balance on the ground that a high level of reserves needs to be kept at all times to meet withdrawal demands.
Investment account
Investment deposits are accepted for a fixed or unlimited period of time and the investors agree in advance to share the profit (or loss) in a given proportion with the bank. Capital is not guaranteed.
Modes of financing
Banks adopt several modes of acquiring assets or financing projects. But they can be broadly 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 parties participating in the various aspects of the project in varying degrees. Profit and loss are shared 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 an initial 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-arranged proportion, 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 bank estimates the expected rate of return on the specific project it is asked to finance and provides financing on the understanding that at least that rate is payable to the bank. If the project ends up in a profit more than the estimated rate the excess goes to the client. If the profit is less than the estimate the bank will accept the lower rate. In case a loss is suffered the 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 bank the 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 agreed period and at the end of that period the lessee pays the balance on the price agreed at the beginning 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 agreed rent and period, and at the end of that period the client automatically becomes the owner of the 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 an agreed price; and
e) Letters of credit where the bank guarantees the import of an item using its own funds for a 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 cover their expenses by levying a service charge. This charge may be subject to a maximum set by 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 to needy 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 currencies at spot rate etc. where the banks own money is not involved are provided on a commission or charges basis.
Prohibited lending
Islamic Banking other than dealing with interest also prohibits any dealing in pork, ography, 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 under Non Banking Finance Companies Reserve Bank Directives 1997 RBI (Amendment) Act 1997, and operate on profit and loss based on Islamic principles. All the Islamic banks have to 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 a distant dream. Nonetheless, countless advocates of Islamic banking have been trying their best over the years to propagate the concept. In furtherance of this propagation the Reserve Bank of India (RBI) constituted a committee in 2007[7] to examine the issue but viewed that Islamic banking cannot be offered by banks in India as well as the overseas branches of local 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 Islamic banking. As a genre of financial services, Islamic banking shuns the very idea of interest rates, and rests on profit-sharing principles. Based on the Sharia''h law, it abhors 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 the public domain.[9]
While the final form of the report is not known, from the newspaper reports it can be collected that the members had pointed out how Indian banking laws come in the way of various 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 simple charging of premium or Hiba is not permissible.
2. 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.
3. 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.
4. Ijarah (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.
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 sales tax 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 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 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 Islamic banking are incorporated then how does it comply with the tax procedure is the moot question. Furthermore RBI cannot act as the lender to such banks because such accommodation by the monetary authority is also interest based. Islamic banks cannot interact 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 is definitely one question waiting to be answered. If the international banks[10] have established Islamic merged it with their object of profit making why can the same be done in India also is not answered. Keeping in mind the flourishment of Islamic Banking all over the world and the muslim population in India these are the questions which have to be answered immediately and with certainty.
------------------------------
[1] Both Islamic and sharia banking mean the same and would be used interchangeably throughout this article
[2] www.islamic-banking.com/
[3] www.megaevents.net/wibc2007/main.php?p=11
[4] One in Malaysia in the mid-forties and another in Pakistan in the late-fifties. Both did not survive
[5] www.isdb.org/irj/portal/anonymous?NavigationTarget=navurl://4af56c7f8e33ae3bdeb62cc164638e52
[6] Supra note 2 and also see www.islamic-banking.com/
[7] Reserve Bank of India to set up a committee headed by Mr Anand Sinha, chief general Manager in-charge, department of banking operations & development to look into the matter and the committee submitted the report.
[8] www.economictimes.indiatimes.com/articleshow/2172818.cms
[9] The newspapers state that it might be because of the sensitive issues it was dealing with.
[10] Giant Western banks or, rather, their Islamic subsidiaries are leading the market for financing that complies with Qur''anic laws forbidding lending money for profit, or sponsoring un-Islamic activities such as gambling or smoking. Citigroup''s Bahrain-based Citi Islamic subsidiary was first into the market in 1996, and now leads the pack with deposits of more than $6 billion. Citi and at least 10 other Western majors dwarf the biggest locally owned rival, Al Baraka of Bahrain, worth a little more than half a billion