Islamic Banking in India – Realising the Dream

By: Fayaz Ahmad Lone, Research Scholar, Department of Commerce, Aligarh Muslim University, India

01 April, 2011

The fact that India has the third largest Muslim population in the world after Indonesia and Pakistan may come as something of a surprise to many people, who wrongly assume that partition in 1947 effectively divided the Muslim and Hindu populations into separate nations – the Muslim-dominated East and West Pakistan (now two states, Pakistan and Bangladesh) and the Hindu-dominated, secular state of India. There are approximately 156million Muslims living in India today, 13-14% of the population, although that percentage is much higher in some regions such as in Kerala and the disputed state of Jammu and Kashmir.

There are, however, no Islamic banks in India and no conventional banks with Islamic windows. As Mr Lone points out in his article there are statutory and regulatory problems for anyone wishing to set up an Islamic bank in India, but perhaps more problematic is the highly emotional response of those opposing any changes to allow Islamic banking. The emotional issues, which are embedded in India's political history, will be much more difficult to address.

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The Scope for Islamic Banking in India

Globalisation and the convergence of financial services mean that Indian banks will face an increasingly tough competitive environment, but there is tremendous scope for banks, particularly Islamic banks, because India needs major investment in its infrastructure. Islamic banking, however, has to be positioned as professional banking and not religion-based banking, which can have serious political implications and as a result the Indian regulatory authorities must be approached patiently and logically. That having been said, India does offer great promise for the development of Islamic financial services, not least because the Indian capital market is the most liberalised in the world and there is a good financial infrastructure.

On the downside some experts feel that there is a shortage of Islamic banking expertise in the country and the general public are unaware of what Islamic banking has to offer. In response to the problem of lack of expertise, in July 2009 the Aligarh Muslim University (AMU) launched a course in Islamic banking and finance. Initially the university is offering a diploma course in Islamic banking and finance, but also plans to offer a masters' degree through the Department of Management Studies of AMU.

Opposition to Islamic finance is not only based on religious reasons and fears that that there is insufficient local expertise to sustain the industry, but also on a general level of ignorance about Islamic finance. There is no barrier to non-Muslims who wish to use Islamic financial services. Islamic finance is meant for all mankind, irrespective of religion and with its moral objectives of promoting fairness and social development, it may also provide a solution to the problems of unemployment and poverty in the community. In the Indian town of Maharastra more than 70 farmers committed suicide in 2008, because they had taken loans from banks to finance their grape crop, but due to unseasonal rain their crops were destroyed and they were not in a position to repay the principal amount with interest. Had there been a fully-fledged Islamic banking system in India, this may not have taken place.

The Stock Market

The lack of Shari'ah-compliant investment opportunities has discouraged Indian Muslims from investing funds, not only through the banks, but also through the stock market. The latter problem is being addressed by four asset management companies — Reliance Mutual Fund, UTI Asset Management, Way2Wealth and the newly-approved Edelweiss Mutual Fund. Some of these organisations have already launched Shari'ah-compliant mutual funds and others are planning to do so.

According to UTI sources, the fund house is likely to tie up with Mumbai-based Parsoli Corporation to launch their fund. The Shari'ah Board in Parsoli Corporation will certify the scheme and the Parsoli Islamic Equity index will be the benchmark for the fund. Reliance Money has already launched a Shari'ah-compliant portfolio management service for Muslim HNIs (High-Net-Worth Individuals) and Reliance Mutual Fund is close to filing its prospectus with the regulator to launch an Islamic fund. Company insiders say that the group is in an advanced stage of talks with an Islamic institution to launch the fund. As a next step, Reliance is also planning to launch its entire spectrum of financial services in a Shari'ah-compliant form.

It will, however, take some effort on the part of these funds to get the necessary approvals from the market regulator. According to sources in the industry, the regulator is not very happy to approve these funds as it feels these schemes — intentionally or unintentionally — only solicit investment from a limited class of investors. Moreover, the SEBI (Securities and Exchange Board of India) is still uneasy about the conduct of such funds, for example the screening process used to determine whether stocks are Shari'ah compliant and the method of weeding out ‘impurities' as charity. There are rumours that Taurus Asset Management, which was tipped to launch a Shari'ah fund, is withdrawing its application from the SEBI and perhaps this reflects the difficulties such funds are facing in getting approval from the authorities.

The motivation of these asset management companies is not altruistic in nature, enabling Muslims to participate in the stock market; their rationale for launching such funds in the Shari'ah space is purely commercial. The funds are eyeing scores of rich and religious Muslims, who do not invest in interest-yielding instruments or non-Shari'ah-compliant stocks such as those with links to businesses involved in alcohol, cinemas, pork and other forbidden business activities.

According to research carried out by Dr. Shariq Nisar, Director, Taqwa Advisory and Shari'ah Investment Solutions, out of the 1000 NSE (National Stock Exchange of India) listed companies, 335 are Shari'ah compliant. The market capitalisation of these stocks accounts for approximately 61% of the total market capitalisation of companies listed on the NSE. In fact, the growth in the market capitalisation of these stocks was greater than that of the non-Shari-ah-compliant stocks.

Immense Opportunities

Perhaps, however, the effort will be worthwhile. Talha Sareshwala, chief finance officer of Ahmedbad-based Parsoli Corporation Ltd, has commented that with billions of dollars being deployed by devout investors only in those entities that are in conformity with Shari'ah laws, the opportunities are immense. Since some 13-14% of India's citizens are Muslims, Islamic finance is a domestic fund opportunity as well. Parsoli Corporation Ltd, listed on the Bombay Stock Exchange (BSE), is a non-banking finance company (NBFC) that specialises in channelling funds from domestic and non-resident Muslims into the Indian market. Islamic investments amounting to about $750 million (US) have already been made in the country's capital market and infrastructure sector over the past few months.

Ashraf Mohamdey, chief executive officer of Mumbai-based Idafa Investments Private Limited, another Islamic investment institution in India, is of the opinion that almost 80% of Indian companies are Shari'ah compliant as far as their business in India is concerned, with only a handful being involved in activities such as gaming, casinos or alcohol production.

Indian experts in the area of Islamic finance are working very hard to foster development of the industry in India and as 2011 began the Bombay Stock Exchange along with Taqwaa Advisory and Shari'ah Investment Solutions Ltd. (TASIS) launched a Shari'ah Index with 50 Shari'ah-compliant companies within the BSE 500. The index will be known as the BSE TASIS Shari'ah 50. These 50 companies are highly liquid and strictly adhere to Shari'ah norms. Dr. Sharique Nisar, Director of TASIS, said: ‘BSE has the largest number of Shari'ah-compliant companies in the world, in fact more than the whole of the Middle East and Pakistan.'

There are many Shari'ah-compliant brokerage houses like Parsoli and Idafa in India, but a Shari'ah index with the leading stock exchange in India is a great achievement. DrShariqueNisar said that the index would provide Indian Muslims an opportunity to invest in Shari'ah-compliant shares and would bring in thousands of crores of rupees from the Gulf and other parts of the world. The challenge now is to ensure that potential investors in India and worldwide get to know about the index and the investment opportunities it offers.

New Developments

Islamic banking has been on the rise in the Asia-Pacific region, which now accounts for 60% of the global Islamic banking market. Despite its rise in the rest of the region, however, the penetration of Islamic banking in India has been low. This is especially surprising with India having approximately 156million Muslims, the third largest Muslim population in the world after Indonesia and Pakistan. The Celent report ‘The Rise of Islamic Banking in the Asia-Pacific Region' attributes this primarily to a regulatory block, which allows Islamic banking to operate only in the form of a non-banking financial corporation. An amendment in the Banking Regulation Act of India, 1949 is required to allow the Islamic banks to formally operate as fully-fledged banks in India.

The primary reason for the regulatory problem is the socio-religious nature of the Indian political scene. This is especially evident in the report of the Committee of Financial Sector Reforms chaired by Raghuram Rajan; this report was submitted to the Prime Minister of India in 2010. Although the report recommended principles based on Islamic banking, the term ‘Islamic banking' was deliberately replaced by ‘interest-free banking'. The committee recommended that measures be taken to permit the delivery of interest-free finance on a larger scale, including through the banking system. With this recommendation, the ball is in the government's court and it is up to it to come up with appropriate measures to introduce these products in the Indian banking sector. In parallel, however, a rebranding of the various Islamic banking products is needed to achieve widespread acceptance and serve its foremost purpose of financial inclusion. In addition to the regulations, some experts feel that the infrastructure for Islamic banking is not yet in place and steps must be taken in that regard.

The Rocky Road to Islamic Banking

In 2010 it looked as though the first Islamic bank in the country was about to be set up in Kerala with the active involvement of the Kerala government through the Department of Industries for Kerala. A high level meeting held at Kozhikode on August12 2010 approved a project report prepared by Ernst & Young. Kerala State Industrial Development Corporation (KSIDC), which is the designated agency for the formation of the bank, would hold an 11% stake in the proposed bank. According to government officials, it would be registered as a non-banking finance company, before being transformed into a fully-fledged Shari'ah-compliant bank. The project proposed to raise an initial capital of Rupees 500 crore (crore is 10million in the Indian numbering system) from leading non-resident Indians (NRIs) and Indian business houses. According to sources close to the development, leading NRI businessmen such as MohammedAli, MAYusufAli, CKMenon and other Kerala-based industrialists such as AzadMooppan had shown keen interest in the venture.

Purely based on Shari'ah principles, the bank would avoid interest-based business activities. The proposed Kerala-based bank would invest funds in infrastructure projects and two instruments, bay' al-salam (deferred delivery) and instisna, have been identified for such investments. The bank would invest all its funds in wealth-generating investments and distribute profits to its shareholders. It would also set apart a social fund and provide interest-free loans to Gulf returnees to set up businesses or small scale ventures.

The concept has widespread support among the Muslim community of the state, where a large number of affluent Muslims practice strict Shari'ah principles in business. A large proportion of these individuals do not have a bank account, so the formation of an Islamic bank would be good news for them. According to sources, the biggest challenge facing the Kerala-based bank will be the formation of a Shari'ah supervisory board due to the shortage of suitably qualified scholars.

In 2010, however, a rather more immediate problem reared its head, when DrSubramaniamSwamy, president of India's Janata party and a former government minister, succeeded in putting the project on hold, issuing a writ in the High Court arguing that the involvement of government agencies in setting up an Islamic bank runs contrary to the secular principles enshrined in the Indian constitution. In February 2011 The Kerala High Court dismissed the writ, observing that they had no objection to KSIDC carrying on a business that was in accordance with Shari'ah law in addition to complying with the laws of the country. They also stated that, although the institution was based on religious principles, its motive was not to propagate religion and the state's participation in it was based on purely commercial reasoning.

There are also moves in Jammu and Kashmir, India's most northerly state, where JamiatAhladith is planning to launch Islamic banking, but they will need the permission of the Indian government to do so. This state, however, has special status conferred by article 370 of the constitution and the state can pass the resolution for Islamic banking in the state legislative assembly with little modification from the central government, so there is an expectation that this state will also commence Islamic banking in the not too distant future.

As this issue of NewHorizon went to press Turkey's Bank Asya were reported to be expecting the RBI to rule within 45 days on their application to open a branch offering Shari'ah-compliant lending facilities in India.

The Regulatory Position

Although an RBI (Reserve Bank of India) study group had rejected the concept of Islamic banking, it got the backing of the Raghuram Rajan committee on banking reforms. Commenting on the issue, DrDSubbarao, governor of the RBI, said that under the present Banking Regulation Act it was not possible to licence Islamic banks, because many of the banking principles in place are based on interest payments; separate legislation would be needed to make Islamic banking a reality. Apparently the RBI is now revisiting the issue and a decision is expected shortly.

Conclusion

There is no doubt that a huge potential for Islamic banking in India exists, but, it will need some strong policy decisions to make it a reality. With a population of 156million Muslims India stands to gain tremendous advantages, not least by attracting around $1trillionUS in Islamic investment funds from Gulf countries. This would help the national current account and keep the fiscal deficit in check. Regulators are still in doubt, however, about Islamic banking, having approached the issue from a purely religious perspective. A committee to analyse the impact of Islamic banking on Indian communities regardless of their religious faith has never been established and so the potential of Islamic banking to help to resolve India's real economic problems has not been appreciated.

There is also a fear that Muslims may come to dominate the Islamic banking industry in India. Islamic banking, however, requires a professional expertise beyond religious belief, because it deals with commercial projects not just monetary credit and debit transactions. While Indian Muslims may have an edge in terms of Islamic ethics, they lack the professional expertise to manage modern commercial banking based on Islamic ethics, so perhaps this fear is misplaced.

At the same time it must be borne in mind that Islamic banking can provide immense opportunities to energise the Indian economy with the participation of previously excluded Muslims in Shari'ah-compliant banking and at the same time could lead to substantial inward investment to boost India's further development. It would also help the poor and vulnerable, allowing small manufacturing, retail and agricultural enterprises to access finance as well as providing equity funding for infrastructure projects such as irrigation, dams, roads, electricity and communications projects, which are key to the development of the Indian economy.