Islamic Banking - Two steps forward and four steps backward!

Under Islamic Banking (IB) the sharia laws or Islamic laws of banking are followed. It is also referred to Sharia Banking or Interest Free Banking. Some of the laws/principles used under this kind of banking are  

  • The central theme of Islamic Banking is justice, which under this can only be served by sharing of risk.
  • Usury – levying of unreasonably high interest rates in lending the money. Under IB this is prohibited. As per the Islamic principles of justice and equality, interest should not be charged on the loans given (a debt cannot be used to raise money or in simple terms money should not be used to make money)
  • Interest rate is referred to as As per the Islamic laws a muslim is prohibited from accepting and giving Riba
  • Haram/Halal – under this the strict guidelines will dictate the usage of money for the production of necessary/essential goods to satisfy the population (such as food, clothing, shelter etc)
  • Ghrarar/maysir – gambling in all forms is strictly prohibited
  • Zakat – is one of the five pillars in Islam. Under this the muslims must pay certain alms/donations, to purify their yearly earnings spiritually and physically
  • This money cannot be used for activities such as gambling, speculative trading, in trading of alcohol and pork etc



The origin of Islamic banking can be traced to Mit Ghamr (Egypt) where a bank –Nasir Social Bank- was set up by Ahmad El Najjar in 1963. This bank followed the principles of Islamic Banking i.e. profit sharing and non-interest based banking.

 In 1974, the Organization of Islamic Countries (OIC) established the first Islamic bank called the Islamic Development Bank or IDB. The basic business model of this bank was to provide financial assistance and support on profit sharing basis. After this such banks were opened at various places such as the first private commercial bank in Dubai (1975), the Bahrain Islamic Bank (1979) and the Faisal Islamic bank of Sudan (1977).


As per the World Bank Report of 2015
  • The assets which are Sharia-law complaint are worth $2 tn globally
  • The Islamic Finance Industry has been expanding at a rate of 10%-12% annually
  • In some countries the Islamic banking assets are growing at better pace compared to the other forms of banking
  • There has been a surge of interest in Islamic finance in non-Muslim countries such as the UK, Luxembourg, South Africa, and Hong Kong.
  • Increasingly there is evidence that the Islamic Finance contributes to the global economy, and has the potential to address poverty and inclusive growth


Tools of Islamic Banking
  • In case of savings accounts
    • In one type the customer deposits the money with the bank and is guaranteed by the bank that the whole principal amount would be returned to him
    • In another type the banks would use it to invest in certain pre-specified projects and based on the performance of the projects certain returns can be provided to the clients
  • Ijara (or lease) – an asset is purchased by the bank (on behalf of the customer). Now the bank leases it out to the customer for a pre-specified period and the lease amount. During this the right of usage lies with lessee (client/customer) whereas the ownership rights lie with lessor (banks). Ex- aircrafts, ships, real estate etc
  • Murabaha – asset is purchased by the bank at market price and then sold to the customer at higher price (market up cost and cost plus financing). In this trade the seller is under obligation to specify the profit he is making. The client/customer can repay the amount in installments
  • Mudarabah (or Trust Based Finance) – one party supplies money (in this case bank) and the other party uses it for a specific management/business purpose (borrower/agent). As a principle, the bank should not interfere in the functioning of the business but has every right to demand better usage of its finances (hence referred to as Sleeping Partnership). In case of profits it would be distributed among both the parties but in case of losses only the owner of the capital will bear the complete losses.
  • Musharaka (or partnership) – under this basically two or more financiers can finance a project and will have the right of interfering in the implementation/running of the project. The profits can be shared amongst the investors in the ratio agreed upon and the losses will have to be shared as per their investments only. It’s a joint venture between the bank and the client. Both enter into agreement regarding investment, distribution of profit or acceptance of losses
  • Bai Salam – is a contract wherein the advance payments are done for the goods which would be delivered on a future date. Although the delivery is done in a future date, the goods in discussion should have already been manufactured by the time the contract is signed


Why need Islamic banking?
  • Large devout Muslim population is not covered under the banking operations. This would push forward the idea of financial inclusion (As per Sachar Committee report released in 2006 said that Muslims who compose 13.4% of the total population hold 12.2% of accounts in public sector banks and 11.3% in private sector banks)
  • The Islamic population in India is very high (172 million as per census 2011)
  • As per Standard and Poor, the Islamic Banking has a potential of having assets worth $4 tn worldwide
  • This will not only lead to deposit mobilization but also promote financial inclusion
  • If India needs to move towards less cash economy, then such a huge population (those muslims who do not have accounts) cannot be left out
  • This could be used to provide loans to agriculture
  • There is huge need for institutional investment and since in India we have conventional banking system, the funds from devout countries in the middle east and south east Asia are not entering India


Challenges to Islamic Banking in India
  • Political opposition – some of the allies of the government have already opposed the idea. Their contention is that IB takes Indian Muslims back to the medieval era
  • There is an allegation that Islamic Banking has been used for routing funds for terrorist organizations and their activities (there is no evidence to prove this)
  • The Banking Regulation Act of 1949, does not provide for a parallel banking system (which doesn’t charge interest)
  • The population of Muslims having bank accounts is very limited
  • The Islamic banking has some complexities which have to be taken care of before launching such banks (as India will be trying it for the first time)


Advantage India
  • This would be successful in attracting investments to the tune of $3 tn of Islamic Finance market
  • Huge presence of Islamic population (As per Census 2011-172 million)


Steps towards Islamic Banking
  • A committee was set up in UK in 2002 which suggested amending laws so as to promote Islamic Banking and in 2003 Islamic Bank of UK was set up with five branches
  • The report submitted to the government in 2008 by CFSR-Committee on Financial Sector Reforms (chaired by Raghuram Rajan) batted for Islamic Banking albeit it did not use the word but said there is a need for promoting Interest free banking to cover all the customers (as of now these do not wish to use the banking services as their faith forbids them)
  • RBI in the second half of 2016, has written a letter wherein it has argued for opening the “Islamic window” in conventional banks, which will provide the banking services but as per Sharia Laws


Some facts associated with Islamic Banking
  • The first Islamic Bank was set up in Egypt in 1963
  • Just like the conventional banks adhering to the liquidity ratios prescribed by BCBS (Basel Committee on Banking Supervision), Islamic Banks follow the guidelines issued by Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI)
  • Kerala is the only state which has attempted at providing the Sharia Banking Services (yet to be implemented)
  • In 2016, the IDB (Islamic Development Bank) from Saudi Arabia has shown interest in starting the operations in Gujarat


Approach to the UPSC Exam - Questions
  • There is an argument that the demonetisation has had greater impact on the Muslims as they have not been covered by conventional banks. In the context discuss the importance of the Sharia Banking
  • Shari Banking will not only help in mobilization of deposits, also help in financial inclusion-Analyze
  • Islamic Banking should be a financial argument rather than political-Discuss
  • Write a note on Islamic Banking


FAQ about Islamic Banking Two Steps Forward Four Steps Backward

Is Islamic banking really interest free?

The charters of Islamic banks instruct them to lend on the basis of “profit and loss sharing” rather than for a fixed return. They are to operate like the venture capital companies. Venture capital firms lend to promising entrepreneurs, for a share of any profits, without regard to collateral, track record, or connections.

What are the advantages of Islamic banking?

Islamic Banking model is based on a profit-sharing principle, where the risk is shared by the bank and the customer. This system of financial intermediation contributes to a more equitable distribution of income and wealth.

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