Why Islamic Banking in India is a Good Idea

Whatever benefits Islamic banking may or may not have in its favour, public relations is not one of them. The Reserve Bank of India's recent nod to sharia-based non-banking financial houses met with resistance from the usual suspects. Objections to Islamic banking in India range from regulatory inertia and concern about the unknown to Islamophobia. This is made worse by the existence of few rigorous analyses of Islamic finance.

The first Islamic bank in the world was founded in Egypt in 1963, and since than, the phenomenon has grown slowly but steadily. Conceptually, an Islamic bank has an equity-based capital structure, composed of shareholders' equity and investment deposits based on profit and loss sharing. Just as supervisory issues such as capital adequacy ratios in conventional banking are regulated by the Basel Committee on Banking Supervision (BCBS), Islamic banks follow the standards prescribed by the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI).

The most known factoid about Islamic banking is that it prohibits earning of interest, or riba. Muslims believe that profit should be based on effort; moneylenders expend little effort, their earnings accruing while they sit idle. Islamic banking also prohibits investment in activities considered haram, or sinful, according to sharia. Thus, projects involving alcohol, tobacco, pork products, weapons and defence, and pornography are all forbidden. The system also proscribes gambling and speculative activities. It should be mentioned that Islamic banks keep their doors open to all, including non-Muslims.

It should be noted, however, that while riba is prohibited, equity-based returns on investment are not. Islamic finance covers several types of financial contracts that vary in equity and profit-loss sharing. For the simplest accounts, Islamic banks perform a fiduciary role by primarily protecting the principle and sharing the surplus if any; for savvier depositors, the bank serves as an agency and provides administrative support. Modes of financing such as mudaraba (one partner provides the money and the other contributes expertise) and mushakara (investment, labour, expertise, risk is shared among all parties) may be seen as strictly profit-loss sharing, while murabaha (sale of goods in which profit margin is decided upon by both buyer and seller),  ijara (leasing), and bai-us-salam (advance payment on future delivery of goods) are not. There also exist hybrid of these two types. To enlarge the field of operations of Islamic banking, the requisite infrastructure has been slowly put in place. In 1995, the Dow Jones Islamic Markets Index (DJIMI), a listing of sharia-compliant portfolios, was launched. A special Sharia Supervisory Board oversaw the process, and the stocks are widely traded. In general, Islamic banks have performed as efficiently as conventional banks despite their self-imposed restrictions.

There is nothing inherently problematic about this system; investors are free to choose between conventional and Islamic finance, and the pitfalls of conventional investments such as investor knowledge, information asymmetry, and agency problems also apply to Islamic banking. Regulatory mechanisms such as financial cushions and prudent asset-liabilities structures will enhance the banks' fiduciary role. Like conventional banking, Islamic banking also will require periodic audits and stringent rules on transparency.

India's present laws obstruct the establishment of Islamic banking - the Banking Regulation Act (1949) prohibits the operation of banks on a profit-loss basis (5b), forbids murabaha, or, the buying, selling, or barter of goods (8), impedes ijara, or, bars the holding of immovable property for a period greater than seven years (9), and requires the payment of interest (21). However, there is no reason for these regulations not to be amended. The purpose of regulations is to ensure smooth and standardised operations, not vet business models; the market will be the best judge of the efficiency and pitfalls of Islamic banking.

Undoubtedly, beyond the infrastructural issues, Islamic banking faces many difficulties - given the partnership dimension of business, Islamic banks may have to maintain a closer watch on their investors than a typical bank would. furthermore, Egypt's al-Azhar disagrees with the Pakistani Supreme Court's 1973 interpretation of riba - while the former restricts the meaning to usury, the latter accused the country's banks of engaging in "conventional banking sprinkled with holy water" and interpreted it as all forms of interest. Again, these are questions best left to the investor, the bank, and bodies such as the AAOIFI and DJIMI; the regulatory authority's mandate is only to create and maintain a system with maximum transparency and accountability.

Experts argue that Islamic banking will mobilise enormous capital held by devout Muslims who sparingly participate in the conventional market. The Raghuram Rajan Committee on Financial Sector Reform (2008) also considered interest-free banking, and by 2013, the global market for sharia-compliant assets has risen to $1.6 trillion. Specifically for India, this means institutional money from the Middle East and Southeast Asia, as well as private wealth held by Indian Muslims in and out of the country. Given the number of Indian expatriates in these regions, Islamic banking holds an enticing opportunity for fuller market capitalisation. Sharia-compliant schemes have already shown promise in India - Tata Core Sector Equity Fund, launched in 1996, was tailored to assuage Muslim inhibitions on riba. Furthermore, it would be an added bonus if Islamic banking reduces dead-end investments in gold and jewellry.

No matter, Islamic banking is a political and not financial argument in India. In an environment of minority vote-banking and cynical political manipulation, any idea tagged with a religious prefix is doomed. It should be remembered, however, that Islamic banking is not a mandatory methodology imposed on all financial operations in the country, even in Saudi Arabia. It is an additional choice for the investor, and nothing prohibits one from using different systems for different transactions. While Islamic banking is based on a package of ethical values, ethical investments are not a uniquely Islamic phenomenon - we make daily choices about fair trade coffee, blood diamonds, and other products. Consumers may choose not to patronise a store if the company supports a cause they disagree with, something we have seen with the attempted academic boycott of Israel.

Finally, there is canard of terrorism. This is utter nonsense; there is no evidence to show that Islamic banking makes terrorist funding easier than any other financial activity. As long as transparency is maintained and regular audits performed under RBI guidelines, the system will remain viable. Islamic banks have appeared in several countries from the United Kingdom to Japan and Singapore without causing any disruption in either the financial system or in security.

The debate over Islamic banking is motivated by sectarianism in the guise of technical arguments over regulatory concerns, security, or secular society; none of these arguments survive scrutiny.

Another important economic term to be acquainted with is opportunity cost - by not beginning the process of creating the regulatory infrastructure to also allow Islamic banking, India is losing out on financial opportunities of some consequence.

Jaideep spends most of his time avoiding work; when not married to his books, he likes to cook, sail, and scuba. A great admirer of Hatshepsut, Jaideep refuses to live in the 21st century. He grew up in the Middle East and Europe.When forced into wage slavery, he is a doctoral student in History at Vanderbilt University.