FN 5103: Accounting for Islamic Financial Transactions

Masters in Islamic Finance

Term paperIslamic Banking in India: History, Current Developments and

Future Prospects

Firoz.M.P0900363Jan 2010

1

Islamic banking in India:

History, Current developments

and Future prospects

2

3

Special thanks to

Dr. Shariq Nisar.

4

Abstract:

The purpose of this paper is to discuss the advent of Islamic finance in the non-Islamic country of India. The paper is divided into three main sections namely: History and development, Current issues and Future prospects, necessarily in that order. The paper also aims to propose and emulate the efforts taken by the UK government in their quest towards establishing Islamic finance as an alternative banking system, in the third section. A detailed study of the regulations of the Indian and U.K government is out of scope of this paper. But, such a study would necessarily lead to a better understanding of the regulations and help to develop intricate methodologies so as to establish Islamic banking in India by bringing in necessary regulatory changes. The paper does not aim to provide solutions to implement Islamic banking in India, as there are already numerous papers written on the topic, but only advocates to use United kingdom’s, UK, efforts as a possible reference for implementation.

Finally, an interview conducted with Dr. Shariq Nisar, who is a renowned public figure in India in the area of Islamic finance, is also included as the highlight of this paper, in the second section. I would sincerely thank Dr. Shariq, who also turned out to be a source of motivation for me, for his patience and humility. His opinions have helped me to form a base for this paper and will definitely instigate me towards further research in the field of Islamic finance in India.

5

Glossary

IB Islamic BankingIFI Islamic Financial InstitutionsNBFC Non-Banking Financial CompanyFAP Financial Associations of Persons

IFS Islamic Financial SocietiesICCS Islamic Co-operative Credit Societies,IIFC Islamic Investment and Financial Companies

6

Table of Contents

AbstractGlossary

1. Introduction

2. History and development of IFIs in India2.1 Evolution of Islamic financial institutions2.2 Classification of IFIs

2.2.1 Financial Associations of Persons2.2.2 Islamic Financial Societies2.2.3 Islamic Co-operative Credit Societies2.2.4 Islamic Investment and Financial Companies

2.3 Current status of IFIs

3. Current Issues3.1 Need for Islamic finance in India3.2 Potential of Islamic finance in India3.3 Regulatory roadblocks3.4 Status of IFI initiative in Kerala, India3.5 Interview: Dr. Shariq Nisar

4. Future Prospects: Proposal to use UK’s example as a ready reference4.1 Development of IFI in UK4.2 IFI in UK4.3 Explaining the UK’s success

4.3.1 The role of the UK authorities4.3.2 Taxation

4.3.2.1 Borrowing arrangement 4.3.2.2 Deposit Arrangements 4.3.2.3 Investment bonds

4.3.3 Standardisation4.3.4 Awareness4.3.5 Skills

5. Conclusion

7

1. Introduction

Islamic banking in India has been a topic of discussion for quite sometime

within the Indian sub-continent and those countries which have business and trade

interests with India, especially the middle-east. The excess liquidity in the middle-east

is encouraging the Arabs to look out for more investment avenues and the lack of a

well-developed Islamic financial system in India has been a huge deterrent. It is not

only for the purpose of trade that India needs IFIs but also to cater to the 13% of the

Muslim population in its soil. Most Muslims in India shy away from interest-based

activities and hence, a problem of financial inclusion arises within the Indian

economic system.

The Justice Rajender Sachar committee report, which analyzed the conditions

of Muslims in India, pointed out the lack of access to bank credit to this section of the

society. Alarmingly, Muslims hold only 7.4% of the deposits. Some banks have

identified a number of Muslim concentration areas as ‘negative geographical zones’

where bank credit and other facilities are not easily provided. Also, the study shows

that participation of Muslims in banking related jobs is as low as 2.2%, a clear

indication that the community is uncomfortable with the riba based activities.1

Last year, the Raghuram Rajan committee’s report advocated the need for

interest-free banking activities for the better functioning of the less-privileged part of

the Indian population and for financial inclusion of the neglected societies in terms of

accessibility of affordable funds. Committee reports are one thing and implementation

of their recommendations is another. The Indian authorities have to realize that they

are at the ripe time of the worldly affairs, after the U.S. crisis, to tap further

investments towards India or else they would miss the window of opportunity. It is

worth to point out that India’s neighbour, China, has already issued the license for the

first Islamic bank, recently.

8

2. History and development of IFIs in India

2.1. Evolution of Islamic finance in India

In the earlier days, the Sahabas, Sufies and Arab traders have played a

significant role in spreading Islam, Islamic institutions and Islamic culture in India.

IFIs in some preliminary form such as Bait-ul-Maal have often been used in India by

the Muslims rulers as well as Muslim religious and social workers for collection and

distribution of zakah, sadaqah as well as qard-e-hasaan. However, the institution of

Bait-ul-Maal in India has been mostly used for charitable rather than commercial

purposes. 2

IFIs as economic entities were first established in late 1930s and early 1940s

of the 20th century in India. The Patni C-operative Credit Society Ltd. was established

in 1938 and the first Muslim fund was started in 1941. However, proliferation and

growth of IFIs took place in India only after the independence and their

commercialization took place along with global development of Islamic banks and

Islamic financial institutions in 80s. 2

2.2. Classification of IFIs in India

IFIs in India can be best classified based on their functional model and registration

authority. They are classified as follows:

Financial Associations of Persons (FAP)

Islamic Financial Societies, (IFS)

Islamic Co-operative Credit Societies, (ICCS)

Islamic Investment and Financial Companies, (IIFC)

India’s IFIs basically follow three distinct models and are registered with three

different authorities. There is also a fourth category of IFIs, those who do not have

any independent operational model, nor are they registered under any authority. They

can be classified as Financial Associations of Persons (FAPs). They are not the

product of any time period. Muslim funds (MFs), Islamic welfare societies (IWSs)

and Bait-ul-Maal s which are registered under the Society and Trust act, are classified

as Islamic financial societies (IFS). Those modelled on Co-operative Credit Societies

9

registered under the Registrar of Co-operative Societies are classified as Islamic Co-

operative Credit Societies (ICCSs). Profit and Loss Sharing (PLS) and financial

companies registered under the companies act are classified as Islamic investment and

financial companies (IIFCs). 2

2.2.1 Financial Associations of Persons (FAPs)

FAP are unregistered, privately operated, smaller functional groups operating

in mosques, educational institutions or markets, throughout the country. In mosques

or Anjumans they have taken the form of smaller Bait-ul-Maal s wherein zakah funds

are mobilized along the membership fees and donations, and interest-free qard-e-

hassan loans are also extended. In the educational institutions, they have taken the

form of interest-free chit funds wherein groups of 20 to 30 staff members contribute a

monthly fixed sum. One or two persons share the monthly draw at no cost. In the

markets, the groups of Muslim businessmen coming together for mutual financial

assistance are slightly bigger. Denied by banks and exploited by Marwari

moneylenders who charged over 25% interest, groups of 50 to 100 Muslim

businessmen come together to form an association for mobilizing their own savings

and getting interest-free, low cost loans. The loans provided are used more for

consumption purposes than production purposes. But, recently, more and more

businessmen are adopting this format to augment their business capital. 2

Some of the FAPs are mentioned below:

1. Barkat Association, Belgaum

2. Shantapuram Islamic Finance Corporation, Calicut, Kerala

3. Interest-free Society, Pune

2.2.2 Islamic Financial Societies (IFS) of India

IFSs are registered under the society and Trust Act. of the respective states of

India. They are mainly non-profit welfare oriented institutions, generally smaller in

size, catering to the socio-economic needs of the poor sections of local Muslims. They

are based on Quranic guidelines of Qard-e-hassan, Zakah and Sadaqah. They

mobilize local savings as Amanah and extend interest-free loans usually against the

security of gold ornaments. Some of them mobilize and disburse zakah and Sadaqah

10

funds. Muslim funds operate largely in North India mainly in U.P; Islamic welfare

societies and Bait-ul-Maals operate in south India. There may be over 150 Muslim

funds, Islamic welfare societies and Bait-ul-Maal s functioning in India.

Some of the IFSs are mentioned below:

1. Muslim fund, Deoband, Uttar pradesh

2. Bait-ul-Maal , Chennai, Tamil Nadu

3. Toor Bait-ul-Maal, Hyderabad

2.2.3 Islamic Co-Operative Credit Societies of India

Due to widespread ignorance, ethnic and lingual differences, and lack of

awareness, Indian Muslims did not adopt the interest-free co-operative model so

successfully developed by The Patni Co-operative Society Ltd., of Surat as long as in

1938. It took 37 years for Muslims to successfully establish another interest-free co-

operative society at Mumbai in 1976 viz. Bait-un-Nas’r Urban Co-operative Credit

Society Ltd. It was followed by just one more successful Co-operative society again at

Mumbai, namely Bait-ul-Maal Urban Society Co-operative Credit Society Ltd.

Generally, 10 or more persons come together to contribute their own share capital and

start a Co-operative Credit, Consumers or producers Society. The only problem is, in

India every state has its own Co-operative Society Act and hence Multi State Co-

operative Societies can be started only under Multi-State Co-operative Societies act of

the central government which is rather cumbersome and time consuming. 2

Some of the Co-operative Credit Societies are:

1. The Patni Co-operative Society Ltd, Surat.

2. Bait-un-Nas’r Urban Co-operative Credit Society Ltd., Mumbai.

3. Al-Ansar Co-operative Credit Society Ltd., Hyderabad.

11

2.2.4 Islamic Investment and Financial Companies of India (IIFC)

Non-Banking Financial Companies (NBFC) are important part of Indian

financial system bordering its banking sector as only they can accept Equity funds and

invest on PLS basis. Since interest-free commercial banking on the PLS basis is not

permitted in India, Indian Muslims have only the alternative of establishing PLS Non-

Banking Financial Companies. IIFCs mobilize funds largely through Mudarbah basis.

Share capital is the other important source of funds raised by IIFCs. 2

Most of the income is earned by IIFCs from Ijarah. Murabaha and

Mushrakah. It was in 1980 that the first IIFC called Al-Mizan was established in

Madras (Chennai), Tamilnadu. Share capital of more than INR 35 million was raised

by a group of 19 partnership firms with a mother company as the supervisory board.

Unfortunately, the experiment failed miserably due to 1984-85, when the company

incurred heavy losses mainly due to mismanagement. Al-Mizan was followed by

Bait-un-Nas’r Co-operative Credit Society Ltd. of Mumbai that established the next

group of IIFCs. Many of the IIFCs faced problems due to the implementation of stiff

prudential Norms by RBI in 1997-98. 2

Seyad Shariat Finance Ltd of Tirunelveli in Tamilnadu, established in 1987-

88, is one of the very few IIFCs that is still functioning successfully. There have also

been some fly-by-night IIFCs who exploited the religiosity as well as greed of people

to make fast money and disappeared according to press reports. Many others are

struggling to survive not only due to strict RBI norms but also due to lack of

professional management, transparency and public support especially from the

Muslim community. 2

2.3 Current Status of IFIs

FAPs are perhaps the oldest and more diverse IFIs in India. They do not have

a single format of operating business as they use models of different IFIs as per their

objectives and needs. They belong to the un-organised sector of Islamic finance in

India. FAPs are not peculiar to Muslims as they are also formed by non-Muslims.

They are basically small groups of needy people who mobilize their own savings and

often provide interest-free finance. Lack of rules and regulations, simple and informal

12

operations makes them more flexible, popular and acceptable. Hence, they will

continue to proliferate.2

IFSs are well-found and well spread through out India. They are no-profit

earning, welfare oriented financial societies mobilising and providing interest-free

credit. Basically, the business model consists of mobilizing small savings of Muslims

and providing interest-free loans against security of jewellery or movable assets. The

cost of loan is recovered as service charge. They do not keep any reserves to cover

bad debt. They are not particular about the purpose of the loans and most loans were

given out for consumption purposes. IFSs should start providing purpose based loans

with more emphasis on small business loans. They are in-effect Islamic Non-Govt.

Organisations (NGOs), but in practice they are not able to adopt the posture of NGOs

because of the rigidity of the managements. Many of the problems of IFSs of India are

emerging from lack of a regulatory authority. 2

The common problems with IFIs in India are lack of professionalism and full

involvement of promoters with the IFIs. In fact, most of the IFIs have stopped

functioning.2, 10 Data about doubtful and bad loans is also not maintained or reported.

IIFCs are the only commercial IFIs established to operate on PLS basis in India. All

the other categories are non-profit, interest-free loan advancing societies, geared more

to promote social welfare. IIFCs are the only institutions that struggle to put into

practice as many principles of Islamic finance as possible, and promote profit sharing.

But, most IIFCs failed due to professional incompetence and ignorance of their

customers of the Islamic principles of participation in PLS. Most Muslims knew only

one principle.i.e. prohibition of riba. Sometimes, this ignorance also extended to

Imams and Alims. Lack of transparency and absence of a Shariah supervisory board

are also major problems. Awareness and education among Indian Muslims about

Islamic financial principles is very much essential.2

In order to grab the emerging opportunities, IIFCs / NBFCs will have to

acquire a global outlook and competence. Neither India’s progressive market and its

fast growing economy nor 120+ million Indian Muslims can be neglected for long by

the enterprising Arabs. Hence, the Indian government should make faster and

13

meaningful amendments to the constitutional and regulatory systems to accommodate

IFIs in the near future.

3. Current Issues

3.1. Need for IB in India

When the world is moving towards Islamic banking at its own pace or has

become more curious than ever, after the collapse of conventional banking techniques

as proved by the U.S. sub-prime crisis, where does India stand in this race for setting

up Islamic institutions? Does India need Islamic banking at all? Since the partition in

1947, it has become ever more important for India to stick to its secular, democratic

ideals and continue to bridge the gaps that exist within its citizenry. For over a century

now, however, the Muslim minority in India has been suffering at the hands of its

leaders’ miscalculations and mistakes, exploitation by capitalists, and the relative

apathy of the successive Indian governments. The current status of Indian Muslims is

alarmingly poor with higher illiteracy, higher unemployment, lower income and

higher poverty rates than the Hindu majority. This should be of major concern to the

Indian government and the people of India at large. 3

As a secular democracy, all citizens have equal right to a certain quality of life

and no particular sub-group of the population should be lagging behind in attaining

and exercising that right. It is the obligation of the government to ensure that lagging

minorities have the tools with which they can catch-up to the rest of the nation. One

such tool is credit, and only with proper credit can lagging minorities catch-up and

decrease the economic disparity between them and the majority.3 The establishment

of full-fledged banks practicing Islamic Finance is one step towards decreasing the

economic disparity between Indian Muslims and the rest of their countrymen. This is

why India needs Islamic banking among various other reasons such as promotion of

entrepreneurship in a minority group, the lure of the middle-eastern investments and

social harmony. The most important fact to be recognised at this juncture is that

Islamic banking is not only for Muslims but also for the masses. It is for the whole of

human kind. It aims at economic development by holding the moral and faith-based

values of the religion close to its heart. With Muslims being one of the minorities in

India, unemployment and underemployment among minority populations can be

reduced by supporting minority entrepreneurs in developing businesses.3

14

Indians often migrate to other countries in search of better prospects. Take the

example of Kerala, a southern state in India. As per statistics, remittances from

emigrants constitute 22% of the state’s domestic product4. India has retained its top

position amongst the countries getting remittances for years4. As of 2008, the Gulf

countries altogether had a Keralite population of more than 2.5 million, who send

home annually a sum of USD 6.3 billion5. This trend can also be seen in states like

Tamilnadu and Bihar. The reason why this is mentioned here is that such an outflow

of Indians, belonging to the lower-end of the income level, shows that there is some

sort of inefficiency in the economic system that they find unaccommodating. Though,

millions of dollars are allocated by the government for the upliftment of such groups,

it never reaches the right hands. This is where Islamic institutions can play a major

role with their moral and ethical values. It also has to be borne in mind the history of

clashes between the Muslims and other religions; this is stated to point out how

sensitive the implementation of Islamic banking could become. The responsibility of

catering to a one billion plus population itself is a challenge.

There are many benefits to the development of full-fledged Islamic Banks in

India. Those benefits include a potential bettering of the condition of India’s largest

minority, better integration of that minority into secular-democratic India, increased

savings across the country and an increase in the national GDP growth rate. Given the

limited access that Indian Muslim entrepreneurs have to credit, some reform of the

banking sector is necessary. Reform by opening of Islamic Banks would be beneficial

for all entrepreneurs who have profitable proposals but lack collateral. Those

entrepreneurs include, but aren’t limited to, many economically-disadvantaged Indian

Muslims. By helping economically-disadvantaged Indian Muslims build minority

businesses, the newly-created Islamic Banks could help to generate wealth for Muslim

business owners, create jobs for currently underemployed Muslim workers and will

share the profits generated by those minority businesses among all of the depositors

who hold Profit/Loss-Sharing (PLS) investment accounts.3

15

3.2 Potential of Islamic finance in Indian economy

Muslims in India constitute 10.3% of the world Muslim population and India

ranks third in the list of countries by Muslim population (Pew research, Oct 2009,

Table 1). Considering the structure of Indian workers it has to be admitted that India

cannot grow inclusively unless the growth benefits are duly shared among Indian

workers who do not have any access to funding from banks. Since 50 per cent Indian

workers are engaged into agriculture, Bai Salam could be most powerful financial

instrument to empower farmers, cultivators and agricultural traders. It will help us

increase agricultural exports as well. The second most important sector after

agriculture is the small and medium scale industries or SMEs. The products like

Musharakah, Murabaha, Mudarabah, Istisna, Ijarah etc. could be well utilised by our

SMEs. It will help them grow at an international level. Besides agriculture and SMEs

sectors, Sukuk could be very useful Vehicle to mobilise interest-free financial

resources for the Government to develop required infrastructure. This will also help to

reduce the fiscal deficit of the Government with no cost of interest.

Table 1

With a heavy emphasis on equity and profit-sharing, the chief factor used to

determine whether a project is worth financing in the Islamic system is the expected

profitability of the project. With an emphasis on this factor, the expected profit from

all ventures financed by the bank could be maximized and society as a whole benefits.

With an emphasis on the assets of a borrower (credit-worthiness), expected profits

from all ventures financed in the conventional system are not nearly as high and

society sustains a certain missed opportunity cost, even as banks are repaid their

principal plus interest. Entrepreneurs lacking assets are unable to obtain credit and

16

launch an enterprise in the conventional system, again, due to the emphasis on asset-

based credit-worthiness.3 This is where the principle of social justice can be seen in

the Islamic system: any entrepreneur with a profitable proposal, regardless of asset-

base, would be eligible for credit and would then be able to establish a successful

business enterprise and better his position. Such an arrangement would be a boon to

all those Indians with bright business ideas but lack in asset-based credit worthiness.

The Islamic contracts and ways of conducting businesses, in the true sense, are aimed

to bring harmony and social equity among the people and it is observed as one of the

ways of attaining a life filled with ‘iman and towards becoming a mu’min, as is the

case with any teachings from the Quran and the Sunnah.

3.3 Regulatory roadblocks

Indian banks are governed under the Banking Regulation Act (1949), Reserve

Bank of India Act (1934), Negotiating Instruments Act and Co-Operative Society Act

(1866). None of these laws admit the possibility of an interest free bank. Hence, if and

when an interest free bank is allowed to be established in India, relevant laws will

have to be amended significantly to admit such a possibility and to evolve a different

system of regulation and control. The costs of establishing Islamic Banks in India will

include legal reforms and the development of a new regulatory structure for interest-

free banks. Indian banks have been subjected to a number of banking regulations and

guidelines as prescribed by the RBI.3 Banks in India have to maintain cash reserves

ratio (5.75 per cent at present).7 Statutory Liquidity Ratio (SLR) is another important

condition to be met by the banks. Reserve Bank has decided that all Scheduled

commercial banks (SCB) shall continue to maintain a uniform SLR of 25% on their

total net demand and time liabilities (NDTL) with effect from the fortnight beginning

November 8, 2008, valued in accordance with the method of valuation specified by

the Reserve Bank of India from time to time:

in cash, or

in gold valued at a price not exceeding the current market price,

or,

in unencumbered investment 7

The Central Bank has used Bank Rate to encourage or discourage bank credit

demand in the economy. The above instruments cannot be used for Islamic banks as

17

they do function on the basis of interest. Other sets of conditions which banks have to

meet are capital adequacy, assets classification, provisioning for bad debts and

income recognition norms.

The primary issue which is a permanent eye sore for Islamic banks operating in

the countries with interest based banking is that they cannot function as banks unless

powers of issuing cheques are given to them. They cannot be members of settlement /

clearing house unless they accept two conditions, regarding their liabilities and assets

like conventional banks, that they have to keep fractional cash reserve with the

Central Bank and statutory liquid assets in their assets. Thus, banks in India have to

maintain deposit account with the Central Bank over which they get interest. Since

these assets are interest based, Islamic bank cannot hold them. Consequently, the

Central Bank cannot act as the lender of last resort because such accommodation by

the monetary authority is also interest based.8

Another trouble comes due to unequal treatment of debt and equity fund. The

capital of Islamic financial companies is equity-based operating through profit and

loss sharing. Under the existing government rules profit is taxed while interest is

exempted from tax on the ground that it is a cost item. This puts the Islamic financial

institutions in a disadvantaged position9. Some of the other issues are given below10:

18

The draft report submitted by the working group of Indian Banks Association, May

2008, also mentions about possible modification of the income tax act.

3.4 Status of IFI initiative in Kerala, India

The Kerala State Industrial Development Corporation, KSIDC, was likely to

start a non-banking financial institution under the supervision of Reserve Bank of

India, accepting11% of the share from Kerala government. But by a fresh notice sent

to the State Government and the RBI, the High Court stayed that move. KSIDC

decided to start the institution on the basis of Islamic Shariah, an interest free

banking, and on the grounds of Reserve Bank Act (chapter 3). As the Constitution 25,

26 acts allow the citizen to open such an institution; KSIDC got registered, without

breaching any of the laws. The only difference that makes it different from other non

banking financial institutions is that, it avoids the transactions on the basis of interest.

Understanding from the new studies, that the bulk of NRI Muslim investors

are reluctant to invest in interest based economy, Kerala government decided to

encourage them by setting up such an interest free institution. And also it foresaw that

the new system will boost the development process of the state. Since it is open to non

Muslim investors as well, obviously, it is not a tread against secularism. But the

petitioner argued in his complaint against RBI and state government claiming

KSIDC’s stimulus to set up the parallel institution is violation of secular ideas

provided by the Constitution.

An Islamic bank, or even NBFC, that operates in India, would violate at least the

following laws, rules and regulations, as quoted by the former Union law and justice

minister, Dr. Subramanian swamy:

Partnership Act (1932), which stipulates a maximum of 20 partners, since

KSIDC says it will be an open partnership between it and private investors

without limit.

Wagering (not permitted under Shariah) as per Section 30 of Indian Contract

Act (1872).

Sections 5(b) & (c), 9 and 21 of Banking Regulation Act (1949) on prohibition

of profit-sharing, buying and selling property, and for not charging interest.

19

RBI Act (1934)

Negotiable Instruments Act (1881)

Co-operative Societies Act (1961)

Source: http://www.merinews.com/

20

3.5. Interview with Dr. Shariq Nisar (Un-edited)

Dr. Shariq Nisar holds PhD in Economics with specialization in Islamic finance. At present he is on the board of Bombay based premier Shariah Advisory Company, M/s Taqwaa Advisory And Shariah Investment Solutions (TAASIS) Ltd as Director. He writes regularly on Islamic finance in leading academic and industry magazines and is the joint editor of one of India’s oldest periodicals on Islamic Economics, "Islamic Economics Bulletin". He has delivered several lectures in conferences, including the recently concluded Seventh Harvard University Forum on Islamic Finance, USA and Islamic Non-Banking Financial Institutions: Islamic Alternatives", Kuala Lumpur, 2004. Dr Shariq has more than a decade of rich experience in Indian financial sector. He has worked with some of India’s top Islamic financial institutions. Besides this, he is presently acting as Consultant to several Investment Management firms in India and abroad. He also had a short stint with Citibank at New Delhi.

1. Why is India still reluctant to catch up with the current trend of luring the Gulf investments by establishing Islamic financial institutions and banks? What are the roadblocks? When the high level report by Dr. Raghuram Rajan’s committee has itself advocated the establishment of interest-free banking (@ Islamic banking) for the upliftment of the downtrodden and financially backward in India, why is India still shying away from the billion-dollar opportunity?

India is faced with different sets of challenges with regard to implementation of Islamic banking in the country. Most of the secular countries that have accommodated Islamic banking in their respective countries are homogeneous in many respects but that is not the case with India. India is a very heterogeneous country in terms of language, culture and social preferences. Policy making processes in India for the above mentioned reasons are very slow. It consumes a fair amount of time in India to build consensus with various political setup and pressure groups active in the country. Further, it is an established fact that India is religiously very sensitive country. With long history of communal riots and tensions between Hindus and Muslims it becomes very challenging for even staunchest secular Hindu to sympathize with anything which has an Islamic connotation.

Roadblocks are many: right from political will to regulatory and administrative matters there are host of challenges which Islamic banking is faced with in India. It is Executive’s discretion to accept any Committee’s Report. Even if the Report is accepted it does not mean that implementation will start immediately. We have had experiences in the past where a committee’s report is not accepted or partially accepted or recommendations not agreed upon or implemented. Dr Raghuram Rajan Committee is no exception to this. We also need to understand that the Committee in question was established to advise government on the matter of financial inclusion of large section of our population (Muslims included) which is still away from the main stream finance. In this regard the Committee’s recommendation of Interest-free banking is just one of the many recommendations it has made to the government.

India is not shying away from the opportunity it is evaluating the cost of the opportunity.

21

2. What would be your advice to Islamic NBFCs in India based on the history of functioning of NBFCs like Barkat group, Baitun Nasr (BUN) etc.?

Today it is far more challenging to implement Islamic principles of business under NBFC’s regulation. Prior to the new regulations (1997) it was not so difficult. Today a company wishing to work on Islamic principles either has to compromise with its business viability or its Islamicity. Achieving both the goals is very difficult today. No doubt we have fewer Islamic NBFC’s today then we had ten or fifteen years ago.

May I point out that Baitun Nasr was not an NBFC but a Cooperative Credit Society. Since both Barkat and Baitun Nasr were promoted by same group of people Baitun Nasr had a run on it after the liquidation of Barkat which the former could not sustain eventually. It is unfortunate that despite the management of both the institutions being entirely in different hands and the nature of business also being quite different from each other Baitun Nasr could not be saved.

3. What are the steps taken currently by the Islamic establishments to make Islamic banking (IB) feasible in India?

We need to keep in mind that India is not an Islamic country. Most of the Islamic institutions that are found in the country today are established for “protecting the interest” rather than “promoting the interest”. An overwhelming segment of Muslim population is below poverty line and struggling for their day-to-day life. Nevertheless there are certain groups engaged in creating awareness about Islamic finance among the general public. Muslims in academia especially those in economics, finance and management are also putting their efforts in creating awareness about the opportunities. However these are not sufficient considering the size of the country and the Muslim population that it has. Some professionals have floated a Shariah Advisory Firm (Called TASIS) which till today is India’s only Shariah advisory institution in financial matters. Off late the firm has had some success when it helped launched India’s first Shariah compliant Mutual Fund; India’s first Shariah compliant insurance scheme; and also a venture capital fund. GIC of India (a government of India owned company) has started a Shariah compliant Retakaful scheme with the guidance of TASIS. These four are the only Shariah complaint products in India at the moment. There are few others who have some products identifying it as Shariah friendly as they do not avail the services of any Shariah board for rectifying the product.

(Questions 4, 5 and 6 are based on the assumption that the roadblocks will be cleared in the near future and Islamic banking in India becomes a reality)

4. Which country’s regulatory framework can be used as a reference to set up appropriate changes in the Indian scenario? Could it be that of the UK, Malaysia or Bahrain?

Indian situation is much more unique than the countries mentioned by you. But I think UK could still be a good model to replicate with. Indian regulators are familiar with UK and they respect its regulation.

5. Can we adopt the AAOIFI standards for accounting purposes? Or would it require us to

22

follow Malaysia’s example of following a mix of IFRS and AAOIFI?

I am afraid India would allow any concession on accounting policies. This would be like opening Pandora’s box for them. However, India is committed to bring its accounting policies in tune with IFRS by the next financial year.

6. Do you believe the term “Islamic” banking would actually appeal to the Indians given the diverse cultural and religious background? As mentioned by known personalities, wouldn’t it be better if we avoid the term “Islamic” totally for the Indian system and concentrate on making the Shariah system achieve its true economic purposes rather than bothering about nomenclature? What are the alternatives?

Indian policy makers favouring introduction of Islamic banking in the country have been airing their views on this. I do not consider this to be a big issue because even in certain Muslim countries we see the avoidance of the term Islamic. What is important however, in this regard is that Islamic laws should not be circumvented. When an individual does so it is seen as weakness or lack of commitment whereas when a system does so it smacks of conspiracy and that could be counterproductive.

We have many alternatives words such as Shariah Finance, Ethical Finance, Interest-free Finance or Special Finance. Dr Raghuram Rajan Committee has used the word Interest-free Finance. Anything is ok as long as it is not used to exploit the sentiments and there is genuineness and sincerity in following the Shariah law.

7. Currently, is there any other Shariah compliant mode of investments available in India other than the NBFC s/ Islamic mutual funds?

Yes, as I mentioned above there are Shariah Compliant Venture Fund, Pension Plan, and also a Retakaful scheme. Besides there have been private equity investments based on Istisna and Murabaha contracts.

8. What is future prospect of Islamic mutual funds in India? How steady has been the growth rate in the past few years?

Currently, there is only one Mutual Fund claiming Shariah compliance. There are other two who discretely follow Shariah. Performance of these funds has been very good but other funds too have performed well in the last one year. In fact most part of 2009 markets have been doing well all over the world except very few places.

9. How long would it take to establish IB in India based on your estimates of current political and regulatory scenario?

I can’t comment on the timeline. It mostly depends on political and economic situation in the country. If there is peace in the country then it could be easy for the policymakers to push for it. My impression is, unlike west India is not in hurry to introduce Islamic banking in the country. May be economic situation in those countries are such that they cannot wait any further but India is not in such a situation and therefore there is no hurry for it at the moment.

(End of Interview)

23

4. Future prospects: Proposal to use UK’s example as a ready reference

From the earlier discussions, we can understand the need for IB in India.

Assuming that the Indian government would initiate actions towards the establishment

of IB in India, in the near future, I further my research on to the area of prospective

implementation of IB in India. We have already dealt with the regulatory issues faced

by India. Now that we have understood the problems, lets move on to possible

solutions. One solution is to emulate the efforts of the U.K government. Why U.K?

The subsequent discussions will be an effort towards driving the above point.

The obvious way to go about the implementation is by bringing alternative

regulatory measures which would support the principles of IB. Indian authorities can

start the phase of change from scratch, by studying those regulations which hinder the

process and then by applying the changes. The suggested path would be to use the

efforts of a country, which has already established IB, as a point of reference. This

could fasten the process of implementation and the concerned authorities could get

expert help from the proposed country.

The selection of a reference country is based on the below factors:

Demographics - by religion/ diversity and

Density of Islamic banking activity – indicated by asset size

Non-Islamic country – Where, Muslims form a minority

The above factors were considered by keeping in mind the Indian Diaspora.

Diversity is a main factor, as no other country is as unique and diverse like India.

Even if you travel 1000 miles from any point, the culture, heritage, language, lifestyle

etc. changes drastically. That is how diverse India is. So, when the government

comes up with a new regulation, it will consider all the communities. So, we have to

select a country which is similar to the India, in terms of the above factors, to some

acceptable extent. The list of countries used as sample is given below:

24

It is assumed that a better ‘asset size’ necessarily would indicate the level of

expertise and banking activities of the particular country. Currently, there are 292

banks, both fully Islamic and those offering Islamic windows or selling Islamic

products, there are 115 Islamic investment banks and finance companies, 118

insurance companies, adding up to a total of 525 institutions.12

Even though, Malaysia has a majority Muslim population, it could have been

considered for reference, given its history and dominating position in Islamic banking

activities in Asia. But, Malaysia is plagued with its own set of Shariah issues. Some

of its Shariah views are not accepted by the Middle-east. Since, one of the goals for

India should also be to attract the middle-east investments, it would be better to

follow UK as UK has modelled, in one way or the other, its Islamic banking activities

with an eye to attract the middle-east investments, apart from catering to its minority

Muslim population. For example, the U.A.E is a hugely important market for the UK.

At the end of last year, the UK and the UAE governments made a commitment to

increase bilateral trade to 12 billion pounds by 2015, a 60 percent increase from

current levels.13

25

Map: Islamic assets; Source: The Banker

From the above map, which shows the distribution of Islamic assets at a global

scale, we can see that the asset-size is more concentrated in the middle-east and

Malaysia, followed by U.K and the rest of the world. The Middle-eastern region has

to be excluded from our sample list of reference countries as the majority of the

population is represented by Muslims. We need to pick a country where the majority

is not Muslims, as that would reflect with the structure of India, where the majority of

the population is represented by the Hindus. The rest of the world other than U.K does

not have enough significant Islamic banking activities, which is represented by the

regions shown in green. Since, one criterion of selection is the density of banking

activity; U.K turns out to be the most obvious choice for reference. It is assumed that

more the banking activity and asset-size, the region’s density of Islamic activity is

also noticeable enough and hence, more expertise in conducting the banking business.

26

The table below shows the distribution of the population of UK by religion.

The majority is represented by Christians followed by Muslims and the rest.

Source: Office for National Statistics, UK14

The table below shows the distribution of the population of India by religion. The

majority is represented by Hindus followed by Muslims and the rest.

Source: The Government of India census, 2001. 15

27

From the two tables mentioned, it can be inferred that the UK and Indian

diasporas are similar, except that the majority is Christians in the UK whereas it is the

Hindus in India. As the objective is to also consider a Non-Islamic country, UK fits

the bill perfectly based on the above statistics. Moreover, since the Indian regulatory

framework is loosely based on that of the UK's, UK’s efforts could be easily used as

reference by India. Though, UK is not as diverse as India, it still could be considered

based on the strength of the rest of the two factors.

4.1. Development of IFI in UK

In general, bankers in non-traditional markets such as the UK tend to side with

the GCC model, simply because this is where the greatest liquidity resides. In fact, the

UK has to date introduced more enabling legislation to facilitate access for UK

Muslims and others interested in Islamic ethical finance with products consistent with

Islamic principles than most of the Islamic Development Bank (IDB) member

countries. The Bank of England first identified the sector’s potential in the UK in

2000 and, since then, the Financial Services Authority and the Treasury have

introduced a steady flow of legislative changes to minimise any legislative barriers

preventing the development of Islamic finance in the UK. UK Trade and Investment

has also played a role championing the UK’s success.16

Most of the growth of Islamic finance in the UK has taken place in the last

five years, but the existence of Shariah-compliant transactions in the London financial

markets goes back to the 1980s. Commodity Murabaha type transactions through the

London Metal Exchange were used, in significant volumes, to give liquidity to

Middle Eastern institutions and other investors that fostered the development of a

wholesale market in the UK. This did not, however, cater for retail Muslim

consumers, as the products developed at the time were aimed exclusively at wholesale

and high-net-worth investors. These products were relatively uncomplicated in

structure and fell outside the scope of the regulators.17

Retail Islamic products first appeared in the UK in 1990s but only on a very

limited scale. A few banks from the Middle East and South East Asia began to offer

simple products such as home finance. However, these compared unfavourably with

their conventional equivalents in several respects, including their generally

28

uncompetitive pricing. Most of these products did not fall within the regulatory

framework, so consumers did not have the same protection as other consumers, for

example, the availability of the Financial Ombudsman Service and the possibility of

redress from the Financial Services Compensation Scheme. The growth of the retail

market remained slow throughout the 1990s and early 2000s. But, thanks to the

reforms, UK hosts the only standalone Islamic financial institutions in EU and has the

highest value of Shariah compliant assets of any non-Muslim country.16

4.2. IFIs in UK

Ian Pearson, Economic secretary to the Treasury, wrote: “Looking to the

future, the Government’s approach to Islamic finance will continue to be

characterised by three principles. First, we will be fair. We will not champion Islamic

finance over conventional finance, but will instead strive to create a level playing field

between Islamic and conventional finance. Second, we will be collaborative. Progress

can be delivered most effectively when it involves industry, community groups and

the Authorities working together to achieve shared objectives. Finally, we will be

committed. Where there is a clear role for Government to play, we will continue to do

so.”

According to a report produced by International Financial Services London

(IFSL), at the beginning of 2008 the UK hosted:

five stand-alone Islamic retail and wholesale banks, over twenty conventional

banks with Islamic windows, and one stand-alone Shariah compliant

insurance provider;

at least nine fund managers providing opportunities for investment in Shariah

compliant funds and one Shariah compliant hedge fund manager;

a number of advisory firms (law, accountancy, consultancy, etc) with

considerable experience and expertise in dealing with Islamic finance;

the exchange upon which almost half of all global Sukuk by value are listed;

and

a succession of partnerships offering qualifications in Islamic finance.

29

It is important to note that the legislation uses the term Alternative finance

arrangements rather than specifically referring to Islamic finance, for example

alternative finance investment bonds rather than Sukuk. This means that changes are

not exclusively for Islamic arrangements.18

4.3. Explaining the UK’s success

4.3.1. The role of the UK authorities

Against the backdrop of the global drivers of Islamic finance, the Government, the

FSA and the Bank of England have actively supported the development of Islamic

finance in the UK over the past decade, which are summarized as follows:

In 2000, the Bank of England recognised the potential for retail and wholesale

Islamic finance in the UK and, together with HM Treasury, established a

working group to investigate the obstacles facing the industry. This led to the

first of many legislative measures introduced by HM Treasury to enable the

development of Islamic finance in the UK;

Since 2003, HM Treasury, HM Revenue & Customs and the FSA have

introduced several changes to the tax and regulatory systems in order to enable

UK companies to offer a range of Islamic financial products including Child

Trust Funds, asset finance, mortgages and Individual Savings Accounts

(ISAs);

Since 2004, the Financial Services Authority (FSA) has authorised a number

of Islamic financial firms, which are currently the only standalone Islamic

financial institutions in the European Union. This has been achieved by

applying exactly the same authorisation criteria to both Islamic and

conventional financial institutions, working towards a level regulatory playing

field;

30

In early 2007, UK Trade & Investment (UKTI), through their Financial

Services Advisory Board, agreed to set up a separate sub group to produce a

strategy for the promotion of the UK as a centre of excellence and global

partner for the provision of Islamic financial services. The sub group consisted

of 15 practitioners and representatives from UKTI and HM Treasury. Four

private sector working groups were set up to feed into the sub group on

Banking & Insurance, Legal, Accountancy and Education, Training and

Qualifications (ETQ). The internal strategy was agreed in late 2007 and the

group and its sub groups continue to meet on a six monthly basis to gauge

both the implementation of the strategy and market changes; and

In April 2007, HM Treasury hosted an Islamic finance summit at Number 11

Downing Street, on the back of which an Islamic Finance Experts’ Group

(IFEG) was established. The group consists of a number of UK and

internationally based experts from financial, legal and advisory firms as well

as Government and Muslim community groups. The IFEG has met a number

of times, providing advice to the Government on how to best support the

development of Islamic finance in the UK.

The UK’s current success as a centre for Islamic finance has required a concerted

and coordinated effort between the Authorities, industry and the associated third

parties to address the main barriers to development. These barriers can be grouped

under the following themes:

Taxation and regulation;

Standardisation;

Awareness; and

Skills.

31

4.3.2. Taxation:

The first tax legislation catering specifically for Islamic finance arrangements

came in Finance Act 2003, in the area of stamp duty land tax (SDLT). It catered for

individuals using alternative property financing arrangements (covering Islamic

mortgages), removing the double charge to SDLT that might otherwise arise where a

financial institution buys a property and then re-sells it to the individual. The SDLT

provisions were extended in 2005 to equity sharing arrangements, and in 2006 to

companies.

4.3.2.1. Borrowing arrangements

Finance Acts 2005 and 2006 saw the introduction of two types of borrowing

concepts. In 2005, Government legislated for Murabaha, referred to in the legislation

as purchase and resale arrangements. In this type of arrangement, where the return

equates in substance to the return on an investment of money at interest, it will be

taxed as if it were a loan.

The second type of borrowing catered for in 2006 was diminishing

Musharakah, or diminishing shared ownership, a form of property or other asset

financing under which the borrower progressively acquires the lender’s share in the

asset, at the same time paying a rent or financing charge for the share of the assets the

lender retains. This type of contract can be used in Home Purchase Plans

4.3.2.2. Deposit arrangements

Finance Act 2005 introduced the deposit arrangement that is recognised for

regulatory purposes, which is based on Mudarabah. This is referred to as a profit

share return. For the investor, the return is taxed as if it were interest and the

legislation switches off the tax rules that might otherwise treat it as a distribution, so

the deposit-taker receives a deduction for the payment. In Finance Act 2006, Wakala,

or profit share agency, was introduced where the investor appoints an agent to manage

a sum of money being invested, receiving a return out of the investment proceeds that

equates in substance to an interest-like return.

32

4.3.2.3 Investment bonds

The provisions in Finance Act 2007 looked to help facilitate Sukuk issuance in

the UK. For this type of transaction, known as alternative finance investment bonds,

legislation seeks to apply the same tax treatment that would be applicable were the

alternative finance investment bonds to be a debt instrument. This was seen by

industry as an important first step in facilitating Sukuk issuance. However, it was

recognised that, while these rules would help, technical issues still remained from the

issuer’s perspective. These have been addressed in Finance Act 2008 with regards to

SDLT and stamp duty reserve tax and with further changes to be addressed through

Finance Bill 2009 for SDLT on alternative finance investment bond transactions.

The Government has also looked to act following discussions with industry in

other areas such as Community Investment Tax Relief (CITR), where the principles

of Islamic finance were seen to fit well with the CITR scheme, but required

amendments to allow for money received or onward-investment through alternative

finance to be included within the scheme.

Finally, following consultation with organisations such as the Muslim Council

of Britain, Child Trust Fund rules have been specifically designed to allow the

provision of accounts that are compliant with Shariah law.

4.3.3 Standardisation

The lack of commonly accepted standards for products and practices in any

industry can be a barrier to development. This is because it is likely to increase costs,

thereby reducing competitiveness relative to substitutes. This has been particularly

true for Islamic finance, where the sector has had to address the standardisation

challenges that face all rapidly evolving industries, while also taking into account the

dynamic nature of Shariah interpretation.

The UK government did not intend to adopt a state-led approach, unlike countries

like Malaysia which has its own national Shariah board, to improve standardisation in

Islamic finance. The Government believes that such an approach would be

inappropriate in the UK for the following reasons:

33

the UK Authorities are secular bodies, not religious regulators;

it could fragment the industry along regional lines where different jurisdictions

prescribe different systems; and

it could stifle industry innovation and development by adopting a rigid

approach to standardisation.

The UK Authorities maintain close links with all the international standard setting

bodies. The FSA meets with these bodies bilaterally, attends their conferences and

also reviews their material. In the retail market, there is a smaller range of available

products, which are generally less complex than wholesale market products. Many of

the preferred forms of documentation have been prepared by individual banks

themselves, which is an expensive process, thereby increasing the costs to that firm of

bringing a product to market.

4.3.4 Awareness

The UK Authorities have adopted the following approach to raising levels of

awareness about Islamic finance:

raising overall levels of financial capability and inclusion, in which the

availability of a Shariah compliant alternative provides an additional choice

for consumers;

regulating Islamic finance to the same high standards as conventional finance,

so consumers can be confident that they are protected by the same safeguards

as they would be with conventional finance; and

taking action to ensure that the Islamic finance consumers are provided the

same level of advice and transparency as would be afforded to conventional

finance consumers, so they can make well-informed purchases.

4.3.5 Skills

The UK is already leading Europe in the development of Islamic finance training

courses. These range from introductory and entry level courses, to postgraduate level

study and continuing professional development programmes. As such, providers

range from specialist companies and community institutions to top universities.

34

5. Conclusion

The history of IFIs in India shows that India has had its own experiences with

Shariah based banking in one form or the other, right from the period of the Mughal

rule. In a way, the Indian Muslims have experienced IB right from an early stage

when compared to the UK. But, UK has taken the lead in establishing IFIs at a

sturdier pace due to the business opportunities presented by the liquidity problem of

the oil-rich middle-eastern countries and also to cater to its more than 2 million strong

Muslim population. India can launch a project to study the efforts of the UK and try to

form a basic framework to execute the changes in the Indian economic system. UK’s

approach of using alternative names other than the conventional Islamic names for the

process and the products is worth pointing out and India could use this as one of its

agenda for implementing IFIs.

Public perception and awareness can be cited as the main reasons for the

failure of most IFIs in India.2 In a society like India, with diverse religions, cultures

and economic practices, survival and growth very much depends on the perception

and readiness of the population to understand that IFI is for the benefit for the entire

nation and not only for Muslims. Unless Muslims themselves steadfastly adhere to the

values of interest-free PLS finance, they cannot influence and convince non-Muslims,

nor create a lobby so essential to influence decision making, to get necessary support

to establish and manage IFIs in India. The formation of a powerful lobby is essential

in a country like India, an example or two can be taken from the Jewish lobby in the

United states which is formed by a group a wealthy and influential Israelis with

interests in presidential campaigns, educational fields, media etc. The aim of the

lobby should be the upliftment of the economically downtrodden Muslims and to

influence the establishment of policies and regulations to support the creation of IFIs.

Finally, I wish to end this paper with a reminder to the Muslims in India to

educate themselves more on Islamic financial principles and to help realize the non-

Muslims that Islamic financial principles are necessarily for the entire human kind

and are not the domain of any one society.

Bibliography

35

1. Social, Economic and Educational Status of the Muslim Community of India – Prime Minister’s high level committee – November 2006; pg. 133, 1692. Islamic Financial Institution of India: Progress, Problems and Prospects; Bagsiraj3. A proposed introduction of Islamic banks in India – Omar Khan4. http://www.migrationinformation.org/Feature/display.cfm?ID=5775. http://www.hindu.com/2008/08/19/stories/2008081954710500.htm6. Mapping the Global Muslim Population: A Report on the Size and Distribution of the World’s Muslim Population, Pew Research Center7. http://www.rbi.org.in/8. Islamic banking in India – M Y Khan International Journal of Islamic Financial Services Vol. 5 No.49. Obstacles of Islamic banking in India, Abdul Azim Islahi Islamic Economics Research Center, KAU, Jeddah, KSA [http://mpra.ub.uni-muenchen.de/18540/1/MPRA_paper_18540.pdf]

10. Islamic Non-Banking Financial Institutions in India: Special Focus on Regulation; Dr. Shariq Nisar and Mohsin Aziz - 2004

11. http://www.merinews.com/ 12. Top 500 Financial Islamic Institutions - The Banker - November 2007 13. http://www.english.globalarabnetwork.com/201003105125/Economics /lord-davies-uk-and-the-middle-east-remain-great-trading-partners.html 14. http://www.statistics.gov.uk/cci/nugget.asp?id=954 15. http://censusindia.gov.in/Census_Data_2001/India_at_glance/religion.aspx 16. The development of Islamic Finance in the UK: the Government’s

perspective – HM Treasury – December 2008 17. Islamic finance in UK: Financial Services Authority (FSA), UK – 2007 18. Growth and diversification in Islamic finance: KPMG Report – 2007

36