THINK TANK

It is in Indias strategic interest to adopt Islamic Finance with the

right safeguards, says Sanjay Banka
Islamic Finance?
I
slamic Finance (IF) began its jour-
ney fve decades ago and is one of
the fastest growing and evolving
sectors in global finance. This
system is based on the principles
of Islamic law (the Sharia), and it has
several innovative and unique prod-
ucts that are in line with the religious
laws ofering investment and banking
opportunities. The estimated funds
with Islamic Financial Institutions
(IFIs) along with their associates have
grown from a meager USD 100 bil-
lion in 2000, to over USD 1.3 trillion
by 2010. Some international banks
with strategic interests in the Gulf
region like Citigroup, HSBC, Standard
Chartered Bank, and Deutsche Bank
have also ventured into the Islamic
banking business. It is estimated that
there are over 300 IFIs scatered over
75 countries.
Its stupendous growth was made
possible by unstinted support from
the enormous, untapped wealth in
the Gulf countries, the growing in-
tegration of the GCC countries with
the world economy, and its regula-
tory evolution. Despite this, IF assets
with certain exceptions (Ijarah, Bai
al Salaam, and Istisna). Money is just
a medium of exchange and hence
making money from money is not
permited;
l
Discourages businesses which deal
in unethical goods and services
(Haram);
l
Promotion of profit-sharing and
risk-sharing by Musharakah and
Mudharabah;
l
Introduces an Islamic tax (Zakat).
All IFIs are required to make col-
lections in this benevolent fund and
distribute it to the poor and needy
either directly or through religious
institutions amounting to about
2.5 per cent of the total income of
banks, and it may increase up to 10
per cent in the case of certain assets.
In order to ensure Sharia compli-
ance, IFIs are required to constitute
a Sharia Supervisory Board (SSB)
consisting of Sharia experts; or they
can hire independent experts to advise
them on Islamic banking products.
The Bahrain-based Accounting and
Auditing Organisation for Islamic
Financial Institutions (AAOIFI) lays
down important tenets of Islamic
finance. Among other Islamic or-
ganisations which also prescribe
standards are the Islamic Financial
Services Board (IFSB), Fiqh Academy
of Organisation of Islamic Countries
(OIC), and the International Islamic
Financial Markets (IIFM).
Islamic banking products
Islamic banking operates on the
principle of Shirakh (partnership) and
Mudharabah (proft sharing). Based on
such principles, IFIs may decide the
nature of the project, the pre-agreed
Should India Embrace
represent below 2 per cent of global
banking assets and it remains an un-
derpenetrated market across many
asset classes and geographies.
It has atracted the interest of policy
makers and central bankers having
crossed boundaries into the US, UK,
and Japan. There are signs of this
activity in India as well, despite stif
arguments against adopting this sys-
tem due to its non-standardised law,
individual interpretation, and difer-
ences in rulings between scholars. It
will be in Indias favour to adopt this
system in a calibrated fashion, to serve
its strategic interests; by building in
safeguards that will mitigate any risks
and pitfalls associated with it.
Key tenets of Islamic Finance
Islamic Finance and Banking are
based on some key tenets of the Sharia
and IFIs have to ensure that their busi-
ness activities are compliant with the
religious laws (See Chart 1).
Some key tenets that it has adopted
are the following:
l
Prohibits payment of interest (Riba)
and excessive risk-taking (Gharar),
Chart 1: Islamic Banking Framework
Islamic Finance & Banking
Banking, Trade & Project Finance & Insurance
Shirakah (Partnership) and Mudharabah (Prot Sharing)
Prot Sharing
Non Prot Sharing
Musharakah Mudarbah
Murabaha Ijarah
Salaam Istisna
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"Sharia" principles, Guidelines of AAOIFI, IFSB etc and Sharia Boards
32 CFOCONNECT

July 2012
THINK TANK
rate of return, and even the location
of the project. The following table
gives an insight into various Islamic
banking products, while there may
be slight variations in terminologies
between markets.
Among the key profit-sharing
products (See Chart 2) in Islamic bank-
Chart 2: Islamic banking products
Genre Product(s) Key Features
Prot-sharing Musharkah A Joint Venture between IFI and a customer. It envisages prot-sharing in a pre-agreed
(Joint Venture, Prot ratio, but loss sharing in proportion to equity contribution. Musharakah may take 2 forms
& Loss sharing ) Shirkat-ul-milk and Shirkat-ul-adq.
Mudharabah
(Sleeping Partnership, A sleeping partnership between IFI as sleeping partner (Rabb-ul-maal) and the customer
Prot sharing) (Mudharib). IFI contributes capital while the customer invests expertise and effort. Prot-
sharing is done in a pre-agreed ratio, but loss, if any, is fully borne by the bank. Due to the
high risk, this is not a popular product.
Non-prot sharing Murabaha
(Mark-up or A Murabaha contract either involves (i) the sale-repurchase agreement of a borrower-held
cost-plus nance) asset (negative short sale) or (ii) the lenders purchase of a tangible asset from a third party
on behalf of the borrower (back to-back sale). The re-sale price is based on original cost
(i.e., purchase price) plus a pre-specied prot markup imposed by the lender so that the
borrowers repurchase of the asset amounts to a loss-generating contract. This is done in
2 stages. In the rst stage, the bank purchases the assets at customers request (non-legally
binding); and in second stage the Bank sells the assets to customer on deferred payment
basis. The Bank is obliged to inform the buyer its cost price and estimated prot. The bank
bears risk of loss in case customer reneges on his promise.
Ijarah The bank (the lessor or mujir) procures the desired assets and leases them to the
(lease nance) customers (the lessee or mustajir). The customers thus fund their project nance through the
lease route. The lessor retains the liability for repairs and maintenance of the assets, while
operating expenses are borne by the lessee.
Forward Contracts Bai al Salaam or Salaam Used for working capital nance, whereby the bank (acting as the buyer) enters into a forward
(advance payment ) contract with the borrower to purchase the asset at a discounted price and pays the purchase
price in advance (effectively working capital loan). The discount compensates the bank for
the interest. Under normal circumstances, a sale cannot be affected unless the goods are in
existence at the time of the bargain. However, this exception is permitted provided the goods
(tangible) are dened as to quantity, quality and workmanship and the date of delivery is xed.
Bai muajjal A contract for sale of good on deferred payment basis either in one transaction or multiple
installments. The date of payment must be certain and not contingent on some event(s).
Istisna Istisna is a purchase contract for an asset, whereby the bank (acting as the buyer) places
(future assets) an order with the seller (customer), to purchase the asset to be constructed or delivered on
a xed date in the future. The purchase price can be paid later or in a deferred manner as
against Bai al salaam where it is payable in advance. These contracts are executed in case of
technology and real estate transactions.
Bank Accounts Current Account Operated under al-wadiah principles and hence no interest is paid by the IFI. The funds
received are used only for liquidity adjustment.
Savings Account Operated under al-wadiah principles. The customer is not given an assured interest rate as in
conventional banking. Instead hiba (or premium) is paid.
Investment Account These accounts also called Prot Sharing Investment Accounts (PSIA) received under
Mudharabah al-mutalka principles and referred as Displaced Commercial Risk (DCR). Here
depositor bears the risk of losing capital, while also being entitled to earn voluntary prots
(tabarru) instead of absolute commitment of interest. These funds may be deployed by IFI in
equity, Ijarah, commodity, or Murabahah fund.
Other Products Zakat All customers are required to contribute from 2.5 per cent to 10 per cent of their net assets
depending on the assets.
Qard Al Hasanah A benevolent interest-free bank loan to the poor and needy, either directly or through Islamic
charity institutions.
Takaful Since commercial insurance goes against the principle of interest payment (riba), al-maisir
(gambling), and al-gharar (risk taking), hence customers contribute tabarru (donation) to a
common fund and the persons suffering losses are paid from the common pool. The balance
left, if any, is payable back to members at agreed schedules.
ing are Musharakah and Mudharabah.
The Musharakah form of fnancing is
being used increasingly by Islamic
banks to fnance domestic trade and
imports, as well as to issue leters of
credit. There are two main forms of
Musharakah, namely, permanent and
diminishing. In the frst, the contract
period is not specifed, and hence it
can continue as long as the parties in-
volved remain interested. This model
is suitable for fnancing projects that
have a longer gestation period. In the
second form, the banks equity in the
project keeps diminishing till it be-
comes zero, and fnally, ownership of
July 2012

CFOCONNECT 33
THINK TANK
project assets stands fully transferred
to the customers. A diminishing Mush-
arakah provides for payment over and
above the banks share in the profts.
In a Mudharabah contract, the bank
does not have the right to interfere
in the management which is the sole
responsibility of the entrepreneur.
However, the bank has every right
to specify conditions that will ensure
beter management of its funds. In
practice, however, Mudharabah has
not made much progress on the asset
side of the balance sheet due to the
huge risk involved; nonetheless on
the liability side, Islamic banks accept
funds based on Mudharabah in invest-
ment accounts.
The non-profit or loss-sharing
products include Murabaha, Ijarah, and
Salam. Murabahah is the most popular
mode. IF also permits forward con-
tracts, with some variants like Bai al
salaam, and Istisna. A unique feature
of forward contracts in IF requires
that the seller of the forward contract
must own the underlying asset at the
time of making the contract and must
receive full payment in advance, or
in a deferred arrangement as agreed.
Sukuk bonds The most
favourite product
Sukuk bonds have emerged as the
most popular mode of fund raising in
IF. Sukuk refects an ownership inter-
est in an underlying asset, transaction,
or project with undivided, propor-
tionate ownership. These bonds are
designed innovatively in accordance
with the Sharia, whereby the underly-
ing assets are transferred to a special
purpose vehicle (SPV). The SPV acts
as Trustee (Wakalah) and raises funds
against the asset by issuing the bonds.
Since these bonds have real under-
lying assets, they are listed, freely
tradable, and the pricing is based on
market performance of their portfolio.
They have become increasingly popu-
lar and in 2010, the total issuance was
USD 45 billion per annum (See Chart
3). Sukuk issuances during 2001-2010
were primarily by corporates (63
per cent), followed by sovereign (34
per cent), and quasi sovereign (3 per
cent). During this period, the GCC
has seen the largest issuance (83 per
cent) followed by others including
Malaysia, Indonesia, Pakistan, Sudan,
and Brunei. The annual returns on the
bonds ranged from 3.75 per cent to 6.5
per cent, but in some cases, the returns
were as high as 10.75 per cent. In terms
of tenor, it ranged from 12 months to
480 months with an average tenor of 60
months. Sukuk is structured primar-
ily as Sukuk al Murabaha, but there are
other structures like Sukuk al Ijarah, Su-
kuk al Salam, Sukuk al istithmar, Sukuk al
Istisna, Sukuk al Wakalah, and Sukuk al
Musharakah. The most notable Sukuk
issuance was by Cagamas Berhad
Malaysia, in June, 2007, raising USD
5.79 billion with a tenor of 480 months.
Sukuk issuances from non-Islamic
countries were a meagre 2 per cent.
Some non-Islamic Sukuk issues in-
clude Nomura Holding Plc, Japan
(July 2010, USD 100 million), and
General Electric, USA (November
2009, USD 500 million). Both adopted
the Sukuk Ijarah route which offers
the highest fexibility in the case of
the CDR. Sovereign Sukuk issuance
provides more depth to the market
encouraging corporates and other
government-owned entities to enter.
Sukuk has also faced defaults and
restructuring and in the last three
years, defaults have occurred in sev-
eral, high-profle Sukuk bonds includ-
ing Kuwait-based Investment Dar and
International Investment Group and
the US energy frm East Cameron. In
the event of default, a debt restruc-
turing is a litle complex as against
the conventional CDR. The status of
Sukuk holders is to be determined as
secured creditors, unsecured creditors,
or preferential creditors depending
on the Sukuk model adopted. This
priority is determined with reference
to terms and conditions of the Sukuk
certifcates, the trust deed, and related
documentation; and above all, the
Sharia Boards interpretation.
Legal hurdles for Islamic
Finance in India
IF protagonists have been making
regular representations to the Indian
Government to adopt Islamic Bank-
ing and the RBI had constituted a
commitee under the chairmanship
of Anand Mohan Sinha (presently
Deputy Governor, RBI) in 2006. The
commitee submited its report in 2007,
recommending that under the current
legal framework, Islamic Banking
products cannot be permited as these
are against the basic principles of the
Banking Regulation Act, 1949 (BR
Act). Some major incongruities that
the committee pointed out are the
following:
l
Risk-sharing and participating in
the business of customers forms the
core of Islamic Banking which is not
in accordance with the BR Act;
l
Deposits placed by customers
under conventional banking are
guaranteed as to capital protection
and agreed interest rate. However,
in Islamic Banking the depositor
bears considerable risk in certain
bank accounts as to capital and
return;
l
Equity participation which forms
the basis of several Islamic Banking
products like Musharakah will have
to be examined on a case-by-case
basis as per restrictions imposed
under the BR Act.
l
India will also have to analyse
(Source: International Islamic Financial Market-IIFM Sukuk Report- Second Edition, May 11)
Chart 3: Sukuk issuance 2001-2010
60000 Size (mm)
Year
30
336
1990
1,172
1,371
6,410
8,140
12,180
30,034
48,887
18,597
25,727
45,123
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
40000
20000
0
34 CFOCONNECT

July 2012
THINK TANK
whether IF will dilute the role of
the Reserve Bank of India (RBI) and
the Securities and Exchange Board
of India (SEBI), and if so, how to
mitigate the associated risks;
l
The BR Act disallows products
where the bank can invest the
money in equity funds (in India,
equity exposure is determined by
a separate set of rules);
l
In view of asset ownership inher-
ent in Islamic bonds and sale of
such bonds from one customer to
another there may be issues on
stamp duty, central sales tax, and
state tax laws which will open up
a Pandoras Box requiring several
changes across all states. India be-
ing a federal state will have dif-
fculty in implementing a coherent
taxation structure across all states
to ensure compliance to Islamic
Finance products. We are already
facing huge challenges in imple-
menting the Goods and Services
Tax (GST) despite having a general
consensus;
l
Islamic Finance regulators are
facing challenges in introducing
standards to ensure compliance
with capital adequacy norms as
required by Basel III norms; and.
l
Approval of the Sharia Board for
every new product to be introduced
has created a unique regulatory
challenge and hence it requires a
more mature governance regime.
However, Islamic banking prod-
ucts are slowly being ushered into
India. Tata AMC, belonging to the
respected Indian business house the
Tata Group, has already launched a
Sharia-compliant mutual fund called
the Tata Ethical Fund, to atract global
investment in India. So has Bajaj Alli-
anz. These funds have collected over
Rs 500 crore and they invest in equi-
ties of Sharia-compliant companies
and other instruments permited by
the Sharia.
In 2010, the state-owned Kerala
State Industrial Development Corpo-
ration (KSIDC) had planned to start an
institution based on Islamic banking
principles named Al-Baraka Financial
Services, which was stayed by the
Kerala High Court, but withdrawn
recently. More recently, the RBI has
cancelled the NBFC licence of Kerala-
based Alternative Investments and
Credits (AICL), which had started an
Islamic Banking product in violation
of RBI guidelines. This ruling has clari-
fed that NBFCs cannot ofer Islamic
banking products in defance of RBI
jurisdiction.
Indias policy interest in IF
India has set up an ambitious tar-
get of USD 1 trillion investments in
the infrastructure sector which calls
for radical policy changes and initia-
tives to atract global funds, and this
may require us to reconsider Islamic
Financing as an alternate source of
funding to meet our strategic interests.
However, given our legal framework
and social sensitivities, the follow-
ing would be some real challenges
for India:
l
Constitution of Sharia Advisory
Boards in the RBI and at banks
level may be tantamount to grant-
ing legal sanction to Sharia laws in
our polity;
l
There may be need to change
the Indian accounting standards
as well. India is already facing a
challenge in implementing Ind-AS
(Indias variant of IFRS), and this
will create another roadblock in our
efort to harmonise our accounting
standards with IFRS;
l
Our political parties have used
priority sector and minority sec-
tor lending as a political tool for
vote bank politics ignoring basic
economics. There is a concern that
the ruling parties may grant high
subsidies and equity funds to such
IFIs. Certain groups in India have
already started clamouring for
interest-free fnance to the micro
fnance sector and students under
the umbrella of Islamic Finance.
This clearly indicates the risk of
defaults and NPAs which we are
exposed to, arising from loans
waivers to such groups; and
l
The spectre of illegal funds entering
the Indian markets, especially from
countries which have become terror
havens is alarming. In case the RBI
approves a limited Sukuk strategy,
it will have to ban countries which
support anti-Indian activities.
It is evident that the nature of Is-
lamic Banking difers signifcantly to
conventional banking and structural
changes will be required to the BR
Act and other laws to accommodate
this in India.
The roadmap ahead
India needs to adopt a selective
and staggered approach towards
Islamic Finance. First, the RBI will
need to cross the rubicon by permit-
ting Indian corporates to issue Sukuk
bonds globally. The Sukuk strategy
will help the country to meet its tar-
get of infrastructure development by
atracting low-cost funds. Second, in
line with the strategy pursued by oc-
cidental banks, the RBI may consider
permiting branches of Indian banks in
GCC countries to start Islamic bank-
ing and create an additional channel
of funding for India. But permiting
IF in India in full scale will require an
extremely cautious strategy, given the
evolution of our social and banking
framework since independence in a
quintessential secular manner. The
fund infow into IFIs in India espe-
cially from GCC countries will need to
be monitored forensically, regarding
money laundering and legality, even
as we try to avoid any stereotyping.
The case study of China, Hong Kong,
or Japan as cited by some quarters is
not applicable to India due to difer-
ences in our demographic paterns,
social fabric, and historical experience.
The perception that Islamic banking is
more resilient to fnancial crises than
conventional finance has also been
proven wrong, in view of the high
profle Sukuk defaults. Clearly, India
will need to adopt a multi-pronged
strategy in the national interest which
will enhance our understanding and
experience of IF and enable us to take
a right decision at an opportune mo-
ment in future.
The author is Sanjay Banka
FCA, FCS, MCSI (UK), MIMA,
MICA, Additional
Vice President, Finance, at
Viom Networks Limited. He can be
contacted at sbanka9@gmail.com.
The views expressed in this article are his
personal views and the author retains
copyright to this article.
July 2012

CFOCONNECT 35