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)

The Man Who Broke The Bank of England

People in Finance are generally stereotyped as evil masterminds. If there was ever an individual who fully embodied this stereotype, it would have to be the famous English high-profile currency speculator. Meet George Soros, who is notoriously titled “The Man Who Broke The Bank of England“.

 

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(Source: GeorgeSoros)

 

So, how did Soros “break” the Bank of England, the English Central Bank? For this, you need to have a first-hand understanding of how the European Exchange Rate Mechanism (ERM) works. Before the introduction of Euro as a currency, the English Pound traded against several European currencies under the purview of the ERM. The ERM basically promised a fixed rate of the English Pound against several European currencies (To put it in technical terms, The Pound was ‘pegged’ to many European currencues). That is to say, regardless of how bad the economic conditions were at home, the value of the home currency would remain about the same – the Bank of England promised this. And so, every other currency under the ERM had their exchange rates fixed (pegged) against several other ERM currencies. The elaborate and perplexing system of ERM is of little interest to anyone these days.

 

However, many speculators predicted that the Pound being in the ERM was not sustainable and that it would lead to a financial crisis. At the center of this huge outcry was George Soros. Known for his ability to take massive amounts of risk, Soros called a spade a spade. Under his advise, many private fund houses started selling the Pound to ‘anyone who would buy’ and started accumulating other stable currencies – the majority being the U. S. Dollar. If you’re wondering why he would advise this – remember that Soros predicted that the Pound will fall. This meant that a single Dollar note would fetch him more Pounds in the future than today. On top of this, Soros and his accompanying private funds shorted the Pound.

 

John Major, the then Prime Minister of England, did not like this one bit. He did everything in his power to prove Soros and his followers wrong. He asked the Bank of England to raise the policy interest rates to as much as 10 percent. He also authorized an unprecedented accumulation of the English Pound that was being sold by Soros and his private funds. These steps were aimed at maintaining the exchange rate of the Pound vis-a-vis the other European currencies under the ERM system. But soon, the Bank of England noticed that they were running out of Foreign Currency Reserves to purchase the Pound back. Meanwhile, Soros kept on selling and shorting more and more Pounds. Meaning, they stood to make massive amounts of money provided the Pound fell (On the flipside, they also stood to make massive losses if the Pound, in fact, did not fall or worse, rose instead).

 

But soon, the Bank of England gave up. The Pound crashed. The day this happened would later be named the “Black Wesnesday“. The losses estimated would pile up to £3.3 Billion. Soros would personally make £1 Billion out of the deal. Shortly afterwards, the Bank of England pulled the Pound out of the ERM system and promised to stabilize it in phases.

 

How-soros-broke-the-bank-of-England
(Source: ForexIllustrated)

 

Later, the Bank of England bitterly blamed George Soros for turning the tide against the market and making individual profits at the cost of massive public losses.George Soros himself felt he did not deserve his infamous title. Says Soros in his book ‘Soros on Soros: Staying Ahead of the Curve‘, “If I had gone against the market, instead of guessing where the market going, my action would not have for example led to the collapse of the pound sterling. Although I believe the man who caused the bankruptcy of the Bank of England was not really me. Market was the one who did it. I guess where the market was going and was an important element of it because I gave him momentum. But I did not cause the bankruptcy of the Bank of England.”

 

Supporters of Soros claim that the Bank of England broke itself – and simply needed a decoy to pin the crisis on. Critics of Soros accuse that the speculator took a position and then manipulated the market participants using his expertise and knowledge, thus manufacturing profits out of thin air. This is now termed in the investment circles as “the Soros effect“.

 

So, is George Soros, and all Finance people in general, inherently evil? George Soros himself provides an interesting answer: “I was a Human Being before I became a Businessman“.

 

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