Islamic Finance in India: A New Beginning?

It was an Indian scholar, Dr Muhammad Nejatullah Siddiqi who provided the first theoretical model for an Islamic bank in his celebrated book “Banking without Interest” in the 1960s. He went on to contribute immensely to the development of Islamic economics as a discipline. Way back in 1996, the Xavier Institute of Management in Bhubaneswar, India launched the first online course in Islamic banking and finance. The Third Harvard University Forum on Islamic Finance in 1998 had two delegates from India – Zafar Sareshwala and Mohammed Obaidullah presenting a paper on Strategic Analysis of Islamic Funds, closely followed by launching of an Islamic Equity Fund by the former in the UK. In 1999, the world’s first online community IBF Net was launched. The same year, the first online certification program in the world in the field was launched from India, sponsored by the IBF Net virtual community. India also witnessed the launch of the Parsoli-IBF Equity Index the same year, an initiative by Zafar Sareshwala supported by IBF Net.

Yet, it is only in 2016 we see the first definite signs of introduction of Islamic finance in India. It is not that there have not been sincere efforts by proponents of Islamic finance in this regard. Who does not remember the innumerable seminars and conferences by the Delhi-based Institute of Objective Studies; the untiring and high-pressure lobbying by the Delhi-based Indian Center of Islamic Finance; the RBI’s periodic attempts to study the feasibility of Islamic banking in India, only to find the existence of major legal obstacles; the Kerala government’ plans to set up the first Islamic FI as an NBFC, only to be bulldozed by the legal challenges of an inimitable Dr Swamy (which of course fizzled out later, but not before inordinately delaying the pace of the entire exercise)? A sense of despair was setting in with a growing realization that India is perhaps not ready yet for Islamic finance, even when the rest of the world had embraced it. However, it now appears to be a case of misplaced pessimism. In February 2015, in his very second meeting after taking over as the Chancellor of Maulana Azad National Urdu University, Br Zafar Sareshwala took concrete steps towards introduction of Islamic banking and finance as a discipline in the university. He has delivered once again. Going by the recent report in the media the IDB Group, the key backer of Islamic finance across the globe is going to have a presence in India and Br Zafar is slated to direct its India operations.

Islamic finance can bring many benefits to the Indian financial system. In the world’s largest democracy that firmly believes in and practices pluralism, Islamic finance can significantly enhance financial inclusion. It can bring the large number of excluded Muslims into the formal financial system through financial instruments that do not violate their fundamental beliefs. In the giant Indian economy that is now bracketed with the economies of US, China and Japan, Islamic finance can offer creative financial solutions to meet the financing requirements of key sectors of the economy, e.g. infrastructure, agriculture, micro, small and medium enterprises. It can provide depth to the financial system and contribute to greater stability. It can help develop India’s awqaf sector through innovative mechanisms that facilitate participation of finance providers in the process. And last, but not the least, it can help provide a financing solution to Hajj pilgrims. What follows is a brief note on the economic and political enablers and constraints for Islamic banking and finance as well as for financing of hajj and awqaf development in India. The implications for a possible strategic intervention by IDBG are then presented.

Regulatory Environment for Islamic FIs

An enabling regulatory environment is a fundamental requirement for the creation and sustained growth of the Islamic financial system. In what follows, the study examines the major regulatory enablers and constraints as they impact specific components of the Islamic financial system. We begin with Islamic commercial banking.

Islamic Commercial Banking

The regulatory framework governing commercial banking comprises: Indian Banking Regulation Act (1949); the Reserve Bank of India Act (1935) and the Negotiable Instruments Act. Some major constraining provisions in them (i) require interest to be paid on deposits; (ii) disallow banks from trading; (iii) disallow banks from entering into any kind of profit sharing or partnership; and (iv) disallow banks from acquiring any immovable property other than for private use. Almost all major Islamic modes of deposits, financing and investment are thus, ruled out for Indian commercial banks. Major provisions to the Banking Regulation Act that would require amendment are as follows:

• Section 21 of the Act requires payment of interest on savings deposits. Pure interest-free deposit or with an element of gift (without obligatory element) is not permissible, ruling out wadiah deposits. Also ruled out are mudarabah-based term deposits.
  Section 8 explicitly disallows a bank to engage in any kind of trade, thus, clearly ruling out murabaha, salam and other trade-based modes.
  Sections 6 of the Act indicates the forms of business a banking company can undertake, and does not allow any kind of profit-sharing and partnership contract including mudarabah and musharakah.
• Section 9 of the Act prevents the bank from owning any sort of immovable property other than private use, for any period exceeding seven years from the acquisition thereof, thus, ruling out longer-term ijarah, such as, for Islamic home finance.
• Section 19-2 restricts a bank’s ability to invest in stocks. It disallows a bank from holding equity in any company of an amount exceeding thirty percent of the paid up share capital of that company or thirty percent of its own paid up share capital and reserves whichever is less.
• Section 36 disallows a bank from floating a subsidiary abroad to undertake business other than what is allowed as banking business as per section 6, thus ruling out Islamic overseas subsidiaries.
• Section 24 and 42 mandatorily require a bank to hold a percentage of the ratio of its assets in liquid and interest-bearing assets, thus, resulting in its forced involvement with interest.

Besides the above, there are some other major constraints in the fiscal environment. Most Islamic banking products involve exchange and offering these products may not be feasible due to stamp duty, central sales tax and state tax laws that will apply depending on the nature of the transfer.

The upshot of the above is that Islamic banking experiment is not possible without a new law, or multiple amendments to the existing regulations.

Islamic Investment Banking

Islamic asset management companies are a clear possibility in the Indian capital market. These can set up Shariah-compliant mutual funds, private equity and venture funds and also provide portfolio management services. An Islamic AMC may be set up under registration with the Securities Exchange Board of India (SEBI), the apex capital market regulator. A couple of Islamic equity funds and a venture fund have been permitted by SEBI and been in operation for a few years.

While sukuk are yet to make a beginning in India, asset securitization itself has a long history in India with a sound enabling framework. Shariah compliant sukuk based on pass-through structures, such as, sukuk-al-ijara are a clear possibility under SEBI regulations.

Islamic Financial Cooperatives

Islamic financial cooperatives are also a clear possibility under the Indian Co-operative Societies Act (1866). Such institutions may be set up at national level or regional levels or as a network of cooperatives, similar to the Credit Unions in USA. The regulations provide ample flexibility to the institution to accept deposits from members and design financial instruments that conform to Shariah. A cooperative-based model however, may be perceived as less robust and credible due to lax regulatory and supervision norms. Further, since the cooperation model permits increase in capital through increased membership alone (as it employs one-member-one-vote rule in contrast to one-share-one-vote rule under the corporate model), funding remains a major constraint.

Islamic NBFCs

A more balanced solution for introduction of Islamic finance in India perhaps lies with the corporate model of Non-Banking-Finance-Company (NBFC). The NBFC framework permits a range of Islamic modes, such as, financial and operating leasing, trade financing through deferred-payment-sale, sale and buy back and profit sharing through the private equity route. Islamic NBFCs can therefore, provide financial services in several forms, e.g. equipment finance, microfinance, venture finance, housing finance and infrastructure finance.

The regulations relating to NBFCs are enunciated in Chapter IIIB of Reserve Bank of India Act and directions, notifications and circulars issued by the RBI from time to time based on the provisions of the Act. A key direction that impacts Islamic NBFCs is the Fair Practices Code direction. Other laws like Foreign Exchange Management Act and rules and policies framed there under impact foreign investment and external commercial borrowings by Islamic NBFCs and as they regulate other companies also. But a few provisions in the said policies (ECB policies) are related to interest and affect Islamic NBFCs. Then there are general commercial laws which govern any transactions whether Islamic or otherwise, e.g. the Indian Contract Act, the Negotiable Instruments Act and the Prevention of Money Laundering Act.

What are the major provisions that compel NBFCs to engage in activities that are not exactly Shariah-compliant?

The fair practices code requires all NBFCs to declare the rate of interest they will charge from clients. It also requires an NBFC to adopt an interest rate model taking into consideration cost of funds, risk premia for different sectors and declare the same in its website. This makes musharakah and mudarabah financing for business difficult. It may be noted that one of the two Islamic NBFCs that has been using participatory financing recently was disallowed by RBI from continuing in financing business.
Secondly, an NBFC will lose its status if trade income exceeds financing income or financial assets falls below 50%. This will be a problem if murabaha income exceeds financing income except if murabaha is so structured to fall within the ambit of financing. Moreover the assets will be taxed at the point of purchase and for the value addition i.e. margin in murabaha and ijara.
Thirdly, while accepting deposits the NBFC has to declare a rate of interest or at least a minimum rate of interest. And a certain percentage (15%) of the amount of deposits collected must be invested in interest-bearing noted securities to meet the Statutory Liquidity Ratio (SLR) requirement. Non-deposit-taking NBFCs with net owned funds of more than one billion rupees (USD 200 million approx) are also required to maintain SLR in noted interest bearing securities.
Fourthly, when NBFCs opt for flexible rate financing, the varying rate of interest must be linked to some benchmark index like LIBOR.

Notwithstanding the above constraints, an NBFC enjoys greater regulatory and operational freedom than its commercial bank counterpart. It also enjoys greater support among policy makers as far as interest-free finance is concerned.

An Islamic NBFC as a legal entity has now been validated by court verdict.

The concept of Islamic NBFC is strengthened by the following observations of the Raghuram Rajan Committee Report on Financial Sector Reforms in India: (i) Measures should be taken to permit the delivery of interest-free finance on a larger scale through NBFCs; (ii) It would be possible, through appropriate measures, to create a framework for such products without any adverse systemic risk impact. The Report strongly advocates Islamic microfinance as a way to enhance financial inclusion and address poverty.

There is a huge need for infrastructure finance in India and various policy measures under discussion at highest levels are infrastructure sukuk and infrastructure NBFCs. Also expected is a relaxation in norms for foreign direct investment in NBFCs.

A recent Report of Key Advisory Group of Finance Ministry on NBFCs (2012) recommends allowing of participative finance (note 4.3) in the following words:

In the backdrop of the recent concerns pertaining to levy of usurious rate of interests by Micro Financial Institutions and earlier RBI guidelines on Fair Practice Code in 2009 (to ensure transparency in charging high rates of interests by NBFCs), charging of high interests on loans disbursed to retail borrowers, has always raised issues in India. This can be mitigated if NBFCs are expressly allowed to undertake participative financing which consist of financings in a manner that returns are linked to the actual cash flows of the venture for which financing was availed but such that the returns are capped. Mezzanine financing is one such form….We therefore urge the RBI to issue a clarificatory circular stating therein that the 2nd January 2009 circular on Fair Practice Code applies to those NBFCs that are disbursing interest based loans and does not prohibit NBFCs from undertaking other forms of financing such as participative financing / non-interest based financing.

Br Zafar Sareshwala has opted for the NBFC route, and for very good reasons. He has already articulated the strategy and has rightly identified SME financing, financing of waqf development and financing for the artisans as his priorities. The initiative could not have materialized without the direct patronage of Hon’ble Prime Minister of India and should go a long way in alleviating poverty and destitution of the marginalized sections of our society.