Islamic banking can tap into new sources of finance

The biggest problem with the term ‘Islamic bank’ is that it carries the word ‘Islam.’ It is almost like the elephant in the poem we read in school, of six blind men trying to describe it based on the various parts they touched. Instead, let’s look at the idea by calling it ‘interest-free banking’.

As intermediaries of the financial system, conventional banks accept deposits and lend money on the basis of a predetermined rate of interest. Under a non-interest-based system, any payment or acceptance of interest is prohibited. The system operates on the basis that the return on investment (the equivalent of ‘interest’ under the conventional banking system) is a compensation for the risk taken by the investor by providing fund for commercial activity. Hence, under a system that prohibits interest, money can be lent on a profit-sharing basis, sans interest.

ALSO READ:

IMA fraud: Ponzi in the name of ‘Halal’

‘IMA scam was due to investors’ greed’

Benjamin Franklin said, “money begets money and its offspring begets more.” Non-interest bankers, however, believe that “money does not beget money.” It is only when ‘money’ joins hand with human labour that it gets transformed into ‘capital’ and acts as a catalyst for the production of goods and services. Capital is eligible to share the surplus money or profit. The profit-sharing ratio may be prefixed, but determining the rate of interest linked to the amount of money lent is prohibited.

If the above approach is applied to a bank, some basics will change. On its liability side, the bank will not be able to pay a return on the deposits it receives. On the asset side, the bank will not be able to demand an interest/return on the sums lent. This is because guaranteed repayment of the principal amount lent is permissible, but guaranteed repayment of the ‘capital’ lent in a business venture is not. Such a concept, to be applied to a bank, will require a clear understanding of the business venture and very close appraisal and follow up to ensure that the return on investment is always positive. It will also require a very high level of business ethics.

Central Banks the world over, as the regulators of financial systems, have prescribed that a banking company cannot be allowed to share the business risk of the borrower. Hence, they insist that a banking company: (a) be prohibited from taking commercial risks; (b)pay and charge a predetermined return (based on time value of money) both on its liability and asset side; (c) assure capital guarantee for deposits, and to achieve this it must ensure that loans granted by it are secured.

To fall in line with these demands, a non-interest bank resorts to contracts for the transfer of interest in the underlying physical assets involving sale-purchase, lease, diminishing lease, mortgage by conditional sale, ‘credit sale’ or deferred payment sale and similar other tools to ensure that its investment is free from business risk. This makes the non-interest bank have all the qualities of a conventional loan contract with an interest clause in as much as: (a) the return on capital gets fixed on day one; (b) the return of capital is guaranteed; and (c) the modality for carrying out the investment ensures that there is no commercial risk on the bank.

Being satisfied that these three pillars of commercial banking practice are in place, regulators have allowed non-interest banks in the US, UK and other countries. Today, non-interest banks operate in almost 70 countries, along with conventional banks. The transactions were, however, not cost effective as it involved payment of conveyance charges, taxes and cess, etc., twice over. Hence, exemption from payment of taxes/stamp duties twice, in a single loan transaction, as also parity in tax matters was sought and granted in order to create a level playing field. No changes in any banking statute of these countries was sought or granted.

Indian initiative

The introduction of non-interest banking in India has been examined from time to time, both by the RBI and the government. In 2006, the RBI constituted a working group to examine whether interest-free‘ investment bonds’ could be introduced in India. It concluded that “In the current statutory and regulatory framework, it would not be feasible”. The idea was shelved. After the financial meltdown in the US, the need for financial sector reforms became relevant. The committee constituted by the Ministry of Finance stressed, among other things, the need for a closer look at the issue of interest-free banking.

This was followed by the formation of an inter-departmental group (IDG) to examine the “legal, technical and regulatory issues” for introducing interest-free banking. The IDG recommended the gradual introduction of interest-free products. The latest in the series is the committee report on ‘Medium-Term Path on Financial Inclusion’, constituted by the Reserve Bank (December 2015). It recognised that after the launch of the Pradhan Mantri Jan Dhan Yojana (PMJDY), financial inclusion has improved but there are still significant gaps. Based on its recommendation, the RBI in its 2016-17 annual report observed that “some sections of Indian society have remained financially excluded” from using banking products with an element of interest.

It proposed to explore the modalities of introducing interest-free banking products through specialised interest-free windows in commercial banks, with simple products like demand deposits, agency and participation securities, offering products based on cost-plus financing, deferred payment and deferred delivery contracts.

The report is important because it acknowledged that the introduction of interest-free products did not require any statutory changes and it would be sufficient to issue a separate set of regulations for governing non-interest banks. It is now for the government to take a view.

Advantages

Under the conventional system, interest builds up and compounds, even when there is loss in the business. Since this does not happen in non-interest banks, it makes the system borrower-friendly.

The investment model adopted by a non-interest bank creates physical assets. Hence, even in large infrastructure projects, if the investment becomes bad, the ownership right on the assets remains with the bank. This puts the bank in a better position to manage NPA and recover a substantial amount.

The investment does not involve the disbursement of funds (except for working capital). As a result, the syphoning or diversion of funds by promotors is rather difficult.

As the economy grows, all stakeholders benefit. This leads to spread of wealth and brings general wellbeing rather than allowing the concentration of wealth in a few hands.

The introduction of non-interest banks will encourage those who want to avoid interest in commercial dealings and therefore do not avail the banking services. This will help increased use of funds for commercial purposes rather than blocking funds in unproductive assets like gold or real estate.

The introduction of a non-interest bank will also send a message that India is open for interest-free commercial transactions. Because India is a fast-growing economy, it is likely to become an investment destination for fund managers desirous of making an investment for profit, sans interest. This is, therefore, an opportunity waiting to be tapped.

(The author has worked as Joint Legal Adviser with the RBI, and a World Bank project for revising banking & finance laws, including Islamic Banking of Bangladesh – The Billion Press.)