Islamic Banking Edited

8/3/2019 Islamic Banking Edited

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Chapter-1

1) I slamic Banking An Introduction

Modern banking system was introduced into the Muslim countries at a time

when they were politically and economically at a low ebb, in the late 19th century.

The main banks in the home countries of the imperial powers established local

branches in the capitals of the subject countries and they catered mainly to the import

export requirements of the foreign businesses. The banks were generally confined to

the capital cities and the local population remained largely untouched by the banking

system. The local trading community avoided the foreign banks both for

nationalistic as well as religious reasons. However, as time went on it became

difficult to engage in trade and other activities without making use of commercial

banks. Even then many confined their involvement to transaction activities such as

current accounts and money transfers. Borrowing from the banks and depositing their

savings with the bank were strictly avoided in order to keep away from dealing in

interest which is prohibited by religion.

With the passage of time, however, and other socio-economic forces

demanding more involvement in national economic and financial activities, avoiding

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the interaction with the banks became impossible. Local banks were established on

the same lines as the interest-based foreign banks for want of another system and they

began to expand within the country bringing the banking system to more local people.

As countries became independent the need to engage in banking activities became

unavoidable and urgent. Governments, businesses and individuals began to transact

business with the banks, with or without liking it. This state of affairs drew the

attention and concern of Muslim intellectuals. The story of interest-free or Islamic

banking begins here.

The first modern experiment with Islamic banking was led by Ahmed El Najjar

in the Egyptian town of MitGhamr when in 1963; a saving bank based on profit

sharing was set up. The experiment lasted until 1967 by which time where nine such

banks in the country.

These banks neither charged nor paid interest, but invested the funds collected

in trade and industry, either directly or in partnership with others and shared the

gains made with their depositors.

The world's first Islamic bank was founded back in 1975, it is only in the last

five years or so that Islamic finance has surged. Sniffing opportunity, conventional

banks are now scrambling to set up Shari'a-compliant operations; and there has been a

flurry of all-Islamic start-ups, from full-service investment banks to specialist

advisory firms. Products have moved beyond lending, insurance and investment funds

to include sukuk, hedge funds, currency swaps, and more.

In the 1970s, a number of Islamic bank came into existence in the Middle East,

e.g., The Dubai Islamic Bank (1975); the Faisal Islamic Bank Of Sudan (1977), the

Faisal Islamic Bank Of Egypt(1977) and the Bahrain Islamic Bank, to mention a few.

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In most countries individuals and private organizations took the initiative for

establishment of interest free banking. But in Iran and Pakistan, the government

took such initiatives. Even in India, there was a proliferation of interest free saving

and loan societies in the 1970s.

1.1) Concept of Islamic banking

The concept of Islamic Banking has been derived from a verse of the Holy

Quran that says, Allah has allowed trade and prohibits Riba(interest or

usury).. Islamic Banking is based on the principle of sharing profit and loss from

trading and commercial activities and the prohibition of loans. Interest is considered

to be unfair, exploitative and unproductive according to the Islamic laws.

According to the Holy Quran the three principles that define general trading

and commerce include:

Risk taking (ghrom)

Work and effort (kasb)

Responsibility (daman)

These three elements constitute the principles of general business today, where

profit are created with an equivalent counter value. For e.g., in the retailing business,

the retailer purchases goods from the wholesaler at $20 per unit and sells it retail at

$30. The profit margin of $10 usually signifies the work and effort (kasb) component

in the business. This is the imputed his skills and knowledge to promote the sale as

well as buying from supplies at lowest cost. He is also risking (ghrom) his capital as

there is no guarantee he can sell the goods at a profit for example, purchasing 1,000

units will cost him $20,000. He stands to lose his money capital if people stay away

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from the goods due to changes in taste and preferences, economic slowdown, natural

calamities, etc. finally, he is responsible (daman) for any defects found in the goods

sold. By way of warranties, customers can return defective goods in exchange can

return defective goods in exchange for news ones.

Based on the above, it is fair to say that profits created from trading contain the

element of risk, work and responsibility. The trader deserves the profit because he has

fulfilled the tripartite principle of trading. Riba, on contrary, is illegitimate because it

is created without fulfilling the above three principles. The bank is not risking its

capital, because all loans are collateralized. It is also not liable for any adverse

outcome befalling the borrower. Islamic banking products should be able to make

evident the three elements of risk, effort and responsibility to claim legitimacy.

Otherwise, the religious labeling is inaccurate and may fail to reflect the morality of

Islamic banking business.

Islamic banking products are so designed hat it is able to make evident the

three elements of risk, effort and responsibility to claim Shariah legitimacy.

The banks can thus earn profits only from three areas, namely: trading leasing

and by direct financing in profit- and loss sharing contracts. Different instrument

are devised to earn profit in any of these ways. However, the condition of these

transactions must conform to the Islamic laws.

1.1) Brief History

Islamic banking had its beginning from small-scale interest-free savings bank

which were created in Egypt in 1963. These banks were not overtly Islamic for the

fear of offending the political authorities. These saving banks did not pay interest to

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the depositors nor they charged any interest from their borrowers, investing mainly in

trade and industry. The banks depositors were paid a share of the profit of the

borrowers; hence they were acting more like saving and loan institution rather than

commercial banks. The Nasr social bank, established in Egypt in 1971, was created as

an interest-free commercial bank, but still without specific reference to Islam.

Finally , in 1974 the Islamic development bank (IDB), as an intergovernmental

bank aimed at proving development funds or projects in less well-off member

countries. The IDB provides fee-based financial services and profit-sharing financial

assistance. The IDB operations, which are free of interest, are explicitly based on

Shariah principles. After that gradually other Islamic banks came up in the Middle

East, South East Asia, Malaysia and even in Philippines and India.

1.2) Features of Islamic Banking

It emerges that all this that Islamic banking has three

distinguishing features;

It is interest free

It is multi-purpose and not purely commercial

It is strongly equity-oriented.

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The literature contain hardly any serious criticism of the interest free character of

the operation, since this is taken for granted , although concerns have been expressed

about the lack of adequate interest free instruments. The multi-purpose and extra

commercial nature of the Islamic banking operation does not seem to pose intractable

problems. The abolition of interest makes imperative for Islamic banks to look for

other instrument, which render operation outside the periphery of commercial

banking avoidable. It has been argued that the replacement of predetermined interest

by uncertain profit is not enough to render a transaction, since profit can be just as

exploitative as interest.

1.1) Principles

Islamic banking has the same purpose as conventional banking except that it

operates in accordance with the rules of Shariah, known as Fiqh al-Muamalat (Islamic

rules on transactions). The basic principle of Islamic banking is the sharing of profit

and loss and the prohibition of Riba (usury). Amongst the common Islamic concepts

used in Islamic banking are profit sharing (Mudharabah), safekeeping (Wadiah), joint

venture (Musharakah), cost plus (Murabahah), and leasing (Ijarah).

In an Islamic mortgage transaction, instead of loaning the buyer money to

purchase the item, a bank might buy the item itself from the seller, and re-sell it to the

buyer at a profit, while allowing the buyer to pay the bank in installments. However,

the fact that it is profit cannot be made explicit and therefore there are no additionalpenalties for late payment. In order to protect itself against default, the bank asks for

strict collateral. The goods or land is registered to the name of the buyer from the start

of the transaction. This arrangement is called Murabaha. Another approach is EIjara

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wa EIqtina, which is similar to real-estate leasing. Islamic banks handle loans for

vehicles in a similar way (selling the vehicle at a higher-than-market price to the

debtor and then retaining ownership of the vehicle until the loan is paid).

Islamic banks lend their money to companies by issuing floating rate interest

loans. The floating rate of interest is pegged to the company's individual rate of

return. Thus the bank's profit on the loan is equal to a certain percentage of the

company's profits. Once the principal amount of the loan is repaid, the profit-sharing

arrangement is concluded. This practice is called Musharaka. Further, Mudaraba is

venture capital funding of an entrepreneur who provides labor while financing is

provided by the bank so that both profit and risk are shared. Such participatory

arrangements between capital and labor reflect the Islamic view that the borrower

must not bear all the risk/cost of a failure, resulting in a balanced distribution of

income and not allowing lender to monopolize the economy.

1.2) Banking Operation

There are five categories of operating Islamic bank:-

1. The Islamic Development Bank

2. The banks which operate in countries where the whole banking system is

supervised by religious bodies (like in Pakistan)

3. The banks which operate, co-exist with commercial banks ( like in Jordan,

Egypt, Malaysia)

4. Islamic banks also exist in non Muslim countries where authorities do not

recognize their Islamic character.

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5. Islamic banks, which exist in non-Muslim countries whose monetary

authorities, do recognize their Islamic character (for instance, the Faisal

International bank (FIB) based in Copenhagen, Denmark, registered under the

Danish Banking Supervisory Board).

1.1) Conventional Banking: Differences and Similarities

Both banking systems are financial intermediary institutions. Current and

demand deposit accounts are the same as in the conventional banking system in the

sense that the deposits are guaranteed (but interest is not payable).

The financial intermediation banking is based on the concept of borrower-

lender and isolation of depositors (surplus category) from investors and those

seeking finance for their projects (deficit category). In such form of banking,

depositors do not consider the risk of the end lenders; they only take the risk of end

lenders whom it has separated from sources of money, whereas the institution of

Islamic banking is based on the concept of Mudarabah i.e., partnership in profit

where capital and management may join together to create value.

As far as financing is concerned, like conventional banks, these banks are also

in the business of financing trade and services, primary form of lending such as

loans with service charges apart from the business of no-cost loans where each

bank is expected to set aside a part of its funds for no-cost loans to the needy i.e.,

small farmers, producers, entrepreneurs etc.These banks, like conventional banks, also provide services like money-

transfer, bills collection etc., at a cost where the banks own money is not involved.

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The conventional banker works as a risk manager as is considered with all

types of risk such as credit, market, interest rate, legal and other risks. The Islamic

banker has got one added risk to manage which may be called Shariah is observance

risk.

One major difference between the two forms of banking is in the handling of

delinquency and default. When a debtor/borrower delays payment of debt, interest

will accrue on his delayed portion till the borrower ultimately defaults, and is

incapable of repaying his debt. Such interest will compensate for the lost business.

But this cannot be done in Islamic banking system because it is considered as

usurious. This is a loss-making preposition for the Islamic banks because they will

not be compensated for the lost profit.

The main sources of the banks funds consist of the accounts available to

the customers are:

Demand Deposit Account (Current or Checking Accounts)

Savings Account

General Investment Account

Special Investment Account

In savings deposit the customers deposit earn no interest and the investment is

in the form of profit sharing. Hence, positive rate of return is not guaranteed. The

depositor will not receive any premium if the bank incurs a loss on its investmentprojects. Term deposits (both Short-term and Long- term) earn a certain rate of return

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based on the banks profits and on the deposit maturity. Table 1 gives a list and

purpose of the various instruments.

Some conventional banking activities are not conducted by Islamic banks this

include transactions involving interest in all forms; bonds, bank deposits, and

certificates of deposits and the discounting of commercial paper. Most Islamic banks

also forbid the purchase of stocks in companies dealing with interest (including

western).

T able 1 : An Alternative System

Accounts Purpose Nominal

Value

Guaranteed

Profit Risk

Nature

Demand

Deposit

Accounts

To keep the

excess

liquidity

available on

demand

Yes None None

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Savings

Account

A

precautionarydeposit, may

also earn some

profit

Yes Not

guaranteed

Low

General

Investment

Account

The deposit

holder earns

profit

Yes From

investment in

Projects share

in all

activities

High

Special

Investment

Account

Available to

wealthy

clients

Yes Negotiated

amount

High

These pure Islamic banking products are very similar to venture capital finance,

in western banking terminology, or non-recourse project finance and equity

investments. Hence it involves investing and not lending and therefore on a

anathematic basis it is similar to the Germany, Japanese and Spanish banking system

rather than the British or American system.

Over the years Islamic financial products have become more diversified toinclude variable rate equity based mechanism as well as hedging instruments that

strengthen the risk management capabilities of the Islamic banks.

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In the area of regulation, the Accounting and Auditing Organization for Islamic

Financial Institutions(AAOIFI) was established in 1991 by several major Islamic

financial institutions to regulate international accounting and auditing standards for

the industry it promulgates on Islamic financial institutions; it does, however, work

closely with respective central banks and governments.

Today, Islamic banking is estimated to be managing funds of US$200bn

annually . its clientele is not only confined to Islamic countries but are also spread

over Northern Africa, the Far East, India, Europe and United States. Banks from all

over the world, which include western banks like HSBC, Citigroup and UBS are

moving fast to a secure a place in the market. With the coming in of such western

institutions some widely held misconceptions about Islamic banking being conducted

exclusively within the Muslim community have come to an end. It is estimated that

more than 250 Islamic institutions are operating worldwide.

Chapter- 2

Islamic Banking as An Alternative banking Concept

The concept of Islamic banking evolved on the basis of Shariah principles.

While in conventional banking, interest is acceptable; in Islamic banking interest in

any form is strictly prohibited. The alternative banking concept is being promoted by

Islamic development bank which undertakes all development activities of any

conventional development bank like World Bank.

2.1) Foundations

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The basic principle of Islamic banking originate in the axioms of justice and

harmony with reality and the human nature.

The most genuine and plain definition of financing is that it is the provision of

factors of production as well as goods and services without requiring an immediate

counterpart to be paid by the receiver. For instance, a laborer finances the employer

by waiting until the end of the month for getting compensation for the working hrs

given throughout the month, and the real capital owner finances that entrepreneur by

waiting until the sale of production to get a portion of the net outcome.

Islamic financing is no more than that in its full, plain and direct sense. Islamic

finance is a name for providing factor of production, goods and services for which

payment is deferred so simple and so straight forward. This is the essence of Islamic

banking practices.

Islamic banking provides financing in the form of equipment, machinery, and

other producers and consumer goods for deferred payments. It also provides means of

payment as producer principal in projects on the basis sharing the actual real life

outcome of a production process.

In lending, the lender gives real goods to the borrower against the motional

right, called debt. Hence lending changes the nature of what is owned from real

balance to a legal commitment, which is purely an inter personnel concept. However

direct investment does not seem to be favored by traditional banks. Quoting a recent

article in the World Bank Research Observer.

2.2) Operations of Islamic banks

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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 function of mobilizing financial resources and using them to

finance those who are in need for investable funds. The difference lies in the 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.

2.2.1) Fund Mobilization

Resources are mobilized from shareholders and saving owners. Shareholders

own the banks net equities while saver participate in the ownership of the banks

investments. In other words, saving is mobilized on the basis of sharing rather than

interest based lending.

In Islamic banks, deposits agreement is a contract to provide funds that will be

managed by the banks on behalf of the owner, as an appointed agent. 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 owners and the bank would have lost it s efforts that went without

compensation.

The Islamic banking has usually two categories of deposits:

1. Investment deposits that share in the return of investment operation in

proportion to the amount of deposit and on the basis distributing the net

return on a contracted ratio. Islamic banks usually differentiate between

long and short run investment deposit committed for longer period.

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2. Demand Deposit which are guaranteed and represent liabilities and they do

not earn any return

2.2.2) Fund Utilization

Islamic banks use available funds by means of three major categories of

financing modes: sharing modes, sale modes and leasing modes. None of them has

any interest component.

2.2.3) Fund Sharing Modes

The principle is simple as much as its natural. The Islamic banks provide

financing to projects on the expectation of a share in the return. There are two of

application of this principle: full partnership and non-voting partnership or financing.

In full partnership, the bank would be represented on the board of executive

director and would share in formulating policies and managerial decisions, while in

non-voting financing, Islamic banks fully entrust managerial decision making to the

user of funds.

2.2.3.a) Sales Modes

The idea of sales modes of financing is also simple. The bank would be asked

to buy the goods and give them to users against future repayments. The simplest of

them is derived from regular sales contract. Where the bank sells the real goods,

equipment and machinery to their users at an agreed upon marked-up price.

All sale based modes can end up in one lump sum deferred payments or ininstallments spread throughout a certain period of time.

2.2.3.b) Leasing Modes

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As practical is leasing companies and recently in many traditional banks

leasing modes can have a variety of forms with fixed or variable rents declining or

fixed ownership, operational or financial, along with different conditions regarding

the status of leased asset at the end of the lease period.

2.1) Growth of Islamic banks

A quick reading of Islamic history tells us that practices of certain forms of

banking activities go back as early as 1200 years ago in Baghdad, Damascus, Fez and

Cordoba. Deposits in current accounts and use of checks were well known in these

Muslims cities at that early date. Also, inter-city money transfers were a known

practice between cash depositors and practitioner Banker who also used to bemoney exchangers at the same time.

However, the early contemporary Islamic banks , the wall street journal

comments that if its present rate growth continues, within ten years they are expected

to handle around 40 to 50% of total saving of the Muslim world.

On the average, about 30% of the funds were allocated to trade, 19% to

industry, 13% to the service, 12% to real estate and 9% to the agriculture.

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This diversity in sectorial financing seems to be significant in terms of the

dominance of a specific economic activity within each region and development and

application of Islamic financing instruments compatible with the economic need of

the region.

2.2) Islamic banking as a new choice

2.4.1) Islamic Banks and Banking Community

Nowadays, most Muslim countries have Islamic banks 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 benefit of competition . Few

countries have also switched to Islamic banking system.

Although the nature of Islamic banking transaction requires special attention

from Central Banks and Monetary authorities, the relationship between them have

gone reasonably smooth, effective and constructive.

As we noticed earlier, Islamic banking operation have their own characteristics

both on the financing and resource mobilization sides. Their application does not

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require bankers pr customers to have a particular religion, ethnicity or language. Their

success or failure depends only on managerial ability to provide competitive services.

2.4.2) Islamic Banking as an Alternative Approach

One might wonder whether Islamic banking and finance is an alternative

approach to modern banking. In fact, the banking business is no more than a possible

means to satisfy the need of society according to the prevailing condition and

circumstance. Those needs should always govern the means not be its subject.

The most important development in modern banking is the art of mobilizingfunds for investment. In contrast, Islamic banking is a system that provides financing

and attracts savings on the basis of profit/loss sharing. One may have to think

positively of such a scheme. By waiving the interest factor, we find an alternative

vehicle to provide financing on a different basis, which should be judged on it own

merit.

Economists have proven that the wider the freedom of choice the higher the

level of social welfare in addition, wider choice implies greater respect of human

rights. When an alternative concept such as Islamic banking is introduced a new

choice is open to market with obvious economic and social benefits.

Introducing Islamic banking as a new choice has also further benefits related to

the advantages it provides to fund user. Commodity and service producer would

certainly appreciate equal opportunities for obtaining capital based on the merit of the

business rather than on their personal credit worthiness alone.

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Therefore, we would like to recommend strongly to the western world that all

obstacles remaining in the way of establishing Islamic banks in their countries be

removed.

2.1) Challenges and Prospects

The biggest challenges Islamic banks have faced from their very beginning is

how to narrow the gap between the Islamic banking model and its application, in

other words, between theory and practice.

Islamic banks have been trying hard to meet those challenges through several

means, the first is to work for better understanding of the concept upon which their

operations are based. This has been a success to the extent that now traditional

bankers are mostly co-operative and accommodating. Central banks have also come

forward with new ideas of better methods for supervision and control to suit the

operation of Islamic banks.

Another means is to train their staff in his new form of banking and press for

more banking and financial innovation which are necessary for the new modes offinance. Fortunately, financial engineering has come in handy with bold and new

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ideas in finance, which made the Islamic model so much more applicable. Innovation

in this regard did not come exclusively from Islamic banks.

Nonetheless, many challenges still remain not the least to the predominance of

Murabaha ( sale mode) in the operation of some Islamic bank, as well as the relative

scarcity of short-term Islamic institutions.

The prospects of Islamic banking and finance will depend extensively on the

ability of Islamic banks to continue facing challenges with resourcefulness and

creativity in addition to being worthy of trust and understanding.

Chapter- 3

Islamic Banking and Development

3.1) Developmental Characteristics of Islamic Modes of Financing

The essential characteristics of Islamic modes of financing is their direct and

undetectable link to real or physical transactions. Sharing modes are only possible for

productive enterprises that involve real life business that increase quantity or

improve quality or enhance usability of real goods and services and by doing that

such business generate a return that can be distributed between the entrepreneur and

the financier.

In other words, Islamic financing is purely a real-life, real-goods financing. No

financing can find its way to the Islamic system without passing through the

production and/or exchange of real goods and services.

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In contrast with traditional methods, Islamic financing not centered only around

creditworthiness and ability to loans and return. The key word in Islamic financing is

worthiness and profitability of the project and the exchange of goods and

merchandise, while the ability to recover the financing principal becomes the result of

profitability and worthiness of the project itself.

Consequently, the nature of Islamic financing makes it exclusively restricted to

the construction, establishment and expansion of productive project and to the

exchange and trade of commodities. Whether it is done by means of sharing, sale or

lease contracts, Islamic financing is bound by the extent of transaction in good

market. The Islamic modes of financing, by virtue of their very nature, are

incompatible and inapplicable for debt rescheduling, debt swap, financing of

speculative cash balances, inter-bank liquidity speculative transfers and other purely

monetary activities that make a substantial part of contemporary activities of

traditional bank.

3.2) Social Commitment of Islamic Banking

The religious ideas on which Islamic banks are based are so integrated with

ethical and moral values to the extent that these new institutions that are called

Islamic banks cannot detach themselves from socio-moral consideration even if they

try , especially that their own environment including both staff and client, expects

from them such socio-moral commitment and always measure them.

Many Islamic banks also establish social funds especially designed forrelieving economic hardship of the poor and needy. The early Zakahdues on

shareholders equities as well as many investment depositors who give their consent

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to the banks management for the deduction and distribution of Zakah annually usually

finance this funds.

Moreover, many Islamic banks contribute to research and community

development and assign sometimes-substantial amounts for these objectives.

Additionally, many Islamic banks usually work within a traditional banking

environment, and have working relationship with traditional banks. According to the

Islamic Shariahs earned interest cannot be considered an income and it is to be

disposed of to the poor in the way that does not directly benefit the bank. Hence,

those Islamic banks that happen to earn interest spend them on benevolent social

activities.

In other words, while profit maximization is equally essential to the Islamic

banks as other business, the underlying philosophy of these institutions is conducive

towards social commitment and activities that usually cannot be interpreted by the

motive of profit maximization.

3.3) Developmental activities of the Islamic Development Bank (ISDB)

Islamic development banks have to board areas of financing: project

construction and expansion and trade operation. Project financing includes transport

and communication , gas, electricity, water and other public utilities, agriculture and

agro-industries, industrial and mining projects, social services and other

developmental projects in addition to technical assistance provided for the purpose of

project preparation, inception and feasibility studies. Trade financing covers both

inter member countries trade and import of member countries from the rest of the

world.

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The IDB has established a close contact with Islamic banks in different

countries in order to meet the financial and developmental needs of its member

countries. The IDB plays the role of a promoter and coordinator between the IBD and

Islamic banks have resulted in launching institutions and preparation of studies on

subject like liquidity management and other related matters, medium and long term

investment as well as on new financial instruments.

The IDB has in collaboration with indigenous entrepreneur setup Islamic banks

in different members countries. Apart from equity participation, the IDB provides

assistance and help in development of procedures manual for the operations of the

banks another cooperative efforts having far-reaching consequences is the pilot

project to make the capital structure and financing of companies having interest-

bearing debts compatible with the principles of Shariahs. IDB is also making

strenuous efforts to contribute to the capacity building of Islamic banks and to

mobilize them to co-finance project.

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Chapter- 4

Islamic Banking : Modes of Financing

Islamic banking has found acceptance from many section of the society for its

interest free and non-exploitative nature. However, there is a growing dispute

between the two major modes of financing available under this system

(i) Profit and loss sharing modes

(ii) Fixed returns mode

True modes of financing

An Islamic bank is a financial institution which identifies itself with the spirit

of Shariah, as laid down by the Holy Quran and Sunnah, as regards its objective,

principles, practices and operations.

To replace interest, the ideal mode of financing under the Islamic bankingsystem is financing on profit and loss sharing (PLS) basis. To safeguard the interest

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of depositors/investors, these types of loans, as a matter of policy, do not constitute a

significant source of financing by Islamic bank.

The bulk of financing by Islamic banks has to be equity oriented. In these

modes of financing, the losses are shared by the financier along with the entrepreneur

in the ration of their respective capitals. The profit are however, shared in an agreed

ratio.

While designing an alternate to interest based system, it was realized that

large scale resorting to PLS system of Islamic banking could pose serious risks andhazards to Islamic banks due to widespread tendency to adopt unethical account

practices to conceal true profit, high rate of illiteracy and host of other reasons.

Financing on PLS basisThe Real alternate to interest on loans in an Islamic framework is financing on

PLS basis a shift from debt- based transaction to investment based funding on PLS

system of Islamic banking in a conducive environment would not only ensure a

healthier financing portfolio and of course higher rate of return to depositors but

would also lead to optimum allocation of resources for overall economic growth

welfare of the society, individually and collectively.

It is however, accepted that banks allowing financing on PLS basis are exposed

to risk of losses as even a profitable company may sustain genuine loss due to various

factors even beyond their control.

In actual practice however, we find that traders and industrialists, etc. generally

earn substantial profit with the funds of a large number of depositors but they do not

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share these profits with the banks for onward passing on the share to be depositors.

The injustice can be avoided if banks accept deposit on PLS basis according to its true

spirit and also allow bulk of financing on the same basis. This will bring prosperity in

the society, as a large number of depositors will be receiving higher rate of return on

their deposits.

In the Islamic banking system, the concept is that of ratios in which profit and

losses are shared instead of fixed, predetermined interest and mark-up/ profit rates.

The issue of possible injustice due to inflation and recession, in money lending

transaction, was settled by Islam over 1400 years ago, as PLs system absorbs the

impact of inflation as regard the sharing of operational results are concerned. A

glaring example is that of partnership where there is no dispute between partners due

to high inflation or otherwise.

Model Islamic Bank

It is important that the requisites for total implementation and success ofIslamic in a country, include re-shaping the society restructuring of the economic

system and re-framing of the laws according to the dictates of Islam. The most

important and the difficult task however is the reformation of society which has to be

undertaken as ongoing process.

We therefore, need to change our priorities and at least as much emphasis

should be laid on improving the ethics, honesty and values of the society as is being

done for expansion of Riba free banking. This will then create a conducive

environment for more and more financing under profit and loss sharing system

Islamic banking.

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In view of the position explained here in above and consideration the real

difficulties in presently adopting the PLS system of Islamic banking for bulk of the

financing for trade, industry and agriculture, it is felt that the need of the hour is to

establish Model Islamic banks is an also GCC countries as also in other Islamic

countries where a large number of interest free banks have been operating for number

of years.

The Proposed Model Bank would be a commercial bank. While the objective of

the bank would be to earn profit, it would identify itself with the Shariah as regards

objectives, principles, practices and operations. The Proposed bank would undertake

all normal banking business as in done by the interest based banks but the provision

of Shariah would be kept in view at all times.

The Proposed Model bank would accept deposits investment on PLS basis. It

would develop risk- bearing but competitive products for deposits investments where

in depositors investors are given reasonable assurance of higher return as also safety

of their funds.

The sponsor directors of the proposed model bank should be Muslim scholars,

jurists, chartered accountants, economists, banker and investors. All these person

should be men of integrity and of highest reputation. They should also have

unshakeable faith and commitment in the Islamic banking system.

It is sincerely believed that the proposal of Model Islamic bank is not only

feasible but is the need of the hour. The successful operational results of this bank

would also motivate the existing Islamic banks to enhance their share of financing on

PLS basis.

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Modes of financing

Banks adopt several modes of acquiring assets or financing projects. But theycan be broadly categorized into three areas: investment, trade and lending.

4.1) Investment financing :

This is done in three main ways:

i)Musharaka (Partnership Finance)

Where a bank may join another entity to set up a joint venture, both parties

participating in the various aspects of the project in varying degrees. Profit and loss

are shared in a pre-arranged fashion. This is not very different from the joint venture

concept. The venture is an independent legal entity and the bank may withdraw

gradually after an initial period.

ii) Mudarabha( Entrepreneurial Finance)

Where the bank contributes the finance and the client provides the expertise,

management and labour. Profits are shared by both the partners in a pre-arranged

proportion, but when a loss occurs the total loss is borne by the bank.

iii) Financing on the basis of an estimated rate of return

Under this scheme, the bank estimates the expected rate of return on the

specific project it is asked to finance and provides financing on the understanding that

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at least that rate is payable to the bank. (Perhaps this rate is negotiable.) If the project

ends up in a profit more than the estimated rate the excess goes to the client. If the

profit is less than the estimate the bank will accept the lower rate. In case a loss is

suffered the bank will take a share in it.

4.2) Trade Financing :

This is also done in several ways. The main ones are:

i) Mark-up

Where the bank buys an item for a client and the client agrees to repay the

bank the price and an agreed profit later on.

ii) Leasing

Where the bank buys an item for a client and leases it to him for an agreed

period and at the end of that period the lessee pays the balance on the price agreed atthe beginning an becomes the owner of the item.

iii) Hire-purchase

Where the bank buys an item for the client and hires it to him for an agreed

rent and period, and at the end of that period the client automatically becomes the

owner of the item.

iv) Sell-and-buy-back

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Where a client sells one of his properties to the bank for an agreed price

payable now on condition that he will buy the property back after certain time for an

agreed price.

v) Letters of credit

Where the bank guarantees the import of an item using its own funds for a

client, on the basis of sharing the profit from the sale of this item or on a mark-up

basis.

4.3) Le as ing Financing :

Main forms of Leasing are:

i) Loans with a service charge

Where the bank lends money without interest but they cover their expenses by levying a

service charge. This charge may be subject to a maximum set by the authorities.

ii) No-cost loans

Where each bank is expected to set aside a part of their funds to grant no-cost

loans to needy persons such as small farmers, entrepreneurs, producers, etc. and to

needy consumers

iii) Overdrafts

Also are to be provided, subject to a certain maximum, free of charge.

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4.4) Deposit Accounts :

All the Islamic banks have three kinds of deposit accounts: current, savings and

investment.

i) Current accounts

Current or demand deposit accounts are virtually the same as in allconventional banks. Deposit is guaranteed.

ii) Savings accounts

Savings deposit accounts operate in different ways. In some banks, the

depositors allow the banks to use their money but they obtain a guarantee of getting

the full amount back from the bank. Banks adopt several methods of inducing their

clients to deposit with them, but no profit is promised. In others, savings accounts are

treated as investment accounts but with less stringent conditions as to withdrawals

and minimum balance. Capital is not guaranteed but the banks take care to invest

money from such accounts in relatively risk-free short-term projects. As such lower

profit rates are expected and that too only on a portion of the average minimum

balance on the ground that a high level of reserves needs to be kept at all times to

meet withdrawal demands.

iii) Investment account

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Investment deposits are accepted for a fixed or unlimited period of time and the

investors agree in advance to share the profit (or loss) in a given proportion with the

bank. Capital is not guaranteed.

Chapter- 5

Islamic Banking : Current Practices and Challenges

Islamic banking practices have been widely accepted by many Muslimscustomers both in Muslims and non Muslims countries, there are certain operational

challenges faced by modern Islamic banks.

Interest free banking popularly referred to as Islamic banking, tracing back its

origin in Egypt around the year 1963, has grown at the rate of 15%. Ever since its

inception in a tiny Egyptian village Islamic banking has never looked back. Financial

intermediation based on the concept of interest may not promote humanitarian

goals such as full employment, equitable distribution of income and wealth and

economic stability. Islamic banking and finance is largely based on the concept of

profit and loss sharing modes.

5.1) Rational reason behind prohibition of interest

The interest system is perceived to be incapable of allocating available liquid

funds among firms and activities in the society according to considerations of

efficiency, productivity and growth. An Islamic system based on profit /loss sharing

financing methods would an efficient substitute in principle.

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The interest system maintains a pattern of income distribution, which is based

towards wealthy individuals, and large business that can afford to pay and receive

interest. An Islamic financial system on the other hand, justifies an income

distribution pattern that promotes economic efficiency, productivity and other actual

factors contributing to the total value added.

The interest system contributes to passive behavior to develop among people

who possess liquid funds since the availability of excess funds acts as a deterrent

from participating in risk financing.

Prohibition of interest does not affect savings / investments or mobilization of

funds as it is based on the religious principles and is considered more ethical by the

religious people.

Reasons for the rise in Islamic banking in non Muslim Countries

Besides Islamic or predominantly Muslim countries, Islamic banking is

attracting tremendous attention in countries that are considered to be strictly secular

or with minuscule Muslim population such as the UK, Germany, Switzerland,

Luxembourg, etc. One does wonder why these countries are attracted to Islamic

banks. But there is a strong economic sense in it. Firstly, these countries are

financially developed. Markets in these countries are saturated. So, they are always on

the lookout for products and range. Secondly, though their Muslim population is not

as big as in many other countries, these are people of high net worth. They are mostly

professional and businessmen settled in these countries for a better lifestyle. So, itpays to serve them. And thirdly, most of the top most financial institutions are MNCs

operating in all parts of the world including over 55 Islamic countries, these

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institutions are offering financial services, so it is convenient for them to offer these

services in their home country also. These institutions also have an eye on the petro-

dollars flows, which are moving very fast from the developed countries to emerging

markets. So, to check the outflow of petro-dollars from these countries, it is necessary

that they offer Islamic options in their home countries too.

Most of the large western financial institutions have their own Islamic

subsidiaries or Islamic windows or products aimed at their Islamic clientele. The

importance of Islamic banking is also evident by the decision of major stock

exchange such as Dow Jones and FTSE to offer Islamic indices. Statistics from the

international association of Islamic banks suggest that assets managed by Islamic

banks have grown quite substantially during the last few years.

5.2) Implementation C hallenges

Most of the challenges of Islamic banks are related to the age and size of the

institutions comprising this sector. Relatively, their age and size is very small,

therefore, the biggest and most important challenge for Islamic banking is its

regulation. Most of the Islamic financial institutions are grown spontaneously.

Consequently, there is no central organization, which can guide or regulate these

institutions. Another big hurdle for Islamic banking is lack of adequately trained

manpower. Most of those working at present have switched from conventional

banking to the Islamic one. They are experienced in banking operational, but their

understanding of Islamic banking or its underlying concept is fairly poor. Moreover,

the roots of Islamic banking lie in ethical concerns. Unless, the overall ethical

standards of the society are fairly high, it is difficult to implement Islamic banking

concepts in the fullest sense.

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The moral hazards related to under over reporting of profits / loss is another

issue. At the same time, refusal of depositors to accept losses in case of genuine

reverses suffered by Islamic banks has also posed a big challenge to the industry.

Some technical and market related risk can also be considered as serious challenge for

Islamic banking institution , as the major market for Islamic banks are in third world

countries whose undeveloped financial and communication infrastructure poss a big

challenge to the growth of these institutions.

5.3) Short coming in current practice

The current practices under three categories: deposits, modes of financing (or

acquiring assets) and services. There seems to be no problems as far as banking

services are concerned. Islamic banks are able to provide nearly all the services that

are available in the conventional banks. The only exception seems to be in the case of

letters of credit where there is a possibility for interest involvement. However some

solutions have been found for this problem -- mainly by having excess liquidity with

the foreign bank. On the deposit side, judging by the volume of deposits both in thecountries where both systems are available and in countries where law prohibits any

dealing in interest, the non-payment of interest on deposit accounts seems to be no

serious problem. Customers still seem to deposit their money with interest-free banks.

The main problem, both for the banks and for the customers, seem to be in the

area of financing. Bank lending is still practiced but that is limited to either no-cost

loans (mainly consumer loans) including overdrafts, or loans with service charges

only. Both these types of loans bring no income to the banks and therefore naturally

they are not that keen to engage in this activity much. That leaves us with investment

financing and trade financing. Islamic banks are expected to engage in these activities

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only on a profit and loss sharing (PLS) basis. This is where the banks main income is

to come from and this is also from where the investment account holders are expected

to derive their profits from. And the latter is supposed to be the incentive for people to

deposit their money with the Islamic banks. And it is precisely in this PLS scheme

that the main problems of the Islamic banks lie.

5.4) Problems in implementing PLS scheme

In the over half-a-decade of full-scale experience in implementing the PLS

scheme the problems have begun to show up

Table 1 shows the term structure of investment by 20 Islamic Banks in 1988. It

is clear that less than 10 percent of the total assets goes into medium- and long-term

investment. Admittedly, the banks are unable or unwilling to participate in long-term

projects. This is a very unsatisfactory situation.

Table 1: Term Structure of Investment by Islamic banks, 1988

Term Structure of Investment by 20 Islamic Banks, 1988

Type of Investment Amount* % of Total

Short-term 4,909.8 68.4

Social lending 64.2 0.9

Real-estate investment 1,498.2 20.9

Medium- and long-term investment 707.7 9.8

The main reason of course is the need to participate in the enterprise on a PLS

basis which involves time consuming complicated assessment procedures and

negotiations, requiring expertise and experience. The banks do not seem to havedeveloped the latter and they seem to be averse to the former. There are no commonly

accepted criteria for project evaluation based on PLS partnerships. Each single case

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has to be treated separately with utmost care and each has to be assessed and

negotiated on its own merits. Other obvious reasons are:

a) such investments tie up capital for very long periods, unlike in conventional

banking where the capital is recovered in regular installments almost right from the

beginning, and the uncertainty and risk are that much higher,

b) the longer the maturity of the project the longer it takes to realize the returns

and the banks therefore cannot pay a return to their depositors as quick as the

conventional banks can. Thus it is no wonder that the banks are averse to such

investments.

Small scale businesses form a major part of a countrys productive sector.

Besides, they form a greater number of the banks clientele. Yet it seems difficult to

provide them with the necessary financing under the PLS scheme, even though there

is excess liquidity in the banks.

5.5) Future of Islamic Banking

There is no centralized institutions from where one can get the exact size of

Islamic banking in terms of deposits/ assets, etc. however, estimates suggest that the

overall Islamic finance industry, which includes Islamic banking, non- banking,

mutual funds, leasing, real estates, stock market to the charitable financing

institutions, has grown manifolds during the last two decades. Taking into account

15% annual growth of the industry during the last decades, even a conservative

estimates will put the Islamic finance size beyond $ 1,000bn.

One estimate suggest that the global size of the Islamic economy to be around

2.5% of the total global economy and 12% of the developing economy. A large

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number of Muslim also live in many secular countries like India, UK, USA and other

Asian , South African countries. As a whole, Muslims comprises approximately 1/5th

of the total world population. Conservatively, if it is assumed that Muslims on an

average have half the resources per capita as compared to their non Muslim

brethren, still 1/10th of the world resources are with Muslims. Of this, even if 50%

Muslims are interested in any kind of Islamic countries. One obvious fact remains,

that many kind of Islamic countries are still under-banked due to their inhibition in

dealing with interest based banking.

According to one western observer, the growth in Islamic banking and finance

is primarily driven by the fact that Muslims during the last 15 to 20 years have built

significant wealth that necessitates banking services, they are inhibited in fully

participating in conventional finance operation due to the fact that usury is a very

serious sin in Islam. Consequently, in view of many leading authorities, this market

will be responsible for managing at least 50 to 60% of the total saving of Muslim

world wide in 8 to 10 years time.

5.6) Islamic banking in other sectors

A. Equity Funds

Islamic investment equity funds market is one of the fastest growing sectors

within the Islamic financial system. Currently there are approximately 100 Islamic

equity funds worldwide. The total assets managed through these funds currently

exceed US$5 billion and is growing by 12-15% per annum. With the continuous

interest in the Islamic financial system, there are positive signs that more funds will

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be launched. Some western majors have just joined the fray or are thinking of

launching similar Islamic equity products.

Despite these successes, this market has seen a record of poor marketing as

emphasis is on products and not on addressing the needs of investors. Over the last

few years, quite a number of funds have closed down.

Most of the funds tend to target high net worth individuals and corporate

institutions, minimum investments ranging from US$50,000 to as high asUS$1,000,000.

Target markets for Islamic funds vary, some cater for their local markets e.g

Malaysia and Gulf based investment funds. Others clearly target the Middle East and

Gulf regions, neglecting local markets and have been accused of failing to serve

Muslim communities.

Since the launch of Islamic equity funds in the early 90's, we have seen the

establishment of credible equity benchmarks by Dow Jones Islamic market index and

the FTSE Global Islamic Index Series. The website failaka.com monitors the

performance of Islamic equity funds and provide a comprehensive list of the Islamic

funds worldwide.

B. Involvement in non banking activities

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It is due to historical reasons that banks have evolved purely as a financial

institution. They are suited to attract money, keep it in safe custody, lend it under

safety, invest it profitably and enjoy the capacity to create the means of payment. A

bank has to maintain a balance between income, liquidity and flexibility. While

allocating its funds it has to be meticulously sensitive about the factors like capital

position and rate of profitability of various types of loans, stability of deposit,

economic conditions, influence of monetary and fiscal policy, ability and experience

of banks personnel and credit needs of the area. So far these banks thrive on a fixed

rate of return a portion of which is passed on by them to the depositor. Thus the entireeffort of a bank is directed towards money management and it is not geared to act as

an entrepreneur, trader, industrialist, contractor or caterer.

Traditional banks do perform a certain amount of project evaluation when

granting large medium- and long-term loans. But doing such detailed evaluation as

would be required to embark on a PLS scheme, such as determining the rates of

return and their time schedule, is beyond the scope of conventional banks. So is the

detailed accounting and monitoring necessary to determine the actual performance.

Chart of Other non Banking activities of Islamic Banking

Under Islamic banking these exercises are not limited to relatively few large

loans but need to be carried out on nearly all the advances made by the bank. Yet,widely acceptable and reliable techniques are yet to be devised. This is confounded

by the fact that no consensus has yet been reached on the principles. Both the

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unprecedented nature of the task as well as the huge amount of work that need be

done and the trained and experienced personnel needed to carry them out seems a

daunting prospect.

C. Training Of Staff

In 1994, the Institute launched a program of lectures in the field of Islamic

finance. The program proved to be highly popular and attracted audiences from

highly prestigious financial, legal, accounting, business and academic organizations.

The aim is to diffuse and disseminate information about developments in the

Islamic financial system, to exchange views, share experiences and to highlight the

opportunities and problems associated with the Islamic financial system.

Chapter 6

CASE STUDIES

6.1) Islamic Banking Potential Impact : Case Study on India

Islamic banking in India

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The period from 1930s to 1974 is characterized by theoretical writings on

Islamic economics and banking, which can be term as the foundation period of

Islamic banking. A country, which can rightly claim to have played a pioneering role

in the development of Islamic economics and finance, is India. It not only produced

some of the most prominent scholars of the Islamic financial world but also played a

very catalytic role in the practice of Islamic finance.

An analysis of the literature on the subject reveals that during the first of the

20th century, almost half of the total literature available in the world was in the

URDU language, and the rest being either in English or in Arabic. In English the first

ever book on the subject was by Indian professor. Some other works that are

considered milestones in the development of present day Islamic economics are also

by Indian scholars. A graduate of Allahabad University has the distinction of

publishing the first ever work exclusively devoted to the subject of Islamic banking.

Endeavors to establish interest free financial institutions in India precede the

writing on this issue. The first such attempt on this issue can be traced to thebeginning of the cooperative movement in the country in the 1890s at Patni Co-

operative Credit Society (1939) of Gujarat is still continuing its business. Northern

India, which can boast of having the largest number of Muslim funds in the country

today, has the distinction of establishing the first Muslim fund in the country in 1940.

According to the information I collected, there are not less than hundred such Muslim

funds in the country with interest free deposits about Rs.1200mn.

Bombay, the financial capital also used to have some of the finest Islamic

financial institutions in the country. But the crises among NBFCs in the late 1990,

which saw the closure of over 45,000 finance companies, had its effect on some of the

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citys most prominent Islamic finance companies. And after the tragic event of

Barkats liquidation in May 2000, Islamic financial activities in the city came to the

halt. However, before being liquidated Barkats along with some others had succeeded

in convincing the Tatas to launch a mutual fund targeted primarily at Muslim

investor.

The current prospectus of Islamic banking and finance in the country can be

seen from two angles. Firstly , the internal demand and secondly the external supply.

Internal demand arises particularly from the huge Muslim population between 130

15 mn ( the second highest Muslim populated country in the world). High awareness

of Islamic financial products and high saving of the community give another

indication of the huge potential for Islamic finance in the country.

From the supply side also Islamic finance has a huge potential in India. High

Net worth Indians (HNIs)working in the Middle East are flush with petrodollars. The

Indian economics is the one of the fastest growing economy of the world. It has the

potential to grow at the rate of over 8% for the next 50 years; however what it lacks is proper infrastructure. Once India opens its market to Islamic and other Islamic

financial institutions in the Middle East and elsewhere to invest in India. The

Government of India too seems to be quite aware of the benefits of these institutions

coming to India and may be because of this it has recently constituted a Committee of

expert under the RBI to look into the matters of Islamic banking.

Facts and fictions about Islamic banking in India:It is unfortunate that our financial sector regulators, bankers and professional

have failed to see the prospects of Islamic Banking in India, thats why RBI or any

other committee have yet to visualize the scope of Islamic banking in India. So far

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Islamic banking has been considered as a mere religious matter for Indian Muslims

and thus it is not allowed with a fear of financial segregation, a threat of parallel

banking system for RBI along with any hidden fear for SCBs to lose Muslim

depositors. There has never been any public committee analyzing the impact of

Islamic banking in India because Muslims of India were never so evocative about

features of Islamic banking in India while the other community members had no

background to conceive this concept to required level for projecting its utility for

Indian economy. Off Course the concept of Islamic banking is driven by ethics of

Islam, but it has more economic utility compared to its religious vigor which needssome genuine study by professionals having basic knowledge of Islamic banking and

expertise on Indian economy because Islamic banking carries more advantageous

features to boost real sector economy compared to financial sector. It is a need of the

hour that Indian government should constitute a committee on public domain to study

and analyze the economic significances of Islamic banking for the Indian economy.

Economic analysis of Islamic Banking in India:

Islamic banking may not be allowed just for a community as a religion based

banking business, but it should be allowed after thorough study of its potential to

resolve our real economic problems. The report by Sinha Committee was incomplete

and thereafter still we have to find any report on economic viability of Islamic

banking and its impact on inclusive growth. We have to remove the prejudices about

Islamic banking and need to study it as a core economic issue irrespective of its base

driven form Islam.

Future leaders of Islamic banking in India:

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There might be a prejudice among top bankers that since Islamic banking

originates from Islam, Muslims might take a lead in Islamic banking and their

supremacy in banking sector may not be sure after Islamic banking. However the

reality may be far different from the fiction. Indian Muslims are hardly capable to

hold major shares of Islamic banking business in India as they lack required

infrastructure, financial depth, banking creditability to attract the general depositors

and investors under Islamic Banking. Islamic banking is not a childrens game. It

requires even better professional expertise compared to conventional banking because

it deals more with commercial projects than mere monetary credit and debittransactions. Indian Muslims may feel privileged in terms of Islamic ethics required

for Islamic banking but they certainly lack professional efficiency to manage modern

commercial banking on Islamic ethics. Our leading nationalized bank (SBI) is

somehow reaching to that expertise which may be required to manage a complex

banking project such as Islamic banking, but they have to hire services of experts on

Islamic Banking. The RBI code of conduct to SCBs putting thrust on SMEs is

reflecting the need of advanced commercial banking in India which would be focus

under Islamic Banking. The performance by SBI has been best among nationalized

banks to lend commercial credits. But still majority of unorganized sector workers

who are non-bankable due to collateral problems are actually needing equity finance

instead of debt finance. All the difference among nationalized banks operation and

Islamic banking is the mechanism of credit and deposits. Under Islamic banking

mechanism thrust would be on equity deposits and credits while interest chargedwould be replaced by profit margins on commercial credits and interest expended

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over deposits would be replaced by dividend on equity finance with deposits

mobilized as equity deposits by banks.

It is expected that with introduction of Islamic banking in India, the first choice

of depositors and investors would be nationalized banks as despite contradiction of

interest, Indian Muslims have a confidence in nationalized banks. To ensure security

of deposits majority of Muslims depositors would prefer to join Islamic banking

managed by nationalized banks. However it is expected that Foreign Investors

looking to invest in India through Islamic banking, would prefer to have services of

foreign banks. As far Indian Muslims are concerned, they have to make hard efforts

to find their place in managing Islamic banking in India because they lack required

financial depth; infrastructure and more importantly they have poor credibility among

the depositors and investors due to some past failures of financial institutions.

Beside to take political, social, religious and diplomatic advantages, Islamic

banking is more desired for Inclusive growth of India. It is all important to evaluate

probable impact of Islamic banking in different segments of Indian economy. Everysegment is expected to enjoy its benefits.

(i) The 150 millions Indian Muslims would enjoy their religious rights in banking

sector with provision to get rid of interest which is strictly prohibited in Islam.

(ii) With introduction of Islamic banking, the UPA government may get advantage

to please the second largest community of India who are somehow

uncomfortable with linking of recent terrorist attacks with only Muslim

community or in other words by hearing the terminology of Islamic terrorism.

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(iii) With introduction of Islamic banking, Indian government will gain diplomatic

advantages to make financial dealings with Muslim dominated nations

especially to attract trillion dollars of equity finance from gulf countries.

(iv) The operation of Islamic banking will allow the Muslims to work with majority

community in banking sector which is not found in proportion to their

population share so far, because RBI has just 0.78% Muslims and SCBs have

just 2.2% Muslim employees. Similarly Muslims have a poor employment rate

in NABARD and SIDBI because every where financial institutions are dealing

with interest and Muslims do not like to work with interest based banking andfinancial institutions. It is a major factor causing financial exclusion of Indian

Muslims. With Islamic banking this exclusion may be removed and it would

definitely help us build civil society economy.

Islamic Banking is rated as one of the urgent needs of Indian economy as it is

the only banking mechanism which seems to arrest the liquidity and inflation problem

along with allowing GDP growth with adequate share in all segments. The increased

percentage share in GDP by agriculture or manufacturing industry, or per capita

income growth is just not indicative of true inclusive growth. For real inclusive

growth, we have to ensure increase in income and employment status of workers at all

segments. Empirical evidences reflects that though India has registered better growth

rate in recent years, the number of poor living below poverty line has increased in our

country. It may be noted that the household consumption is directly related to

household income which has declined in recent years; while corporate savings are

directly related to income of corporate sector which has increased. Thus we may

conclude that with better GDP growth rate in recent years, our corporate sector has

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snatched the fruits of growth, while majority of work force have failed to enjoy the

fruits of development.

The prime economic advantages of Islamic banking could be as following

Islamic Banking and Financial Inclusion

Though we do not have any survey to compare community wise financial

exclusion in India, the primary study of data available through Sachar Committee

report reflects that still around 50% Muslims are financially excluded and banking is

inversely related to concentration of Muslim Population. The reason is just

prohibition of interest in Islam and thus wherever Muslims are concentrated; they find

means practicing interest free banking through societies and NBFCs. With inception

of Islamic banking it is expected that Muslims will join Islamic banks which will

remove their financial exclusion.

Business of nationalized banks would be increased:

So Indian Muslims are looking for Interest free banking to avail much neededcredits for development which is possible through introduction of Islamic Banking in

India. This may add at least approximately 60 millions Muslims to formal financial

sector. Through this financial inclusion of Indian Muslims to formal sector Islamic

Banks, it is expected that Indian nationalized banks may see additional savings worth

1,00,000 crores and credit worth over Rs. 2,00,000 crores which may help banks to

gain higher rate of profits compared to their SLR. After successful operation of

Islamic banks by our nationalized banks, private banks may also enter into dealing

with Islamic banking.

Stock Market Capitalization

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Since Islamic banking focuses on equity deposits and finance, it is expected

that Stock market will be the most preferred avenue for investments by future Islamic

banks of India because currently it is our stock market which is attracting new

investments under Shariah Finance schemes. With advanced art of technology for

investment with liquidity and profitability, it is expected that majority of deposits

with Islamic banks in India will be preferably canalized to stock market. It would be

the safest and fasted mode of deploying equity funds. Thus Islamic Banks may add

additional 6 million new D mat accounts with expected capital gain of Rs. 60,000

crores from domestic market and around 1 trillion US $ through Islamic Banksmanaged by foreign bankers in India.

Formal Sector Economic Agents

Under Islamic banking the formal sector economic agents like corporate firms

listed with stock markets would be the first likely beneficiary of Islamic banking

because their shares would be subscribed through investors at Islamic banks. All the

companies listed in stock markets will have additional potential subscribers to

genuinely subscribe their shares instead of mere trading stocks to gain for speculation.

Islamic banking will bring Revolution:

Islamic banking will allow the manufacturing and retail enterprise of

unorganized sector and agriculture to obtain equity finance which would bring

revolution in Indian economy because our majority of poor and vulnerable workers

are associated to agriculture and unorganized sector that are not in a position to afford

financial risks for capitalization which is required to increase their productivity and

income levels. Their financial background is not encouraging SCBs to extend debt

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finance to them in lack of collaterals. While in case of Islamic banking the inadequate

capital ratio in unorganized sector could be resolved through equity finance which

might be a revolution is our agriculture and unorganized sector; with improved capital

ratio, our poor and vulnerable workers associated with agriculture and unorganized

sector might be able to compete with the formal sector workers with their enhanced

productivity. This might induce our leaders to substitute grants and subsidies with

financial institutions focusing on equity finance because self reliability is more

important for growth which never comes through grant and subsidies but with

successful utilization of equity finance. The stabilization fund for poor farmers andartisans may be utilized to experiment such finance with Islamic banking.

Islamic Banking and Public Finance:

Islamic banking may further help us mobilize capitals on equity base to meet

the investment needs for irrigation, dams, roads, electricity, and communication

projects along with other infrastructure where public finance is insufficient and debt

finance may be cause deficit to the government. With Islamic banking raising equity

funds would be easier for banks. We must not forget that over 50% of our rain fed

lands need irrigation which need equity finance to reduce the credit costs. The total

investment in infrastructure, in 200607 was estimated to be around 5% of GDP. It

has to be 9% of GDP by 2011-12, it means that we would require Rs. 2,07,291 crores

in 2006-07 and Rs. 5,74,096 crores by 2011-12 to finance our infrastructure. The total

investment amounts to Rs 20,56,150 crore for the 11 th five year plan. Of which Rs.

14,36,559 crores is supposed to be met from Public Investment wile Rs. 6,19,591from private investments. Islamic banking through promoting equity finance from

national and international markets may reduce this burden effectively with keeping

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public finance well under control and probably we may need not to worry about fiscal

deficit as well.

Since Islamic banks may also have managerial control over commercial

financing, government might use banking units as source to mobilize taxes as well

which might reduce mobilization costs for public revenue and increase margins for

governments.

Islamic Banking and Indian Economy:

Viewing the probable multi dimensional positive impacts of Islamic banking on

Indian economy, there are many reasons to smile for Islamic banking in India. It is

helping our financial sector maintaining stability while helping real economic sector

attain inclusive growth. The public finance would be much benefited through Islamic

banking by generating investment funds on equity basis. Thus Islamic banking should

be considered as a core economic need of the economy instead of viewing it as a

religious matter for Indian Muslims. By any projections, it is expected that Islamic banking may help us mobilize business up to 5% our GDP with making due

corrections in financial and real markets. Therefore it should be considered as a

genuine economic need of the nation instead of considering it as religious, social or

political issue. Hope all patriot Indians will flag green signal to Islamic banking as it

is opening the doors towards faster and more inclusive growth An approach to 11th

five year plan of India.

Since we have no project or viability report on this issue, it would be better to

form a committee on public domain to analyze Islamic banking and its impact on

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Indian economy before we take any action in this regard because a delay but careful

step is far better than any hasty move with prejudice.

6.2) Islamic Banking and Its Potential Impact : A Case study onIndonesia

Islamic banking was introduced a little late in the largest Muslim Populated

nation in the world Indonesia. Nevertheless, it has gained popularity and acceptance

in a short span of time. This case analyzes the experience and the progress of Islamic

banking in Indonesia with the help of the support offered by Shariah Bureau of bank

of Indonesia.

Since the representative of the Shariah Buerau of Bank Of Indonesia

responsible for the supervision and development of Islamic finance will focus on the

experience and progress of Islamic banking in Indonesia., I will focus on some

questions about the impacts of that banking, particularly in rural areas, and aspects

that the Bank Indonesia representatives will not focus on.

Islamic banking is a worldwide phenomenon involving a variety of institutions

and instruments, not one project or institution. In the past few decades, Islamic

institutions and instruments have developed in many countries, including the UnitedStates. In certain countries Iran, Sudan, and Pakistan all or most financial

intermediation conforms to Islamic law as defined by local authorities. All three of

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these countries also have banking authorities that govern the general level of charges

and returns in the system and these are not usually market-governed systems.

In most other countries, including Indonesia, Islamic transactions and

institutions make up a small part of the total and must compete with conventional

financial institutions There is even considerable Islamic banking in the United States.

If the terms and conditions of Islamic transactions differ too much from those of

conventional institutions they become hard to sustain. The terms and conditions of

Islamic institutions therefore tend to converge with conventional ones.

Islamic instruments are simply a narrow group of familiar financing

instruments. Any transaction, with any distribution of proceeds, can be conducted as a

lease, a sale, a partnership, a fee-generating transaction, or a loan. Islamic instruments

generally avoid loans. Though the scheduled distribution of proceeds may be the

same as for a conventional loan, the legal risk in case of default is often different in

the different forms of financing.

Those who promote Islamic finance often prefer partnership arrangements in

which profits or turnover is shared because this conforms more fully to the goals of

Islamic banking. One goal of Bank Indonesia in promoting Islamic banking is to

increase the proportion of financing involving such sharing. Nonetheless, more than

80 percent of Indonesian Islamic financing is in fixed-term forms, mirroring the

pattern throughout the world.

Many involved in Islamic banking would like to minimize the differences

between Islamic and conventional banking and thus they welcome fixed-term forms.

However, because the instruments differ in some degree they typically require some

adjustment from their conventional counterparts. For example, in Islamic

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transactions, the bank often holds the title of the property concerned. U.S. banking

authorities have ruled this unobjectionable provided that title holding is only a matter

of form to accommodate Islamic structures.

THE EXAMPLE OF INDONESIA

Indonesia, with the worlds largest population of Muslims, has come to Islamic

or Shariah banking fairly late. Many of Indonesias Muslim leaders do not believe

that commercial interest in its modern form is prohibited, although others do. After

some false starts, Islamic financial institutions are developing rapidly and have the

enthusiastic support of many young people and intellectuals. The work of the Shariah

Bureau of Bank Indonesia demonstrates that Indonesia, especially in particular parts

of the country, has considerable unmet demand for Islamic banking.

Islamic banking in Indonesia has some unusual characteristics. Like most

microfinance institutions in Indonesia, Islamic institutions, micro or otherwise, are

generally pr

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