Islamic Banking and Finance: Role and Relevance in a Recessionist Economy (Part-1)

The growth of Islamic Banking and Finance as a new discipline, particularly in the context of the global economic recession that is in force today, has been, to say the least, quite remarkable. Not only has this been so at the national level, but at the international level too interest in, and practice of, this new emerging discipline have been steadily gaining ground, with premier academic institutions and universities taking up the subject as part of their curricula. A research group from the Indian Institute of Management, Bangalore, (IIMB) recently talked to BIJU ABDUL QADIR, Executive Editor of YOUNG MUSLIM DIGEST, on the implications of this growing interest in Islamic Banking and Finance for a recession-hit economy such as the one in place now. Presented hereunder is the text of that interview.

IIMB: The success of the early phases of Islamic banking has been attributed to religious faith. Given that 15% of Indian population is Muslim, shouldn’t Indian banks enter into the practice?

BAQ: The role of faith in any practice or mode of conduct based on the Islamic worldview – howsoever secular that practice may seem – is, indeed, undeniable. Of course, it is another matter altogether that Islam cannot be classified in the category of religion per se, simply because unlike the classic notion of what a religion should be, Islam’s is not merely a personal affair involving the believer and his, or her, God. This is inasmuch as Islam stresses on rules and regulations for the believer not just in his personal life, but even in his interaction with the world around him, starting from the other humans with whom he interacts and to the animal and plant life that directly, or indirectly, permeates his life. Thus, Islam’s policy of action, as also its prescription for human welfare, are both oriented holistically to embrace life in its totality, leaving little to human speculation or conjecture.

The domain of economic activity in human life is no exception to the welfare prescriptions of Islam. That the practicing Muslim believer co-opts for such economic remedies as given by Islam is but a matter of course. Islamic banking – or, more precisely, a system of banking that is based on the principles of Islamic Economics – as a feasible Islamic alternative in banking procedures is, today, a reality in many countries irrespective of whether these countries host a large or small Muslim population. As such, quite apart from the faith-factor involved, India too should be looking seriously into this rapidly growing sector for the benefit and long-term security that it will mean for even the non-Muslim majority in the country, let alone its Muslim populace that is, incidentally, the world’s second largest concentration of Muslims as minority in any single country. After all, the prescriptions of Islamic Finance – like other recommendations in Islam – are meant for all people, not just Muslims. India with a 13-15% Muslim population, the highest in a non-Islamic country, should have been in the forefront of Islamic banking initiatives, but it is yet to be permitted here. It will hugely benefit the Indian economy by attracting investments from the cash rich Middle Eastern economies on the lookout for new investment destinations. In fact, five Indian companies – Reliance Industries, Infosys Technologies, Wipro, Tata Motors and Satyam Computer Services – already figure in the Standard & Poor’s BRIC Shariah Index.

IIMB: Banks are highly regulated in India. Would they be allowed to practice Islamic Banking? How do you think this practice will emerge in India? Do you think the existing players will introduce or the new players will introduce and would that be the way forward?

BAQ: Back in 2005, the Reserve Bank of India (RBI) was asked by the Government to look into the feasibility of introducing Islamic Banking within the system of banking already existing in the country. Almost a year later, in 2006, the members of the committee submitted their recommendations, but the regulator, perhaps held back by obvious sensitivities, had not yet put the findings in the public domain. The report, when eventually published, pointed out how Indian banking laws come in the way of various Islamic banking principles. For instance, in the case of the saving bank account (or Al Wadiah, in the Islamic Banking lexicon), Section 21 of the Indian Banking Regulation Act requires payment of interest on such deposits. Thus, interest-free deposits and a simple charging of premium, or Hiba in Islamic parlance, is not permissible. The Mudarabah (for term deposit or investment) product in Islamic Banking also faces a similar hurdle. Here again, Section 21 of the Indian banking regulation Act disallows such products where the bank can invest the money in equity funds (in India, equity exposure is determined by a separate set of rules), and the client has complete freedom in the management. As can be seen here, in the straitjacketed world of Banking and Finance in India, Islamic Banking was still just a subject of simple academic interest a few years ago. However, the more recent and ongoing global economic crisis that has developed and imploded into the deepest recession in more than seventy years has had policy makers and financial experts everywhere – India included – thinking out solutions on their toes. It is in this context that Islamic Banking and Finance, with its enviable track-record of growth and security even in the face of the current meltdown, emerges as the sustainable alternative. The Islamic banking and financial system has largely been unaffected and has proved itself resilient because it is transparent, ethical and based on profit-loss sharing. Indeed, it is this urgent need to look into solutions to the financial crisis that is also effecting India that has now prompted none less than the Prime Minister, Dr. Manmohan Singh, himself to appoint recently the high profile Raghuram Rajan Committee on Financial Sector reforms in India to take yet another look into the possibility of Islamic Banking in India. The government commission’s findings and recommendations this time round was not only positive but also highly appreciative of the Islamic Banking venture. Finally recommending the introduction of interest-free finance, the Raghuram Commission advised the government to take measures for the delivery of the service on a large-scale, including through the banking system. This has been a sea-change in government outlook, thanks mainly to the economic crisis which has generated such intellectual ferment and soul-searching in the financial world. Recently, even a former Director of the Reserve Bank of India, Abdul Hasib, went on record with the following statement at a seminar on the Global Financial Crisis and Islamic Economic System organized by Jamaat-e-Islami Hind in Mumbai: “Unless there are amendments in the Banking Regulation Act of India, 1949, Islamic Banking system can be introduced in India.”

Despite all the regulatory hurdles to full implementation under the RBI, it is a measure of the robust confidence in Islamic Banking that the Kerala government has gone one step ahead and announced recently the formal launch of an Islamic Bank in the state. Back in September 2009, Kerala’s Finance Minister, Thomas Isaac, told the assembly that the Kerala government will set up an Islamic bank in the state. The share capital of the proposed bank has been fixed at Rs.1,000 crore, Isaac said, adding that an advisory committee would be set up shortly to work out the details. Involving non-resident Keralites and Kerala-based businessmen in the project, a core committee was set up and several meetings held following a feasibility study conducted by a consultant. The study has found that a bank under the Shariah rules of Islamic banking is feasible and viable here. The proposed financial body will not receive or pay interest and will have Shariah-compliant products. The profits made out of investments will be distributed among shareholders. A Shariah-board will decide on the type of investments in which the Bank will involve itself. If Balakrishnan, the then Principal Secretary to the Department of Industries in the state, is to be believed, the institution based on Islamic finance set to begin in Kerala will have branches all over the country and will gradually emerge as a Global Islamic Bank. While presenting the blueprint for Islamic finance institution in Kerala at a seminar, he also made it clear that the institution will be registered as a Non-Banking Financial Institution (NBFI) since the Reserve Bank of India is still to give the green signal for the operation of Islamic banks in the country. The institution will have a private management, but will be supported by the government.

[Ed: Since the time this interview was given, the progress of the proposed Islamic financial service was repeatedly obstructed by legal petitions filed against the project at the High Court. With these petitions now being turned down, and with a formal license recently issued for the project, the path lies open for the first Islamic financial service in the country which enjoys government support. The project is now put forward by the Cheraman Financial Services Ltd (CFSL) for the Kerala State Industries Corporation (KSIDC). A formal announcement on CFSL, the latest incarnation of Al Baraka Financial Services under which name the project was first drafted, was made for the purpose of officially registering RBI’s support for the project. Also see: http://themalaysianreserve.com/main/sectorial/islamic-finance/4384-licence-for-kerala-islamic-finance]

Muslims constitute the second largest community in Kerala, accounting for close to 24% of the 3.2-crore population. Kerala is also an interesting case study in how demographics, foreign exchange income, and literacy combine in making Islamic banking a real possibility in Indian conditions. According to a study done by the Centre for Development Studies, 48 percent of 18.5 lakh non-resident Keralites are Muslims. Furthermore, of the total remittances of Rs. 24, 525 crore (about $49 million) to the state in 2007, Muslims remitted Rs. 12, 158 crore (Rs. 24.3 million).

IIMB: Globally all the implementations has Shariah board regionally. How is it relevant in the Indian context?

BAQ: As the name itself suggests,Islamic Economics and Finance is based on the principles of the Shariah or the Islamic code of law. Granted this basic premise, Islamic Banks and financial institutions – quite irrespective of the region where they function – must necessarily adhere to the Shariah. Regional variations in the legal structure cannot influence Islamic banking if it is to remain just that – Islamic. As such, in the Indian context too, the Shariah-boards of Islamic finance institutions in the country must stick to the guidelines of the Islamic Shariah where they pertain to financial dealings. Anything less in conformity might end up as anything else, but certainly not Islamic banking. Look at the Islamic banking institution being mooted by the Kerala government itself: a Shariah-board consisting of an international panel of Islamic scholars and economists is already being proposed and is geared towards implementation for it now.

Realistically, however, the complexity of Islamic banking as compared to conventional banking is that products must comply not only with the secular laws of a country but also to the interpretations of the holy Qur’an by Islamic scholars. A central tenet of Shariah is the prohibition of Riba (interest). Moreover, Islamic law does not permit the use of funds in activities it deems impermissible (Haram), such as alcohol or gambling. However, Shariah interpretations can also vary by region and country due to different interpretations by different school of thoughts. The inclusion of Shariah-supervisory boards (or at a minimum, a Shariah-counselor) thus introduces a new body in the organizational structure of any bank endeavoring to offer Islamic banking. Their primary role is to assure the Islamic bank transactions are compliant with Shariah and they help as well in designing Shariah-compliant bank products and processes. Such expertise raises the attractiveness of Shariah-compliant financial (SCF) intermediaries to investors considering SCF. However, the Shariah is open to interpretation and Islamic scholars are not in complete accordance regarding what constitutes SCF. Islamic finance laws and regulatory practices vary across countries. The lack of concurrent viewpoints makes it difficult to standardize Islamic financing. Many observers view standardization of SCF regulations as important in increasing the marketability and acceptance of Islamic products.

Given the relevance of SCF to global economics today, international institutions have been established to promote international consistency in Islamic finance. For instance, the Islamic Financial Services Boards (IFSB), based in Malaysia, puts forth standards for supervision and regulation. As another example, the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), based in Manama, Bahrain, issues international standards on accounting, auditing, and corporate governance. Many leading Islamic financial centers around the world have adopted international SCF regulation standards. U.S. federal banking regulators have provided some formal guidance about Islamic products. The Office of the Comptroller of the Currency (OCC) issued two directives concerning Shariah-compliant mortgage products. In 1997, the OCC issued guidance about Ijara (‘lease’), a financial structure in which the financial intermediary purchases and subsequently leases an asset to a consumer for a fee. In 1999, the OCC recognized Murabaha (‘cost-plus’), under which the financial intermediary buys an asset for a customer with the understanding that the customer will buy the asset back for a higher fee.

IIMB: Banking and Technology go hand in hand. Given that conventional is highly automated now in Indian scenario, the new introduction of Islamic Banking would bring in other technological challenges. How are banks equipped to handle this? Do you foresee banks offering Islamic Products along with conventional products?

BAQ: Globally, Islamic finance is estimated to be worth about $300 billion, growing at 15-20% annually. With this growth, demand for banking products compliant with Islamic law, or Shariah, continues to grow throughout the world. The Islamic assets growth, in turn, leads to the creation of more Islamic banks and the addition of Shariah-compliant products at conventional banks. Banks, working with Islamic scholars, have been able to create a set of profitable banking products that meet the financial needs of their customer base while ensuring adherence to the principles of Shariah. Thus, the market’s share will always be inclined towards the core systems vendors whose system will provide flexibility, scalability, and is more customer-centric. A vendor that provides an Islamic bank model, which can also be easily modified through parameterization will maintain high ranking in vendors’ evaluation. Islamic banks will seek vendors that maintain skilled Islamic banking experts. Those that have been involved in several implementations, in either introducing Islamic banking products or shaping the bank’s processes, will gain the big market momentum. Recently, many conventional banks, including some major multinational Western banks, have also started using Islamic banking techniques. All this is encouraging. Banks moving into Islamic banking require compliance with Shariah principles. This compliance has significant effect on bank products, processes and technology systems. As a direct consequence, a sub-section of information technology (IT) services catering to the Islamic Finance institutions is emerging. The technology implications vary considerably depending on delivery structure, such as through stand-alone Islamic operation or ‘Islamic windows,’ and type of Islamic products offered. This affects both banks and core system providers, with market likely to present diverse opportunities for different vendor types. IT vendors have not been late in realizing the potential of this growing market. The main reason for this constant vigilance is the way Islamic Banking has transformed with new products and services, which are constantly upgraded for better customer service and compliance with the Shariah guidelines.

Islamic banking system vendors maybe classified into two segments. First, there are the conventional vendors who have transformed/ customized their existing products to meet SCF requirements, and the second are the vendors who only offer Islamic systems. Most of the conventional core banking vendors (like Temenos, Misys, Infosys, Tata Consultancy and Oracle FS) have developed Islamic systems to cater to the market. Large banking software vendors have successfully created Islamic banking software based on their conventional platform to fit the Islamic banking requirements. However, their initial customers still feel that they ended up being midwifes because of the poor understanding of vendors’ requirements. Small IT companies that anticipated the growing Islamic banking market and managed to be the early entrants do face a situation whether to invest in further R&D or to wait for a potential client before committing any more funds. Nevertheless, the majority of Islamic Banking solution providers are present in India (28%) followed by Malaysia (10%), Switzerland (7%), England (7%), Kuwait (7%), Singapore (7%), Pakistan (7%), Turkey (4%), Bangladesh (4%), Indonesia (4%), USA (3%), Lebanon (3%), Iran (3%), UAE (2%), and Thailand (3%)

(To be concluded)