Insights into Editorial: RBI shows interest in no-interest banking. What does it mean?

Print Friendly, PDF & Email

 

 


Insights into Editorial

RBI shows interest in no-interest banking. What does it mean?


 

Summary:

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 Centre 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.rbi demonetization

  • The central bank’s proposal is based on examination of legal, technical and regulatory issues regarding feasibility of introducing Islamic banking in India on the basis of recommendation of the Inter Departmental Group (IDG).
  • In late 2008, a committee on Financial Sector Reforms, headed by former RBI Governor Raghuram Rajan, had opined the need for a closer look at the issue of interest-free banking in the country.

 

What exactly is Sharia/Islamic banking?

Sharia banking refers to banking activity that conforms to Islamic law or Sharia. The fundamental principle of Islamic finance is the rejection of usury, along with the requirement that there must be no engagement in immoral businesses. Usury is seen as the levying of unreasonably high interest rates while lending money. Interest is Riba, which in its current interpretation, covers all interest — not just excessive interest. Under Islamic law, a Muslim is prohibited from both paying and accepting interest. Thus, Sharia banking means money can only be parked in a bank without interest — and this money cannot be used for speculative trading, gambling, or trading in prohibited commodities such as alcohol or pork.

 

Need for Islamic Banking:

Certain faiths prohibit the use of financial instruments that pay interest. The non- availability of interest-free banking products results in some Indians, including those in the economically disadvantaged strata of society, not being able to access banking products and services due to reasons of faith. This non-availability also denies the country access to substantial sources of savings from other countries in the region.

Therefore, introduction of Sharia or Islamic banking could bring more Muslims into the banking system, and help in the inflow of institutional wealth from entities operating in the Islamic world to the Indian economy. Sharia banking is not restricted to Muslims alone, and other communities who are interested in other forms of banking like ethical banking could be allowed to participate.

 

How Sharia compliant banks operate?

  1. Credit:

There are mainly three instruments here:

  • Ijara: It is for those who want to take credit from a Sharia compliant bank. Here, the bank purchases the asset on behalf of the client and allows its usage for a fixed rental. After a mutually agreed time, the ownership of the asset is transferred to the client.
  • Murabaha: It is for working capital, in which the asset is purchased by the bank at market price and sold to the customer at a mutually-decided marked-up cost. The client can repay in instalments.
  • Musharaka: It is a joint investment by the bank and the client, in which both contribute to funding an investment or purchase, and agree to share the profit or loss in agreed-upon proportions.

 

  1. Savings:

For savings accounts, there are two kinds of deposits.

  • In one, customers can deposit their savings and allow the bank to use this money, with the assurance that they would get the full amount back. The bank is not liable to pay interest to the savers. However, some banks do give a certain sum back to the account holder as profit accrued from their operations.
  • In the other kind, the holder allows the bank to invest his money in specific projects and gets returns after a stipulated term based on how the business performs.

 

Sharia banking globally:

A 2015 World Bank report estimated Sharia-compliant financial assets to be in the range of US $ 2 trillion, covering bank and non-bank financial institutions, capital markets, money markets and insurance. The Islamic Finance Industry has been expanding at a rate of 10%-12% annually. According to the World Bank, in many Muslim countries, Islamic banking assets have been growing faster than conventional banking assets. There has also been a surge of interest in Islamic finance in non-Muslim countries such as the UK, Luxembourg, South Africa, and Hong Kong.

 

What are the drawbacks?

Even though the concept is sound, the calculation method adopted by each bank differs significantly. Though the outcome may not be detrimental to the bank or the consumer, due to the restriction in procedure, a degree of uncertainty exists for both the bank and the customer.

Alteration of terms of financing may be more troublesome. Should a customer choose to alter the terms of financing, a new Sale and Buy-back agreement needs to be created and signed. A conventional loan would only require the amendment to be stamped which incurs less cost.

 

What needs to be done?

India’s present laws obstruct the establishment of Islamic banking – the Banking Regulation Act (1949) prohibits the operation of banks on a profit-loss basis, forbids murabaha, or, the buying, selling, or barter of goods, impedes ijara, or, bars the holding of immovable property for a period greater than seven years, and requires the payment of interest.

These regulations need to be amended. The purpose of regulations is to ensure smooth and standardised operations, not vet business models; the market will be the best judge of the efficiency and pitfalls of Islamic banking.

 

How does India benefit from Islamic banking?

Introduction of Islamic Banking was mooted by Raghuram Rajan in his report on the Financial Sector in the year 2008 where he recommended that interest-free banking techniques should be operated on a larger scale so as to give access to those who are unable to access banking services, including those belong to economically disadvantaged section of the society.

  • There are many advantages in introducing an Islamic window in the banks. For instance, majority of companies in the Stock Exchange are shariat compliant (this number is more than the shariat complaint companies on the Stock Exchange in Malaysia), thus this would result in attracting huge funds in the domestic market alone.
  • An Islamic Banking window will encourage many from the Muslim community to come forward and invest in projects thereby mobilising huge amount of capital which they may not be willing to put in the banks. This also means that India will be able to attract huge investments from West Asia and from those who invest only in shariat compliant projects.

 

Conclusion:

Over the past decade Islamic finance has emerged as an effective tool for financing development worldwide, including in non-Muslim countries. Major financial markets are discovering solid evidence that Islamic finance has already been mainstreamed within the global financial system — and that it has the potential to help address the challenges of ending extreme poverty and boosting shared prosperity. However, there is some political opposition for its introduction in India. Because of the strict adherence to not paying or taking interest, Sharia banking will call for a complete overhaul of the banking regulatory system. There is also concern that India lacks adequate manpower trained in Sharia banking. These issues need to be addressed at the earliest.