Building blocks of Islamic banking

Updated: Aug 1 2005, 05:30am hrs
The Reserve Bank of India has appointed a committee to examine the feasibility and possibility of facilitating Islamic banking in India. Islamic banking is a recent concept, which is slowly replacing interest-based banking in many parts of the world. The Islamic finance is based and functions on the basis of a model which does not involve interest on lending as well as on deposit, and financial institutions like banks share both profits and losses from the business. The modus operandi of these banks are worth considering for an economy whether it is a secular or Islamic state.

Islamic banks use the principle of Almudarib-udarib, which means they mobilise financial funds on the basis of profit sharing and extend the same to the users on the same basis. There are two broad instruments for mobilising deposits and extending finance, viz. Mudarabah and Musharakah. In case of these instruments, the return cannot be fixed in advance and it is determined ultimately by the profits earned by the business. Whether they are depositors or bankers, they have to share profits as well as losses. Uarze-hasna is another instrument for deposit mobilisation and for extending finance. On this instrument, the bank does not pay dividend. They are like current deposits. In addition to deposits, an Islamic bank can raise resources by issuing equity shares. Equity shareholders participate in the management of Islamic banks. Let us have a little more explanatory analysis on Islamic instruments and their modus operandi to make the readers of an alternative model of banking. As mentioned above, Mudarabah, an instrument in Islamic banking is a contract between the bank and the entrepreneur (manager) or user of the capital. The bank in this case does not participate in the business and the profit is distributed between them, according to the ratios fixed in the agreement between both parties. The financial loss is borne by the bank and the entrepreneur (manager) bears the loss by not getting any return in compensation for the opportunity cost of his own labour and managerial work. Musharakah is a contract between the bank and entrepreneur. Here, the financier (bank) participates in the management and also shares the profit and loss. While profits are distributed according to an agreed ratio, the loss is borne in proportion to the share of each in the total capital. Murabahah is a sale contract with a profit mark-up. The client purchases such commodity from the bank at a deferred price, which includes an agreed profit margin or mark-up.

Here, the transaction consists of one agreement between the Islamic bank and supplier of the commodity and a second agreement between the bank and the client who placed the order with the bank for a commodity. Ijarah (leasing finance) is a contract to supply assets like machinery, air-planes, ships or trains on lease.

The asset purchased by the bank as per the requirement of client (lessee) and sold at a pre-determined price to lessee but the lessor (bank) keeps the ownership of the assets with all the rights as well as responsibilities, which is an integral part of the ownership. However, Islamic banks in India do not function under banking regulations.

They have been working as NBFCs or credit co-operative societies. The Islamic banks if set up cannot maintain cash reserve and SLR since these involve interest. They cannot be treated as scheduled banks and cannot avail facility of settlement and clearing system and therefore they cannot issue cheques.

Other constraints are inability to maintain capital adequacy and would be unable to interact with interest based banks and money market in India. The RBI can think of setting up a single window in some banks like State Bank of India to do Islamic banking. Malaysia also started Islamic banking by opening Islamic banking sections or Islamic banking windows attached to the existing banks. Moreover, Islamic banking will require a new legislation to start Islamic bank.

The author is former economic advisor to Securities and Exchange Board of India Ltd