ISLAMIC BANKING: PROSPECTS & CHALLENGES

Brennen College Seminar 27 October 2014

PA Shameel Sajjad Director – Zirva Institute of Islamic Finance

Outline

• The Inherent Problem with Conventional Banking

• The Alternative of Islamic Banking

• Challenges Posed by the Law in India

The Inherent Problem with Conventional Banking

The Instrument of Interest

• The concept of interest presumes the usage of capital as a factor of production and claiming a reward for the usage like the other factors of production vis a vis land, labour and organization.

• But in reality capital is not an original factor of production.

• It is only a means to acquiring other factors of production.

• This is evident from the fact that capital can’t go directly into production like other factors but will be used only in the procurement of any of the other factors of production that can be directly used in the process of production.

• This argument is supported by several economists including Ludwig Heinrich Edler von Mises (1881 – 1973); the world renowned philosopher, Austrian School economist, sociologist, and classical liberal – “It is true that majority of the economists reckon money among production goods. Nevertheless, arguments from authority are invalid; the proof of a theory is in its reasoning, not in its sponsorship; and with all due respect for the masters, it must be said that they have not justified their position very thoroughly in the matter.”

• The concept of the “right to interest on capital” creates the necessity for securing the capital loaned and the interest thereupon.

• Securing this right and ensuring repayment of capital and payment of interest can’t depend upon the “financial destiny of the enterprise”.

• This makes the whole mechanism of conventional banking “collateral based” even for risky enterprises.

• With the existence of ‘collateral’ as an essential condition for lending, conventional banking system can never become inclusive.

• Rather it becomes exclusively reserved for the sections of population who are relatively well off with some asset base (which can be offered as a collateral).

• This reality can be verified in the Indian context from the statistics issued by the Reserve Bank of India.

• The number of loan accounts constituted only 14 per cent of adult population - In rural areas, the coverage is 9.5 per cent against 14 per cent in urban areas.

• The extent of exclusion from credit markets can be observed from a different view point. Out of 203 million households in India; 89 million are farmer households. 51.4 per cent of farm households have no access to formal or informal sources of credit while 73 per cent have no access to formal sources of credit.

• However after 1991, the share of non institutional sources has increased; specifically, the share of moneylenders in the debt of rural households increased from 17.5 % in 1991 to 29.6% in 2002.

• The financially excluded sections largely comprise marginal farmers, landless labourers, oral lessees, self employed and unorganised sector enterprises, urban slum dwellers, migrants, ethnic minorities and socially excluded groups, senior citizens and women.

• Source: Text of speech by Smt. Usha Thorat, Deputy Governor, Reserve Bank of India at the HMT-DFID Financial Inclusion Conference 2007, Whitehall Place, London, UK on June 19, 2007.

• For India, financial inclusion has become a key policy concern as there are over 600 million citizens who lack basic banking and financial services.

• In India, financial exclusion has strong linkages with poverty and is predominantly concentrated among the vast sections of disadvantaged and low income groups.

• One of the important factors behind rising farmer suicides in the countryside is the lack of access to credit from banks and institutional sources and the inability to repay due to loss of crops.

• In the early 2000s, India launched a massive drive to bring most of its population under the formal banking system.

• However, 90% of the 100 million accounts opened under the plan are unused and close to half of India’s 1.2 billion-strong population still don’t have bank accounts.

• The number of the Indian poor constitutes 33% of the global poor, which is pegged at 1.4 billion people.

• According to World Bank estimate, India had 456 million people or about 42% of the population living below poverty according to the new international poverty line of US$ 1.25 per day.

• If the international poverty line is slightly raised from the US$ 1.25 /day to US$ 2 / day the scenario is further disheartening.

• Based on that measurement, India had 828 million people, or 75.6% of the population living below the poverty line surpassing the sub Saharan Africa, considered the world’s poorest region with 72.2% people without US$ 2 / day.

Key Facts and Figures

• 41% of the population in India is unbanked.

• 40% is unbanked in urban areas.

• 61% is unbanked in rural areas.

• Only 14% of the population have loan accounts.

• 9.5% in rural areas.

• 14% in urban areas.

• 203 million households in India

• 147 million households in rural areas

• 89 million are farmer households.

• 51.4% of farm households have no access to formal or informal sources of credit.

• 73% of farm households have no access to formal sources of credit.

• Share of money lenders in debt finance has increased.

The Islamic Alternative

• By taking out the “interest” out of the process of financial intermediation Islamic baking has strong nexus with actual production and distribution on the ground.

• Money as such doesn’t have a “right to earn.” The right to positive revenues is an entitlement which is granted by partaking the risks and uncertainties of productive activities.

• When this maxim is established collateral will have no significant role as far as financing for productive activities are concerned.

• This is because there is no binding responsibility on the entrepreneur to guarantee the repayment of the capital and interest. The binding responsibility is to share the revenue / profit of the venture.

• As soon as this happens the focus shifts to inherent capability of the venture to generate profits which will depend in turn on a number of factors like demand for the commodity / brand, capability of the entrepreneur, quality of management, sincerity of the entrepreneur etc.

• Thus a financial atmosphere is established in which the asset backing of the clients of the bank will be of little use to the bank and the rich and the poor will be on a level playing field; a scenario where the richness of the rich will no longer be a privilege and the poverty of the poor will no longer be a an obstacle.

• Thus Islamic banking is a transition from “aristocratic / feudal / undemocratic” banking to “democratic banking for the masses”.

• For the bank its positive returns will be worked out on the basis of the “Portfolio theory”. That is even after the due diligence exercised before investing in projects if some projects fail they will be made up by the success of other projects.

Potential High Impact Areas for Islamic Banking in India

Agriculture

• "Slow agricultural growth is a concern for policymakers as some two-thirds of India’s people depend on rural employment for a living. Current agricultural practices are neither economically nor environmentally sustainable and India's yields for many agricultural commodities are low. Poorly maintained irrigation systems and almost universal lack of good extension services are among the factors responsible. Farmers' access to markets is hampered by poor roads, rudimentary market infrastructure, and excessive regulation."

• —World Bank: "India Country Overview 2008"

• "With a population of just over 1.2 billion, India is the world’s largest democracy. In the past decade, the country has witnessed accelerated economic growth, emerged as a global player with the world’s fourth largest economy in purchasing power parity terms, and made progress towards achieving most of the Millennium Development Goals. India’s integration into the global economy has been accompanied by impressive economic growth that has brought significant economic and social benefits to the country. Nevertheless, disparities in income and human development are on the rise. Preliminary estimates suggest that in 2009-10 the combined all India poverty rate was 32 % compared to 37 % in 2004-05. Going forward, it will be essential for India to build a productive, competitive, and diversified agricultural sector and facilitate rural, non-farm entrepreneurship and employment. Encouraging policies that promote competition in agricultural marketing will ensure that farmers receive better prices."

• —World Bank: "India Country Overview 2011

• Share in National Income: The contribution from agriculture has been continuously falling from 55.1% in 1950-51 to 37.6% in 1981-82 & further to 18.5% in 2006-07. But agriculture still continues to be the main sector because it provides livelihood to majority of the people.

• Largest Employment Providing Sector: in 1951, 69.5% of the working population was engaged in agriculture. This percentage fell to 66.9% in 1991 and to 56.7% in 2001. However, with rapid increase in population the absolute number of people engaged in agriculture has become exceedingly large.

Islamic Banking Solutions to the Farming Sector

• Salam – Advance Purchase of Crops

• Muzara’a – Share Cropping

• Musaqath – Crop Sharing for Maintenance

Infrastructure

• The infrastructural requirement of India is US$ 1 trillion.

• This can’t be financed by government funding alone.

• Islamic banks can issue sukuk to address this requirement.

• This will not introduce any additional debt burden on the citizens of India.

• We currently have a per capita debt of Rs. 33,000/-

• The debt repayment for 2014/15 is seen at 1.397 trillion rupees.

Micro Medium and Small Enterprises

• MSMEs are the real growth drivers in any economy.

• Overall finance gap in MSME sector is 32.5 trillion rupees (MSME Census, RBI, SIDBI).

• MSMEs largely require equity financing. • But the demands of listing and the competitive

conventional equity markets are not easily accessible for them.

• This vast need can be financed by Islamic banks which rely on risk financing which is the essence of the MSME sector.

Obstacles for the Introduction of Islamic Banking in India

• Section 5 (b) and 5 (c) of the Banking Regulation Act, 1949 prohibit the banks to invest on Profit Loss Sharing basis -the very basis of Islamic banking.

• Section 8 of the Banking Regulations Act (BR Act, 1949) reads, “No banking company shall directly or indirectly deal in buying or selling or bartering of goods…”

• Section 9 of the Banking Regulations Act prohibits bank to use any sort of immovable property apart from private use –this is against Ijarah for home finance.

• Section 21 of the Banking Regulations Act requires payment of Interest which is against Sharia.

Operational Issues

• SLR Requirements – Banks have to invest at least 25% of their NTDL (Net Demand and Time Liability) in government securities.

• CRR Requirements – 6.5% of NTDL should be deposited with RBI on which interest accrues.

• Call Money – Call Money Rate on Borrowing from other banks which carries interest.

• Repo Transactions – Banks borrow from the Central Bank which carries interest.

Raghuramrajan Committee Report

Chapter 3: Broadening Access to finance Page 35

• “While interest-free banking is provided in a limited manner through

NBFCs and cooperatives, the Committee recommends that measures be

taken to permit the delivery of interest-free finance on a larger scale,

including through the banking system. This is in consonance with the

objectives of inclusion and growth through innovation. The Committee

believes that it would be possible, through appropriate measures, to

create a framework for such products without any adverse systemic risk

impact.”

THANK YOU!!

Contact details

shameelsajjad.pa@zirvabs.com

+91 9745 812 277

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THANK YOU!!

Contact details

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+91 9745 812 277