Islamic banking can help tap into new sources of finance

By K A Najmi

As intermediaries of the financial system, conventional banks accept deposits and lend money on the basis of a predetermined rate of interest. Under a non-interest-based system, any payment or acceptance of interest is prohibited. The system operates on the basis that the return on investment (the equivalent of “interest” under the conventional banking system) is a compensation for the risk taken by the investor by providing fund for commercial activity. Hence, under a system that prohibits interest, money can be lent on a profit-sharing basis, sans interest.

The Approach of a non-interest bank

It was Benjamin Franklin who said “money begets money and its offspring begets more”. Non-interest bankers, however, believe that “money does not beget money”. It is only when “money” joins hand with human labour that it gets transformed into “capital” and acts as a catalyst for the production of goods and services. Capital is eligible to share the surplus money or profit. The profit-sharing ratio may be prefixed but determining the rate of interest linked to the amount of money lent is strictly prohibited.

If the above approach is applied to a bank, some basics will change. On its liability side, the bank will not be able to pay a return on the deposits it receives. On the asset side, the bank will not be able to demand an interest / return on the sums lent. This is because guaranteed repayment of the principal amount lent is permissible, but guaranteed repayment of the “capital” lent in a business venture is not. Such a concept, to be applied to a bank, will require very clear understanding of the business venture and very close appraisal and follow up to ensure that the return on investment is always positive. It will also require a very high level of business ethics.

Problem with the approach and its resolution

Central Banks, the world over as the regulators of financial systems have prescribed that a banking company cannot be allowed to share the business risk of the borrower. Hence, they insist that a banking company:

(a)   needs to be prohibited from taking commercial risks,

(b)  has to pay and charge a predetermined return (based on time value of money) both on its liability and asset side,

(c)  has to assure capital guarantee for deposits and to achieve this they must ensure that the loans granted by it are secured.

In order to fall in line with the demand of the regulators, a non-interest bank resorts to contracts for transfer of interest in the underlying physical assets involving sale-purchase, lease, diminishing lease, mortgage by conditional sale, “credit sale” or deferred payment sale and similar other tools to ensure that their investment is free from business risk. This makes the non-interest bank have all the qualities of a conventional loan contract with an interest clause in as much as:

(a) The return on capital gets fixed on day one,

(b) The return of capital is guaranteed and

(c) The modality for carrying out the investment ensures that there is “no commercial risk” on the bank.  

 Being satisfied that these three pillars of commercial banking practice are in place, regulators have allowed non interest banks to carry on banking business in USA and then UK and slowly in various other jurisdictions. Today, non-interest banks operate in almost 70 countries along with the conventional banks.  The transactions were, however, not cost effective as it involved payment of conveyance charges, taxes and cess, etc. twice over. Hence, exemption from payment of taxes/stamp duties twice, in a single loan transaction, as also parity in tax matters was sought and granted in order to create a “level playing field”. No changes in any Banking Statute of these countries was sought or granted.

Indian initiative

The introduction of non-interest banking in India has been examined from time to time, both by the RBI and the Government. In the year 2006, the RBI constituted a working group to examine whether interest free “investment bonds” could be introduced in India. It concluded that; in “In the current statutory and regulatory framework, it would not be feasible”. Thus, the matter got shelved. After the financial meltdown in the US, the need for financial sector reforms became a matter of great relevance. The committee constituted by the Ministry of Finance interalia  stressed the need for a closer look at the issue of interest-free banking in the country.

This was followed by formation of an inter-departmental group (IDG) to examine the “legal, technical and regulatory issues” for introducing interest free banking. The IDG recommended gradual introduction of interest-free products. The latest in the series is the Committee report on “Medium-Term Path on Financial Inclusion” constituted by Reserve Bank (December 2015). It recognised that after the launch of the Pradhan Mantri Jan Dhan Yojana (PMJDY), the financial inclusion has improved but there were still significant gaps.

Based on the recommendation of the committee, the Reserve Bank in its Annual Report for 2016-17 observed that “some sections of the Indian society have remained financially excluded” from using banking products with an element of interest. It proposed to explore the modalities of introducing interest-free banking products in India through specialised interest-free windows in commercial banks with simple products like demand deposits, agency and participation securities, offering products based on cost-plus financing, deferred payment and deferred delivery contracts. The report is important because it acknowledged that introduction of interest free products did not require any statutory changes and it would be sufficient to issue a separate set of regulations for governing the non-interest banks. It is now for the government to take a view.

Advantages of a Non-Interest Bank

Under the conventional system, interest keeps building up and is allowed to get compounded, even when there is loss in the business.  Since this does not happen in non-interest banks, it makes the system borrower-friendly. It is therefore not uncommon for the consumers, especially those seeking small loans, to approach a non-interest bank rather than a conventional bank.

The investment model adopted by a non-interest bank creates physical assets. Hence, even in large infra projects, if the investment becomes bad, the ownership right on the assets remains with the bank. This puts the bank in a better position to manage NPA and recover a substantial amount.

The investment does not involve disbursement of fund (except for working capital). As a result, the syphoning or diversion of fund by the promotors is rather difficult.

As the economy grows, all the stake holders are benefited. This leads to spread of wealth and brings general well-being rather than allowing concentration of wealth in a few hands.

The introduction of non-interest banks will encourage those who want to avoid interest in commercial dealings and therefore do not avail the banking services. This will help increased use of funds for commercial purposes rather than getting the funds blocked in unproductive assets like gold or real estate.

The introduction of a non-interest bank will also send a message that India is open for interest-free commercial transactions. Because India is a fast-growing economy, it is likely to become an investment destination for fund managers desirous of making investment for profit, sans interest. This is therefore an opportunity waiting to be tapped.

(The author has worked as Joint Legal Advisor with the RBI, and a World Bank project for revising banking & finance laws including Islamic Banking of Bangladesh. He is presently a Partner in Link Legal ILS, a full service law firm where he deals with Banking and Finance matters, including foreign Investment)