Govt, RBI mull ways to introduce Islamic banking

Central bank asked to examine the possibility of making interest-free model part of India’s `75 trillion banking system

Dinesh Unnikrishnan
Updated16 Oct 2012, 08:37 PM IST
Reserve Bank of India governor D. Subbarao said last week that the apex bank was holding talks with the government on how existing laws can be restructured or amended &#8216;so that they are in conformity with Islamic banking&#8217;. Photo: Hemant Mishra/Mint<br />
Reserve Bank of India governor D. Subbarao said last week that the apex bank was holding talks with the government on how existing laws can be restructured or amended &#8216;so that they are in conformity with Islamic banking&#8217;. Photo: Hemant Mishra/Mint(Hemant Mishra/Mint)

Mumbai: India may be closer to allowing Islamic banking than ever before with the central bank and the finance ministry discussing ways in which rules need to be changed to allow the interest-free practice that’s compatible with Shariah law.

add_main_imageDemands by Muslim groups over the past few decades to allow the method have thus far been stalled because of concerns over incompatibility and fears that it could be used as a conduit for terror funding.

Reserve Bank of India (RBI) governor D. Subbarao said last week that the apex bank was holding discussions with the government on how existing laws can be restructured or amended “so that they are in conformity with Islamic banking”. RBI has thus far maintained that Islamic banking is not feasible in India as existing regulations do not permit interest-free banking.NextMAds

The finance ministry recently wrote to RBI asking it to examine the possibility of making the interest-free model part of India’s 75 trillion banking system.

Interest isn’t allowed under Shariah law as it’s equated with usury; instead, lenders get a share of any profit made by the borrower, while having to absorb any losses.

The finance ministry’s communication to RBI followed a meeting with the National Commission for Minorities (NCM) in June, a constitutional body headed by former chief information commissioner Wajahat Habibullah.

NCM asked the apex bank to take a fresh look at Islamic banking. Following this, the National Committee on Islamic Banking (NCIB), a non-profit body, submitted an action report to RBI in this regard. Mint has reviewed these documents.

The NCIB report argues that it’s not necessary to change banking laws to implement interest-free products, though tax laws would need to be amended.

“The only area where a change is necessary is the tax laws, as they do not match with the sale and investment-based contracts offered by participator banks such as wakala (agency contract), murabaha (trust-based sale), musharaka (joint venture),” said H. Abdur Raqeeb, convenor, NCIB.sixthMAds

Supporters of Islamic banking say its implementation will lead to money coming in from organizations that can only make Shariah-compliant investments. Critics say it will destabilize the secular nature of the country’s banking system by imposing the laws of one religion, besides facilitating terror funding.

D.K. Mittal, financial services secretary, declined to say whether the government was considering any change in laws to facilitate Islamic banking, saying it’s a “larger issue”.

An email to RBI asking about the steps being taken to study the proposal was unanswered.

“At this stage, the government has not made up its mind on whether Islamic banking is feasible in the country,” a senior member of Parliament said on condition of anonymity. “But certainly, there is a push from influential quarters to bring it in the country.”

Islamic banking based on Shariah law is known as participatory finance, or interest-free banking in some countries. The collection or payment of interest and the funding of businesses engaged in alcohol, pornography and weapons of mass destruction, all considered haraam (unlawful) in Islam, are prohibited.

Unlike conventional banking, which treats customers as debtors and creditors, in Islamic banking, the customer is an investor in the bank’s business.

“Our (existing) banking system is based on the philosophy that money must become more money (by accruing interest) as time passes. One can imagine why people who benefit from that do not want any other model to enter this system,” said Nejatullah Siddiqui, an economist.

India has 26 public sector banks, 20 private banks and 41 foreign banks. The total assets of the 40 listed banks, as on 31 March, stood at 71.64 trillion. But half of the country’s population still does not have access to formal financial services and are dependent on informal money lenders.

Both the government and RBI are promoting financial inclusion programmes to bring the unbanked population into the formal system. But for some Muslims, a banking system not compliant with the Shariah may be an issue. A Shariah-compliant option could encourage them to become part of the banking system. India has about 170 million Muslims.

Globally, Islamic banking is common in West Asian countries, the UK, Japan and Singapore. The global market for Shariah-compliant assets reached $1.3 trillion in 2011 from $509 billion in 2006, according to the UK Islamic Finance Secretariat, a part of TheCityUK, an independent body in London that promotes the UK’s financial services industry.

Shariah-compliant Sukuk Bonds, or debt instruments equivalent to securities in the conventional banking system, are also common in the Islamic banking system.

Global rating agency Standard and Poor’s, in a 13 October report, said Islamic banking could help ease funding constraints in the infrastructure sector.

“The growing and deepening market for Islamic financing is a key reason why we think this market is worth considering for the infrastructure sector,” it said. “We also believe that infrastructure projects are a logical fit for Islamic finance, which is governed by Sharia and predicated on asset-backing and shared business risk.”

There is strong resistance against the prospect of Islamic banking in India.

“The fundamental issue is we cannot have two laws in the same system. It doesn’t make sense,” said Subramanian Swamy, economist and president of the Janata Party.

Madan Sabnavis, chief economist at rating agency Care Ratings, holds similar views.

“Pricing is important for any market to function and interest is what determines the price value of a commodity,” he said. “Questions arise on how does one determine the critical efficiency parameters, level of bad loans and capital adequacy of such institutions... I do not believe a parallel system can exist.”

Swamy, a long-time critic of the model, also worries that Islamic banking “can open channels for terrorist organizations to channel money into India”, and that “since such organizations will encourage only Muslim customers, the international Muslim organizations (may) want to use this as a tool to encourage people to convert to Islam.”

Swami moved the Kerala high court in 2009 against the inception of a financial institution, Al Barakah Financial Services Ltd, that was to be run on Islamic banking principles backed by the state-owned Kerala State Industrial Development Corporation (KSIDC). The high court dismissed the petition in early 2011. KSIDC has an 11% stake in Al Barakah, which is yet to start operations, while the rest is held by a few non-resident Indian businessmen.

Sabnavis also said “chances of terrorists using this channel can also not be ruled out... The fact is that nobody will be able to monitor where this money is coming from and its ultimate end-use”.

Habibullah refutes this argument. “It is stupid to think Islamic banking will facilitate funding channels to terrorist organizations. It is simply another form of banking being done in other countries and is one more option to the people in India.”

“Terrorist money can come in anyway, even with or without Islamic finance,” said Thanveer Mohiddeen, chief operating officer, Alternative Investments and Credits Ltd, or AICL, a Kerala-based non-banking financial company (NBFC) that began operations in 1999 in accordance with Shariah principles. “Indian Muslims are financially backward and Islamic finance can change this scenario.”

RBI in April barred AICL from providing further finance, charging the firm with not complying with its fair practice code for NBFCs that requires them to declare the interest rate at which they lend to borrowers. AICL moved the Bombay high court in May against the RBI order cancelling its licence. As of March, AICL had a loan book of 7 crore. The case is still pending in the high court.

The apex bank’s discomfort with the Islamic banking model may not change despite all the recent activity.

In 2007, an RBI-appointed working group under then executive director Anand Sinha that was examining the financial instruments used in Islamic banking, said that under existing regulations it was not feasible for banks in India to undertake Islamic banking or to allow their branches to carry out Islamic banking operations abroad.

In 2008, though, the Raghuram Rajan committee on financial sector reforms suggested implementing interest-free banking in the country.

“The committee recommends that measures be taken to permit the delivery of interest-free finance on a larger scale, including through the banking system... it would be possible, through appropriate measures, to create a framework for such products without any adverse systemic risk impact,” the panel said.

It also pointed out that as certain faiths prohibited financial instruments that involved interest payments, a section of Indians was unable to access banking products and services. “This non-availability also denies India access to substantial sources of savings from other countries in the region,” it said.

“The model of Islamic banking can be implemented (in India) only when regulations are conducive,” said Ashvin Parekh, partner, financial services, at global consultancy Ernst and Young India, adding that it was premature whether it can be misused. “The right approach is that right KYC (know your customer) disclosures are put in place to avoid misuse.”

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First Published:16 Oct 2012, 08:37 PM IST
HomeIndustryBankingGovt, RBI mull ways to introduce Islamic banking

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