A 01260107 Ios R Islamic Bank
A 01260107 Ios R Islamic Bank
A 01260107 Ios R Islamic Bank
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Abstract: Innumerable changes have been witnessed in the Indian banking sector since last six decades.
Various generations of financial sector reforms has changed the face and complexion of the Indian Banking
Sector which is adopting various innovative practices with the focus on inclusive growth. Islamic banking is one
such practice which is being considered in full fledged manner which otherwise has been practiced in an
informal way. Islamic banking has set its foot on the path of rapid growth throughout the globe and India could
not be isolated from it, looking at immense potential. The 1st Ernst & Young World Islamic Banking
Competitiveness Report 2011 presented at the 18th Annual World Islamic Banking Conference stated that
Islamic banking assets with commercial banks globally will reach US$1.1 trillion in 2012, a significant jump of
33% from their 2010 level of US$826 billion. The conventional banking as practiced by the Indian banking
sector in its present form does stand in the way of the principles of Islamic banking which prohibits transaction
on the basis of interest and operate on profit and loss based on Islamic principles. Introduction of interest free
banking will require a lot of changes in the Banking Regulation Act.
Key Words: Interest free banking, Financial exclusion, Inclusive growth, Islamic financial institution,
I. Introduction
Innumerable changes have been witnessed in the Indian banking sector since last six decades. From
nationalisation in the 60‘s to liberalisation in the 90‘s this sector has been forging ahead as a significant element
of the Indian Financial System. A well developed banking system is a pre-requisite for smooth and effective
functioning of any economy. The basic function of the banking sector has been mobilising savings from the
surplus entities and channelising them to deficit entities for productive purposes. These functions are based on
the premise of interest rates, interest being given to depositor and interest being charged by the bank for lending.
An alternate to this conventional banking system is Islamic banking which prohibits transaction on the basis of
interest and operate on profit and loss based on Islamic principles. Islamic banking has set its foot on the path of
rapid growth throughout the globe and India could not be isolated from it, looking at immense potential. The 1st
Ernst & Young World Islamic Banking Competitiveness Report 2011 presented at the 18th Annual World
Islamic Banking Conference stated that Islamic banking assets with commercial banks globally will reach
US$1.1 trillion in 2012, a significant jump of 33% from their 2010 level of US$826 billion. Looking at the
global recognition of Islamic Banking the RBI also weighed the option of introducing Islamic banking in the
main stream of the Indian banking sector and constituted a committee in 2007 to examine the issues relating to
Islamic banking. This can be the appropriate time for introduction of Islamic banking in India, when world is
gripped under the impact of the subprime crisis, fallout of conventional banking based on interest and interest
trap. Before discussing the convergence of Islamic banking into the mainstream banking sector it would be
appropriate to highlight the concept of Islamic banking. In the following discussion Islamic banking and interest
free banking are used interchangeably.
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Islamic Banking: Inclusion in the Indian Banking Sector
An essential feature of an Islamic Sharia compliant product is Sharia scholar approval or Fatwa. Hence
Islamic banks and conventional bank that invest some of their capital in Islamic finance through Islamic window
have a relegious board or committee composed of Sharia sholars which examines proposed transactions and in
case of Islamic bank reviews the overall activities of the bank for compliance with Sharia law.
companies registered under the Companies Act. The number of Islamic financial institutions operating in India
are estimated to be around 300 with total demand deposits of around Rs. 800 million. With the growing
awareness and increase in demand for interest free banking, Islamic banking in India started in a limited manner
by certain Non-Banking Financial Companies. 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 and do not function under banking regulations. The Indian banks are goverened by the Banking
Regulation Act 1949, Reserve Bank of India Act 1934, Negotiatiable Instruments Act and Co-Operative Society
Act which is based on the premise of interest charge and does not allow interest free banking which is the main
pillar of Islamic banking.
The study of TASIS (Taqwaa Advisory and Shariah Investment Solutions) on ‗Muslim Financial
Institutions in India (MFIs):Analysis and Scope of their Islamicity Under the Current Financial Reforms‘
conveys the increasing awareness and interest of Islamic funds in India. Based on their study of certain selected
Islamic Financial Institutions for the period 1998-2002 it has been found that Deposits and Advances percentage
are on continous increase. The amount of the total deposits of these selected institutions have increased from Rs.
246.36 million in 1998 to Rs. 476.54 million in 2002 whereas the advances has grown in 2002 to Rs.148.68
million from Rs.88.1 million in 1998. The average annual growth in deposits have been found out to be around
18% whereas the average annual growth in advances are found out to be 14.04%. This suggests that there is
immense potential of Islamic banking in India
III. Comparison of the Islamic Banking with the Conventional Banking Especially In
Context Of The Indian Banking Sector.
The call for Islamic banking in India necessitates its comparison with the conventional banking
practices of India. This is important for creating a framework for co-existence of Islamic banking along side the
conventional banking practices. The following account on the liability side are discussed below:
Current account : It is the only account where similarities can be drawn between Interest free banking and
conventional banking practiced under the Banking Regulation Act. Current account deposits does not involve
payment of interest to depositors.
Savings Account ( Al Wadiah) : Section 21 of the Banking Regulation Act requires payment of interest on
such deposits where as in case of Islamic banking 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 (Mudarabah): Section 21 of the Banking Regulation 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. Where as under the Islamic banking laws
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. Section 19(2) provides
for restriction on any banking company holding shares in any company whether as pledgee, mortgagee or
absolute owner. No bank can hold shares in any company, whether as pledge, mortgagee or absolute owner, of
an amount exceeding 30% of the paid-up share capital of that company or 30% of its own paid-up capital and
reserves
Looking to the asset side the rules of the Banking regulaton Act that is in contrast to the principles of
Islamic banking are discussed below :
Project Financing (Mudharabah or Musharakah) : Sections 5, 6 of the Banking Regulations 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. Wheres sharing of risk and loss is the fundamental principles
if Islamic banking and principles of Al mudharabah or Musharakah are used for project financing. The former
works in a manner used in the case of investment deposits. In this, bank provides the entire capital and the
borrower, often an entrepreneur, provides the management services. The profit is shared accordingly to an
agreed proportion while the loss is borne by the bank alone. Under the model of Musharakah, the bank shares
the cost of project with the entrepreneur based on an agreed proportion basis and both parties have the right to
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Islamic Banking: Inclusion in the Indian Banking Sector
participate in the management of the projects. The profit from the project is distributed according to an agreed
ratio, which is not necessarily the same as the share in the cost.
Home finance (Ijarah) : In case of home finance the bank buys the asset and leases it to the customer for a
rental fee which includes the cost of the house plus a profit margin. The bank owns the asset till the last
instalment is paid. After payment of the last instalment the customer becomes the owner of the house. As
against Islamic banking where the banks owns the asset and hold the title, Section 9 of the Banking Regulation
Act 1949 prevents the bank from holding any sort of immovable property other than private use. According to
the provisions of the Act it can acquire and hold and generally deal with any property or any right, title or
interest in any such property which may form the security or part of the security for any loans or advances or
which may be connected with any such security.
Other practices by the RBI (Reserve Bank of India) as a lender of last resort and regulator of the
monetary measures which comes in the way of Islamic banking is that the commercial banks have to keep a
part of their deposits with the RBI in form of cash for which the RBI prescribes the CRR (Cash Reserve Ratio)
from time to time. The RBI pays interset on these deposits. The banks also have to meet the criteria of SLR
(Statutory Liquidity Ratio) where it has to park certain percentage of their funds into central government
securities and other approved securities on which it earns interest. This is in contravention to the principle of
Islamic Banking which prohibits Interest.
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Islamic Banking: Inclusion in the Indian Banking Sector
a)Islamic banking operations could enable inclusive growth in India : Financial Inclusion is considered to
be critical for achieving inclusive growth; which itself is required for ensuring overall sustainable growth in the
country. The approach to Financial Inclusion in developing countries such as India is thus somewhat different
from the developed countries. In the latter, the focus is on the relatively small share of population not having
access to banks or the formal payments system whereas in India, the focus is on the majority who are excluded.
One of the reasons cited for the deplorable conditions of the Muslims in the Sachar Committee Report on socio-
Economic status of the largest minority segment in India has been low access to credit by the community. ‗The
financial exclusion of Muslims has far-reaching implications for their socio-economic and educational
upliftment. Self-employment is the main source of income of Muslims. To empower Muslims economically, it
is necessary to support self employed persons by ensuring a smooth flow of credit to them‘. One reason which
can be attributed for low participation of Muslims in the banking sector is the financial practices of the
conventional banking which is entirely based on interest. The table below shows the minimal presence of the
Muslim community in banking practices.
Muslims constitute the second largest religious group whose population was enumerated to be 138
million according to the 2001 census. The Sachar Committee report estimates that as of 2006 it must have
crossed 150 Million people. Despite being a significant percentage of 13% (which forecasted might grow to
19% by 2040) the aggregate deposits with the Scheduled commercial banks remain to a low of 7.8%. The
estimated credit loss to Indian Muslims stands to be 27.3% of their deposits which amounts to a whopping RS.
64,770 crore. This calls for speeding up the creation of a framework for starting the interest free banking in a
full fledged manner. This can lead to the inclusive growth of the country.
b)Solution for liquidity problem: India could not be insulated from the downturn in the global economic
scenario. With the liberalized financial sector the impact of recession could be seen on the movements of funds.
With the FII‘s (Financial Institutional Investors) pulling their money to adjust their liquidity solutions back
home the capital market of India saw huge amount of loss. The government has been continuously easing out
the interest rates for injecting growth in the economy. According to the CSO estimate regarding the GDP, it
might be around 7.6% for the year 2008-09 which many of the research institutes feel is very optimistic
looking at the global scenario. Global ECS Research at Goldman Sachs estimate the GDP growth rate to be
around 6.7% for the first quarter of 2009. Global Financial Services firm Nomura has cut the GDP forecast to
5.8% for year 2012-13. To arrest this negative trend in growth the government will have to come up with lot of
monetary changes which will have ramifications on the whole financial sector . Islamic Banking can be one of
the instrumental force in addressing this type of issues. Islamic banking is based upon sharing of profit or loss
which is near to the equity side. Opening of Islamic banks in India with amendments to the Banking
Regulations Act regarding equity participation of banks can lead to the depth of the capital market and easy
access of funds to the corporate houses.
―Equity based financing with the absence of interest earnings in any form drives domestic savings and
real growth. Equity based financing through Isamic banking is set to rapidly increase the exposure of equity
market and hence liquidity.‖( G. Pvaithra, 2008)
c)Attracting foreign capital :The adoption of Islamc banking can also help the Indian economy in attracting
investments from cash rich Middle East countries and muslim NRI‘s who would park their savings otherwise in
other countries providing Islamic banking at an opportune time when India is becoming an attractive investment
destination driving on its strong fundamentals. Realising its importance some of the private sector companies
are viewing it as a mechanism for attracting capital. Five Indian companies, Reliance Industries, Infosys
Technologies, Wipro, Tata Motors and Satyam Computer Services figure in the Standard & Poor‘s BRIC
Shariah Index, comprising of stocks from the four emerging countries — Brazil, Russia, India and China. The
Shariah compliant constituents in the index represent the most liquid stocks trading on developed market
exchanges, specifically the Hong Kong Stock Exchange, the London Stock Exchange, NASDAQ and NYSE.
d)Minimizing risk exposure of banks: Banks always have to bear the brunt of defaults simply because of
neglect in credit analysis. Islamic banking follows strict norms of credit rating which to a great extent minimize
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Islamic Banking: Inclusion in the Indian Banking Sector
the occurrence of bad debts. Under the models of Musharakah the bank shares the cost of project with the
entrepreneur based on an agreed proportion basis and both parties have the right to participate in the
management of the projects. The profit from the project is distributed according to an agreed ratio, which is not
necessarily the same as the share in the cost. The important feature of both the parties participating in the
management reduces the chance of loss as both are conscious in managing the funds and the entrepreneur cannot
think of utilizing the funds in irresponsible manner.
IV. Conclusion
The Indian Financial Sector is forging ahead to meet its objective of financial inclusion as a part of
broader principles of inclusive growth and Islamic banking is one of the solution towards financial inclusion.
The stage for introduction of Islamic banking in India have been set, but it is a matter of time before it is given
green signal. But introduction of Islamic banking without a solid framework will lead to chaos and conflicts.
There for preparatory work is essential for including the Islamic banking in the mainstream Banking sector
which at present lies in the domain of Non-Banking Financial Companies. This demands amendments in the
banking laws that are governed by the Banking Regulations Act 1948 as amended from time to time.
Introduction of Islamic banking will lead to inclusion of certain chunks of population who refrain from the
mainstream banking due to their faith and they are a sizeable percentage from among the 13% (2001 Census) of
Muslims which are forecasted to be 19% by 2040.
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