ISLAMIC BANKING
Islamic banking is a banking system as per the Sharia (Islamic law).
According to Islamic Law, money has no intrinsic value and is only a medium of exchange. So it cannot be sold at a profit and is permitted to be used as per Shariah only. As a medium of exchange, Shariah prohibits money to be bought and sold at a profit (i.e. interest or ‘riba’ in Arabic) since currency with no intrinsic value does not add value to a transaction. This is why commodities such as gold, silver, rice, barley, etc have been used as currency in civilizations following Islamic law since the sixth century.
Shariah Law also prohibits any sort of investment in businesses that are considered haraam or against the principles of Islam. Broadly, it is disallowed for Shariah-compliant investments to be in interest-bearing assets, companies that derive significant portions of revenue from interest income, gambling, pornography, pork, alcohol, and drug (not pharmaceutical) because The Shariah law reasons that these industries are detrimental to society and should be discouraged.
WHAT DOES SHARIAH SAY?
Islamic law prohibits all such transactions in which some or all of the following components are present:
* Any return on money that is predetermined in amount (or percentage) and therefore includes modern-day Interest. (Riba). According to Shariah, there is no such thing as “risk-free“ investments and either party should bear the risk of financial loss in a transaction. For example, a financial institution that loans an entrepreneur some money should is disallowed to force the entrepreneur to pay up in the case of a business loss, and loan repayments are done with the principal plus profit concept. In case of bankruptcy, the financial institution can liquidate mortgages to repay the principal. To protect the interest of the financial institutions, Shariah allows the financial institution to monitor funds and asset allocation
* Uncertainty (Gharar) in contracts, which means a prohibition on the sale of items whose existence or characteristics are not certain, and which are ambiguous upon contractual terms. Transfer of assets can be done only through ownership or proxy. Shariah law emphasizes asset banking nature in transactions. This makes transactions significantly less risky but discourages having significant portions in accounts receivable. Therefore, Shariah-compliant companies have different cash management practices and their cash conversion cycles are often low positive numbers.
* Gambling (Maisir) — applies to the dealings in futures and options to their speculative level.
* The activities relating to the trade of commodities prohibited (Haram) by Islam like; activities relating to the provision of pork, alcohol, and gambling services.
HISTORY OF ISLAMIC BANKING
* Islamic banking has been practiced since the sixth century but on a much smaller scale. Typical moneylenders would be landowners, rich merchants, and sometimes kings.
* The first successful modern-day example of an Islamic bank was seen in Malaysia. In 1963 Tabung Haji came into being with a total of 1281 depositors which increased to 867220 depositors, with deposits over 1 bn dollars. It came into being due to the high demand for interest-free money for Hajj(pilgrimage).
* Formation of Naseer Social Bank in Cairo in 1972.
MODERN ISLAMIC BANKING
* Dow Jones Islamic Market Index came into being in 1999 for investors willing to invest in Shariah compliant projects.
* US has the American Finance House LARIBA.
* The UK also issued Islamic bonds known as Sukuk in 2014.
* The UK permitted a complete Shariah compliant bank called the Islamic Bank of Britain and became the first non-Islamic country to do so.
* Many non-Islamic countries like China, Germany are now opening Islamic windows in conventional banks.
HOW CAN BANKS FUNCTION WITHOUT TAKING INTEREST?
Riba or interest under Islamic Law means anything in “excess” — the investor should not make an “undue” profit from the hard work of the other. But it is permitted to follow a system of reasonable profit and return from investment where the investor takes a well-calculated risk. Thus, Islamic banks make available accounts that provide profit or loss instead of interest rates. The banks use this money collected by them and invest in something that is Shariat compliant, that is not haraam, and does not involve high risks. Thus, businesses involving alcohol, drugs, war weapons, etc. as well as all other high-risk and speculative activities are prohibited. Islamic Banking, therefore, acts as an agent by collecting the money on behalf of its customers, investing them in Shariat compliant projects, and sharing the profits or losses with them. The various modes of financing in Islamic Banking are:-
1.) Mudharaba
* i) Mudharaba, according to jurists, is a social contract whereby one gives his property to another to carry on business therewith and the profit to be shared between them according to the specked terms such as one-half, one-third or so. So the investor is not allowed to make an undue profit from interest but he is allowed to make a profit by taking a risk in investing elsewhere. Thus the Islamic bank accounts have profit and loss transactions without interest rates. The depositors put their money into the bank’s investment account and agree to share profits with it. In this case, the depositors are the providers of the capital, and the bank functions as the manager of funds.
- ii) Entrepreneurs seek finance from the bank for their businesses on the condition that profits accruing from their business will be shared between them and the bank in a mutually settled proportion, but that any loss will be borne by the bank only. In this case, the bank functions as the provider of capital, and the entrepreneur functions as the manager.
i) Entrepreneurs seek finance from the bank for their businesses on the condition that profits accruing from their business will be shared between them and the bank in a mutually settled proportion, but that any loss will be borne by the bank only. In this case, the bank functions as the provider of capital, and the entrepreneur functions as the manager.
2.) Murabaha
In this mode, the bank, at the request of its client, purchases the specified goods from a third party against payment. Immediately on the transfer of ownership of the goods as also obtaining its physical or, in most cases, the constructive possession, the bank sells these goods to the client at cost plus an agreed fixed profit margin. The client then takes physical possession of the goods and undertakes to pay the price to the bank either in installments or in a lump sum, at an agreed later date.
3.) Musharakha
The real alternate to interest on loans in an Islamic framework is financing on a Profit and Loss Sharing (PLS) basis- a shift from debt-based transaction to investment-based funding. In this mode of financing, the losses are shared by the financier along with the entrepreneur in the ratio of their respective capitals. The profits are, however, shared in an agreed ratio. The rates of returns are thus replaced by ratios.
3.) Ijarah
The lease contract is not a sale of the object, but rather a sale of the usufruct (the right to use the object) for a specified period of time. The use of usufruct is permissible in Islam, as evidenced by the various verses and Hadith.
3.) Qard Hassan
It is a loan extended on a goodwill basis, mainly for welfare purposes. The borrower need only pay back the amount they borrowed, with no interest. On principle, Islam does not allow interest. Should a borrower encounter difficulty, the lender must extend the repayment time. They can voluntarily waive repayment of part of the loan, or all of it.
ISLAMIC BANKING IN INDIA
It was first brought up by Raghuram Rajan in his report on the Financial sector in 2008. He recommended that interest-free banking techniques can be very beneficial for those who are unable to access banking services and increase financial inclusion.
The proposal of RBI for the opening of an Islamic Banking window has received mixed reactions from many especially in the light of the recent Uniform Civil Code debate and is likely to take a political angle instead of a financial one.
Currently, Islamic banks are disallowed by Indian law. But, Shariah-compliant alternatives to traditional Financial instruments such as leasing, subscriptions, investments, Shariah-compliant mutual funds operate in multiple forms through NBFCs. The only problem is that no Shariah-compliant NBFC in India is allowed to take customer deposits because any institution taking customer deposits has to provide a fixed rate of income.
ADVANTAGES TO INDIA
Investments in Islamic banking have skyrocketed since the 2008 recession. Now especially after the recession due to Covid-19, opening up Islamic investments would bring significant investment from East Asia, Middle East, the US, UK
* Islamic banking is a less risky investment than conventional banking and has seen following by Muslims and non-Muslims alike. Therefore, it would significantly reduce risk at a macro level in the banking sector of India
* It will attract huge funds in the domestic market and enhance financial inclusion as followers of Abrahamic faiths are disallowed to put their money in interest-bearing assets.
CONCLUSION
Islamic banking is a very old system of banking. In its modern-day form, it has been rapidly evolving since the 1970s and today almost all financial instruments available in conventional systems have a Shariah-compliant alternative to them.
The system chooses social responsibility for profitability. Although Islamic banks typically have lesser profitability compared to a conventional bank where interest income is guaranteed, Islamic financial assets have been very resilient to recessions due to their asset-backed nature. This strategy can be used in hedging and diversification of investments.
Islamic banking is not designed to replace conventional banking. Rather, it offers a different asset-backed approach to banking.
Both the benefits and demerits of Islamic banking can be seen in how they are adopted in western countries and countries with both banking systems operating simultaneously.
Central banks and regulators can experiment with Islamic banking by opening an Islamic bank window in their conventional banks.
By Arpit Satpathy | Class of ’22 | Indian Institute Of Management Tiruchirappalli
Nadeem Ahmed Najeeb |Class of ’21 | Indian Institute Of Management Tiruchirappalli
REFERENCES
i) https://www.consultancy.uk/news/3102/ey-islamic-banking-growth-on-the-increase-across-globe
iii) https://www.researchgate.net/publication/272236489_Islamic_Banking_Concept_and_Methodology
iv) https://corporatefinanceinstitute.com/resources/knowledge/finance/islamic-finance/
