Islamic Banking – A system with no usury

By Joanna Joshua

INTRODUCTION TO THE CONCEPT OF ISLAMIC BANKING

As one can logically conclude from the term, Islamic banking is a system that has its roots in Shariat Law, which says that money has no intrinsic value.[1] It prescribes that no one should make any undue profit from it or gain any interest from it. This means that no one should pay any fee for borrowing money (also known as riba),[2] as charging interest and investing money in businesses is considered to be haram under Muslim law derived from the Qu’ran.[3]

To illustrate, consider that a customer deposits money in a savings account which can be withdrawn on demand. The bank guarantees that there will be returns but no interest is charged. The bank may charge the customer for maintaining the money and the customers usually do not mind paying this and see it as giving a gift (hibah).[4] This can be compared to debt financing where a businessman borrows a certain amount of money to be repaid within a stipulated period with interest from a capital owner. If he makes a profit, this will be easy for him to do but if his business runs into a loss, he will have to pay back the loan along with interest from his resources while the capital owner loses nothing. This is viewed as an undue profit for the capital owner under Islamic Banking principles

EVOLUTION OF ISLAMIC BANKING SYSTEM

Islamic banking practices were customs that most Muslims followed at their own will. In the Middle East and African countries like Egypt, there were small scale Islamic banks set up to help the disadvantaged sections of society.[5] In the late 1950s, the first experimental local Islamic Bank was established in Pakistan’s rural areas where no interest was charged.[6] This started expanding gradually to other parts of the world. For instance, in 1963, a financial institution called Tabung Haji in Malaysia lent money for the Hajj pilgrimage without charging any interest and they had 8,67,220 depositors who made deposits of over 1 billion Malaysian dollars.[7] The formation of the International Islamic Bank for Trade and Development in 1975 led to a rise in the economic standards of all Islamic countries, especially those that are members of the Organisation of Islamic Cooperation.[8] It has now found a commonplace in many nations around the world. In fact, in 1999, the Dow Jones Islamic Market Index became official.[9]

How does Islamic banking work?

Qu’ran 2:30 says that man was created as a representative of God on Earth.[10] This concept has had a bearing on Muslims and they believe that they must help needy people through their businesses. They also believe that wealth is a means and not an end so they must not hoard money unnecessarily according to Qu’ran 9:34 and 9:35.[11]

Since this system is based on the concept of interest-free banking, no undue profit must be gained by anyone. However, reasonable profit may be gained, and investments pertaining to low risk businesses are allowed. Since ‘low-risk’ is a very subjective term and no exhaustive list of the same can be made, Islamic banks make calculations and ascertain the businesses that do not involve high risk.[12] They also give their customers’ accounts where only profit or loss can be made without any interest rates. The money that is collected is used to invest in these low risk businesses such as tutoring, direct sales, certain service businesses, etc. This is known as a Sharia Compliant Project as it does not involve any haram.[13] On the other hand, businesses involving weapons, alcohol, drugs, etc are haram in nature and also involve high risk. The profits of the Shariat Compliant Projects are shared among all the customers of the bank.

There are many Shariat Compliant Projects that are covered by Islamic banks. The most popular ones are:

  1. Mudarabah – In this project, one party provides money and the other provides expertise on a particular field or subject. The capital owner may choose not to take part in the working of the business. They share profits according to the ratio decided by them at the beginning of the business. However, if there is a loss, the capital owner must bear it because it is the risk of loss that entitles him to benefit from the profits when made. The expert or the manager does not bear any financial loss because the loss he bears is seeing that his work and time has been wasted. However, the capital amount is reduced to that extent and he will not be rewarded for his labour.[14]
  2. Murabaha – Instead of lending money for a mortgage transaction, the bank buys it from the seller and resells it to the buyer at a profit and they may pay in instalments but there are no penalties for late payments. The bank is therefore compensated for the time value of the money in the form of the profit margin. Collateral is also taken as security.[15]
  3. Musharaka – This is a joint venture where, in each project the parties take up, the profits and losses are shared equally or in a predetermined ratio.[16]

ISLAMIC BANKING IN INDIA

Islamic banking is now prevalent in many non-Islamic countries as well, such as China, USA, UK, Germany, etc.[17] This is done through windows that have been opened in conventional banks. They also have separate Islamic banks as seen in the UK which was the first nation to do so by opening the Islamic Bank of Britain (now known as Al Rayan Bank) and issuing Islamic bonds known as sukuk in 2014.[18] The USA also has an American Finance House known as LARIBA which is riba free and offers Shariat Compliant Projects.[19]

Despite having a sizable population, the Muslim community is financially and socially backwards when compared to the other classes in India. As opined by the Sachar Committee, adoption of Islamic Banking system will encourage them to come forward and invest.[20] Another advantage is that there will be a more equitable distribution of wealth as wealthy people will stop hoarding their money and will deposit it in these accounts for reasonable profits. This is because this system is more financially stable. For example, an Islamic investment product is backed by Sharia laws, which will curb it from being of sub-prime quality. It is also asset-backed which makes it equity-based and not debt-based which limits speculative behaviour that is otherwise seen in the market. Further, if introduced, the inadequate labour capital in the informal unorganised sector such as agriculture and manufacturing will be solved through equity financing offered by Islamic banking.

However, the understanding of riba is vague. Since there is a thin line between riba and profit, many bankers feel that Islamic banking and conventional banking methods are similar.[21] The Constitution also provides for the ideal of equality and therefore steps must be taken to put them on an equal footing with the rest of the population. However, it also impliedly prohibits Islamic banking. On a reading of Article 14, we see that equality means that those who are equal must be treated equally and those who are not must be treated alike.[22] Since many view Islamic banking as being similar to traditional banking methods, if the former is adopted, it will be seen as treating two ‘equal persons’ unequally and this will make the Banking Regulation Act, 1949 unconstitutional. On the other hand, some believe that these two banking systems are not the same. Thus, two unequals must not be treated equally and this will also mean that Islamic banking cannot be adopted in India.

This concept was mooted by the former governor of the Reserve Bank of India, Mr Raghuram Rajan in his report in 2008.[23] He believed that this must be done to give access to those who belong to economically weaker sections of society. Further, if this is incorporated in India, a huge amount of funds can be raised because many companies in the stock exchange are Sharia Compliant.

Although this suggestion was made with good intentions, there are many complications involved. The Banking Regulation Act stipulates the payment of interest, which is riba. This is against the principles of the Islamic Banking system. The definition of ‘banking’ in Section 5(b) of the Act means accepting money from the public to indulge in investments, which means that it may not include just low-risk businesses. Further, it does not mention interest as a prerequisite. Section 8 of the Act prohibits direct or indirect selling of goods except when there is realisation of a security given to or held by it. Since in Murabaha, the customer’s assets are taken as security, the same cannot be prohibited.

Section 17(1) of Reserve Bank of India Act, 1934 gives RBI sole authorisation to transact in businesses that involve accepting money without interest from the central or state government or local authorities or other banks. This means that if Islamic banking becomes a reality in India, only the RBI can take part in these projects unless these provisions are amended.

The question of recognition of this system was raised in the case of Commissioner of Wealth Tax, Bhopal v. Abdul Mohammed Ali.[24] The issue here was whether tax deductions would apply on an interest-free loan. The Supreme Court held that it would apply but also stated that this judgement does not mean that they have decided upon this subject finally to support situations where the lack of repaying ability is attributed to these kinds of loans.

A good way to facilitate Islamic Banking will be to allow Non-Banking Financial Institutions (NBFIs) to use it. This is why the RBI in 2013, allowed the Kerala State Industrial Development Corporation to float an NBFI called Cheraman Financial Services Limited (CSFL) to function as a Sharia-based NBFC with an authorised capital of 1,000 crores.[25] It has boosted the economy of the state and almost 50,000 crores lay unclaimed as interest money. Most of this is remittance from Muslims working in Middle Eastern nations as they cannot collect this interest as per the Sharia Law. It would be easier to facilitate the entry of this system if a separate law is enacted in the same way that Malaysia did with the Malaysian Islamic Banking Act, 1983, that will not substitute the Banking Regulation Act but will support it.

IMPACT OF COVID-19 ON ISLAMIC BANKING

Due to the COVID-19 pandemic, there has been uncertainty in all spheres of business but oil prices adversely impact the Islamic banking sector.[26] This is because it impacts Small and Medium Enterprises (SMEs). As compared to traditional methods of banking, Islamic banking has a larger exposure to SMEs.[27]

However, it may also have some positive effects by accelerating trends such as socially responsible investing, sustainability and digitalization. All financial institutions around the world are trying to increase digital banking transactions during this time which in turn provides an added boost for Islamic Banks to do the same.

The United Nations Development Program (UNDP) stated that Shariat compliant financing instruments could be a part of the pandemic response plans to help countries recover from the pandemic. It can improve environmental, social and governance (ESG) performance.[28]

CONCLUSION

Islamic banking is a system without any usury and has evolved to a significant extent over the years. It used to exist only in the Middle East but is now a part of many banking systems across the world. A common misconception is that this system is only for Muslims. It must be noted that many of its customers around the world are Non-Muslims, and hence the government cannot use this as an excuse to say that it breaches the idea of secularity. Further, the Indian financial system is either way far from being secular as it has the concept of Hindu Undivided Family as well.

The Islamic Banking system functions on moral concepts and has the power to ensure economic stability without imposing interest. There is also a range of Compliant projects available to choose from. Islamic banks are expected to have future in implementation of models that rely on profit, loss and sharing. It is recommended that they operate as specialised banks to monitor investments more efficiently and inexpensively.

Opinion expressed by the authors are personal.


[1] Islamic Banking, Institute of Islamic Banking and Insurance, (Apr. 09, 2020), http://www.Islamic-banking.com/Islamic_banking.aspx (last visited on Aug. 30, 2015).

[2] id.

[3] Āyatullāh Sayyid Muḥammad Taqī al-Mudarrisī al-Ḥusaynī, Laws of Islam 386 (2016).

[4] Jomy M. Joseph, How Islamic banking works without interest,  The Week (Jul 29, 2020),  https://www.theweek.in/content/archival/news/biz-tech/islamic-banking-interest-free-system.html.

[5] Seema Rao, What is Islamic Banking and why does the RBI want it in India?, Scroll in, (Mar 24, 2020), https://scroll.in/article/822234/what-is-islamic-banking-and-why-does-the-rbi-want-it-in-india

[6] R. Wilson, Banking and Finance in the Arab Middle East, St Martin’s Press, New York, (1983).

[7] Tabung Haji, Tabung Haji Gov., (Apr. 1, 2020), https://www.tabunghaji.gov.my/en/corporate/corporate-information/about-us

[8] What is ITFC, International Islamic Trade and Finance Corporation, (Mar. 22, 2020), https://www.itfc-idb.org/en/content/what-itfc.

[9] supra at 4.

[10] Qu’ran 2:30.

[11] Qu’ran 9:34 – 9:35.

[12] Islamic Banks Commercial Transactions, Financial Islam – Islamic Finance, (Mar. 31, 2020), http://www.financialislam.com/investment-andtransactions.html.

[13] James Chen, Shariah Complaint Funds, Investopedia, (Mar. 20, 2020),  https://www.investopedia.com/terms/s/shariah-compliant-funds.asp.

[14] Mufti Mohammed Taqi Usman, An Introduction to Islamic Finance 32 (1998).

[15] id.

[16] Musharaka, Institute of Islamic Banking and Insurance, (Apr. 9, 2020), https://www.islamic-banking.com/explore/islamic-finance/shariah-rulings/question-answers-shariah-rulings/musharakah

[17] Ismail Ozsoy, Conceptual Fundamentals and Basic Features on Islamic Banking, Economic Herald of Donbas Quarterly 4(22), 2010.

[18] Press Release, Al Rayan Bank wins ‘Best Islamic Bank in the UK’ for pioneering Sukuk deal, Al Rayan Bank, (Feb. 04, 2019), https://www.alrayanbank.co.uk/useful-info-tools/about-us/latest-news/feb-2019/al-rayan-bank-wins-%E2%80%98best-islamic-bank-in-the-uk%E2%80%99-for-pioneering-sukuk-deal/

[19] The LARIBA Model, LARIBA, (12 Apr. 2020), https://www.lariba.com/sitephp/model.php

[20] National Commission for Minorities: Statutory Recommendation (2005), http://ncm.nic.in/sachar%20report.pdf .

[21] Sunit Arora, Dropping the Idea of Islamic Banking in India Will Leave Millions Shortchanged, The Wire, (22 Apr. 2020), https://thewire.in/banking/islamic-banking-rbi.

[22] Gauri Shankar v. Union of India, A.I.R. 1995 S.C. 55.

[23] Planning Commission, A Hundred Small Steps: Report of the Committee on Financial Sector Reforms (2008), http://planningcommission.nic.in/reports/genrep/rep_fr/cfsr_all.pdf .

[24] Commissioner of Wealth Tax, Bhopal v. Abdul Mohammed Ali, 1988 AIR 1417.

[25] Bernardo Vizacino, RBI allows non-bank Islamic finance firm, Reuters, (Apr 12, 2020), http://in.reuters.com/article/ 2013/ 08/ 20/ Islamic-finance-india-idINDEE97J07L20130820.

[26]  H. Mohamed & H. Ali, Blockchain, Fintech, and Islamic finance: Building the future in the new Islamic digital economy, Walter de Gruyter GmbH & Co KG, (2018).

[27] Stuart Brown, How COVID-19 will reshape Islamic finance markets, The Jakarta Post, (Jun 15, 2020), https://www.thejakartapost.com/academia/2020/06/05/how-covid-19-will-reshape-islamic-finance-markets.html

[28] R. Baldwin, B.W. di Mauro, Mitigating the COVID economic crisis: Act fast and do whatever it takes, VoxEu. org, CEPR, (2020).

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