FN 5103: Accounting for Islamic Financial

Transactions

Masters in Islamic Finance

Term paper
Islamic Banking in India: History, Current Developments and
Future Prospects

Firoz.M.P
0900363
Jan 2010

1
 Islamic banking
in India:
History, Current
developments
and Future
prospects

2
Special thanks to

Dr. Shariq Nisar.

3
Abstract:

The purpose of this paper is to discuss the advent of Islamic finance in the
non-Islamic country of India. The paper is divided into three main sections namely:
History and development, Current issues and Future prospects, necessarily in that
order. The paper also aims to propose and emulate the efforts taken by the UK
government in their quest towards establishing Islamic finance as an alternative
banking system, in the third section. A detailed study of the regulations of the Indian
and U.K government is out of scope of this paper. But, such a study would necessarily
lead to a better understanding of the regulations and help to develop intricate
methodologies so as to establish Islamic banking in India by bringing in necessary
regulatory changes. The paper does not aim to provide solutions to implement Islamic
banking in India, as there are already numerous papers written on the topic, but only
advocates to use United kingdom’s, UK, efforts as a possible reference for
implementation.

Finally, an interview conducted with Dr. Shariq Nisar, who is a renowned

public figure in India in the area of Islamic finance, is also included as the highlight of
this paper, in the second section. I would sincerely thank Dr. Shariq, who also turned
out to be a source of motivation for me, for his patience and humility. His opinions
have helped me to form a base for this paper and will definitely instigate me towards
further research in the field of Islamic finance in India.

4
Glossary

IB Islamic Banking
IFI Islamic Financial Institutions
NBFC Non-Banking Financial Company
FAP Financial Associations of Persons
IFS Islamic Financial Societies
ICCS Islamic Co-operative Credit Societies,
IIFC Islamic Investment and Financial Companies

5
Table of Contents

Abstract
Glossary

1. Introduction

2. History and development of IFIs in India

2.1 Evolution of Islamic financial institutions
2.2 Classification of IFIs
2.2.1 Financial Associations of Persons
2.2.2 Islamic Financial Societies
2.2.3 Islamic Co-operative Credit Societies
2.2.4 Islamic Investment and Financial Companies
2.3 Current status of IFIs

3. Current Issues
3.1 Need for Islamic finance in India
3.2 Potential of Islamic finance in India
3.3 Regulatory roadblocks
3.4 Status of IFI initiative in Kerala, India
3.5 Interview: Dr. Shariq Nisar

4. Future Prospects: Proposal to use UK’s example as a ready reference

4.1 Development of IFI in UK
4.2 IFI in UK
4.3 Explaining the UK’s success
4.3.1 The role of the UK authorities
4.3.2 Taxation
4.3.2.1 Borrowing arrangement
4.3.2.2 Deposit Arrangements
4.3.2.3 Investment bonds
4.3.3 Standardisation
4.3.4 Awareness
4.3.5 Skills

5. Conclusion

6
1. Introduction

Islamic banking in India has been a topic of discussion for quite sometime
within the Indian sub-continent and those countries which have business and trade
interests with India, especially the middle-east. The excess liquidity in the middle-east
is encouraging the Arabs to look out for more investment avenues and the lack of a
well-developed Islamic financial system in India has been a huge deterrent. It is not
only for the purpose of trade that India needs IFIs but also to cater to the 13% of the
Muslim population in its soil. Most Muslims in India shy away from interest-based
activities and hence, a problem of financial inclusion arises within the Indian
economic system.

The Justice Rajender Sachar committee report, which analyzed the conditions
of Muslims in India, pointed out the lack of access to bank credit to this section of the
society. Alarmingly, Muslims hold only 7.4% of the deposits. Some banks have
identified a number of Muslim concentration areas as ‘negative geographical zones’
where bank credit and other facilities are not easily provided. Also, the study shows
that participation of Muslims in banking related jobs is as low as 2.2%, a clear
indication that the community is uncomfortable with the riba based activities.1

Last year, the Raghuram Rajan committee’s report advocated the need for
interest-free banking activities for the better functioning of the less-privileged part of
the Indian population and for financial inclusion of the neglected societies in terms of
accessibility of affordable funds. Committee reports are one thing and implementation
of their recommendations is another. The Indian authorities have to realize that they
are at the ripe time of the worldly affairs, after the U.S. crisis, to tap further
investments towards India or else they would miss the window of opportunity. It is
worth to point out that India’s neighbour, China, has already issued the license for the
first Islamic bank, recently.

7
 2. History and development of IFIs in India

2.1. Evolution of Islamic finance in India

In the earlier days, the Sahabas, Sufies and Arab traders have played a
significant role in spreading Islam, Islamic institutions and Islamic culture in India.
IFIs in some preliminary form such as Bait-ul-Maal have often been used in India by
the Muslims rulers as well as Muslim religious and social workers for collection and
distribution of zakah, sadaqah as well as qard-e-hasaan. However, the institution of
Bait-ul-Maal in India has been mostly used for charitable rather than commercial
purposes. 2

IFIs as economic entities were first established in late 1930s and early 1940s
of the 20th century in India. The Patni C-operative Credit Society Ltd. was established
in 1938 and the first Muslim fund was started in 1941. However, proliferation and
growth of IFIs took place in India only after the independence and their
commercialization took place along with global development of Islamic banks and
Islamic financial institutions in 80s. 2

2.2. Classification of IFIs in India

IFIs in India can be best classified based on their functional model and registration
authority. They are classified as follows:

• Financial Associations of Persons (FAP)

• Islamic Financial Societies, (IFS)
• Islamic Co-operative Credit Societies, (ICCS)
• Islamic Investment and Financial Companies, (IIFC)

India’s IFIs basically follow three distinct models and are registered with three
different authorities. There is also a fourth category of IFIs, those who do not have
any independent operational model, nor are they registered under any authority. They
can be classified as Financial Associations of Persons (FAPs). They are not the
product of any time period. Muslim funds (MFs), Islamic welfare societies (IWSs)
and Bait-ul-Maal s which are registered under the Society and Trust act, are classified

8
as Islamic financial societies (IFS). Those modelled on Co-operative Credit Societies
registered under the Registrar of Co-operative Societies are classified as Islamic Co-
operative Credit Societies (ICCSs). Profit and Loss Sharing (PLS) and financial
companies registered under the companies act are classified as Islamic investment and
financial companies (IIFCs). 2

2.2.1 Financial Associations of Persons (FAPs)

FAP are unregistered, privately operated, smaller functional groups operating
in mosques, educational institutions or markets, throughout the country. In mosques
or Anjumans they have taken the form of smaller Bait-ul-Maal s wherein zakah funds
are mobilized along the membership fees and donations, and interest-free qard-e-
hassan loans are also extended. In the educational institutions, they have taken the
form of interest-free chit funds wherein groups of 20 to 30 staff members contribute a
monthly fixed sum. One or two persons share the monthly draw at no cost. In the
markets, the groups of Muslim businessmen coming together for mutual financial
assistance are slightly bigger. Denied by banks and exploited by Marwari
moneylenders who charged over 25% interest, groups of 50 to 100 Muslim
businessmen come together to form an association for mobilizing their own savings
and getting interest-free, low cost loans. The loans provided are used more for
consumption purposes than production purposes. But, recently, more and more
businessmen are adopting this format to augment their business capital. 2

Some of the FAPs are mentioned below:

1. Barkat Association, Belgaum

2. Shantapuram Islamic Finance Corporation, Calicut, Kerala
3. Interest-free Society, Pune

2.2.2 Islamic Financial Societies (IFS) of India

IFSs are registered under the society and Trust Act. of the respective states of
India. They are mainly non-profit welfare oriented institutions, generally smaller in
size, catering to the socio-economic needs of the poor sections of local Muslims. They
are based on Quranic guidelines of Qard-e-hassan, Zakah and Sadaqah. They
mobilize local savings as Amanah and extend interest-free loans usually against the

9
security of gold ornaments. Some of them mobilize and disburse zakah and Sadaqah
funds. Muslim funds operate largely in North India mainly in U.P; Islamic welfare
societies and Bait-ul-Maals operate in south India. There may be over 150 Muslim
funds, Islamic welfare societies and Bait-ul-Maal s functioning in India.

Some of the IFSs are mentioned below:

1. Muslim fund, Deoband, Uttar pradesh

2. Bait-ul-Maal , Chennai, Tamil Nadu
3. Toor Bait-ul-Maal, Hyderabad

2.2.3 Islamic Co-Operative Credit Societies of India

Due to widespread ignorance, ethnic and lingual differences, and lack of
awareness, Indian Muslims did not adopt the interest-free co-operative model so
successfully developed by The Patni Co-operative Society Ltd., of Surat as long as in
1938. It took 37 years for Muslims to successfully establish another interest-free co-
operative society at Mumbai in 1976 viz. Bait-un-Nas’r Urban Co-operative Credit
Society Ltd. It was followed by just one more successful Co-operative society again at
Mumbai, namely Bait-ul-Maal Urban Society Co-operative Credit Society Ltd.
Generally, 10 or more persons come together to contribute their own share capital and
start a Co-operative Credit, Consumers or producers Society. The only problem is, in
India every state has its own Co-operative Society Act and hence Multi State Co-
operative Societies can be started only under Multi-State Co-operative Societies act of
the central government which is rather cumbersome and time consuming. 2

Some of the Co-operative Credit Societies are:

1. The Patni Co-operative Society Ltd, Surat.

2. Bait-un-Nas’r Urban Co-operative Credit Society Ltd., Mumbai.
3. Al-Ansar Co-operative Credit Society Ltd., Hyderabad.

10
2.2.4 Islamic Investment and Financial Companies of India (IIFC)
Non-Banking Financial Companies (NBFC) are important part of Indian
financial system bordering its banking sector as only they can accept Equity funds and
invest on PLS basis. Since interest-free commercial banking on the PLS basis is not
permitted in India, Indian Muslims have only the alternative of establishing PLS Non-
Banking Financial Companies. IIFCs mobilize funds largely through Mudarbah basis.
Share capital is the other important source of funds raised by IIFCs. 2

Most of the income is earned by IIFCs from Ijarah. Murabaha and

Mushrakah. It was in 1980 that the first IIFC called Al-Mizan was established in
Madras (Chennai), Tamilnadu. Share capital of more than INR 35 million was raised
by a group of 19 partnership firms with a mother company as the supervisory board.
Unfortunately, the experiment failed miserably due to 1984-85, when the company
incurred heavy losses mainly due to mismanagement. Al-Mizan was followed by
Bait-un-Nas’r Co-operative Credit Society Ltd. of Mumbai that established the next
group of IIFCs. Many of the IIFCs faced problems due to the implementation of stiff
prudential Norms by RBI in 1997-98. 2

Seyad Shariat Finance Ltd of Tirunelveli in Tamilnadu, established in 1987-

88, is one of the very few IIFCs that is still functioning successfully. There have also
been some fly-by-night IIFCs who exploited the religiosity as well as greed of people
to make fast money and disappeared according to press reports. Many others are
struggling to survive not only due to strict RBI norms but also due to lack of
professional management, transparency and public support especially from the
Muslim community. 2

2.3 Current Status of IFIs

FAPs are perhaps the oldest and more diverse IFIs in India. They do not have
a single format of operating business as they use models of different IFIs as per their
objectives and needs. They belong to the un-organised sector of Islamic finance in
India. FAPs are not peculiar to Muslims as they are also formed by non-Muslims.
They are basically small groups of needy people who mobilize their own savings and
often provide interest-free finance. Lack of rules and regulations, simple and informal

11
operations makes them more flexible, popular and acceptable. Hence, they will
continue to proliferate.2

IFSs are well-found and well spread through out India. They are no-profit
earning, welfare oriented financial societies mobilising and providing interest-free
credit. Basically, the business model consists of mobilizing small savings of Muslims
and providing interest-free loans against security of jewellery or movable assets. The
cost of loan is recovered as service charge. They do not keep any reserves to cover
bad debt. They are not particular about the purpose of the loans and most loans were
given out for consumption purposes. IFSs should start providing purpose based loans
with more emphasis on small business loans. They are in-effect Islamic Non-Govt.
Organisations (NGOs), but in practice they are not able to adopt the posture of NGOs
because of the rigidity of the managements. Many of the problems of IFSs of India are
emerging from lack of a regulatory authority. 2

The common problems with IFIs in India are lack of professionalism and full
involvement of promoters with the IFIs. In fact, most of the IFIs have stopped
functioning.2, 10 Data about doubtful and bad loans is also not maintained or reported.
IIFCs are the only commercial IFIs established to operate on PLS basis in India. All
the other categories are non-profit, interest-free loan advancing societies, geared more
to promote social welfare. IIFCs are the only institutions that struggle to put into
practice as many principles of Islamic finance as possible, and promote profit sharing.
But, most IIFCs failed due to professional incompetence and ignorance of their
customers of the Islamic principles of participation in PLS. Most Muslims knew only
one principle.i.e. prohibition of riba. Sometimes, this ignorance also extended to
Imams and Alims. Lack of transparency and absence of a Shariah supervisory board
are also major problems. Awareness and education among Indian Muslims about
Islamic financial principles is very much essential.2

In order to grab the emerging opportunities, IIFCs / NBFCs will have to

acquire a global outlook and competence. Neither India’s progressive market and its
fast growing economy nor 120+ million Indian Muslims can be neglected for long by
the enterprising Arabs. Hence, the Indian government should make faster and

12
meaningful amendments to the constitutional and regulatory systems to accommodate
IFIs in the near future.
3. Current Issues

3.1. Need for IB in India

When the world is moving towards Islamic banking at its own pace or has
become more curious than ever, after the collapse of conventional banking techniques
as proved by the U.S. sub-prime crisis, where does India stand in this race for setting
up Islamic institutions? Does India need Islamic banking at all? Since the partition in
1947, it has become ever more important for India to stick to its secular, democratic
ideals and continue to bridge the gaps that exist within its citizenry. For over a century
now, however, the Muslim minority in India has been suffering at the hands of its
leaders’ miscalculations and mistakes, exploitation by capitalists, and the relative
apathy of the successive Indian governments. The current status of Indian Muslims is
alarmingly poor with higher illiteracy, higher unemployment, lower income and
higher poverty rates than the Hindu majority. This should be of major concern to the
Indian government and the people of India at large. 3

As a secular democracy, all citizens have equal right to a certain quality of life
and no particular sub-group of the population should be lagging behind in attaining
and exercising that right. It is the obligation of the government to ensure that lagging
minorities have the tools with which they can catch-up to the rest of the nation. One
such tool is credit, and only with proper credit can lagging minorities catch-up and
decrease the economic disparity between them and the majority.3 The establishment
of full-fledged banks practicing Islamic Finance is one step towards decreasing the
economic disparity between Indian Muslims and the rest of their countrymen. This is
why India needs Islamic banking among various other reasons such as promotion of
entrepreneurship in a minority group, the lure of the middle-eastern investments and
social harmony. The most important fact to be recognised at this juncture is that
Islamic banking is not only for Muslims but also for the masses. It is for the whole of
human kind. It aims at economic development by holding the moral and faith-based
values of the religion close to its heart. With Muslims being one of the minorities in
India, unemployment and underemployment among minority populations can be
reduced by supporting minority entrepreneurs in developing businesses.3

13
 Indians often migrate to other countries in search of better prospects. Take the
example of Kerala, a southern state in India. As per statistics, remittances from
emigrants constitute 22% of the state’s domestic product4. India has retained its top
position amongst the countries getting remittances for years4. As of 2008, the Gulf
countries altogether had a Keralite population of more than 2.5 million, who send
home annually a sum of USD 6.3 billion5. This trend can also be seen in states like
Tamilnadu and Bihar. The reason why this is mentioned here is that such an outflow
of Indians, belonging to the lower-end of the income level, shows that there is some
sort of inefficiency in the economic system that they find unaccommodating. Though,
millions of dollars are allocated by the government for the upliftment of such groups,
it never reaches the right hands. This is where Islamic institutions can play a major
role with their moral and ethical values. It also has to be borne in mind the history of
clashes between the Muslims and other religions; this is stated to point out how
sensitive the implementation of Islamic banking could become. The responsibility of
catering to a one billion plus population itself is a challenge.

There are many benefits to the development of full-fledged Islamic Banks in

India. Those benefits include a potential bettering of the condition of India’s largest
minority, better integration of that minority into secular-democratic India, increased
savings across the country and an increase in the national GDP growth rate. Given the
limited access that Indian Muslim entrepreneurs have to credit, some reform of the
banking sector is necessary. Reform by opening of Islamic Banks would be beneficial
for all entrepreneurs who have profitable proposals but lack collateral. Those
entrepreneurs include, but aren’t limited to, many economically-disadvantaged Indian
Muslims. By helping economically-disadvantaged Indian Muslims build minority
businesses, the newly-created Islamic Banks could help to generate wealth for Muslim
business owners, create jobs for currently underemployed Muslim workers and will
share the profits generated by those minority businesses among all of the depositors
who hold Profit/Loss-Sharing (PLS) investment accounts.3

14
3.2 Potential of Islamic finance in Indian economy
Muslims in India constitute 10.3% of the world Muslim population and India
ranks third in the list of countries by Muslim population (Pew research, Oct 2009,
Table 1). Considering the structure of Indian workers it has to be admitted that India
cannot grow inclusively unless the growth benefits are duly shared among Indian
workers who do not have any access to funding from banks. Since 50 per cent Indian
workers are engaged into agriculture, Bai Salam could be most powerful financial
instrument to empower farmers, cultivators and agricultural traders. It will help us
increase agricultural exports as well. The second most important sector after
agriculture is the small and medium scale industries or SMEs. The products like
Musharakah, Murabaha, Mudarabah, Istisna, Ijarah etc. could be well utilised by our
SMEs. It will help them grow at an international level. Besides agriculture and SMEs
sectors, Sukuk could be very useful Vehicle to mobilise interest-free financial
resources for the Government to develop required infrastructure. This will also help to
reduce the fiscal deficit of the Government with no cost of interest.

Table 1

With a heavy emphasis on equity and profit-sharing, the chief factor used to
determine whether a project is worth financing in the Islamic system is the expected
profitability of the project. With an emphasis on this factor, the expected profit from
all ventures financed by the bank could be maximized and society as a whole benefits.
With an emphasis on the assets of a borrower (credit-worthiness), expected profits
from all ventures financed in the conventional system are not nearly as high and
society sustains a certain missed opportunity cost, even as banks are repaid their
principal plus interest. Entrepreneurs lacking assets are unable to obtain credit and

15
launch an enterprise in the conventional system, again, due to the emphasis on asset-
based credit-worthiness.3 This is where the principle of social justice can be seen in
the Islamic system: any entrepreneur with a profitable proposal, regardless of asset-
base, would be eligible for credit and would then be able to establish a successful
business enterprise and better his position. Such an arrangement would be a boon to
all those Indians with bright business ideas but lack in asset-based credit worthiness.
The Islamic contracts and ways of conducting businesses, in the true sense, are aimed
to bring harmony and social equity among the people and it is observed as one of the
ways of attaining a life filled with ‘iman and towards becoming a mu’min, as is the
case with any teachings from the Quran and the Sunnah.

3.3 Regulatory roadblocks

Indian banks are governed under the Banking Regulation Act (1949), Reserve
Bank of India Act (1934), Negotiating Instruments Act and Co-Operative Society Act
(1866). None of these laws admit the possibility of an interest free bank. Hence, if and
when an interest free bank is allowed to be established in India, relevant laws will
have to be amended significantly to admit such a possibility and to evolve a different
system of regulation and control. The costs of establishing Islamic Banks in India will
include legal reforms and the development of a new regulatory structure for interest-
free banks. Indian banks have been subjected to a number of banking regulations and
guidelines as prescribed by the RBI.3 Banks in India have to maintain cash reserves
ratio (5.75 per cent at present).7 Statutory Liquidity Ratio (SLR) is another important
condition to be met by the banks. Reserve Bank has decided that all Scheduled
commercial banks (SCB) shall continue to maintain a uniform SLR of 25% on their
total net demand and time liabilities (NDTL) with effect from the fortnight beginning
November 8, 2008, valued in accordance with the method of valuation specified by
the Reserve Bank of India from time to time:
• in cash, or
• in gold valued at a price not exceeding the current market price,
or,
• in unencumbered investment 7
The Central Bank has used Bank Rate to encourage or discourage bank credit
demand in the economy. The above instruments cannot be used for Islamic banks as

16
they do function on the basis of interest. Other sets of conditions which banks have to
meet are capital adequacy, assets classification, provisioning for bad debts and
income recognition norms.

The primary issue which is a permanent eye sore for Islamic banks operating in
the countries with interest based banking is that they cannot function as banks unless
powers of issuing cheques are given to them. They cannot be members of settlement /
clearing house unless they accept two conditions, regarding their liabilities and assets
like conventional banks, that they have to keep fractional cash reserve with the
Central Bank and statutory liquid assets in their assets. Thus, banks in India have to
maintain deposit account with the Central Bank over which they get interest. Since
these assets are interest based, Islamic bank cannot hold them. Consequently, the
Central Bank cannot act as the lender of last resort because such accommodation by
the monetary authority is also interest based.8

Another trouble comes due to unequal treatment of debt and equity fund. The
capital of Islamic financial companies is equity-based operating through profit and
loss sharing. Under the existing government rules profit is taxed while interest is
exempted from tax on the ground that it is a cost item. This puts the Islamic financial
institutions in a disadvantaged position9. Some of the other issues are given below10:

17
The draft report submitted by the working group of Indian Banks Association, May
2008, also mentions about possible modification of the income tax act.

3.4 Status of IFI initiative in Kerala, India

The Kerala State Industrial Development Corporation, KSIDC, was likely to
start a non-banking financial institution under the supervision of Reserve Bank of
India, accepting11% of the share from Kerala government. But by a fresh notice sent
to the State Government and the RBI, the High Court stayed that move. KSIDC
decided to start the institution on the basis of Islamic Shariah, an interest free
banking, and on the grounds of Reserve Bank Act (chapter 3). As the Constitution 25,
26 acts allow the citizen to open such an institution; KSIDC got registered, without
breaching any of the laws. The only difference that makes it different from other non
banking financial institutions is that, it avoids the transactions on the basis of interest.

Understanding from the new studies, that the bulk of NRI Muslim investors
are reluctant to invest in interest based economy, Kerala government decided to
encourage them by setting up such an interest free institution. And also it foresaw that
the new system will boost the development process of the state. Since it is open to non
Muslim investors as well, obviously, it is not a tread against secularism. But the
petitioner argued in his complaint against RBI and state government claiming
KSIDC’s stimulus to set up the parallel institution is violation of secular ideas
provided by the Constitution.

An Islamic bank, or even NBFC, that operates in India, would violate at least the
following laws, rules and regulations, as quoted by the former Union law and justice
minister, Dr. Subramanian swamy:

• Partnership Act (1932), which stipulates a maximum of 20 partners, since

KSIDC says it will be an open partnership between it and private investors
without limit.
• Wagering (not permitted under Shariah) as per Section 30 of Indian Contract
Act (1872).

18
 • Sections 5(b) & (c), 9 and 21 of Banking Regulation Act (1949) on prohibition
of profit-sharing, buying and selling property, and for not charging interest.
• RBI Act (1934)
• Negotiable Instruments Act (1881)
• Co-operative Societies Act (1961)

Source: http://www.merinews.com/

19
3.5. Interview with Dr. Shariq Nisar (Un-edited)

Dr. Shariq Nisar holds PhD in Economics with specialization in Islamic finance. At present he is on the
board of Bombay based premier Shariah Advisory Company, M/s Taqwaa Advisory And Shariah Investment
Solutions (TAASIS) Ltd as Director. He writes regularly on Islamic finance in leading academic and
industry magazines and is the joint editor of one of India’s oldest periodicals on Islamic Economics,
"Islamic Economics Bulletin". He has delivered several lectures in conferences, including the recently
concluded Seventh Harvard University Forum on Islamic Finance, USA and Islamic Non-Banking Financial
Institutions: Islamic Alternatives", Kuala Lumpur, 2004. Dr Shariq has more than a decade of rich
experience in Indian financial sector. He has worked with some of India’s top Islamic financial institutions.
Besides this, he is presently acting as Consultant to several Investment Management firms in India and
abroad. He also had a short stint with Citibank at New Delhi.

1. Why is India still reluctant to catch up with the current trend of luring the Gulf investments
by establishing Islamic financial institutions and banks? What are the roadblocks? When the
high level report by Dr. Raghuram Rajan’s committee has itself advocated the establishment
of interest-free banking (@ Islamic banking) for the upliftment of the downtrodden and
financially backward in India, why is India still shying away from the billion-dollar
opportunity?

India is faced with different sets of challenges with regard to implementation of

Islamic banking in the country. Most of the secular countries that have
accommodated Islamic banking in their respective countries are homogeneous in
many respects but that is not the case with India. India is a very heterogeneous
country in terms of language, culture and social preferences. Policy making
processes in India for the above mentioned reasons are very slow. It consumes a fair
amount of time in India to build consensus with various political setup and pressure
groups active in the country. Further, it is an established fact that India is religiously
very sensitive country. With long history of communal riots and tensions between
Hindus and Muslims it becomes very challenging for even staunchest secular Hindu
to sympathize with anything which has an Islamic connotation.

Roadblocks are many: right from political will to regulatory and administrative
matters there are host of challenges which Islamic banking is faced with in India. It
is Executive’s discretion to accept any Committee’s Report. Even if the Report is
accepted it does not mean that implementation will start immediately. We have had
experiences in the past where a committee’s report is not accepted or partially
accepted or recommendations not agreed upon or implemented. Dr Raghuram Rajan
Committee is no exception to this. We also need to understand that the Committee in
question was established to advise government on the matter of financial inclusion of
large section of our population (Muslims included) which is still away from the main
stream finance. In this regard the Committee’s recommendation of Interest-free
banking is just one of the many recommendations it has made to the government.

India is not shying away from the opportunity it is evaluating the cost of the
opportunity.

20
2. What would be your advice to Islamic NBFCs in India based on the history of functioning
of NBFCs like Barkat group, Baitun Nasr (BUN) etc.?

Today it is far more challenging to implement Islamic principles of business under

NBFC’s regulation. Prior to the new regulations (1997) it was not so difficult. Today
a company wishing to work on Islamic principles either has to compromise with its
business viability or its Islamicity. Achieving both the goals is very difficult today. No
doubt we have fewer Islamic NBFC’s today then we had ten or fifteen years ago.

May I point out that Baitun Nasr was not an NBFC but a Cooperative Credit Society.
Since both Barkat and Baitun Nasr were promoted by same group of people Baitun
Nasr had a run on it after the liquidation of Barkat which the former could not sustain
eventually. It is unfortunate that despite the management of both the institutions being
entirely in different hands and the nature of business also being quite different from
each other Baitun Nasr could not be saved.

3. What are the steps taken currently by the Islamic establishments to make Islamic banking
(IB) feasible in India?

We need to keep in mind that India is not an Islamic country. Most of the Islamic
institutions that are found in the country today are established for “protecting the
interest” rather than “promoting the interest”. An overwhelming segment of Muslim
population is below poverty line and struggling for their day-to-day life. Nevertheless
there are certain groups engaged in creating awareness about Islamic finance among
the general public. Muslims in academia especially those in economics, finance and
management are also putting their efforts in creating awareness about the
opportunities. However these are not sufficient considering the size of the country and
the Muslim population that it has. Some professionals have floated a Shariah
Advisory Firm (Called TASIS) which till today is India’s only Shariah advisory
institution in financial matters. Off late the firm has had some success when it helped
launched India’s first Shariah compliant Mutual Fund; India’s first Shariah
compliant insurance scheme; and also a venture capital fund. GIC of India (a
government of India owned company) has started a Shariah compliant Retakaful
scheme with the guidance of TASIS. These four are the only Shariah complaint
products in India at the moment. There are few others who have some products
identifying it as Shariah friendly as they do not avail the services of any Shariah
board for rectifying the product.

(Questions 4, 5 and 6 are based on the assumption that the roadblocks will be cleared in the
near future and Islamic banking in India becomes a reality)

4. Which country’s regulatory framework can be used as a reference to set up appropriate

changes in the Indian scenario? Could it be that of the UK, Malaysia or Bahrain?

Indian situation is much more unique than the countries mentioned by you. But I think
UK could still be a good model to replicate with. Indian regulators are familiar with
UK and they respect its regulation.

5. Can we adopt the AAOIFI standards for accounting purposes? Or would it require us to

21
follow Malaysia’s example of following a mix of IFRS and AAOIFI?

I am afraid India would allow any concession on accounting policies. This would be
like opening Pandora’s box for them. However, India is committed to bring its
accounting policies in tune with IFRS by the next financial year.

6. Do you believe the term “Islamic” banking would actually appeal to the Indians given the
diverse cultural and religious background? As mentioned by known personalities, wouldn’t it
be better if we avoid the term “Islamic” totally for the Indian system and concentrate on
making the Shariah system achieve its true economic purposes rather than bothering about
nomenclature? What are the alternatives?

Indian policy makers favouring introduction of Islamic banking in the country have
been airing their views on this. I do not consider this to be a big issue because even in
certain Muslim countries we see the avoidance of the term Islamic. What is important
however, in this regard is that Islamic laws should not be circumvented. When an
individual does so it is seen as weakness or lack of commitment whereas when a
system does so it smacks of conspiracy and that could be counterproductive.

We have many alternatives words such as Shariah Finance, Ethical Finance, Interest-
free Finance or Special Finance. Dr Raghuram Rajan Committee has used the word
Interest-free Finance. Anything is ok as long as it is not used to exploit the sentiments
and there is genuineness and sincerity in following the Shariah law.

7. Currently, is there any other Shariah compliant mode of investments available in India
other than the NBFC s/ Islamic mutual funds?

Yes, as I mentioned above there are Shariah Compliant Venture Fund, Pension Plan,
and also a Retakaful scheme. Besides there have been private equity investments
based on Istisna and Murabaha contracts.

8. What is future prospect of Islamic mutual funds in India? How steady has been the growth
rate in the past few years?

Currently, there is only one Mutual Fund claiming Shariah compliance. There are
other two who discretely follow Shariah. Performance of these funds has been very
good but other funds too have performed well in the last one year. In fact most part of
2009 markets have been doing well all over the world except very few places.

9. How long would it take to establish IB in India based on your estimates of current political
and regulatory scenario?

I can’t comment on the timeline. It mostly depends on political and economic

situation in the country. If there is peace in the country then it could be easy for the
policymakers to push for it. My impression is, unlike west India is not in hurry to
introduce Islamic banking in the country. May be economic situation in those
countries are such that they cannot wait any further but India is not in such a
situation and therefore there is no hurry for it at the moment.
(End of Interview)

22
4. Future prospects: Proposal to use UK’s example as a ready reference
From the earlier discussions, we can understand the need for IB in India.
Assuming that the Indian government would initiate actions towards the establishment
of IB in India, in the near future, I further my research on to the area of prospective
implementation of IB in India. We have already dealt with the regulatory issues faced
by India. Now that we have understood the problems, lets move on to possible
solutions. One solution is to emulate the efforts of the U.K government. Why U.K?
The subsequent discussions will be an effort towards driving the above point.

The obvious way to go about the implementation is by bringing alternative

regulatory measures which would support the principles of IB. Indian authorities can
start the phase of change from scratch, by studying those regulations which hinder the
process and then by applying the changes. The suggested path would be to use the
efforts of a country, which has already established IB, as a point of reference. This
could fasten the process of implementation and the concerned authorities could get
expert help from the proposed country.

The selection of a reference country is based on the below factors:

• Demographics - by religion/ diversity and

• Density of Islamic banking activity – indicated by asset size
• Non-Islamic country – Where, Muslims form a minority

The above factors were considered by keeping in mind the Indian Diaspora.
Diversity is a main factor, as no other country is as unique and diverse like India.
Even if you travel 1000 miles from any point, the culture, heritage, language, lifestyle
etc. changes drastically. That is how diverse India is. So, when the government
comes up with a new regulation, it will consider all the communities. So, we have to
select a country which is similar to the India, in terms of the above factors, to some
acceptable extent. The list of countries used as sample is given below:

23
 It is assumed that a better ‘asset size’ necessarily would indicate the level of
expertise and banking activities of the particular country. Currently, there are 292
banks, both fully Islamic and those offering Islamic windows or selling Islamic
products, there are 115 Islamic investment banks and finance companies, 118
insurance companies, adding up to a total of 525 institutions.12

Even though, Malaysia has a majority Muslim population, it could have been
considered for reference, given its history and dominating position in Islamic banking
activities in Asia. But, Malaysia is plagued with its own set of Shariah issues. Some
of its Shariah views are not accepted by the Middle-east. Since, one of the goals for
India should also be to attract the middle-east investments, it would be better to
follow UK as UK has modelled, in one way or the other, its Islamic banking activities
with an eye to attract the middle-east investments, apart from catering to its minority
Muslim population. For example, the U.A.E is a hugely important market for the UK.
At the end of last year, the UK and the UAE governments made a commitment to
increase bilateral trade to 12 billion pounds by 2015, a 60 percent increase from
current levels.13

24
Map: Islamic assets; Source: The Banker

From the above map, which shows the distribution of Islamic assets at a global
scale, we can see that the asset-size is more concentrated in the middle-east and
Malaysia, followed by U.K and the rest of the world. The Middle-eastern region has
to be excluded from our sample list of reference countries as the majority of the
population is represented by Muslims. We need to pick a country where the majority
is not Muslims, as that would reflect with the structure of India, where the majority of
the population is represented by the Hindus. The rest of the world other than U.K does
not have enough significant Islamic banking activities, which is represented by the
regions shown in green. Since, one criterion of selection is the density of banking
activity; U.K turns out to be the most obvious choice for reference. It is assumed that
more the banking activity and asset-size, the region’s density of Islamic activity is
also noticeable enough and hence, more expertise in conducting the banking business.

25
 The table below shows the distribution of the population of UK by religion.
The majority is represented by Christians followed by Muslims and the rest.

Source: Office for National Statistics, UK14

The table below shows the distribution of the population of India by religion. The
majority is represented by Hindus followed by Muslims and the rest.

Source: The Government of India census, 2001. 15

26
 From the two tables mentioned, it can be inferred that the UK and Indian
diasporas are similar, except that the majority is Christians in the UK whereas it is the
Hindus in India. As the objective is to also consider a Non-Islamic country, UK fits
the bill perfectly based on the above statistics. Moreover, since the Indian regulatory
framework is loosely based on that of the UK's, UK’s efforts could be easily used as
reference by India. Though, UK is not as diverse as India, it still could be considered
based on the strength of the rest of the two factors.

4.1. Development of IFI in UK

In general, bankers in non-traditional markets such as the UK tend to side with
the GCC model, simply because this is where the greatest liquidity resides. In fact, the
UK has to date introduced more enabling legislation to facilitate access for UK
Muslims and others interested in Islamic ethical finance with products consistent with
Islamic principles than most of the Islamic Development Bank (IDB) member
countries. The Bank of England first identified the sector’s potential in the UK in
2000 and, since then, the Financial Services Authority and the Treasury have
introduced a steady flow of legislative changes to minimise any legislative barriers
preventing the development of Islamic finance in the UK. UK Trade and Investment
has also played a role championing the UK’s success.16

Most of the growth of Islamic finance in the UK has taken place in the last
five years, but the existence of Shariah-compliant transactions in the London financial
markets goes back to the 1980s. Commodity Murabaha type transactions through the
London Metal Exchange were used, in significant volumes, to give liquidity to
Middle Eastern institutions and other investors that fostered the development of a
wholesale market in the UK. This did not, however, cater for retail Muslim
consumers, as the products developed at the time were aimed exclusively at wholesale
and high-net-worth investors. These products were relatively uncomplicated in
structure and fell outside the scope of the regulators.17

Retail Islamic products first appeared in the UK in 1990s but only on a very
limited scale. A few banks from the Middle East and South East Asia began to offer
simple products such as home finance. However, these compared unfavourably with
their conventional equivalents in several respects, including their generally

27
uncompetitive pricing. Most of these products did not fall within the regulatory
framework, so consumers did not have the same protection as other consumers, for
example, the availability of the Financial Ombudsman Service and the possibility of
redress from the Financial Services Compensation Scheme. The growth of the retail
market remained slow throughout the 1990s and early 2000s. But, thanks to the
reforms, UK hosts the only standalone Islamic financial institutions in EU and has the
highest value of Shariah compliant assets of any non-Muslim country.16

4.2. IFIs in UK
Ian Pearson, Economic secretary to the Treasury, wrote: “Looking to the
future, the Government’s approach to Islamic finance will continue to be
characterised by three principles. First, we will be fair. We will not champion Islamic
finance over conventional finance, but will instead strive to create a level playing field
between Islamic and conventional finance. Second, we will be collaborative. Progress
can be delivered most effectively when it involves industry, community groups and
the Authorities working together to achieve shared objectives. Finally, we will be
committed. Where there is a clear role for Government to play, we will continue to do
so.”

According to a report produced by International Financial Services London

(IFSL), at the beginning of 2008 the UK hosted:

• five stand-alone Islamic retail and wholesale banks, over twenty conventional
banks with Islamic windows, and one stand-alone Shariah compliant
insurance provider;
• at least nine fund managers providing opportunities for investment in Shariah
compliant funds and one Shariah compliant hedge fund manager;
• a number of advisory firms (law, accountancy, consultancy, etc) with
considerable experience and expertise in dealing with Islamic finance;
• the exchange upon which almost half of all global Sukuk by value are listed;
and
• a succession of partnerships offering qualifications in Islamic finance.

28
 It is important to note that the legislation uses the term Alternative finance
arrangements rather than specifically referring to Islamic finance, for example
alternative finance investment bonds rather than Sukuk. This means that changes are
not exclusively for Islamic arrangements.18

4.3. Explaining the UK’s success

4.3.1. The role of the UK authorities

Against the backdrop of the global drivers of Islamic finance, the Government, the
FSA and the Bank of England have actively supported the development of Islamic
finance in the UK over the past decade, which are summarized as follows:

• In 2000, the Bank of England recognised the potential for retail and wholesale
Islamic finance in the UK and, together with HM Treasury, established a
working group to investigate the obstacles facing the industry. This led to the
first of many legislative measures introduced by HM Treasury to enable the
development of Islamic finance in the UK;

• Since 2003, HM Treasury, HM Revenue & Customs and the FSA have
introduced several changes to the tax and regulatory systems in order to enable
UK companies to offer a range of Islamic financial products including Child
Trust Funds, asset finance, mortgages and Individual Savings Accounts
(ISAs);

• Since 2004, the Financial Services Authority (FSA) has authorised a number
of Islamic financial firms, which are currently the only standalone Islamic
financial institutions in the European Union. This has been achieved by
applying exactly the same authorisation criteria to both Islamic and
conventional financial institutions, working towards a level regulatory playing
field;

29
 • In early 2007, UK Trade & Investment (UKTI), through their Financial
Services Advisory Board, agreed to set up a separate sub group to produce a
strategy for the promotion of the UK as a centre of excellence and global
partner for the provision of Islamic financial services. The sub group consisted
of 15 practitioners and representatives from UKTI and HM Treasury. Four
private sector working groups were set up to feed into the sub group on
Banking & Insurance, Legal, Accountancy and Education, Training and
Qualifications (ETQ). The internal strategy was agreed in late 2007 and the
group and its sub groups continue to meet on a six monthly basis to gauge
both the implementation of the strategy and market changes; and

• In April 2007, HM Treasury hosted an Islamic finance summit at Number 11

Downing Street, on the back of which an Islamic Finance Experts’ Group
(IFEG) was established. The group consists of a number of UK and
internationally based experts from financial, legal and advisory firms as well
as Government and Muslim community groups. The IFEG has met a number
of times, providing advice to the Government on how to best support the
development of Islamic finance in the UK.

The UK’s current success as a centre for Islamic finance has required a concerted
and coordinated effort between the Authorities, industry and the associated third
parties to address the main barriers to development. These barriers can be grouped
under the following themes:

• Taxation and regulation;

• Standardisation;
• Awareness; and
• Skills.

30
4.3.2. Taxation:
The first tax legislation catering specifically for Islamic finance arrangements
came in Finance Act 2003, in the area of stamp duty land tax (SDLT). It catered for
individuals using alternative property financing arrangements (covering Islamic
mortgages), removing the double charge to SDLT that might otherwise arise where a
financial institution buys a property and then re-sells it to the individual. The SDLT
provisions were extended in 2005 to equity sharing arrangements, and in 2006 to
companies.

4.3.2.1. Borrowing arrangements

Finance Acts 2005 and 2006 saw the introduction of two types of borrowing
concepts. In 2005, Government legislated for Murabaha, referred to in the legislation
as purchase and resale arrangements. In this type of arrangement, where the return
equates in substance to the return on an investment of money at interest, it will be
taxed as if it were a loan.

The second type of borrowing catered for in 2006 was diminishing

Musharakah, or diminishing shared ownership, a form of property or other asset
financing under which the borrower progressively acquires the lender’s share in the
asset, at the same time paying a rent or financing charge for the share of the assets the
lender retains. This type of contract can be used in Home Purchase Plans

4.3.2.2. Deposit arrangements

Finance Act 2005 introduced the deposit arrangement that is recognised for
regulatory purposes, which is based on Mudarabah. This is referred to as a profit
share return. For the investor, the return is taxed as if it were interest and the
legislation switches off the tax rules that might otherwise treat it as a distribution, so
the deposit-taker receives a deduction for the payment. In Finance Act 2006, Wakala,
or profit share agency, was introduced where the investor appoints an agent to manage
a sum of money being invested, receiving a return out of the investment proceeds that
equates in substance to an interest-like return.

31
4.3.2.3 Investment bonds
The provisions in Finance Act 2007 looked to help facilitate Sukuk issuance in
the UK. For this type of transaction, known as alternative finance investment bonds,
legislation seeks to apply the same tax treatment that would be applicable were the
alternative finance investment bonds to be a debt instrument. This was seen by
industry as an important first step in facilitating Sukuk issuance. However, it was
recognised that, while these rules would help, technical issues still remained from the
issuer’s perspective. These have been addressed in Finance Act 2008 with regards to
SDLT and stamp duty reserve tax and with further changes to be addressed through
Finance Bill 2009 for SDLT on alternative finance investment bond transactions.

The Government has also looked to act following discussions with industry in
other areas such as Community Investment Tax Relief (CITR), where the principles
of Islamic finance were seen to fit well with the CITR scheme, but required
amendments to allow for money received or onward-investment through alternative
finance to be included within the scheme.

Finally, following consultation with organisations such as the Muslim Council

of Britain, Child Trust Fund rules have been specifically designed to allow the
provision of accounts that are compliant with Shariah law.

4.3.3 Standardisation
The lack of commonly accepted standards for products and practices in any
industry can be a barrier to development. This is because it is likely to increase costs,
thereby reducing competitiveness relative to substitutes. This has been particularly
true for Islamic finance, where the sector has had to address the standardisation
challenges that face all rapidly evolving industries, while also taking into account the
dynamic nature of Shariah interpretation.

The UK government did not intend to adopt a state-led approach, unlike countries
like Malaysia which has its own national Shariah board, to improve standardisation in
Islamic finance. The Government believes that such an approach would be
inappropriate in the UK for the following reasons:

32
 • the UK Authorities are secular bodies, not religious regulators;
• it could fragment the industry along regional lines where different jurisdictions
prescribe different systems; and
• it could stifle industry innovation and development by adopting a rigid
approach to standardisation.

The UK Authorities maintain close links with all the international standard setting
bodies. The FSA meets with these bodies bilaterally, attends their conferences and
also reviews their material. In the retail market, there is a smaller range of available
products, which are generally less complex than wholesale market products. Many of
the preferred forms of documentation have been prepared by individual banks
themselves, which is an expensive process, thereby increasing the costs to that firm of
bringing a product to market.

4.3.4 Awareness
The UK Authorities have adopted the following approach to raising levels of
awareness about Islamic finance:

• raising overall levels of financial capability and inclusion, in which the

availability of a Shariah compliant alternative provides an additional choice
for consumers;
• regulating Islamic finance to the same high standards as conventional finance,
so consumers can be confident that they are protected by the same safeguards
as they would be with conventional finance; and
• taking action to ensure that the Islamic finance consumers are provided the
same level of advice and transparency as would be afforded to conventional
finance consumers, so they can make well-informed purchases.

4.3.5 Skills
The UK is already leading Europe in the development of Islamic finance training
courses. These range from introductory and entry level courses, to postgraduate level

33
study and continuing professional development programmes. As such, providers
range from specialist companies and community institutions to top universities.

5. Conclusion
The history of IFIs in India shows that India has had its own experiences with
Shariah based banking in one form or the other, right from the period of the Mughal
rule. In a way, the Indian Muslims have experienced IB right from an early stage
when compared to the UK. But, UK has taken the lead in establishing IFIs at a
sturdier pace due to the business opportunities presented by the liquidity problem of
the oil-rich middle-eastern countries and also to cater to its more than 2 million strong
Muslim population. India can launch a project to study the efforts of the UK and try to
form a basic framework to execute the changes in the Indian economic system. UK’s
approach of using alternative names other than the conventional Islamic names for the
process and the products is worth pointing out and India could use this as one of its
agenda for implementing IFIs.

Public perception and awareness can be cited as the main reasons for the
failure of most IFIs in India.2 In a society like India, with diverse religions, cultures
and economic practices, survival and growth very much depends on the perception
and readiness of the population to understand that IFI is for the benefit for the entire
nation and not only for Muslims. Unless Muslims themselves steadfastly adhere to the
values of interest-free PLS finance, they cannot influence and convince non-Muslims,
nor create a lobby so essential to influence decision making, to get necessary support
to establish and manage IFIs in India. The formation of a powerful lobby is essential
in a country like India, an example or two can be taken from the Jewish lobby in the
United states which is formed by a group a wealthy and influential Israelis with
interests in presidential campaigns, educational fields, media etc. The aim of the
lobby should be the upliftment of the economically downtrodden Muslims and to
influence the establishment of policies and regulations to support the creation of IFIs.

Finally, I wish to end this paper with a reminder to the Muslims in India to
educate themselves more on Islamic financial principles and to help realize the non-
Muslims that Islamic financial principles are necessarily for the entire human kind
and are not the domain of any one society.

34
Bibliography

1. Social, Economic and Educational Status of the Muslim Community of

India
– Prime Minister’s high level committee – November 2006; pg. 133, 169
2. Islamic Financial Institution of India: Progress, Problems and Prospects;
Bagsiraj
3. A proposed introduction of Islamic banks in India – Omar Khan
4. http://www.migrationinformation.org/Feature/display.cfm?ID=577
5. http://www.hindu.com/2008/08/19/stories/2008081954710500.htm
6. Mapping the Global Muslim Population: A Report on the Size and
Distribution of the World’s Muslim Population, Pew Research Center
7. http://www.rbi.org.in/
8. Islamic banking in India – M Y Khan
International Journal of Islamic Financial Services Vol. 5 No.4
9. Obstacles of Islamic banking in India, Abdul Azim Islahi Islamic
Economics Research Center, KAU, Jeddah, KSA
[http://mpra.ub.uni-muenchen.de/18540/1/MPRA_paper_18540.pdf]
10. Islamic Non-Banking Financial Institutions in India: Special Focus on
Regulation; Dr. Shariq Nisar and Mohsin Aziz - 2004
11. http://www.merinews.com/
12. Top 500 Financial Islamic Institutions - The Banker - November 2007
13. http://www.english.globalarabnetwork.com/201003105125/Economics
/lord-davies-uk-and-the-middle-east-remain-great-trading-partners.html
14. http://www.statistics.gov.uk/cci/nugget.asp?id=954
15. http://censusindia.gov.in/Census_Data_2001/India_at_glance/religion.aspx
16. The development of Islamic Finance in the UK: the Government’s
perspective – HM Treasury – December 2008
17. Islamic finance in UK: Financial Services Authority (FSA), UK – 2007
18. Growth and diversification in Islamic finance: KPMG Report – 2007

35