Economics of Islamic Banking in India

Economic exigencies and political expediency in a country with more Muslim population than Pakistan, at least after six decades of independence, should consider introduction of Islamic Banking as part of reforms in the Banking Sector. Since this intervention requires some important changes in the regulatory regime in line with those obtaining in more Muslim liberal countries like Malaysia, the logic and logistics in this regard require some explanation which this article intends to present.  It is good to recall that even Raghuram Rajan Committee on Financial Sector Next Generation Reforms made a reference to this aspect.


Prospects for Islamic Banking in India:

Few companies are already dealing big in Shariah Investments funds. Many financial sector players eying upon trillion dollars Islamic investment funds. Parsoli and Eastwind have launched their Islamic Indices; and Reliance Money and Religare have launched Shariah compliant PMS, and Indian Stock market is observing fair business in Shariah Compliant Stocks. If China is going for Islamic banking to attract Islamic Investment Funds, why should India hesitate developing Islamic banking with 150 millions Muslim who may help to pool around one trillion dollars Islamic investment funds from Gulf countries that too on equity base; which may keep our national current account and fiscal deficit under control?


No visualization document for Islamic banking in India:

So far Islamic banking has been considered as a religious matter for Indian Muslims and thus it was denied with a fear of financial segregation, a threat of parallel banking system along with a hidden fear for SCBs to loose Muslim depositors. There has never been any public committee analyzing the impact of Islamic banking in India because Muslims of India were never so evocative about features of Islamic banking in India. Though the concept of Islamic banking is driven by ethics of Islam, it has more economic rationality compared to its religious rigour which needs some genuine study by professionals having basic knowledge of Islamic banking with expertise on Indian economy because Islamic banking carries more advantageous features to boost real sector economy compared to financial sector.


Islamic banking and bankruptcy:

Islamic banking also restrains the chances of bankruptcy because it adheres to strict credit rating system by disallowing indebted economic agents to avail more debt finance. The strict regulations for credit rating under Islamic banking could save our financial and economic enterprises from bankruptcy. The Islamic banking mechanism would certainly strengthen the credit rating system to provide security of funds for depositors and investors. Moreover since equity finance by Islamic banking allows the banks to recover the assets by right of ownerships, it would be fairer on the part of financial institutions to recover assets in case of bankruptcy or crisis by any individual or enterprise.  


Islamic Banking for Inclusive Growth:

Islamic banking is more desirable for achieving Inclusive growth of India. It is interesting to evaluate probable impact of Islamic banking in different segments of Indian economy. Islamic Banking has the potential to tame the liquidity and inflation problems along with allowing inclusive growth. Structural changes in the Indian economy during post-reform period are no barometer for equitable growth. For real inclusive growth, we have to ensure increase in income and employment status of workers in all segments. Empirical evidences reveals that though India has registered better growth rate in recent years, the number of poor living below poverty line has increased. Our household consumption which has declined in recent years is driven by household income; while corporate savings reflects income of the corporate sector which has increased over the years during the last decade and half. The fruits of growth seem to have favoured more the corporate sector than vast sections of population below the poverty line.


Similarly the share of financial sector in GDP has increased in recent years. It is well known that the SCBs extend debt finance. The interest component ipso facto becomes part of GDP.  Interest rate sensitivity to inflation is well known. However, equity finance if extended with far lower costs of credit has potential to restrict inflation and there is enough evidence from West Asia in this regards.  Simultaneously the dividend shared by depositors on equity finance helps equitable distribution of income generated by financial sector.  Once the basic difference between the debt and equity credit is understood, it will be easy to appreciate its potential contribution to better economic growth.


With low collateral strength of farmers and poor workers associated with unorganized sector manufacturing units and retail service outlets do not encourage SCBs to extend more debt finance. With schemes of loan waiver, the debt markets are shrinking in agriculture sector. Even the SHGs and JLG schemes of Micro Finance have failed to add livelihood stocks for the poor and vulnerable. Inequitable distribution of resources led naturally to serious imbalances both across sectors and regions and need systemic corrections that are possible with the new instrumentality of Islamic Banking. It is time that the policy makers realise these options as imperative at this moment of economic history when the youth unrest is showing itself in drifting to intrusive terrorist attractions. Enough price has been paid by the economy that cannot afford this any longer.


Insights into Islamic banking reveal its potential to build infrastructure for our agriculture sector where the economies of scale are hostile to adding new infrastructure to the farm worker households. Islamic banking could also help our unorganized sector due to its non-insistence on collateral as a precondition for lending even small sums of money. This would also alter the desperate labour-capital ratios in rural India, in particular, in States like Uttar Pradesh, Bihar, West Bengal and the seven sisters of North East.  Financial empowerment of the vulnerable sections of population is a near possibility at quicker pace with Islamic Banking.


Islamic banking may induce our political leaders to substitute grants and subsidies with equity finance schemes through specialized financial institutions because equity finance allows access to credit without adding debts to borrowers. Equity Finance helps achieve self-reliance. The stabilization funds for poor farmers / artisans may be utilized to experiment such finance. Islamic banking unlike what many think has less to do with religion than with economics.


Islamic Banking and Financial Inclusion:

Though we do not have any survey to compare community wise financial exclusion in India, the study of data available through Sachar Committee report reflects Muslims are most disadvantaged community in financial sector, and banking is inversely related to concentration of Muslim Population. Muslims have over 80% financial exclusion due to interest based deposit and credit schemes available with financial institutions and SCBs. Due to restrictions on Islamic banking India, financial sector could not attract even the rich Muslims to partake in the growth story of India. Even the worker participation in institutional growth is evident from the Muslims employed in the financial sector, if one were to go by the statistics put out in this regard: RBI and SCBs, have just 0.78% and 2.2% share of Muslims in employment with RBI and SCBs. Similarly the participation of Muslims in specialized financial institutions and corporations like SIDBI, NABARD and NMDFC is also desperate. Hard to believe but true, that even Institutions like National Minority Development and Finance Corporation (NMDFC) have no Muslim managers.


The Sachar Committee Report reflects that Indian Muslims have a share of 7.4% in saving deposits while just get 4.7% in credit (in terms of PSAs). If we consider this as a standard proportion in national aggregate deposits at and credits by SCBs according to annual report of RBI for year 2007-08, Indian Muslims annually loose around Rs. 63,700 crores because Muslims would have a credit deposit ratio of 47% against national average of 74%. It shows that Indian Muslims annually loose around 27% of their deposits (by not availing as credits). After Islamic banking this deficit may be removed to curb financial loss to Indian Muslims. With 31% Muslims living below poverty line and 40% Muslim workers as own account workers, this big deficit of credit is apparently a serious economic disadvantage. Muslims avail just 4% and mere 0.48% credits from special financial institutions like NABARD and SIDBI respectively because there also the community has to indulge in interest which is strictly prohibited in Islam. Of course, although it is well understood that the credit worthiness does not get related to either caste or creed but on the related assets and repayment capabilities the underlying assets could generate, quicker and easy access to finance has the innate potential for asset creation and related product markets at least in the domestic environ as proved in the SHG group efforts in the southern States.  


The schemes launched by RBI, NABARD, SIDBI and Ministry of Finance for financial inclusion focus on providing access to credit and other financial products. Just as allowing access to Meat shops for non-vegetarians by definition is the surest route for excluding all vegetarians, interest-based banking system has a potential for exclusion of a majority of Indian Muslims. On the other hand, introduction of Islamic banking will allow the Muslims to work with other community members in banking sector; it would definitely help us build civilized economy.


Introduction of Islamic banking in India apart from pleasing 150 million Indian Muslims, the second largest community of India, our government will certainly gain diplomatic advantage to make financial dealings with Muslim dominated nations especially to attract trillion dollars of equity finance from gulf countries. The fall of giants in the world financial sector like Lehman Brothers in the aftermath of the US sub-prime mortgage crisis, we need to be alert to the alternate sources from where FDIs could flow into the Indian economy and Islamic nations are the potential alternatives. Our opening the doors for Islamic Banking at this juncture would also accelerate the fund inflows and slight decoupling of the US Dollar to inviting the Euro. Since Islamic Banking encourages equity finance even the small players could enter the Equity Markets and the SME bourses likely to come into being shortly would have better access through Islamic Banking channels as the SMEs mostly have inadequate collaterals to offer for their expansion needs in their growth stage.


Islamic banking and nationalized banks:

It must be made clear, however, that Islamic banking is not a children’s game. It requires even better professional expertise compared to conventional banking because it deals more with commercial projects than mere monetary credit and debit transactions. Indian Muslims may feel privileged in terms of Islamic ethics required for Islamic banking but they certainly lack professional efficiency to manage modern commercial banking on Islamic ethics. The organic link between the Islamic and nationalized banking emerges from the innate professional competencies developed by Institutions like the SBI, Bank of Baroda, Bank of India, Corporation Bank that has recently opened its representative office in Dubai with a view to shortly raise to the status of a commercial bank, Under Islamic banking mechanism thrust would be on equity deposits and credits while interest charged would be replaced with profit margins on commercial credits and interest expended over deposits would be replaced by dividend on equity finance with deposits mobilized as equity deposits by banks. 


It is expected that with introduction of Islamic banking in India, the first choice of depositors and investors would be nationalized banks as despite contradiction of interest, Indian Muslims have a confidence in nationalized banks. To ensure safety of deposits majority of Muslims depositors would prefer to join Islamic banking managed by nationalized banks. However it is expected that Foreign Investors looking to invest in India through Islamic banking, would prefer to have services of foreign banks. As far as Indian Muslims are concerned, they have to make hard efforts to find their place in managing Islamic banking in India because they lack required financial depth; infrastructure and more importantly they have poor credibility among the depositors and investors due to some past failures of financial institutions.


Interest-free banking may add Muslims to formal financial sector. Through this financial inclusion of Indian Muslims to formal sector Islamic Banks, it is expected that Indian nationalized banks may see additional savings and credit which may help banks to gain higher rate of profits compared to their SLR. After successful operation of Islamic banks by our nationalized banks, private banks may also enter into business of Islamic banking.


Stock Market Capitalization

Since Islamic banking focuses on equity deposits and finance, it is expected that Stock market will be the most preferred avenue for investments by future Islamic banks of India because currently it is our stock market which is attracting new investments under Shariah Finance schemes. Technological innovations would facilitate easier flow of equity-based deposits of Islamic Banks into the rising Indian Stock Markets. It is just common sense that when equity based financing takes place through Islamic banking route, the number of D -mat accounts may surge in millions. 


Corporate Sector and Islamic Banks

Even the Corporate sector would be a gainer. All the companies listed in stock markets will get additional potential investors to genuinely subscribe their shares instead of speculator trading. Even the Bond Markets may stabilize.  Long term resources for the infrastructure sectors like the irrigation, power, Oil, and communication projects could be faster and easier through Islamic Banking route. New modes of public private partnerships for the execution of infrastructure projects may emerge. The total investment in India for infrastructure, during 2006–07 was estimated to be around 5% of GDP. It has to be 9% of GDP by 2011-12, it means that we would require Rs. 207,291 crores in 2006-07 and Rs. 574,096 crores by 2011-12 to finance our infrastructure. The total investment amounts to Rs 20,56,150crores for the 11th five year plan of which Rs. 1436,559 crores is supposed to be met from Public Investment while Rs. 6,19,591 from private investments.

Islamic banking through promoting equity finance from national and international markets may reduce this burden of keeping national current account and fiscal deficit well under control and probably we need not to worry about interest payment on borrowings. Since Islamic banks may also have managerial control over commercial financing, government might use Islamic banking units as source to mobilize tax revenues as well, which might reduce mobilization costs for public revenue for governments.


With equity finance, our Government may also convert grants, subsidies and stabilization funds into equity for Islamic Banks to lend equity finance to priority sector agents instead of highly subsidized lending which costs a lot to the exchequer.


Islamic banking to counter Terrorism:  

The experience of Islamic banks of Malaysia and Britain may be interesting; as in Malaysia, the Chinese businessmen are the biggest customers of Islamic banking; in Britain also, Islamic banks are not for Muslims alone. Stringent anti-money laundering measures are in place in these countries and have seen far less terrorist intrusions during the last decade. The Shariah principles require transparency in monetary routes. Every extended credit under Islamic Banking will need supportive document with managerial control of the fund to monitor the use of credits, which may not be available with debt finance under interest-based banking. All we have to put is a fairer and strict audit system to monitor the fund flows. The universal nature of banking through Islamic Banks prevents surreptitious routes for investments and mutual funds.  The petro-dollars and SDRs have the potential for greater flows and these would also contribute to more dynamic commodity markets. With the financial muscle, the youth among the Muslims may look to better contribution to domestic GDP through better education and higher productivity.


In fine, Islamic Banking should be seen as a powerful economic instrument capable of creating multi-sectoral impacts and should therefore be invited with lot of cheer instead of sneer. It contributes to greater stabilization, helps the real economy significantly, and reduces unemployment and more than any thing acts as a powerful antidote to poverty sans huge subsidies and grants that are making a big dent in our fiscal framework. It would open the doors for financial inclusion faster and quicker.


*The author would like to thank Dr. B. Yerram Raju, Regional Director, PRMIA, Hyderabad Chapter and Dr. Ausaf Ahmad, Former Economist, IRTI, IDB, Jeddah for their valuable guidance in making out this paper.

5 Responses to "Economics of Islamic Banking in India"

  1. Stephan Zimmermann   September 26, 2008 at 5:43 pm

    It is high time that we look not only at traditional, “proven” Western economic theories, but at the alternatives available for the immediate and long-term future world-wide. This applies equally to India or the United States.One of those alternatives is to take the time to understand the essence of Islamic (sharia) banking principles.As a retired professor of economics, I routinely called on my students to think about the ethical, moral and social principles required to achieve growth and stability, rather than just “maximizing” profits. Integrating the positive principles of Islamic banking in practice might well have avoided the current worldwide “meltdown.”Just as blame for the current crisis is being placed at the feet of any of a number of individuals and institutions, so a positive, objective look forward to alternatives is not too soon.The results depend on people of good will, rather than short-sighted, profit-driven greed or power, no matter their ethnicity or religious persuasions.

    • Zahid   October 2, 2008 at 8:07 am

      Approach of Prof. Stephen Zimmermann is appluadable. Such approoches help us devlop of societies and nations.

  2. S. Roy   September 27, 2008 at 5:43 pm

    This article has a high “fog index”. It contains numerous statements – though mostly are rhetoric. The author quotes data without references. Any reference data MUST be corroborated from a credible source.Also, a mistake contained in the article may be a small one; however it is indicative of the general message the article is trying to convey. The article states that”…Indian Muslims annually loose around Rs. 66,700 crores because Muslims have a credit deposit ratio of 47% against national average of 74%. It shows that Muslims of India loose around 27% of their deposits….”What kind of mathematics is this? When one subtracts a percentage from another, one gets “percentage points” – NOT “percentage”. The whole concept of banking based on Sharia law (which basically disallows making money by investing money) is abject nonsense. The “Islamic banking” can only work properly in a land of Oz. One has to be a fool to believe in what disavows fundamental arithmetic! The fools of course are the investors. What do the organizations that accept funds from such investors do? They laugh all the way to where else?They laugh all the way to the Islamic bank!!To me, it seems that the author thinks that most readers are mushrooms.

  3. Zahid   October 2, 2008 at 8:08 am

    The references should definitely be mentioned. For this article, especially the data regarding financial exclusion, I request Mr. Roy to please study my old article on ‘Financial Exclusion of Indian Muslims.’ The source of data is not perfect nevertheless; I like to inform him that I have abstracted the data from Sachar Committee Report 2005 and Annual Report of RBI 2007-08. It would make it clear how Indian Muslims are loosing 27% of their savings by not availing as credits.