By Rajat Mittal
Islamic Finance: The Pull of the Mainstream
Charging and paying of interest dominate the global financial market. Banking and financing in the conventional system is a virtual impossibility without interest because the incentive to invest or borrow money is generally driven by the potential profit or loss in the form of interest. The interest rate is powerful tool used by the central banks to set policy. The mere fluctuation in the interest rate poses potentially crippling effects on any economy.
Islamic banking on the other hand has the distinguishing characteristic of banking without interest (riba). Riba is prohibited under Shari’a, or Islamic law, so investors may share in the risk of an investment rather than passively acquire a return on capital. This, along with other Shari’a prohibitions, makes Islamic banking seemingly incompatible with, and incapable of growth in, the interest-dominated global financial market. The current state of Islamic banking, which mostly consists of rudimentary banking methods, seems to support this view. The world, however, is witnessing a resurgence of Islamic religious ideals and new demand for more sophisticated Shari’a-compliant banking services. Nonetheless, the demand does not change the seemingly irreconcilable differences between Islam and conventional banking. This poses the question: can Islamic financing grow beyond its rudimentary stage and become a competitive market in the global financial system in general and India in particular and emerge as an important instrument of financing?
Despite the scope, imprint and recent optimistic trends of Islamic finance on the global economy, Islamic finance faces several ideological and structural challenges to full integration in the Indian economy. This article aims at illuminating these challenges and providing a general overview as to how Shari’a-compliant finance system be implemented in India and how it can evolve as a dynamic mode of corporate financing by utilizing the untapped liquidity offered by the Muslim investors in the country.
Banking according to Islamic practices
Role of Islamic Tenets and Teaching in a Muslim’s Financial Affair
As an initial proposition, it should be understood that religious laws in Islam govern all aspects of life. Islam is a religion that governs life based on moral obedience and compliance with Qur’an and other sources of Shari’a. Shari’a permeates every aspect of a Muslim’s life by acting as a mandate from God on how to live one’s life individually and collectively in a society. To promote this comprehensive life, Islam forbids Muslims from engaging in activities involving “interest or riba, gambling, pornography, alcohol, drugs, and other things which Islam considers abhorrent”. Because Islam does not separate finance and faith, financial affairs of each Islamic practitioner are necessarily implicated. Muslims do not view Islam as existing in addition to economics or any other aspect of society, which subjects the entire area of banking to religious considerations.
Islamic Prohibition of Interest
Arising out of the Islamic tenet of concern for the community flow the anti-abuse concepts applicable in financial affairs. The primary example of this anti-abuse concept is the Qur’anic prohibition of riba, which “seeks to prevent usurious conditions in exchanges and loans” so that there is no commercial exploitation of the poor and weak. The prohibition appears in several passages in the Qur’an. One passage states that God does not view interest as true wealth because it represents unearned income.
Development of the Islamic Banking Movement
The first Islamic financial institution was a mutual savings bank formed in the Egyptian town of Mit Ghamar in 1963. In less than five decades, Islamic Banking has grown from a mere idea into a substantial subset of the financial industry. It has evolved into a system capable of harmonizing classical religious precepts, social responsibility, traditionalism with the modern exigencies of globalized banking. Today according to the International Monetary Fund, there are over three hundred Islamic Financial institutions in more than 75 countries with total assets worldwide exceeding $250 billion and growth rates exceeding 15 percent a year, which clearly suggests that this mark will be soon surpassed. As of June 2006, Moody’s estimated that there are over 250 Islamic mutual funds, with a total of $300 billion in assets.
Financial Techniques and Practices utilized by Islamic Financial Institutions
The Islamic prohibition of interest does not mean, however, that capital is without cost in an Islamic system or that a party cannot profit from a lending arrangement. On the other hand, Islam recognizes capital as a factor of production and encourages profit when achieved through legitimate means.
- Mudaraba, which is one form of financing equivalent of venture capitalism.
- Musharaka, which is a joint venture finance structure with two or more partners each contributing capital or labor and sharing the profits and losses of the venture in accordance with a formula agreed upon before the transaction is consummated.
- Sukuk, which has emerged as an important Islamic vehicle because of the channel it creates for the corporate giants outside the Muslim world to tap in the liquidity offered by the Islamic investors, particularly in the Persian Gulf. Sukuk (which roughly translates to “certificates”) — in essence is an asset-backed security structured in compliance with the precepts of Shari’a, somewhat similar to a trust certificate or bond.
Islamic Financing in India: Bringing Money to the Companies and Prosperity to people
The Trend world wide
Islamic banking and finance is no longer an uncertain experiment. Although Islamic Banking is in its infancy — only forty years old compared to the four hundred year old conventional banking industry — it has become a major player in the global financial economy. Islamic Finance is now a sturdy table supported by two strong legs, the Islamic capital market and Islamic Banking. The amount of market capitalization being done by the Islamic Financial Institutions in the major world economies also supports this trend. Reference can be made to the Dow Jones Islamic Index in this regard.
Another passage concerning the ban of interest from the Torah’s prohibition of interest. A final condemnation warns that those who receive riba are waging war with God and shall be “inhabitants of fire and abide there forever.”
Shari’a-compliant infrastructure fund is on its way. A finance group, 2i Capital Group, in a consortium with Oman-based Amwal Investment SAOC has launched a $300-million offshore Shari’a-compliant Indian Infrastructure Development Fund. 2i Capital Group operates in UK, Mauritius and India. The fund with seven years tenure has been registered with Securities and Exchange Board in India. Even though a few steps have been made in the right direction but when one looks at the above figures of market capitalization in these economies, the fact remains that Islamic Financial Market remains to be tapped in India.
Relevance of Islamic Financing in India
Islamic Financing is of great relevance in India not only from the perspective of the companies that benefit from it but also because of the social good it seeks to achieve.
More than one billion people worldwide are believed to be the followers of the Islamic faith which is more than 20 percent of the world’s population. Countries with Muslim-majority population are distinguished by significant economic and political statistics. As a group they generate over 10 percent of the global GDP and constitute 10 of the 11 members of the OPEC. Nationally, Islam is the second most practiced religion after Hinduism. There are approximately over 151 million Muslims in India’s population as of 2001, i.e., 13.4% of the population. Currently India has the third largest population of the Muslims in the world. The financial field of Islamic banking is estimated to be growing 15% a year worldwide and, as already pointed out previously, according to the International Monetary Fund, there are over three hundred Islamic Financial institutions in more than 75 countries with total assets worldwide exceeding $250 billion. As of June 2006, Moody’s estimated that there are over 250 Islamic mutual funds, with a total of $300 billion in assets. These statistics demonstrate the economic importance of the Shari’a-compliant banking in India even though it is true that these figures of the total assets, when considered from a worldwide perspective, are small in relation to total banking assets, but the figures are significant, especially when notes that the asset base has been steadily increasing. Therefore it is true to say that Islamic Banking is gaining momentum worldwide as an alternative to the traditional western, interest based banking and should therefore be made available to the Muslims in India who desire to comply with the strictures of the Islamic financial practices.
Structuring Islamic Financial Institutions in India — Banking Regulations in India and the problem in the establishment of Islamic Banks
Under the existing legal regime in the country a banking company is allowed to take in deposit from the public only if it complies with the necessary regulations. The Reserve Bank of India prescribes number of banking regulations and guidelines that are required to be complied by these banking companies. Banks in India have to maintain cash reserves ratio (8.5 per cent at present) of which 3 per cent does not get interest and remaining 5.5 per cent get interest at the rate of 4 per cent per annum. This system of banking is primarily based on interest, which makes it impossible for the banks to function on Islamic Principles. Therefore, the Islamic Banks in India do not function under the aforementioned banking regulations and are licensed under Non Banking Finance Companies Reserve Bank Directives 1997, RBI (Amendment) Act 1997, operating on profit and loss based on Islamic principles. However, the reach of such banks is very limited catering mainly to the local needs with the exception of a few that operate across districts and states. Some of the key operations of these banks include (a) providing housing loan on the basis of co-ownership, venture finance on Mudarabha basis as well as on Musharaka basis (b) education (c) investments made in the government securities, small savings schemes or units of mutual funds and (d) most significantly in the shares of some of the companies.
Conclusion
Globalization will require the international commercial environment to recognize and integrate both Islamic and conventional forms of commerce and finance as the Islamic financial institutions have established a world presence over the last four decades and indications are that the asset base of these Islamic institutions will continue to grow. Further corporate financing through Islamic banking has much to contribute to India. As it is a financial system that concerns itself not only with profit, but also with largely ignored benefits of social justice. It acts as a counterweight and possible agent of constructive reform to a system that may have become excessively reliant on debt and interest. It also places a positive emphasis on partnership and profit sharing investment and offers additional resources of entrepreneurial capital.