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Building blocks of Islamic banking
The Financial Express, August 1, 2005
MY KHAN
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