Economics of Islamic Banking in India

Syed Zahid Ahmad

In the past few years Islamic finance in general and Islamic investment business in particular have gained considerable ground. Prominent global financial players such as McKinsey and Beary’s Group have introduced Shariah-compliant investment funds. China has recently opened its doors to Islamic banking in order to attract investment of funds from Muslim countries. Islamic banks in China and the UK are attracting even non-Muslim customers in a substantial way.

In India, East Wind has launched an Islamic Index while Reliance Money and Religare have launched Shariah-compliant Portfolio Management Services. Shariah-compliant stocks in the Indian stock market indicate positive trends.

Unfortunately, a great deal of misconception surrounds the issue of Islamic banking in India. Islamic banking is generally believed to be an exclusively religious domain of Muslims and it is feared that the introduction of Islamic banking in the country would lead to financial segregation and that in consequence of the move the country’s scheduled banks might lose Muslim depositors.

It needs to be clarified that the scope of Islamic banking need not be confined to the Muslim community alone; rather, its doors should be open to the wider Indian society. Regrettably, no study has been carried out on the economic viability and sustainability of Islamic banking in India and its potential for inclusive growth.

Islamic banking requires a far greater level of professional expertise compared to conventional banking because it deals more with investment projects than with monetary credit and debit transactions. Indian Muslims lack the requisite professional expertise to run modern commercial banking along Islamic lines. The State Bank of India, which is the country’s leading commercial bank, has the requisite expertise and infrastructure to manage the complex project of Islamic banking.

The Reserve Bank of India’s directions to scheduled commercial banks emphasise lending to the small and micro enterprises. In essence this reflects the significance of the Islamic approach to banking. The majority of borrowers from the unorganised sector are non-bankable due to collateral problems. They actually need equity finance rather than debt finance. The approach of Islamic banking is fundamentally different from the conventional approach in that it emphasizes equity deposits and credits while the instrument of interest is replaced by profit and loss sharing arrangements.

It is likely that even after the introduction of Islamic banking in India the first choice of depositors and investors would be nationalized banks. Indian Muslims also have confidence in nationalized banks. To ensure security of their deposits, the majority of Muslims depositors would prefer to join Islamic banking managed by nationalized banks and not the banks run by Muslims under the pretext of Islamic banking. However, it is expected that foreign investors looking to invest in India through Islamic banking would prefer to avail of the services of foreign banks. As far Indian Muslims are concerned, they have to make serious efforts to find their place in managing Islamic banking because they lack the necessary financial strength, expertise and infrastructure. More importantly, they have poor credibility among the depositors and investors due to the failure of a few financial institutions run along Islamic lines.

There are reasons to believe that Islamic banking, as and when introduced in India, would be helpful on several counts.

• The 150 million-strong Muslim community in the country will have no hesitation in participating in banking transactions because the instrument of interest will not be there.
• With the introduction of Islamic banking, Indian government will have the diplomatic advantage of financial dealings with Muslim countries and thereby attract trillions of dollars of equity finance from the Gulf countries.

• Islamic banking will open new avenues of employment for Muslims and their presence in money and capital markets will improve. At present their presence in the banking sector is far lower than their proportion in the population. For instance, RBI employs 0.78% Muslims and scheduled commercial banks have just 2.2% Muslim employees. Similarly Muslims have a poor presence in NABARD, SIDBI and other financial institutions. Since financial institutions carry out interest-based transactions, many Muslims have reservations about participating in interest-based banking and financial institutions, resulting in their financial exclusion. The introduction of Islamic banking will redress the situation, at least to some extent.

Economic development is a continuous process and at present India has entered into the stage of high-cost economy. Here cost-push type of inflation is unavoidable. On the one hand, prices continue to rise and, on the other, the value of money, expressed in terms of purchasing power, keeps on declining. The continuation of inflation is highly injurious. If not controlled, it causes immense damage. Economists suggest several methods to overcome this problem, including keeping the “cost component” under control. It is here that Islamic banking can come to the rescue of an inflation-ridden economy. Since India’s scheduled commercial banks and other players in the money and capital markets extend debt finance, the interest component of their transactions adds to the rising costs. Since the credit cost is zero under equity finance, the severity of inflation may be minimised.

The continuation of inflation causes severe inequalities of income and wealth distribution. It is possible, through the introduction of Islamic banking, to control such disparities by curbing inflationary tendencies. In addition to this, the dividends shared by depositors and investors on equity finance would help an equitable redistribution of income generated through the financial sector. These are a few positive points which need to be considered by the country’s financial sector regulators.