Islamic Banking: The Implications of an Interest-less Banking System

Quite a few heads were turned when the Reserve Bank of India (RBI) recently set up a three-member panel to review the feasibility of the Islamic Banking System in India, including Rajesh Verma, a deputy general manager, department of banking operations, Archana Mangalagiri, general manager, non-banking supervision and Bindu Vasu, joint legal adviser. This move was a surprise, considering how an earlier committee appointed in 2007 rejected the idea of implementing such a system in India.

 

dubai-islamic-bank-3_tcm87-21629
(Source: ILMABAD)

 

What is Islamic Banking?

 

Islamic Banking is a Banking System being followed in several parts of the world, mostly in Islamic nations like the Middle East. It follows the Islamic rulings or Shari’ah. Among other things, Islamic Banking prohibits ‘Riba’, roughly translated to ‘Money earned by money’, or in the modern parlance, Interest. The justification given is that money is not seen as an asset in Shari’ah, rather only a medium of exchange. This also means that there is no ‘creditor’ or ‘debtor’ in the system.

 

How do Islamic Banks function?

 

First and foremost, since Interest payments are prohibited, Islamic Banks do not accept deposits. They only ‘lend’ money. In return, instead of interest, the banks take a share of equity in the company. Whatever profit the company makes will then directly translates into better share value for the bank. Of course, if the company does not do well, the bank loses out as well. It is a kind of ‘brotherhood’ under which Islamic Banking operates. In addition to the prohibition of interest, Islamic Banking also prohibits all activities deemed evil by Shari’ah, such as investing in businesses that are related to pork, involving in activities that are highly risky and gambling. The functioning of an Islamic Banking system can be explained somewhat through the below diagram:

 

islamic-banking-cycle

 

Why Islamic Banking in India?

 

The reasoning behind considering the implementation of Islamic Banking in India is that a lot of Muslims in the country shy away from conventional Banking because Shari’ah prohibits it as ‘haram’. The Reserve Bank of India in tandem with the Modi government wants to explore this reform solely for the purpose of furthering financial inclusion, an agenda that is dear to both the central bank and the central government.

 

What are the implications of Islamic Banking?

 

Islamic Banking is very similar to traditional banking, except that traditional banking exchanges its funds for a liability (Debt), whereas Islamic Banking exchanges its funds for equity. In both the cases, the banks earn a ‘fee’ for parting with their funds, over several periods. In case of a default, the traditional bank loses out on interest payment and potentially the principal amount. In Islamic Banking, when the businesses in the bank’s portfolio do badly, the equity value held by the Islamic Bank will erode and the bank will eventually run out of liquidity. But at least, in traditional banking, there is a scope for recovery via Strategic Debt Restructuring and the central bank can control the supply of money via interest rates. In these frontiers, the Islamic Banking system offers little to no solution. There is also a major concern that Islamic Banking is convenient for illegal funds to flow through easily.

But Islamic Banking has become an inevitable part of modern banking and will also be implemented in India. It is only a question of whether or not the entire traditional banking system in India should be overthrown and replaced by Islamic Banking or should both the systems co-exist, that needs answering the most (Islamic Banking system is already allowed in very few banks across India). Hopefully, the latest committee set up by the Reserve Bank of India will find an answer. If not for anything else, there is a good chance that Islamic Banking will be introduced as an add-on service to traditional banking in order to encourage the marginalized sections of the Muslim population to take part in Banking activities.

 

This article was written by Dinesh Sairam (PGDM, XIME-B, Batch 21)

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