1. 1 |
INTRODUCTION
Islamic banking, popularly referred to as interest-free banking, has been gaining
increasing popularity among the regulators in the recent past. The entire banking
system in many countries has been undergoing the transition from conventional mode
of banking to the new concept of interest-free banking. However the transition phase
has not been smooth for many of them as it called for the entire revamping of
existing regulations in the banking system.
Islamic banking or Islamic finance is a financing activity that complies with sharia
(Islamic law) and its practical application through the development of Islamic
economics. Some of the modes of Islamic banking / finance include Mudarabah
(Profit and loss sharing), Wadiah (safekeeping), Musharaka (joint venture),
Murabahah (cost plus), and Ijar (leasing).
Sharia prohibits Riba, defined as interest paid on all loans of money. Islamic banks
offer their services without levying or paying interest to its customers. The absence
of Riba is a unique distinguished feature of Islamic Banks. The emergence of
interest-free Islamic banking has been viewed as a financial innovation.
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Islamic banks have been successful in providing effective financial intermediation for
the last 4 decades. The influx of “petro-dollars” following the Yom-Kippur war and
1973 oil crisis encouraged the development of Islamic banking and since 1975 it has
spread globally. Though Islamic banking has grown faster at the rate of 17.6%
between 2009 and 2013, faster than conventional banking the industry is still short of
innovative Sharia compliant financial products to compete with their conventional
counterparts.
Egypt took the credit of being the first country to experiment this new form of
banking followed by Iran. The central feature of Islamic banking is that no interest
would be charged or paid and the returns would be in the form of profits from trade
in which the money lent or borrowed is invested.
3. 3 |
Though all interest-free banks operate on same basic principles called Shariah
principles, individual banks differ in their application. The attributable factors giving
rise to these differences are laws of the country in which they operate, their objectives
individual banks, circumstances and experiences, the need to interact with other
interest-based bank etc.
In INDIA RESERVE BANK OF INDIA (RBI) had proposed the opening
of “Islamic Window” in conventional banks for a gradual introduction of
Sharia-compliant interest-free banking.
On instruction of the central government, an Inter-Departmental Group
(IDG) setup in RBI has examined the legal, technical and regulatory
issues for introducing interest-free banking in INDIA and has submitted
its report to Government.
4. 4 |
ABOUT THE REPORT
Title of the report:
The present study is titled as “A PROJECT REPORT ON ISLAMIC BANKING”
Objectives of the study:
The following are the objectives of the present study:
To understand the meaning and importance of Islamic banking.
To study about the different products offered by Islamic banks.
To study about Need and importance of Islamic banking in India and
challenges faced by the same
Data and Methodology:
For the purpose of the study secondary data was used. The secondary data
was collected from books magazines and news reports.
Limitations of the study:
Since there is no presence of Islamic Banks in INDIA and so the study has been
made with reference to banks that are present in Western and Middle-Eastern
countries.
6. 6 |
THEORETICAL VIEW
The term Islamic banking refers to a system of banking or banking activity that is
consistent with Islamic law (Shariah) principles and guided by Islamic economics.
The contemporary movement of Islamic finance is based on the belief that “all forms
of interest are riba and hence prohibited”. In addition Islamic law prohibits investing
that are considered unlawful, or haram (such as businesses that sell alcohol or pork, or
businesses that produce media such as gossip columns that are contrary to Islamic
values). Furthermore Shariah prohibits what is called “Maysir” (gambling) and
“Gharar” (speculative transactions). Therefore the use of all conventional derivative
instruments is impossible in Islamic banking.
Islamic banking has the same purpose as conventional banking: to make money for
the banking institute by lending out capital while adhering to Islamic law. Because
Islam forbids simply lending out money at interest, Islamic rules on transactions
(known as Fiqh al-Muamalat) have been created to prevent it. The basic principle of
Islamic banking is based on risk-sharing which is component of trade rather than risk-
transfer which is seen in conventional banking.
Though Islamic law prohibits interest but prohibition on interest does not mean
costless capital in an Islamic system. The main idea is that there should not be any
predetermined benefit attached to the capital. The interesting fact is that Islam permits
profit-sharing. Though profit-sharing ratio is predetermined, the rate of return is not
predetermined.
A positive argument in favor of Islamic banking is that profit-sharing can help in
efficient allocation of resources as the profit-sharing ratio is influenced by market
7. 7 |
forces so that capital flow would be directed to those sectors that offer the highest
profit-sharing ratio to the investors.
HISTORYAND GROWTHOF ISLAMIC BANKING
Although Islamic Banking can be traced back to 8th Century in Muslim countries,
modern Islamic banking Myt Ghamar started in Egypt in 1963 by Ahmed EL Najjar
to appeal to people who lacked confidence in state run banks. Also in that year the
Pilgrims Savings Corporation was founded in Malaysia (although not a bank, it
incorporated basic Islamic banking concepts).
The influx of “petro dollars” following the Yom-Kippur war and 1973 oil crisis
encouraged the development of the Islamic Banking Sector and since 1975 it has
spread globally.
8. 8 |
In order to promote this new form of banking, Islamic Development Bank (IDB)
was set up in 1975 by the Organization of Islamic countries (OIC) at Jeddah, Saudi
Arabia with the primary objective of providing funds for development projects in
member countries. The IDB provides fee-based financial services and profit sharing
financial assistance to member countries.
As of 2010, Islamic financial institutions operate in 105 countries.
Statistics on Islamic banking differ, but according to World Economic
Forum report these are the Top 9 countries for Islamic Finance:
9. 9 |
GLOBAL SHARE OF ISLAMIC FINANCE
BANKING ASSET 2015:
According to the 2013–14 World Islamic Banking Competitiveness Report,
Qatar, Indonesia, Saudi Arabia, Malaysia, United Arab Emirates and Turkey
represented 78% of the international Islamic banking assets (excluding Iran) in
2012, and along with Bahrain are "the driving factors behind the next big wave
in Islamic finance".
1.20%
1.70%
3.80%
5.80%
7.70%
10.50%
14.60%
16.70%
31.70%
PAKISTAN
BAHRAIN
INDONESIA
TURKEY
QATAR
KUWAIT
UAE
MALAYSIA
SAUDI
ARABIA
CHART 2.1
10. 10 |
OPERATIONS OF ISLAMIC BANKS
Contemporary Islamic banks have been founded on the banking model that existed in
Europe and North America, with regard to their main layout, departmental structure
and their basic functions of mobilizing financial resources and using them to finance
those who are in need for investible funds. Obviously the difference lies in area of
modes of financing that are, in the case of Islamic banks, derived from the Islamic
system and structured within the Islamic legal framework.
(I) FUND MOBILIZATION:
Resources are mobilized from shareholders and savers. Shareholders own the banks
net equities while savers participate in the ownership of the banks investment. In other
words, savings are mobilized on the basis of sharing rather than interest lending. In
Islamic banks, depositors are in a sense a special category of shareholders. They do
not share the private equity of the bank such as its building and equipment, but they
do share “as owners of funds” in the profit sharing investment operations of the bank.
In Islamic banks, deposit agreement is a contract to provide funds that will be
managed by the bank, on behalf of the owner, as an appointed agent. Consequently
deposit contracts in Islamic banks are not lending contracts. They are more of agency
or deputation contracts in which depositors authorize the bank to invest their funds
and share the return with them. In case of loss, the financial burden falls on funds
owner and bank would have lost its efforts (management expenses).
Additionally, as in traditional banks, Islamic banks maintain current accounts for their
customers. These offer the services of checking, ATM and electronic access to
banking services. Deposits in current accounts are guaranteed by the Islamic banks
11. 11 |
and they are based on an interest-free lending.
Hence Islamic bank has usually two broad categories of deposits:
1) INVESTMENT DEPOSITS:
Investment deposits are those deposits in which the share in the return of investment
is proportion to the amount of deposits and on the basis of distributing the net return
on a contracted ratio. Islamic banks, usually differentiate between long and short run
investment deposits through this profit sharing ratio by offering higher ratio to
deposits committed for longer periods.
These deposits are not in fact liabilities on the Islamic banks they are rather
investment with it.
2) DEMAND DEPOSITS:
Demand deposits are those deposits which are guaranteed and represent liabilities and
they do not earn any return.
TYPES OF
DEPOSITS
INVESTMENT
DEPOSITS
DEMAND
DEPOSITS
FIG 2.1
12. 12 |
(II) FUND UTILIZATION:
Islamic banks use available funds by means of three major categories of financing
models: sharing model, sales model and leasing model. None of them has interest
component.
(1) SHARING MODEL:
The principle is simple as much as it is natural. The Islamic banks provide financing
to projects on the expectation of a share in return. Obviously, if a project losses, all
capital providers and financing contributors lose together and proportionately. There
are two forms of applications of this principle full partnership and non-voting
partnership or financing.
FUND UTILIZATION
SHARING
MODEL
SALES
MODEL
LEASING
MODEL
FIG 2.2
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In full partnership, the bank would be represented on the board of executive directors
and would share in formulating policies and managerial decisions, while in non-
voting financing, Islamic banks fully entrust managerial decision- making to the users
of funds.
Both groups of sharing models may be formulated so as to share net income. They
may also be permanent, declining or timed; that is ending at a certain future point of
time.
(2) SALES MODEL:
Under this model the bank would be asked to buy goods and give them to users
(producers as well as consumers) against future repayment. Sale model may take
several forms. The simplest of them is derived from regular sale contract where the
bank sells real goods, equipment and machinery to their users at an agreed upon
marked-up price.
3) LEASE MODEL:
As practiced in leasing companies and recently in many traditional banks, leasing
modes can have a variety of forms with fixed or variables rents, declining or fixed
ownership, operational or financial, along with different conditions regarding the
status of leased assets at the end of the lease period.
14. 14 |
ISLAMIC BANKING V/S CONVENTIONAL BANKING
Islamic banking practices differs from the conventional banking in following ways:
1) The main function of Islamic bank is investment financing.
2) No fixed interest bearing deposits are available with Islamic banks.
3) Islamic banks do not grant any overdrafts on current accounts.
4) They are permitted to purchase stock on behalf of client and sell it to him at a profit
over the purchase price.
5) Islamic banks would pay an annual wealth tax known as Zakat at some percentage
of current assets and other modes of income as determined by Shariah Supervisory
Board.
However, in practice many Islamic banks have customized their operations to certain
extent to serve their customers as they are finding it difficult to comply with all the
Shariah principles at a time.
FIG 2.3
15. 15 |
ISLAMIC BANKS AND BANKING COMMUNITY
Today Islamic banks are present in more than 105 countries, operating within their
banking community, under the supervision and control of their respective central
banks. Some countries have only one Islamic bank which is, of course, a disadvantage
because it deprives the prospective clientele from the benefits of competition.
However, there are several countries such as Qatar, Bahrain, Bangladesh and others
that have more than one Islamic bank. In most Middle-Eastern countries, Islamic
banks work side by side with traditional banks and there are many inter-banking and
business relations between both categories. Few countries have also switched to an
Islamic banking system.
In addition many traditional banks have entered this new field of Islamic finance in
several Middle-Eastern countries, very often through establishing Islamic transactions
window, whereby a bank would establish a financially autonomous internal unit that
receives investment deposits on the basis of profit sharing and offer financing to
businesses community by means of Islamic modes of financing. Some banks have
even transformed some of their branches to Islamic banking units. Very recently Citi
Bank formed a fully-fledged corporation for Islamic banking activities under the
name of the Citi Islamic Bank of Bahrain, and it has started operations in that country.
16. 16 |
Although the nature of Islamic banking transactions requires special attention from
central banks and monetary authorities, the relationships between them have gone
reasonably smooth, effective and constructive.
Moreover, many non-Muslim countries have Islamic banking in form or another that
work in coherence and cooperation with existing banking community. Those banks
do not only serve Muslims in those countries, but they are also open to the public for
deposits and financing. Islamic banks operate in some Western countries off-shore as
well as on-shore.
As described earlier, Islamic banking’s operations have their own characteristics both
on the financing and the resource mobilization sides. Their application does not
require bankers or customers to have a particular religion, ethnicity or language. Their
sucess or failure depends only on managerial ability to provide competitive services.
17. 17 |
Products offered by
Islamic Banks
Mudarabaha
(Profit-Loss sharing)
Murabahah
(Sale of goods)
Musawamah
(Bargaining)
Bai salam
Haibah
(Gift)
19. 19 |
Mudarabaha (Profit-loss sharing model)
The Mudarabah (Profit Sharing) is a contract, with one party providing 100 percent of
the capital and the other party providing its specialized knowledge to invest the
capital and manage the investment project. Profits generated are shared between the
parties according to a pre-agreed ratio. If there is a loss, the first partner will lose his
capital, and the other party will lose the time and effort invested in the project The
profit is usually shared 50%-50% or 60%-40% for.
One important feature of Mudarabaha is that the entrepreneur need not provide
security for the financing he receives. The project itself is the security, and the bank
being an equal partner in the enterprise, is its guardian. This should play a very
constructive role in discovering and developing new entrepreneurial and other talents
in the society, especially at the micro level, otherwise unearthed on account of the
unavailability of the collateral/security.
The function of bank in Mudarabaha is very important. It is responsible for
identifying good projects for financing as well as for monitoring their progress and
ensuring proper accounting and auditing. But bank plays no part in managing the
project or in making policy decisions-that is the exclusive domain of the entrepreneur.
Bank being equal partner in project has full legal right to the physical and financial
assets of all the projects and has full access to all the books. This is very important as
it allows the bank to have a true picture of the health of the projects at al times. He
can then take any preventive or corrective action (in extreme cases) and in the event
of the failure of the project it can recover whatever is left of it. This possibility gives
assurance to depositors that their money is safe with banks and the profit and loss
account given to them is reliable and transparent.
20. 20 |
Issues in Implementation:
Firstly the implementation of this system requires the cultivation of new attitudes on
the part of all the participants. From the investor it requires the full understanding that
it may incur loss and that it will wait longer to get results, but it promises a truly a
riba-free income and possibly better profits. From the entrepreneur it requires
complete and accurate book keeping and full disclosure of all his/her/its accounts and
the sharing of his bounty with his financiers, but it provides him with capital without
collateral and the guarantee that in case there is a loss he will not be required to make
it up, provided he had been honest in his dealings and his books will substantiate it.
Secondly banks must have an entrepreneur’s natural talent to spot profitable projects
and to avoid bad ones, and to develop it into a professional tool. The intermediary’s
staff will have to be carefully picked and trained to bring out inherent entrepreneurial
talent. Such intermediaries will have ample reward, as they will have share in the
profits. It requires a new culture, a culture of entrepreneur-financers and of
professionally run partnership companies.
Thirdly, the system is heavily dependent on proper and accurate book-keeping,
accounting and auditing. That requires the availability of trained bookkeepers and
their wide use, as well as professionally responsible and well trained accountants and
auditors. They are the bedrocks of this system. The system requires a high level of
integrity from these personnel, and it is in the interest of all the participants in the
system to respect it. Substantial investment is necessary in the training of such
personnel, and legal protection is necessary to safeguard the independence of auditors.
21. 21 |
According to economist Tarik M. Yousef, long-term financing with Mudarabaha
(profit-and-loss-sharing mechanism) is "far riskier and costlier" than the long term
or medium-term lending of the conventional banks. As a consequence there has been
a "divergence" between the theory of equity-based Islamic finance and the reality of
Murabahaha-dominated practices of Islamic banking.
How does Mudarabaha works:
Share of profits
Capital Invest. Inputs Mgmt.
and Expertise.
expertis
Investors
(rabb-ul-maal)
Entrepreneur
(mudarib)
MUDARABA
3
1 2
FIG 3.2
22. 22 |
Murabahah (Sale of goods)
This concept refers to the sale of good(s) (such as real estate, commodities, or a
vehicle) where the purchase and selling price, other costs, and the profit margin are
clearly stated at the time of the sale agreement. With the rise of Islamic banking since
1975, Murabahah has become "the most prevalent" Islamic financing mechanism.
Murabahah works as finance when the borrower/buyer pays the bank/seller for the
good(s) over a period of time, compensating the bank/seller for the time value of its
money in the form of "profit" not interest. With a fixed rate of profit determined by
the profit margin for the purchase of a real asset, this is a fixed-income loan. The bank
is not compensated for the time value of money outside of the contracted term (i.e.,
the bank cannot charge additional profit on late payments); however, the asset
remains as a mortgage with the bank until the default is settled.
A proper Murabahah transaction differs from conventional interest-charging loans in
several ways. In a conventional sale transaction the buyer is not aware of thea actual
cost associated with the product. But in Murabahah, the cost is made known to the
buyer. Thus it adheres to the Shariah principles that there is no undue exploitation of
the buyer. This disclosure of the actual cost of the product being sold makes
Murabahah transaction different from conventional sale transaction. The buyer/
borrower pays the seller/lender at an agreed upon higher price, instead of interest
charges, but makes a religiously permissible "profit on the sale of goods". The seller/
financer must take actual possession of the good before selling it to the customer; and
must assume "any liability from delivering defective goods"
23. 23 |
The literal meaning of Murabaha is “sale”. There are several conditions which should
be complied with to make a sale acceptable under Shariah principles. Special rules
governing the sale of Murabahah and the correct procedure for using the Murabahah
as an acceptable mode of finance are discussed below.
Requirements of Sale:
In Shariah sale is defined as an exchange of a valuable thing for another valuable with
mutual consent. The rules regarding sale can be summarized as below:
1) Existence of the subject of sale is mandatory. If a non-existent thing is
contemplated for sale, then the sale is not valid according to Shariah.
2) The seller should possess the ownership of the product being sold at the time of the
sale (i.e) the seller cannot sell what he is going to acquire in future.
3) The product should be in the physical or constructive possession of the seller when
he sells it to another person.
4) In addition to the basic rules mentioned above, the sale must be instant and
absolute. The sale that is agreed to be effected on a future date is not valid under
Shariah principles.
5) The subject matter of sale should be measurable in monetary terms.
6) The subject matter of sale should be familiar to the buyer.
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7) The price at which the sale is effected should be certain. If there is uncertainty in
the price, the sale is void.
8) The sale should be unconditional. However if the conditions are recognized as part
of the transaction, then the sale is valid.
Steps involved in Murabahah:
Pitfalls to be avoided in the execution of a Murabahah:
1) Murabaha cannot be used for financing overhead expenses of a firm like payroll,
electricity bills, rental expenses, etc
2) Some clients misuse the instrument to acquire funds which are not subsequently
deployed in purchase of a commodity. They simply obtain funds for unspecified
Bank purchases goods
from seller and sells it to
buyer. (Cost + profit)
Seller sells the goods
to bank.
BUYER TAKES POSSESION
OF GOODS AND PAYS TO THE
BANK IN INSTALLMENTS
BANKING
MURABAHAH
FIG 3.3
25. 25 |
purpose. Such fictitious deals should be carefully detected by the deals should be
carefully detected by the banks before they sign a transaction.
3) International commodity transactions are used for managing liquidity. This also
gives rise to fictitious transactions where physical delivery of a commodity may
not take place. There are instances where all the real commodities are subject to
forward sales which are not permissible under Shariah.
4) Some financial institutions are observed to enter into Murabahah on commodities
already purchased by their clients from a third party. This is unwarranted under
Shariah. If a commodity is purchased by the bank from a client and sold back to
the same client, then it is a buy-back transaction and is not permitted under
Shariah.
Thus Murabahah is not a loan by itself and it is only a sale contract based on cost-
plus. While signing a Murabahah transaction, the sanctioning authority must ensure
that the client should really intend to purchase commodities and fictitious purchases
are avoided. Thus due diligence is required to be exercised by the sanctioning
authority before undertaking a Murabahah transaction.
26. 26 |
Musharakah (Joint venture)
Musharakah is a relationship between two parties or more that contribute capital to a
business and divide the net profit and loss pro rata. This is often used in investment
projects, letters of credit, and the purchase or real estate or property. In the case of
real estate or property, the bank assess an imputed rent and will share it as agreed in
advance. All providers of capital are entitled to participate in management, but not
necessarily required to do so. The profit is distributed among the partners in pre-
agreed ratios, while the loss is borne by each partner strictly in proportion to
respective capital contributions. This concept is distinct from fixed-income investing
(i.e. issuance of loans).
Types of Modern Musharakah:
1) Limited Company: Though this type is controlled by the statutory rules framed by
the Government, its activities are governed by the business practices.
2) Cooperative Societies: it is governed by the statutory rules and its commercial
activities are influenced by the practices prevailing in the business community.
Modern Musharakah
Limited Company Co-operative societies
FIG 3.4
27. 27 |
Management of Musharakah:
According to the principle of Musharakaha , every partner has a right to take part in
its management and to work in it. Different aspects of Musharakah business are:
1) Every partner is an agent for another. The condition of agency is automatically
presumed to be in existence in the contract.
2) Every partner enjoys equal rights in all aspects unless and until specified otherwise.
3) The contract is not invalid on grounds of non-participation in the Musharakah
business but on the ground that a share in the profit exists.
4) Every partner enjoys the right to participate actively in the affairs of the
Musharakah.
In case of limited companies and co-operative societies, the shareholders have the
right to delegate their powers and responsibilities, if they wish so. In the partnership
form, partners distribute the duties and responsibilities among themselves.
Distribution of Profit
Limited companies and co-operative societies distribute their profits according to the
capital of shareholders. Any active participation by a shareholder in Musharakah is
rewarded separately and such payment is treated as an expenditure of Musharakah.
28. 28 |
Liability of Loss
While profits are shared based on some agreed proportions, losses are shared in
proportion to the capital contributions. This is in conformity with the Islamic
principles that loss implies destruction of a portion of the capital and as it occurs, it is
a liability of the owner of capital
New developments in Musharakah:
“Diminishing Musharakah” is a new product that is developed in the recent past. In
this new form both the client and the financing bank participate in the joint ownership
of a property or an equipment or in a joint commercial enterprise. The share of the
financial institution is further divided into units and the client can purchase these units
later over a period of time thus increasing his own share till he purchases all the units.
Thus the client will become sole owner over a period of time. This is the principle of
diminishing Musharakah.
Musharakh form of financing is gaining increasing popularity with a wider spread of
the concept of Islamic Banking. Sufficient research is also being undertaken by many
scholars to bring in the newer developments in this mode of financing such as
diminishing Musharakah. Whichever method is adopted, the experts see to that
Shariah principles are not violated and there is no element of interest in form.
29. 29 |
Musawaha (Bargaining)
If the exact cost of the item(s) sold to the lender/buyer cannot be or are not
ascertained, a financial transaction cannot be done on the basis of Murabahah, it is
called Musawamah (bargaining). Musawamah is the negotiation of a selling price
between two parties without reference by the seller to either costs or asking price.
While the seller may or may not have full knowledge of the cost of the item being
negotiated, they are under no obligation to reveal these costs as part of the negotiation
process. This difference in obligation by the seller is the key distinction between
Murabahah and Musawamah with all other rules as described in Murabahah
remaining the same. Musawamah is the most common type of trading negotiation
seen in Islamic commerce.
Bai Salam
Bai salam means a contract in which advance payment is made for goods to be
delivered later on. The seller undertakes to supply some specific goods to the buyer at
a future date in exchange of an advance price fully paid at the time of contract. It is
necessary that the quality of the commodity intended to be purchased is fully
specified leaving no ambiguity leading to dispute. The objects of this sale are goods
and cannot be gold, silver, or currencies based on these metals. Barring this,
Bai Salam covers almost everything that is capable of being definitely described as to
quantity, quality, and workmanship.
Wakala financing
When an Islamic bank nominates the client as its agent for investing funds to earn
profits it is financing under Wakala.
30. 30 |
Hibah (Gift)
This is a token given voluntarily by a debtor in return for a loan. Hibah usually arises
when Islamic banks pay their customers a 'gift' on savings account balances,
representing a portion of the profit made lending funds from savings account
balances. Unlike interest and like dividends on shares of stock, Hibah cannot be
guaranteed. Additionally, it is not time bound.
Istisna (Manufacturing finance)
Istisna (Manufacturing Finance) is a process where payments are made in stages to
facilitate the work of manufacturing / processing / construction. An installment of
Istisna, for example, may enable a construction company to finance construction of
sections of a building or help manufacturers pay for an order of raw materials. Istisna
helps use of limited funds to develop higher value goods/assets in different stages /
contracts.
Ijarah (Lease)
Ijarah means lease, rent or wage. Generally, the Ijarah concept refers to selling the
benefit of use or service for a fixed price or wage. Under this concept, the Bank
makes available to the customer the use of service of assets / equipment such as plant,
office automation, motor vehicle for a fixed period and price.
Qard Al hassana (Loan contract)
A loan contract between two parties for social welfare or for short term bridging
finance. Repayment is for the same amount as the amount borrowed. The borrower
can pay more than the amount borrowed so long as it is not stated by contract.
31. 31 |
Sukuk (Islamic Bond)
A Sukuk is an Islamic financial certificate, similar to a bond in Western finance that
complies with Sharia - Islamic religious law. Since the traditional Western interest-
paying bond structure is not permissible, the issuer of a Sukuk sells an investor group
a certificate, and then uses the proceeds to purchase an asset, of which the investor
group has partial ownership. The issuer must also make a contractual promise to buy
back the bond at a future date at par value.
Takaful (Islamic insurance)
Takaful is a type of Islamic insurance, where members contribute money into a
pooling system in order to guarantee each other against loss or damage. Takaful-
branded insurance is based on Sharia, Islamic religious law, and explains how it is the
responsibility of individuals to cooperate and protect each other. Takaful insurance
companies were introduced as an alternative to commercial insurance companies,
which go against the Riba (interest), gambling and uncertainty principles, that are
outlawed in Sharia.
Wadiah (Safe-keeping)
In Wadiah, a bank is deemed as a keeper and trustee of funds. A person deposits funds
in the bank and the bank guarantees refund of the entire amount of the deposit, or any
part of the outstanding amount, when the depositor demands it. The depositor, at the
bank's discretion, may be rewarded with Hibah (gift) as a form of appreciation for the
use of funds by the bank.
32. 32 |
INTRODUCTION
Islamic banking is no longer a dream, rather it is a success story across the world,
including some non-Muslim majority countries like, USA, UK, Philippines,
Thailand, Hong Kong and Singapore. There are about 430 Islamic finance institutions
and 191 conventional institutions having Islamic banking and finance windows in 105
countries. Their total assets size is around $1.8 trillion (2013) while the potential size
is around $5 trillion.
Though Islamic banking is fastest growing concept across the world it has not caught
up in India. There are currently a handful of foreign banks operating in the country
which are offering Islamic banking products. These include Lloyds TSB, Citi bank,
Standard Chartered, HSBC and ABN AMRO, which are already operating interest-
free banking in several West Asian countries, Europe and US.
The resilience of the Islamic industry already seen in many parts of the world could
progress further with the distinctive advantages which India can offer. A population
of over 1.3 billion is massive market to tap. India has the capability to offer huge
manpower and natural resources. Moreover it is also one of the fastest growing
economies of the world which attracts investments in form of FDI and FII across the
globe.
The question on whether India should adopt Islamic banking or not is debated for a
long time. At this juncture Islamic banking in India is limited to the co-operative
sector scattered in various states across the country. In reality they are just Non-
Banking Financial Institutions (NBFC) which function on the basis of profit and loss.
They cater to the needs of their locality except for a few that operate across the
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districts or states. As their sources of funds are limited and their existence is small-
scaled they miss out any economies to scale.
NEED ADVANTAGES OF ISLAMIC BANKING IN INDIA
1) Islamic Banking can contributes towards India's economic growth and serves as a
mechanism to overcome the country's liquidity and inflation problem. India has
emerged as the fourth largest economy globally with a high growth rate but still the
per capita income of India stood at $1,527 in 2011, this is perhaps the most visible
challenge. Muslims avail just 4% and 0.48% credits from NABARD and SIDBI
respectively. Islamic banking can boost entrepreneurships in India through its
services of financing. Therefore there is desperate need Islamic banking, which can
be a solution for entrepreneurship development.
2) The Islamic banking system will ensure the participation of Indians living abroad
in the banking and financial systems. This will create an ethical finance-sharing
approach where the poor will benefit the most.
3) Setting up the non-interest based Islamic banking will attract investment from GCC
countries, Middle-Eastern investors, bankers and businessmen. Higher investment
will boost the Indian financial backbone and the infrastructure development of the
country.
4) Islamic banking provides opportunity to promote entrepreneurship by providing
finance on the basis of profit and loss and risk sharing.
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5) Islamic financial services can boost the Microfinance at low cost with its
customary tool based on Shariah.
6) Islamic Banking can work as a complementary to Conventional banking. During
recent (2012-13) financial crisis Islamic banks are less affected compare to
conventional banks.
7) Islamic Banking can contribute tremendously towards growth of agriculture and
unorganised sector and Small and Medium Scale Enterprises by providing interest-
free loans to farmers and workers.
8) Islamic bank will also create job opportunity for the student of Islamic finance
studies, as well as it can also create new field of studies and course for the
upcoming student with for those who want to make career in Islamic banking like
traditional conventional banking.
DE
NEED AND ADVANTAGES OF ISLAMIC BANKING IN INDIA
FINANCIAL INCLUSION
AND INCLUSIVE GROWTH
FLOW OF FUNDS FROM GULF
COUNTRIES AND ECONOMIC
GROWTH
GROWTH OF AGRICULTURE AND SME’s AND
UNORGANISED SECTOR
FIG 4.1
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GOVERNMENT INITIATIVES FOR
INTRODUCTION OF ISLAMIC BANKING IN INDIA
RBI WORKING GROUP:
In 2005, Government of India asked Reserve Bank of India to examine Islamic
banking instruments and constituted a Working Group headed by Mr. Anand Sinha,
Chief Manager, Department of Banking and Operation and Development along with
senior Bankers from SBI, ICICI and Oman International Bank that came up with its
report in 2006 which ruled out Islamic banking on the grounds that the current
regulations did not permit the new banking model. It laid down that firstly appropriate
modifications have to be made in Banking Regulation Act 1949 with separate rules
and regulations. Secondly tax laws have also needed to be looked into. Therefore
Islamic Banking was rejected as it was not feasible it under current banking Act.
NATIONAL WORKSHOP:
After the GOI announcement that Islamic banking is not feasible in India,
several interactive sessions were held by ICIF, one of them was a National
Workshop on “Road Map on Islamic banking” in Sept 2006, which was
participated by prominent National and International Islamic experts and
bankers.
It passed resolution that Islamic Banking is relevant in the 21st century and
India may implement the same by obtaining inputs from the global example in
UK, Malaysia and Singapore. It also chalked out a plan of action as well.
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CFSR-PLANNING COMMISSION REPORT (RAGHURAM RAJAN
COMMITTEE):
In August 2007, Govt. of India under the Planning Commission constituted a high
level Committee on Financial Sector reforms (CFSR) under the chairmanship of Dr.
Raghuram Rajan, former chief economist, IMF along with other eleven members who
are the finest financial and legal minds in the country.
CFSR submitted its final report in Sept. 2008 to Prime Minister with the specific
recommendation on interest free banking in the country. The Committee
recommended that measures should be taken to permit the delivery of interest free
finance on a large scale. NBFCs and cooperatives permitted interest free banking on a
limited scale in India. Interest free banking could lead to the objective of financial
inclusion and innovation and therefore appropriate measures were needed in order to
create a framework for financial products consistent with Shariah law.
INTRODUCTION OF “TAURAUS ETHICAL FUND” BY SEBI:
Participation in stock market was low due to absence of Shariah compliant
investments. In order to encourage active participation The Securities and Exchange
Board of India (SEBI) has given approval for India’s first official Shariah compliant
mutual fund scheme “Taurus ethical fund” in 2009.
KERALA AND ISLAMIC BANKING
Another significant development has taken place in the state of Kerala. Govt. of
Kerala under KSIDC (Kerala State Industrial Development Corporation) has taken a
courageous and commendable step to form an Islamic Investment company named Al
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Barakah Financial Services Company, an NBFC after an exhaustive feasible report
undertaken by a reputed international consulting firm Ernst & Young.
This NBFC will be turned into a global Islamic bank as soon as the Reserve Bank of
India (RBI) accommodates it after an amendment in the Banking regulations.
PROPOSAL TO OPEN “ISLAMIC WINDOW”
On the basis of the recommendation from different committees the Indian
Government undertaking and RBI sanctions the Shariah-compliant Islamic banking in
January 2016.
On 2-12-2016 The Reserve Bank of India (RBI) has proposed opening of “Islamic
window” in conventional banks for “gradual” introduction of Sharia-compliant or
interest-free banking in the country. Both the Government and RBI are exploring the
possibility of introduction of Islamic banking for long to ensure financial inclusion of
those sections of the society that remain excluded due to religious reasons.
So far as per a news report no deadline has been set by RBI for introduction of
Shariah or interest-free banking in India.
However, on the instruction of the Central government, an Inter-Departmental Group
(IDG) set up in RBI has examined the legal, technical and regulatory issues for
introducing interest-free banking in India and has submitted its report to the
government.
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CHALLENGES FOR ISLAMIC BANKING IN INDIA
After many discussions, debates, meeting, committees held to weigh the pros and
cons of Islamic Banking, it has not been implemented in India because of the
following barriers:
AMENDMENTS IN BANKING AND TAX LAWS:
Amendments in Banking Regulation Act 1949 are required in order to introduce the
system of Islamic Banking in India. As Islamic banking is based on the prohibition of
interest, the existing laws will have to be reconstructed or changed in order to allow
Islamic banks to operate in India and confirm with Shariah law. It was held that
Islamic banking was not feasible in India as the Banking regulation Act does not
permit Interest free banking. Further, concerns are raised as to whether banks will
raise a separate window for Islamic banks or whether Islamic banking activities would
be undertaken by a subsidiary. This also requires separate guidelines and regulations.
NO PRE-DETERMINED RETURN IN FORM OF INTEREST
Conventional banks raise the deposits only after a promising a pre –determined
rate of return on their deposits. However, returns under Islamic banking system
will be determined only afterwards which is unviable under current banking
system.
LACK OF EXPERTS
Lack of experts to develop a proper framework for Islamic banking in India
also poses a barrier.
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DIFFICULTIES TO COMPLY WITH SLR REQUIREMENT
Banks have to comply with the SLR requirements of RBI under which the
commercial have to keep their funds in liquid form. A large amount of funds are
locked up as cash, gold and government securities. Government securities are interest
bearing, gold is risky as price fluctuates and cash does not offer any return, making it
unacceptable under Shariah law.
MISCONCEPTION THAT ISLAMIC BANKING IS FOR PEOPLE FROM
PARTICULAR COMMUNITY
Another major hindrance for Islamic banking is the misconception that it is meant
only for one community or one religion. Islamic banking is an alternative to
conventional banking which is meant for people of all religions. Minorities who do
not depend on conventional banking as it does not confirm with Shariah law and
remain financially excluded will majorly benefit from it. However it is open for all
irrespective of their religion or caste.
Islamic banking has barriers in India but it can be addressed with some flexibility and
modifications in regulations which ultimately depend upon the political will. With
huge market in India, influence from Muslim community for Islamic banking and
recommendations by Raghuram Rajan Committee on banking sector reforms,
prospects seem better for Islamic banking in India. Many countries have adopted
Islamic banking which operates along with conventional banking. An analysis of this
mixed banking system in different countries can be made for addressing operational
issues in India.
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CONCLUSION
The adoption of Islamic banking by several Asian and Western countries such as
USA, UK, Hong Kong, Philippines and its contribution to their economic growth
clearly indicates that India too has the potential to become world leader in this
system.
After analyzing the need and advantages of Islamic banking in India it can be
concluded that there is a huge scope of Islamic banking and the future prospects of
Islamic banking is also good. It not only serves the needs and wants of one
community but that of the entire population of the country.
The Government of India and Reserve Bank have taken commendable steps to
introduce Islamic Banking in India. However there are several challenges that are
needed to be addressed for this, the main among them is to amend the Banking laws
in India and to allow a framework for Islamic banking.
Islamic banking should be advertised as an alternative system of banking which runs
on profit and loss sharing and not as an appeasement for any one particular
community. Some experts are of the opinion that these banks should be called
interest-free banks and not Islamic banks. “Indian media has been using the term
Islamic banking for interest-free banking. Interest-free banking should not be called as
Islamic banking. In words of Shafeeq Rahman, a doctorate in Islamic economic “We
should start interest-free banking and not Islamic banking so that all people can use
these services”.
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Bibliography and Webliography
BIBLIOGRAPHY:
1) V. Subbulaxmi, An Introduction to Islamic Banking (2004).
2) Riyazi Farook, The Way Forward To Islamic Banking In India (2007), Islamic
Finance news.
3) Pawandeep, Islamic Banking in India - A study of future potential (2008), CRISIL
Young Thought Leader.
4) Khurram Ajaz khan, Emerging Islamic Banking: Its Need and Scope in India
(2013), Pacific Business Review International.
5) Sartaj Mushtaq, Islamic Banking: Concept and Future Potential in India (2017),
International Journal of Emerging Trends in Science and Technology.
WEBLIOGRAPHY:
1) http://www.news18.com/news/business/islamic-banking-in-india-no-deadline-set-
yet-says-rbi-1370098.html
2) http://www.firstpost.com/world/islamic-banking-india-has-potential-to-become-
world-leader-in-this-system-3127630.html
3) https://indianmoney.com/how/how-do-islamic-banks-function
4) https://www.worldfinance.com/banking/the-rise-of-the-islamic-economy
5) https://www.weforum.org/agenda/2015/07/top-9-countries-islamic-finance/
6) http://www.thehindubusinessline.com/money-and-banking/rbi-opens-door-to
islamic-finance-proposes-interestfree-banking-/article9074824.ece?ref=relatedNews
