Islamic Banking! Now, What is That?

Islamic Banking! Now, What is That?
In a move that has the potential of dramatically alter banking, the government has asked the Reserve Bank of India (RBI) to explore ways to introduce Islamic banking in the country.

Recently, the finance ministry had sounded out the RBI on the subject of introducing Islamic banking in India. The central bank has already formed a senior team to look into the matter. The group is headed by Anand Sinha, chief general manager in charge, department of banking operations and development, and includes senior bankers from State Bank of India and few other government and foreign banks. Some of the foreign banks operating in India already offer Islamic banking products in West Asia and Europe. Interestingly, banking products like these not only exist in West Asian countries, but have also caught on in advanced markets like the UK.

What is Islamic banking?
Islamic banking has the same purpose as conventional banking except that it operates in accordance with the rules of the Shariah, known as Fiqh al-Muamalat (Islamic rules on transactions).
The basic principle of Islamic banking is sharing of profit and loss and prohibition of riba (interest). Amongst the common Islamic concepts used in Islamic banking are profit sharing (mudarabah), safekeeping (wadiah), joint venture (musharakah), cost plus (murabahah) and leasing (ijarah).
In an Islamic mortgage transaction, instead of loaning buyer money, a bank might buy an item from a seller, and sell it to the buyer at a profit, while allowing the buyer to pay the bank in installments. The higher cost might include what would in non-Islamic arrangements have been charged as interest, but there could not be additional penalties for late payment. This arrangement is called murabahah. Another approach is ijara wa iqtina, which is similar to real estate leasing.
In business deals, there are several other approaches to handle a lack of interest. Most important is musharaka, which is equity financing. Further mudaraba means if one entrepreneur is doing the work and the other is giving the funds to finance it then both profit and risk must be shared. Such participatory arrangements between capital and labour reflect the Islamic view that the borrower must not bear all the risk/cost of a failure, as it is Allah who determines that failure, and intends that it fall on all those involved.
Islamic banking is restricted to Islamically acceptable deals, which exclude e.g. alcohols, pork, gambling, etc. Thus ethical investing is the only acceptable investing, and moral purchasing is encouraged

How do these banks operate in India?
There are several Baitul Mals working in cities as well as in villages. Only 10 to 15 Islamic banks with deposits of about Rs 75 crore are operating all over the country in various states. They are actually non-banking finance companies (NBFCs) which work on profits/loss basis. Islamic banks by and large cater to the needs of local area except a few of them operating across districts or states. Their sources of funds are limited and as a result these banks have to operate on small scale missing the economies of scale.
Islamic banks in India provide housing loan, on the basis of co-ownership, venture finance on mudarabah basis as well as on musharaka basis and consumers loans. Some banks finance transports also on the mark up basis via hire purchase. Education finance and skill development finance is also provided by them. Investments are made in government securities, small savings schemes or units of mutual funds. Investment in shares of companies is also made by some Islamic banks. Hire purchase and lease finance are other source of investments.

What are the regulations for Islamic banking in India?
Islamic banks in India do not function under banking regulations. They are licensed under Non Banking Finance Companies Reserve Bank Directives 1997 RBI (Amendment) Act 1997, and operates on profit and loss based on Islamic principles. RBI has introduced compulsory registration system. In the Monetary and Credit Policy for the year 1999-2000, it was proposed that in respect of new NBFCs, which seek registration with the RBI and commence the business on or after April 21, 1999, the requirement of minimum level of net owned funds (NOF) will be Rs 2 crore.
What are the current practices in Islamic banking globally?
Generally speaking, all interest-free banks agree on the basic principles. However, individual banks differ in their application. These differences are due to several reasons including the laws of the country, objectives of the different banks, individual bank’s circumstances and experiences, the need to interact with other interest-based banks, etc. The three important features are the deposits, modes of financing and services.

What are the different deposits available?
All the Islamic banks have three kinds of deposit accounts: current, savings and investment.
1. Current accounts
Current or demand deposit accounts are virtually the same as in all conventional banks. Deposit is guaranteed.
2. Savings accounts
Savings deposit accounts operate in different ways. In some banks, the depositors allow the banks to use their money but they obtain a guarantee of getting the full amount back from the bank. Banks adopt several methods of inducing their clients to deposit with them, but no profit is promised. In others, savings accounts are treated as investment accounts but with less stringent conditions as to withdrawals and minimum balance. Capital is not guaranteed, but the banks take care to invest money from such accounts in relatively risk-free short-term projects.
3. Investment account
Investment deposits are accepted for a fixed or unlimited period of time and the investors agree in advance to share the profit (or loss) in a given proportion with the bank. Capital is not guaranteed.

What are the different modes of financing?
Banks adopt several modes of acquiring assets or financing projects. But they can be broadly categorised into three areas: investment, trade and lending
1. Investment financing
This is done in three main ways: a) Musharaka where a bank may join another entity to set up a joint venture, both parties participating in the various aspects of the project in varying degrees. Profit and loss are shared in a pre-arranged fashion. This is not very different from the joint venture concept. The venture is an independent legal entity and the bank may withdraw gradually after an initial period. b) Mudarabha where the bank contributes the finance and the client provides the expertise, management and labour. Profits are shared by both the partners in a pre-arranged proportion, but when a loss occurs the total loss is borne by the bank. c) Financing on the basis of an estimated rate of return. Under this scheme, the bank estimates the expected rate of return on the specific project it is asked to finance and provides financing on the understanding that at least that rate is payable to the bank. If the project ends up in a profit more than the estimated rate the excess goes to the client. If the profit is less than the estimate the bank will accept the lower rate. In case a loss is suffered the bank will take a share in it.

2. Trade financingThis is also done in several ways.
The main ones are: a) Mark-up where the bank buys an item for a client and the client agrees to repay the bank the price and an agreed profit later on. b) Leasing where the bank buys an item for a client and leases it to him for an agreed period and at the end of that period the lessee pays the balance on the price agreed at the beginning and becomes the owner of the item. c) Hire-purchase where the bank buys an item for the client and hires it to him for an agreed rent and period, and at the end of that period the client automatically becomes the owner of the item. d) Sell-and-buy-back where a client sells one of his properties to the bank for an agreed price payable now on condition that he will buy the property back after certain time for an agreed price. e) Letters of credit where the bank guarantees the import of an item using its own funds for a client, on the basis of sharing the profit from the sale of this item or on a mark-up basis.

3. Lending
The main forms of lending are: a) Loans with a service charge where the bank lends money without interest but they cover their expenses by levying a service charge. This charge may be subject to a maximum set by the authorities. b) No-cost loans where each bank is expected to set aside a part of their funds to grant no-cost loans to needy persons such as small farmers, entrepreneurs, producers, etc and to needy consumers. c) Overdrafts also are to be provided, subject to a certain maximum, free of charge.

What other services are offered by such banks?
Other banking services such as money transfers, bill collections, trade in foreign currencies at spot rate, etc where the bank’s own money is not involved are provided on a commission or charge basis.

What are the deficiencies?
To start with, they have not developed adequate internal control system, as a result their accounting system is not very transparent. A number of times they are not able to follow the directives of regulatory authorities pertaining to deposit acceptance from public. For instance, they hardly go for credit rating. They do not submit required information and data to Reserve Bank of India. Their monitoring system warrants appointment of technical people familiar with reporting system. It is also observed that accounting practices needs to be learned by the officials of these banks. Lack of skilled staff, professionals and infrastructure frustrate their effort to expand and enlarge their operations.

What are major issues and constraints in Islamic banking?
The biggest issue which is a permanent hurdle for Islamic banks operating in 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 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 RBI over which they get interest. The SLR includes government and approved securities. A bank licensed by the RBI becomes part of the monetary system, which means it can create money by deposit generation through deposit acceptance. 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. Islamic banks cannot interact with conventional banks based on principles of interest.The last but not the least, Islamic banking has been constantly in short-term and medium-term operations though some of them are undertaking long-term finance also. It is understood that inability to evaluate projects profitability has tended to act against investment financing. Some borrowers frustrate the banks appraisal efforts as they are not reluctant to provide full disclosures of their business. Moreover, the borrowers do not observe business ethics which make it difficult to establish close bank-clientele relationship — a condition for successful Islamic banking. As a result a number of Islamic banks have been closed during the recent years.(economictimes.indiatimes.com/articles-July 11, 2005)

Insurance: Mustafa Al-Zarqa's Views
By Adil Salahi
In its modern form, insurance was introduced in Muslim countries when many of them were occupied by Western powers.Every now and then I get questions about life insurance. Is life insurance permissible from the Islamic point of view? Most of the readers want to know. The attraction to take a life policy, says, some of the readers, seems too strong when one considers the need for safety in life. My answer to all such questions is:Insurance has become an essential part of business throughout the world. Because there are too many risks that could affect people’s lives and welfare, insurance tries to alleviate the adverse effects of such risks. Insurance has become a highly sophisticated business, with large companies offering cover against a wide range of risks. People take out insurance policies to protect their homes, furniture, vehicles, and jobs, and they also take out health and life insurance.In its modern form, insurance was introduced in Muslim countries when many of them were occupied by Western powers, or when they came under Western influence. In some cases, its introduction was delayed in a country until its international business flourished. Like every thing that came with a “colonial” or Western color, insurance was first viewed by Muslim scholars with grave suspicion. A verdict of disapproval was common to most things thought to be introduced by non-Muslims.Yet insurance is not new, and it was not invented by the Western civilization. The idea of collaboration to reduce the effects of disaster that might hit one or more in a community is as old as human society. In many Muslim cities, business people collaborated, establishing funds to look after anyone of them who might suffer a huge trade loss, as could happen when a cargo ship sank during a storm. While these early efforts catered for a specific risk, the idea behind them is the same as that behind insurance.In the last few decades, a number of eminent scholars discussed insurance at length, arriving at divergent views. One of the best theses written on the subject was published in a book in Arabic by the late Prof. Mustafa Al-Zarqa, who ranked high among the top scholars of the twentieth century. His work is very scholarly, as it shows thorough understanding of the insurance system and how it works. He arrives at a verdict of permissibility of all types of insurance, including life insurance. He points out that insurance inevitably involves an element of gharar, which in Islamic terminology means the sale of an “undefined” or unspecified product. However, he explains that it is rather marginal, and as such it is overlooked, as in other types of transactions involving marginal gharar.There are two main types of life insurance: Term policy and endowment policy. The term policy involves the payment by the insured of modest premiums over an agreed period, say, 20 years, in return for the benefit of his family receiving an agreed large sum of money in the case of his death during that period. If the insured remains alive at the end of the policy, it lapses and he gets nothing. What the insured actually buys with his payments is the peace of mind he gets from the knowledge that should he die, his dependants will have a large sum of money to see them through life until, say, his young children came of age and were able to look after themselves.The endowment policy involves the payment of larger premiums which are invested by the insurance company. When the policy matures, the insured receives the sum assured as well as any share of profits to which he may be entitled under the terms of investment made on his behalf by the insurance company.Both types are permissible from the Islamic point of view, as explained by Professor Al-Zarqa, provided that the insured makes sure that the insurance company invests in legitimate business. If the insurance company invests in what Islam forbids, then taking out its policies becomes forbidden as a result.(www.arabnews.com March 4, 2005) The opinion on Insurance are Prof. Mustafa Al-Zarqa’s own views

Now, Islamic Insurance from LIC
Mumbai
After Islamic banking, it’s the turn of Islamic insurance. Even as the Reserve Bank of India is exploring Islamic banking opportunities for Indian banks, the Life Insurance Corporation of India has set the ball rolling on takaful (Islamic insurance).LIC’s new international joint venture company - Indo-Saudi Insurance Company — will be the first to introduce takaful. This Arabic word means ‘guaranteeing each other’ or joint guarantee.“The entire pricing will be different as the benefits differ from conventional insurance policies,” according to LIC Managing Director, K Mehrotra. Its actuarial team has started working on the pricing mechanism and senior officials have been sent to Saudi Arabia to look into the product, he added.Takaful can be described as cooperative insurance where policyholders contribute a certain amount of money to a common pool. Each member pays his subscription (premium) to help those that need assistance. To some extent, it resembles the chit funds that operate mainly in southern India.The purpose of takaful is not to profit, but to support the belief of “bearing each other’s burden”. Losses are divided, while liabilities spread across the community pooling system. The idea is not to derive any benefits at the cost of others. Instead, it eliminates uncertainty in terms of premium and compensation.“Takaful is a Shari’ah compliant product,” said Mehrotra. It is necessary for LIC to comply with local laws of the land when it starts operations in Saudi Arabia.While LIC will offer a range of insurance products like endowment, money-back, single premium policies, among others, “the returns would need to be inbuilt into the pricing, and cannot be called bonus or profits,” said the managing director.Today LIC announces annual bonuses depending on its investment performance. Under Takaful plans, it would need to build in the possible profits, Mehrotra pointed out.