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Islamic Banking in India

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					Islamic Finance – Analysis of Opportunities, Challenges and
         adoption strategies in the Indian context
                                         Acknowledgement


We would like to thank the following dignitaries for taking time from their busy schedules and
providing valuable insights and opinions which has helped us in our study.


Mufaddal Khumri
Head, Islamic Banking at RAKBANK
United Arab Emirates


Shrikant Puranik
Head Retail Banking- India at Abu Dhabi Commercial Bank
Mumbai, India


Mr. H Abdur Raqeeb
General Secretary- Indian Centre for Islamic Finance,
Member - Muslim Personal Law Board


Badar Iqbal
Chairman, Department Of Commerce
Aligarh Muslim University
Aligarh, India


We would also like to thank Prof. Rejie George Pallathitta, IIMB for his guidance and support in
carrying out this study.
                                                                 Table of Contents
Executive Summary......................................................................................................................... 6
Need for the Study .......................................................................................................................... 7
Principles of Islamic finance............................................................................................................ 8
   Basic Tenets of Islamic Banking ................................................................................................................ 8
        Prohibition on Interest .......................................................................................................................... 8
        Prohibition on trades and investment of chance, speculation and Uncertainty .................................. 8
        Prohibition on Forbidden Businesses ................................................................................................... 9

Islamic Banking Products ................................................................................................................ 9
Islamic Banking around the world ................................................................................................ 10
Growing interest in alternative banking practices ....................................................................... 11
Islamic Banking Industry: Differences and challenges in operations ........................................... 11
Industry Attractiveness of Islamic banking in India ...................................................................... 14
Success criteria and Success factors in Islamic Banks Industry across the world ........................ 15
Status of Islamic Finance in India .................................................................................................. 16
   Consumer NBFCs ..................................................................................................................................... 16
   Investment based NBFCs in India............................................................................................................ 16
        Islamic Indexes .................................................................................................................................... 16
        Islamic Funds ....................................................................................................................................... 17
        Investment by Kerala State Industrial Dev. Corp. ............................................................................... 17

Time Line of Recent Events ........................................................................................................... 17
Obstacles and concerns ................................................................................................................ 19
   Statutory regulations .............................................................................................................................. 19
   1.      Legal Issues ..................................................................................................................................... 19
           Legal issues – invalidating products ................................................................................................ 19
   2.      Unviability Issues: ........................................................................................................................... 19
   3.      Limitation of NBFCs (Non-Banking Financial Company) ................................................................. 19
   4.      RBI requirements ............................................................................................................................ 20
   Amendment Requirements .................................................................................................................... 20

Stakeholder mapping of players ................................................................................................... 21
Strategies for Islamic finance companies based on stakeholder approach ................................. 23
   Methodology of analysis ......................................................................................................................... 23
   Influential and Important Stakeholders: Manage Closely ...................................................................... 23
      Shareholders ....................................................................................................................................... 23
      Shariah advisory Board ....................................................................................................................... 23
      Competitors ........................................................................................................................................ 24
   Important and Non influential Stakeholders:-Keep Informed ................................................................ 24
      Customers ........................................................................................................................................... 24
      Employees ........................................................................................................................................... 26
      Conventional banks............................................................................................................................. 26
      Islamic Community.............................................................................................................................. 26
   Influential and Non Important Stakeholders: - Keep Satisfied ............................................................... 26
      RBI and other Regulators .................................................................................................................... 26
      Rating Agencies ................................................................................................................................... 26
      Government ........................................................................................................................................ 26
      IT Products .......................................................................................................................................... 27

Addressing Institutional voids in India .......................................................................................... 28
Conclusion ..................................................................................................................................... 28
Exhibits .......................................................................................................................................... 29
   Exhibit 1 Partnership Transactions ......................................................................................................... 29
   Exhibit 2 Instalment Credit Sales: ........................................................................................................... 29
   Exhibit 3 Lease ........................................................................................................................................ 29
   Exhibit 4 Sukuk ........................................................................................................................................ 30
   Exhibit 5 Best Islamic banks by country .................................................................................................. 31
   Exhibit 6 Evolution of Islamic Banking industry ...................................................................................... 31
   Exhibit 7 Evolution of Islamic Financial Products ................................................................................... 32
   Exhibit 8 - Dow Jones Islamic Market Index Screening ........................................................................... 32
   Exhibit 9 - Islamic Finance Deals in India – 2007 .................................................................................... 33
   Exhibit 10 –Relative Position of Countries in Global Islamic Finance ..................................................... 33
   Exhibit 11 – New age marketing strategy of Islamic Banking products – Indonesia .............................. 34
   Exhibit 12 – Growth of world-wide assets managed under Islamic Finance .......................................... 34
   Exhibit 13 – Porter’s framework analysis for Islamic finance industry ................................................... 35
Appendix ....................................................................................................................................... 35
   Basic Sources of Islamic Law / Shariah.................................................................................................... 35
   Islamic Finance Products Explained ........................................................................................................ 36
   Major Islamic Financial Institutions ........................................................................................................ 38
   Analysis of Kerala High court Judgement................................................................................................ 39
   Profile Descriptions of Interviewees ....................................................................................................... 39
   Interview Excerpts .................................................................................................................................. 39

Islamic Banking Terms .................................................................................................................. 42
Executive Summary
Even though there has been steady growth of Islamic banking institutions and volume of assets base
managed through Islamic finance principles across the world, India has not shown any improvement
towards adoption Islamic banking practices. Islamic banking has not only been growing owing to the
religious inclination but also due to increase in attitude towards alternative banking principles based on
risk sharing and asset backing against money based financial business transactions.


The purpose of this report is to define Islamic banking principles, understand its products, identify the
challenges involved in Islamic banking industry, study India’s current position on regulations and Islamic
banking infrastructure, and analyse possible adoption strategies for Islamic banking institutions. Apart
from secondary research on many areas of Islamic finance and its Indian context, interviews were taken
to understand the current Indian scenario with respect to regulations and to understand the current
state of affairs in maturity of Islamic banking industry across the world.


The report comprises of the following sections:


       Study on Islamic banking principles and products
       Analysis of industry forces and challenges in Islamic banking through Porter’s framework and
        value chain analysis to identify challenges in its operational aspects
       Analysis of India’s current standing of Islamic financial institutions and restrictions binding the
        industry
       Study on success factors of Islamic banking institutions across the world
       Analysis of adoption strategies for Islamic banking institutions and analysis of requisite
        regulation reforms and infrastructure through stakeholder’s theory approach and conclusion.


The Islamic Glossary provides brief definition of words commonly used in Islamic Banking practice. The
usages of Islamic Banking or Islamic Finance in this document are used interchangeably and are
considered synonyms unless mentioned otherwise.
Need for the Study
Despite being home to one of the largest Islamic population (~150 million), India is yet to adopted
Islamic banking principles. It is estimated that 70-80 % of the Muslim population in India does not invest
money in banking products due to their religious beliefs.i According to the Sachar Committee Reportii
Muslims in India are largely under-privileged, under-employed and under-educated. It is also reported
that Muslims, get only two-thirds amount, as compared to other Minorities, of bank loan disbursed. The
Prime Minister’s 15-point Programme of 1983 has marginalized Muslims while other minorities have
benefitted significantly. Even the employment rate of Muslims in financial institutions is meagre with
0.78% in RBI and 2.2% in SCB’s. Presence of Muslim employee in other financial institution like SIDBI and
NABARD is negligible. For inclusive growth in India, there is a need for extending banking facilities to the
Muslims of India and hence the need for establishing Islamic Banks.
Over the past few years, the concept of Micro-finance has been gaining momentum which aims at
providing loans to the poorest. The Grameen Bank in Bangladesh has provided more than $5 billion in
micro-loans and has played a significant role in uplifting the poor in Bangladesh. Islamic banking
products share the same principles as Micro-financeiii. Infact Islamic banking started out as small
cooperatives based in the lines of European mutual funds. Since its inception in 1987, the National Bank
for Development in Egypt has proved that micro financing can be made a profitable business by
adopting Islamic Banking. Islamic banking products like Mudaraba, Musharaka, and Murabaha (products
explained in detail later) prevent economic exploitation of the poor by prohibiting interest paid on loan.
These products have been tested in markets like Egypt and Yemen and have been successful. Adoption
of Islamic banking principles would encourage the use of Micro-finance and can help in the development
of the poor, of all religions.
Traditionally India has had good trading relations with the Arab countries with over 4.5 million Indians
working in various Arab countries. With India growing at a rate of 8% per annum, and the rest of the
world in a financial turmoil, it forms a safe and secure destination for investments from the Gulf
countries. It is estimated 61% of the listed companies in India are in Shariah complaint businesses. This
is higher than all non-gulf countries with major Islamic investments like Malaysia (57%) and Pakistan
(51%)iv. It is estimated that the number of Shariah compliant stocks in India is higher than that of all
Islamic countries put together. Moreover most of the industries in India which have been the prime
drivers of the GDP like IT services, infrastructure development, automobiles, drug and pharmaceuticals
all fall under the Shariah compliant businesses. Induction of Shariah compliant banking practices would
open up huge inflow of foreign investments from the rich Arab countries. Many non-Muslim countries
have realized this potential and have adopted Islamic banking to boost their economy. China has
recently given approval for setting up the first Islamic bank in the countryv.
Islamic banking provides huge potential for inclusive growth and investments. However there is a
general lack of awareness among the people of India and the lack of regulatory bodies which poses
hindrances in the adoption of Islamic banking principle. Through this report, we have tried to analyse
the opportunities and challenges that arise in adopting the Islamic banking principles in the Indian
context. We have also tried to come up with relevant strategies for bringing up Islamic banking
infrastructure in India.
Principles of Islamic finance
Islamic Finance or Islamic Banking comprises of financial services that follow the principles of Shariah
(also known as Fiqh). Shariah is nothing but a code of conduct with respect to life’s activities based out
of the religion’s 3 major sources – Quran, Sunnah and Hadith (ref appendix)

Basic Tenets of Islamic Banking
The following are the basic tenets of Islamic banking which form the main criteria for development of
various products and services that come under Islamic finance. These differentiate the aspects of Islamic
finance against conventional financial services and products.
         Basic requirements of Islamic Finance against Conventional banking products

                 Interest or Riba        • Prohibition on taking or giving Interest


                                         • Prohibition of trades of chance, gambling ,
              Gambling/Speculation        speculative or uncertainty


                                         • Forbiddance on investing in morally / socially
              Forbidden Businesses        injurious businesses like alcohol, gambling etc.,


.
Hence in general Islamic finance operates on the basis of Profit sharing and fee-based financing
approaches to be compliant with the above requirements.

Prohibition on Interest
Islam fundamentally forbids taking or giving interest (known as Riba) on money. Money itself has no
intrinsic value and forbids people from profiting by lending it, without accepting a level of risk. To make
money from money is prohibited; wealth can only be generated through legitimate trade and
investment.

Prohibition on trades and investment of chance, speculation and Uncertainty
Shariah prohibits involvement in transactions that are speculative or of chance by nature (Masir).
Uncertainty (Gharar) about various terms in the contract is also prohibited, e.g., trading in assets that
one does not own. Ideally, the return has to be frozen upfront – (Upfront profit Booking)
Prohibition on Forbidden Businesses
Shariah prohibits investment in various businesses like alcohol, armaments, drugs, tobacco, gambling
etc., which are considered socially or morally injurious to society and which the Quran prescribes as
forbidden or “Haraam”.
Islamic funds in general cannot be invested in transaction involving conventional financial services,
Entertainment services, manufacturing or distribution of weapons, pork, alcohol and tobacco related
products and any other industries not approved by Shariah board


Zakat
While letting an individual to retain one’s surplus wealth, Islam seeks to increase the well-being of the
community as a whole by process of ‘Zakat’, an individual Islamic tax that proscribes all Muslims to set
2.5% of their income for destitute and deprived sections of society.



Islamic Banking Products
Thus ideally, for millions of Muslims conventional banks are institutions that are to be avoided. Yet
Muslims need banking services to finance their businesses, buy assets like house, car, for savings
deposits etc. The question of whether Muslims can find room for their principles in this fast paced world
is already answered by the fast growing global network of Islamic banks, investment institutions that
have developed during the past 50 years. Refer to Exhibit 7 for timeline of Islamic Banking products
The following are some of the Islamic products and their conventional equivalents. Complete
explanation of Islamic banking products are provided in the appendix.


   Islamic Banking          Conventional Banking                              Explanation
        Product                      Alternative
  Wadiah                 Savings deposit                     Savings deposit that mandates liability on the
                                                             bank to provide assured returns while bank
                                                             can invest them on profitable ventures.
  Murabaha               Cost Plus Financing                 Instalment Credit – Cost plus agreed profit
                                                             Markup Eg., Home Financing
  Musharaka              Joint Venture (Equivalent to Partnership Transaction – with more partners
                         Private Equity Investment of Profits are shared and losses are distributed.
                         conventional              banking
                         practice)
  Ijara                 Leasing                         Operational (Ijarah) and Financial (Ijara wa
                                                        Iqtina)
                                                        Differences in terms of promise to purchase.
  Mudarabah             Profit Sharing                  Partnership Transaction – with one partner
                                                        Profits are shared and losses are distributed.
  Istisna               Construction Finance            Instalment Credit – Construction of good is in
                                                        progress with payment is deferred.
  Sukuk                 Bond Market                     Can posses proportionate part of the asset,
                                                        Underlying      structure     shall       be   Shariah-
                                                        approved contract.
  Al Rahn               Short Term Finance              Instalment Credit Sales
  Takaful               Insurance                       Brief note on Insurance Industry analysis in
                                                        Insurance Sector and Islamic Banking
  Bai Salam             Forward Purchase
  Kafala                Guarantees
  Qarhd                 Non Profit Loans
  Tawaruqq              Reverse Mudarabah               A person purchases a good on credit from the
                                                        seller and sells it to another for cash




Islamic Banking around the world
Islamic banking is a recent phenomenon in the banking industry starting in the 1950’s. The Conference
of the Finance Ministers of the Islamic Countries held in Karachi in 1970, the Egyptian study in 1972, the
First International Conference on Islamic Economics in Mecca in 1976, and the International Economic
Conference in London in 1977 were some of the major steps taken that led to the development of
Islamic banking at an institutional level. The involvement of institutions and governments led to the
application of theory to practice and resulted in the establishment of the first interest-free banks. The
Islamic Development Bank, an inter-governmental bank established in 1975, was born out of this
process. The timeline of regulatory framework development of global Islamic banking industry is present
in Exhibit 6
Today Islamic banks have more than 300 institutions spread over 51 countries, which include major
economies like the US, UK, France, Australia, Malaysia and Indonesia. However major portion of Shariah
complaint assets are held in the Middle-Eastern countries. Iran holds the largest valued Shariah-
complaint assets in the world, with Malaysia being the top country outside of the Middle-East. The
United Kingdom holds close to 2.5% of the Shariah complaint assetsvi.
In 2009, it was estimated that Shariah compliant assets around the world amount to $822 billion which
was a 29% growth over the past yearvii. According to a working paper published by the International
Monetary Fund, Islamic Banking has been consistently growing a rate of 10-15% per year and with signs
of consistent future growthviii. Around the world, Islamic banking principles are becoming increasingly
popular because of its simplicity in financial structuring and adherence to strong ethical practices. The
Vatican had even suggested that conventional banks should look at the rules of Islamic Finance to
restore confidence in the clients during the recessionix. A study by the British University in Dubai
suggests that Islamic banks have performed better than the conventional banks during the recessionx.
Across the world Islamic banking is seeing aggressive growth rates especially in countries that have high
Muslim-population. All these factors and have significantly contributed to the growth of Islamic Banking
around the world. A list of major Islamic financial institutions is provided in the appendix.



Growing interest in alternative banking practices
The aftermath of financial crisis which saw extensive bailouts of financial companies that indulged in
high leverage and huge debts, resulted in many experts calling for asset based banking approaches than
paper money based financing which is one of the biggest selling point of Islamic finance. Apart from this
there has also been growing interest towards ethical banking (banking that lays importance on social
impacts of its loans) and many sections of people concerned about restrictions on their money and
investments being used for financing weapons production, alcohol, tobacco, gambling industry and
other morally hazardous industries which again is an integral part of Islamic banking.



Islamic Banking Industry: Differences and challenges in operations
Islamic Banking involves certain differences in the aspects of how the banking business is run. The
following gives a generic value chain of banking system. This dissection helps in analysing differences
and challenges involved in the different parts of the chain in comparison to conventional banking
industry.
                                Value Chain of Banking Industry

                                   REGULATION COMPLIANCE
                                        RISK MANAGEMENT
                                  TECHNOLOGY DEVELOPMENT
                                        HUMAN RESOURCES

            Inbound             Conception of        Branches,
                                                                           Aftersales
            Logistics           products with         Service
                                                                           consumer
         Fundraising            respect to the        deliver,
                                                                            services
         Marketing              target market       Transaction




Value chain                               Comparison                                            Challenges
  section          Conventional                  Islamic Banking
                    Fund Raising from            Fund raising should be           The biggest challenge is to
                        people based on            targeted with different             incorporate                 Shariah
                        promises           of      set of investor needs               compliance          and         social
 Inbound                assured returns /          like Shariah Compliance             interest as well as ensure
Fundraising             Interest rate / risk       and social interest                 steady     returns        and     tax
   and                  return basis              Marketing based on all              benefits that are available in
                    Marketing          solely     the                    above        other investment options
Marketing
                        based      on     risk     characteristics        along
                        /return                    with return credentials
                        characteristics
                    Established                  Different      views     and     Providing alternatives for all
                        products which are         standards in products               the conventional products like
                        generally universal        w.r.t.               Shariah        deposits, loans, insurances
                        in nature and easily       compliance                          etc., yet reduce complexity
                        understandable            Design        of     product        and      ensure      transparency
                        like deposits, loans       based on target market              across products for better
 Products               and equity funds           and                geography        awareness
conception                                         required                         Increased time to develop
                                                  Issues      like      Islamic       products and implement them
                                                   banking             prohibits       for getting Shariah clearance.
                                                   penalty charges etc.,            Products             should         not
                                                   need to be sorted out               discriminate         conventional
                                                                                       banking       in      terms        of
                                                                                       advantages and overall cost
                                                                                     differences. Eg., Uproar due
                                                                                     to overdraft charges in Lloyd
                                                                                     bank which was £15 whereas
                                                                                                                  xi
                                                                                     £200 for normal banking
               Extensive branches            Proper verification and               Increased complexity, cost
                and       conventional         monitoring required in                and    time       in      transaction,
                systems already in             asset backed Islamic                  documentation                     and
 Branches,      place.                         lending                               agreements required in asset
  Service      Relationships          to     Customers need to be                  based transactions as there
 Delivery,      clients are in terms           properly           educated           are extensive legal contracts
                of      creditors     and      about      products           and     involved
 Products
                debtors                        risks, relationship is like           Personnel need to educated
                                               partners,          investors,         about relationship with clients
                                               buyers and sellers
               Major portion of              As      equity         risk     is    Increased     interaction        like
                aftersales       include       envisaged         in      credit      above issues may increase
                periodic             debt      products,                proper       cost and complications of
 Aftersales     collection                     periodic evaluation of                aftersales
                                               client is required with
                                               respect to change in
                                               risks
               Risk management               Different systems and                 Challenge in coming up with a
                principles            and      procedures are used to                common        scale         for   risk
                systems like capital           mitigate         risks        like    avoidance         and      provisions
                adequacy,           credit     liquidity,               capital      which can be analysed on an
   Risk         risk, liquidity risks,         adequacy         etc.,        and     integrated        basis     on    the
Management      operational          risks     define parameters are                 balance       sheet         of    the
                etc.,      are       well      used      for     evaluating          company.
                defined               and      profit generation
                already in place


               Products              and     IT products are evolving              Challenge lies in deciding
                technology                     and aren’t yet full at                whether      to     use      different
                infrastructure                 the     full      scale        or     software for Islamic banking
                already              well      completely automated                  or select vendors who provide
Technology
                developed             and                                            both conventional and Islamic
Development     used                                                                 products.         However         Top
                                                                                     Islamic core banking solution
                                                                                     providers in this domain are
                                                                                     based out of India.
                            Domain expertise is       Requires people who                  Though         there      has      been
                             available         and      are knowledgeable in                    increasing         institutes     and
      Human                  knowledge           of     this area.                              certifications        offered         in
    Resources                general banking is                                                 Islamic   finance,        there       is
                             prevalent                                                          dearth    in       expertise      and
                                                                                                training capacities
                            CRR,      SLR     and     central       banks         in       Maintaining profitability and
                             capital     adequacy       different          countries            continued ease of operations
    Regulation
                             ratio     are     well     mandate            different            need to be balanced with
    Compliance               defined     and   are      compliances and are                     regulatory compliance.
                             complied with.             complied with



Industry Attractiveness of Islamic banking in India
The industry attractiveness of the Islamic banking in India has been analysed by using the Porter’s 5
forces framework. From the analysis we observe that the industry is moderately attractive. (Exhibit 13)
Bargaining power of Bargaining powers of Threat                       of     new Threat               of Rivalry among
Customers: High                Suppliers: Low             Entrants: Low                  Substitutes:        Competitions:
                                                                                         High                High


India has one of the Islamic banking is a Though India has There                                     are The traditional
largest              Islamic new concept to the many banks and many other banking system
populations         in    the Indian consumers. To financial                             alternatives        in India is well
world. The religious set up Islamic banking institutions,                    they to            banking established and
beliefs of the Muslims as an alternative to do not possess the like                               micro- widely
would make Islamic traditional                  banking required expertise finance,                          accepted. They
banking        an        ideal would require a supply and experience in chits-funds,                         also      offer      a
option.          However of expert staff in the operating by sharia personal etc. wide variety of
Muslims in India are areas               on      Sharia, laws. Also, till the that are very products                            and
used to the traditional economy, commercial Islamic banks and popular                                        have
banking       and        have and               banking institutions          are sources             of customized
little knowledge. Also knowledge. It would proved                     successful loans.                      products           for
a     majority           non- also need setting up of and            profitable,                             every category
Muslim         population academic institutions there                would     be                            of      customers.
and       availability     of to train banking staff very few entrants.                                      Hence it would
well-developed                 in Islamic banking. At                                                        be very tough
network of traditional present, there no such                                                                for         Islamic
banking provide many institution available.                                                                  banks to attract
alternative options to                                                                                       customers
the customers.
Success criteria and Success factors in Islamic Banks Industry across the world
Islamic banks are also financial institutions and have similar objectives, legal modalities and structures
like any other financial institutions, only difference being their description as Islamic.
Income for a bank are generated through three major sources,
    1. Interest income (a factor of net interest margin i.e., difference between cost of funds and
        utilization of funds)
    2. Fee income
    3. Proprietary trading.
In the above list, the first two are highly predictable and fixed source of income in conventional banking.
Since Islamic banking avoids investing in fixed income securities, its main sources of income are 1.
Partnerships / investments based income 2. Fee based income. Since equity based income is highly
unpredictable, there must be increased impetus to focus fee based income which provides steady and
continuous predictable returns.


Like any other private-sector financing firms, their long term profit maximization and sustainability of
the firm would be the biggest fundamental objective for an Islamic bank. However profit maximization is
a narrow term and must be explicated to arrive at different criteria and means of achieving the same.

                                Success Criteria for Islamic Finance institutions


               Long term considerations                                Short Term Considerations


          Increasing Deposits                                Increasing Rate of Profit
          Increasing Quality of service                               Pricing of services
          Expansion of Banking services base                          Earning / Cost Efficiency
          Preservation of Capital                                     Going    after    high      return
          Social commitment                                            investments



To arrive at a general list of factors, the paper “Success factors of Islamic banksxii” by Monzer Kahf came
up with an extensive research on success factors based on a study of world-wide Islamic banks. The
following list narrows down the above criteria to key factors that would be responsible for success.


    1. Increased assets base and Banking Efficiency
This is the bank’s ability to increase its assets base and maximize the profits derived from its assets base
over long term. Increased asset bases not only comes through high value customers and increasing
number of customers but also through increase product bases to bring in more assets of existing
individuals under the bank’s base. Unlike conventional banking increasing returns from assets base not
only increases Bank’s (shareholder’s) wealth but also proportionately increases depositor’s wealth as
relationship is that of partnership and not of fixed interest rates.
    2. High Level of trust
Like a conventional bank that runs on trust, Islamic banks require even more trust due to its equity
nature and complex product types. This depends on the credibility of the institution, its compliance with
Shariah and reputation of the Shariah board.


    3. Preservation of assets of Customer and Bank
Preservation of capital of deposit holders and shareholders as well as yield stability would be a basic
requirement for Islamic bank. Ensuring liquidity, diversification of investment, choice of investment
opportunities and maintaining required ratios would ensure protection of assets. This in turn requires
high degree of financial expertise and engineering.


    4. Social Commitment and services
A main characteristic of Islamic banking is to accommodate community’s faith and belief. Hence
increased social impetus like loans for education, healthcare, marriage and other social services help
increase credibility and attract more asset base for the bank. Facilitating ‘Zakat’ would also help increase
reputation as a ‘wholesome’ Islamic banking institution.



Status of Islamic Finance in India
Interest-free Banking has largely been limited in India, primarily owing to statutory and regulatory
restrictions of Indian banking system, which prohibits such an alternate system. The main areas of
contradiction are the interest-free nature and trading and business activities which are disallowed for
financial intermediaries which is necessary for functioning of Islamic banking system. The following are a
few Islamic finance undertakings existing as of now in India.

Consumer NBFCs
Currently Islamic banking is India is limited to some 10 to 15 NBFCsxiii with deposits less than Rs 75
Crores that operate on small scale with limited funds and missing out on economies of scale. Most of
them cater to the local area and operate on profit/loss basis. They provide housing loan, on the basis of
co-ownership, venture finance based on Mudarabah and Musharakha. Many also provide education and
skill development finance. They are licensed under NBFC Reserve bank directives 1997 RBI (Amendment)
Act and operate on profit and loss basis on Islamic Banking.

Investment based NBFCs in India

Islamic Indexes
Islamic investment funds are inherently restricted from involving in businesses like liquor, tobacco,
conventional financial services etc., Hence there exists a certain level of uncertainty with respect to
shares of companies that can be invested in by Islamic funds. Dow Jones and FTSE have a variety of
indices that comply (compliance prescribe by Dow – Exhibit 8) to Islamic standards. On the similar lines,
(BSE along with Parsoli corporation) has come up with index known as BSE TASIS Shariah 50. NSE also
    has come up with indices (S&P CNX Nifty Shariah / S&P CNX 500 Shariah)xiv based on a similar line of
    screening conditions in tie up with S&P.

    Islamic Funds
    Parsoli Corporation Ltd. and Taqwa Advisory Shariah Investment Solutions are some of the standalone
    asset management companies that specialize in changeling funds from domestic and NRI Muslims to
    Indian market. Islamic investments amounting up to $750 million (US) have already been made in the
    country’s capital market and infrastructure sector in the year 2007xv. Apart from this Reliance Mutual
    Fund, UTI Asset Management, Way2Wealth and Edelweiss Mutual Fund are some e organisations have
    launched Shariah-compliant mutual funds while a few more are coming up. Profit/Loss based financing
    is particularly suited for infrastructure sector which is helping to fund many infrastructure projects in
    India. List of infrastructure projects funded through Islamic fund as on year 2007 is given in the Exhibit 9.
    However in 2009, Parsoli corporation based was found to have committed many demat regularities and
    was imposed a huge penalty and has been disallowed operations in the country.

    Investment by Kerala State Industrial Dev. Corp.
    KSIDC invested 11% in the first government-sponsored interest free NBFC, Al Barakah Financial Services
    which be a unique company with an authorized share capital of Rs 1000 crore. Al Barakah is one of the
    largest Islamic financial institutions globally and the investment body is meant for direct investments
    into infrastructure and other projects in Kerala state with profits shared as dividends and not as interest.
    The rest of the stake is to be owned by NRIs and state’s Muslim population and others interested in the
    business opportunity.



    Time Line of Recent Events

Working Group report of
                                    Kerala High court gives                        Kerala govt. extends full support to
RBI to examine financial
instruments used in Islamic         approval      to       KSIDC                   the interest-free banking system
Banking, headed by Mr.              investment        in   Islamic                 that assists development of the
Anand Sinha, Executive                                                             state, said –CM, Oommen Chandy
Director, RBI.                      Investment Company
            Raghuram Rajan, Planning                   Bank    of     Asya,     Turkish
            commission report pushes
                                                       Bank’s request to open                                RBI   questions      the
            for streamlined introduction
            of Interest-free banking                   office is cleared by RBI and                          procedures of AICL a
                                                       forwarded for approval by                             registered NBFC
                                                       finance ministry



July 2006          Sept 2008                                         Mar 2011
                                           Feb 2011                                        July 2011                  Sept 2011




      1. Working Group Report of RBI (July 2006): “Report of the working group to examine financial
            instruments used in Islamic Banking” was an internal study done by RBI Department of Banking
    Operations and Development, Central Office, Mumbai in July 2006.It was headed by Mr. Anand
    Sinha, Executive Director, RBI. It is the only major study done by RBI so far that explored the
    feasibility of Islamic banking in India.
2. Planning commission recommendation (Sept 2008): In 2008, the Planning Commission appointed
    a committee, headed by IMF former chief economist Raghuram Rajan, to recommend various
    ways to take the country’s financial sector reforms forward. The high profile committee submitted
    a report to Prime Minister Manmohan Singh, who is also chairman of the Planning Commission.
    The suggestions included interest-free banking as an option in accordance with “faith” of a section
    of the society. The committee opined that this was in consonance with the objectives of inclusion
    and growth through innovation. The committee contended that interest free banking is currently
    provided in a limited manner through NBFCs and co-operatives and its delivery should be broad
    based through the banking system.
3. Kerala High court Judgement. (Feb 2011): The High Court rejected the petition filed by Janata
    Party President Dr. Subramanian Swamy challenging the sanction given by the Kerala Government
    (Kerala State Industrial Development Corporation) for investing in 11% equity in Al Barakh
    financial services (NBFC) an Islamic Financial company. The court reiterated that the Kerala
    government’s notification made clear that the purpose is to raise resources through commercial
    activity for developing the state and this does not amount to the maintenance or promotion of
    religion. Appendix (Analysis of high court judgement) provides complete explanation.
4. Application by Turkish Islamic bank (Mar 2011): Bank of Asya, Turkish Bank’s request to open
    office was cleared by RBI and forwarded for approval by finance ministry. As per the statement of
    the Finance ministry official: "So far the bank has only sought permission to open a representative
    office, we are considering their application”
5. Support by Kerala Govt. (July 2011): Kerala govt. reiterates its support for Islamic finance it its
    state. "The Kerala government will extend full support and cooperation to the interest-free
    banking system so that it may be used for the development of the state and we will try to attain
    the central government’s approval for it", he said while inaugurating a national seminar on
    Interest-free   Institutional   Mechanism       for   Banking,   Finance   and   Insurance   held   in
                           xvi
    Thiruvananthapuram.
6. RBI questions Islamic investment activity (Sept 2011):            RBI questions the procedures of AICL
    (Alternative Investments and Credits Limited) a registered NBFC from Kerala. According to the
    regulator, AICL, a registered NBFC, is not complying with the fair practices code under which the
    financier has to lay down the terms and conditions of funding. The development is being closely
    tracked by the proponents of Islamic finance as the outcome could determine how such activities
    may be pursued in India
Obstacles and concerns

Statutory regulations
In 2006, The Reserve Bank of India (RBI) constituted a committee to evaluate if Islamic banking can be
offered in India. The committee examined the option and concluded that Islamic banking cannot be
offered by banks in India as well as the overseas branches of local banks under the present legal
framework.

    1. Legal Issues
Banking Regulation Act, 1949 stipulates the following regulations on banksxvii.
    -   Banks should not invest on Profit Loss sharing basis (which is the very basis of Participant
        banking)
    -   Banking company should not directly or indirectly deal in buying, selling or bartering of goods
    -   Banks are prohibited to deal in any immovable property apart from private use
    -   Banks are required to pay interest which is against Shariah

Legal issues – invalidating products
The above legal framework effectively prevent existing conventional bank to offer Islamic products. The
below is the list of products and their restrictions.
Al Wadiah (for saving bank account): Banking Regulation Act requires payment of interest on such
deposits; thus, interest-free deposit and a simple charging of premium or Riba is not permissible.
Mudarabah, Musharakha (for project finance and SME credit): Regulation does not allow any kind of
profit-sharing and partnership contract.
Ijarah, Istisna (for home finance, leasing and buyback): As against Islamic banking where the banks
owns the asset and hold the title, BR Act prevents the bank from any sort of immovable property other
than private use.
Takaful (mutual / cooperative insurance): As per IRDA regulation this product is prohibited.

    2. Unviability Issues:
Other than the above restrictions the products would be unviable because of the stamp duty, central
sales tax and state tax laws that will apply depending on the nature of the transfer. While interest is
exempted from tax on ground that it is a cost time, the profit/loss nature of Islamic banking is at a
disadvantage as in India the rate of tax on dividends (profits) stands from 15%-20% currently. Moreover
while conventional commercial banks and cooperative societies have the facility of deposit
insurance and credit guarantee (DICGC), no such facility is available for Islamic banking and financial
institutions

    3. Limitation of NBFCs (Non-Banking Financial Company)
The existing Islamic finance organizations thus operate as NBFCs, which are in turn highly limited in their
scale, products and operating capacity. The NBFCs in turn have the following restrictions.
    1. NBFC cannot collect deposits in the manner of a bank. (savings/ demand deposit thus
         disallowed)
    2. NBFC cannot issue checks drawn on itself or issue Demand Drafts like banks
    3. NBFC cannot indulge primarily in agricultural, industrial activity, or in construction of immovable
         property
    4. NBFC cannot accept demand deposits
    5. NBFC is incorporated under company act of 1956, while banks are incorporated under banking
         companies act.

    4. RBI requirements


Apart from these restrictions, the central bank of India stipulates many conditions (BASEL norms) for
running of conventional banks in India. This involves capital adequacy, statutory liquidity requirements
(SLR), Cash reserve ratio etc., and SLR requirement mandates banks to invest atleast 25% of NTDL (Net
demand and Time liabilities) in Government securities which in-turn earn interest. This is fundamentally
not possible in Islamic banking as majority of the liabilities will be tied up in profit sharing basis or asset
backed investments.
SLR Requirements            CRR Requirements            Call Money                   Repo transactions
Banks    mandated       to Banks       mandated    to Banks have overnight Banks can also borrow
invest minimum 25% of maintain atleast 6.5% of borrowing                 practices money from RBI at the
NDTL in interest paying NDTL with RBI which from other banks at repo rate
G-secs                      pays interest on these “call money rate”
                            deposits




Hence any Islamic financing activity in India is severely constrained or disallowed under all the above set
of issues and legalities.

Amendment Requirements
The two major areas where there should be amendments for competitive offering if Interest-free
banking in India are therefore,
    1. Appropriate changes in RBI Policy and requirement
    2. Appropriate amendments in Banking Regulation Act, 1949 and separate rules and regulations
         for Islamic banking
    3. Taxation implications and other legal issues need to be eased for Islamic banking.
             Law Changes                         RBI Policy Changes                 Indian Bank’s association
    1. Banking act changes
                                             1. Allow profit sharing and
    2. Tax laws changes for                                                       1. Insurance mechanism for
                                                interest free loans
       avoiding double taxation                                                      deposit
                                             2. Policy changes for Islamic
       and stamp duties                                                           2. Interbank standards and
                                                banking activities
    3. Treat income from                                                             procedures for Islamic
                                             3. Develop Islamic bond
       partnerships as interest                                                      banks
                                                market
       income


Apart from this the following also need to be done for successful commencement and operations the
Islamic finance in Indiaxviii.


        IRDA should permit Takaful (mutual insurance).
        SEBI needs to draw up micro-venture capital guidelines to permit investment in
         partnerships/LLPs.
        The Government should form an Expert Group on Islamic Finance as in UK from industry,
         citizens, and professionals, representatives from marginalised and Muslim organisations.




Stakeholder mapping of players

Stakeholder mapping is the process of clarifying the position of the various stakeholders in an organization.


The stakeholder theory devised by Friedman identifies stakeholders as internal and external based on their
interest and influence levels on the firm.
   Internal Stakeholders include those who form a part and parcel of the organizational framework as such, i.e.,
    say, owners of the business, customers, suppliers, employees, and so forth.
   External stakeholders do not own or work with the business, but still have an interest in the business. These
    interests may be guided by profit or psychological motives.
Grouping of stakeholders is also done based on
   Influence that they can exert on the organization
   Importance – those stakeholders whose interests and problems are priority for the organization


Initially a complete list of stakeholders for an Islamic banking institution was identified. The stake holders were
then mapped as below.
         Mapping based on Influence/Importance relationship of the stakeholder

                                      Influence



                     Keep Satisfied            Manage Closely
  High        a) Regulators                    a) Board of directors
              b) Rating Agencies               b) Shareholders
              c) Auditors                      c) Competitors
              d) IT Products                   d) Shariah advisory Board


                                                                            Importance


             Monitor (min effort)              Keep informed
                  a) Media                       a) Islamic Community
                                                  b) End consumers/
                                                     Depositors/
  Low                                                Account Holders
                                                  c) Employees
                                                  d) Conventional banks
               Low                                      High




Further mapping based on Internal and External relationship of the stakeholder

                Internal Stakeholders                 External Stakeholders

                           Influential and Important:- Manage Closely

             Shareholders
             Board of directors
             Shariah Advisory board
             Competitors

                         Important and Not influential:-Keep Informed

             Customers                          Conventional banks
             Bankers/Employees                  Public Community
                                                Islamic community


                          Influential and Not Important:-Keep Satisfied

             IT Products                        Rating agencies
             RBI                                Auditors
                                                 Other Regulators
                                                 Government

              Not Influential and Not Important:-Monitor and keep on board


                                                 Media
                                                 Financial training Institutions
                                                 Experts/Scholars
Strategies for Islamic finance companies based on stakeholder approach

Methodology of analysis
To arrive at the best strategies for running of the Islamic banking business, at each stakeholder level the
following analysis previously done were taken into considerations and steps and strategies were arrived
at.
      1. Success Factors of the Islamic banking business
      2. Factors that contributed success of Islamic Banking in developing countries like Malaysia
      3. Appropriateness for the Indian Context

Influential and Important Stakeholders: Manage Closely

Shareholders
A shareholder’s primary concern would be preservation shareholder’s equity and earn a solid return. Shareholder
of an Islamic financial institution may also stand for religiously and ethical cause of the concern. Hence
professional standards in running of the organization and transparent accounting procedures and disclosures
regarding the compliance to the Shariah principles are vital for successful shareholder relationships. Apart from
these hygiene factors, investment on a new concept, on a new country like India would be considered as a risky
investment and the shareholder would expect high returns banking on the possible growth of the segment over a
long term period.


Shariah advisory Board
Globally each Islamic bank runs with a Shariah board of its own which regularly monitors review and
ensures that all the product features and transactions comply with Shariah rules and guidelines.
Currently even though there are minor differences in the compliance levels and guideline mandates,
they are streamlined with in the countries by formations of new Shariah advisory institutions. Shariah
board members would be associated with one or more of these advisory institutions.


Shariah boards are responsible for five main areas in the governance of Islamic finance institutions:
                         Certification of permissible financial instruments through fatwas
                         Verification of transactions’ compliance with issued fatwas (ex post Shariah
                          audit)
                         Calculation and payment of zakat (alms giving)
                         Disposal of non-Shariah-compliant earnings
                         Advice on the distribution of income and expenses among the bank’s
                          shareholders and investment account holders.
Each Shariah board issues a Shariah compliance certificate, conformance with which is considered a
basic benchmark for all financial institutions across the world.
Indian Scenario:
It is important to note that Shariah body should have eminent scholars, economists and financial experts
who are also well versed with religious guidelines and not just Islamic scholars with traditional mind-set.
The pool of such experts may be minimal in India; however there is a high likelihood of many such NRI
experts returning to India from Middle East and other countries who would aspire to be a part of
building of Islamic finance institutions in India.



Competitors
Regulatory clearances can trigger large number of players entering the industry. As competition
increases, there would be pressure on pricing and decreasing margins and it would be required to create
new forms of differentiation apart from Shariah clearance. Some of the majorxix differentiation factors
would be
1. Product development and innovation, 2. Distribution, 3. Operational Excellence, 4. Building trust
A diverse country like India may actually see new innovation in products and features which may add
value to the Islamic finance industry as a whole. Distribution efficiency is very vital to increase the asset
base as a whole and gain quick market share. Technology will play a key part in achieving better
distribution and operational excellence. Automated tools for compliance and monitoring would be a
great cost advantage.
It is also required to have a co-option based approach to bridge institutional voids that would help the
industry flourish and help increase the entire pie of Islamic asset base. Islamic banking consortium may
help in pool Shariah expertise; harmonize products for inter-trading and lobbying with regulators.



Important and Non influential Stakeholders:-Keep Informed

Customers
Customers of Islamic banks vary from normal demand depositors, Islamic credit takers, current account
holders to restricted account holders, unrestricted account holders and investment depositors. From an
Islamic window bank point of view it is important to not just let the customers switch from conventional
banking to Islamic products. Instead the emotional attachment of religious feature like ‘Zakat’ may
attract more asset bases of existing customers to be managed by banks than remaining idle at other
assets like cash or gold.
Designing of appropriate products for customers is vital for attracting and retaining customers. One of
the frameworks that can be used for this is Diffusion of Innovation theory -Rogers (1999, 2003).
                      Factors that increase customer adoption rate of Islamic banking
Consumer               In a new market, consumer awareness about the products is vital for the adoption,
Awareness              in Islamic products the differences between products like Mudarabah, Murabaha
                       etc., should be made clear to the customer
Relative               Apart from the benefit of Shariah compliance, the product must be competitive to
Advantage              the conventional products and should have advantages. This also drives up non-
                       Muslim customers. For e.g., In Malaysia for certain products up to 40% of the asset
                       bases under Islamic finance come from non-Muslims.
Compatibility          The products must be compatible with existing tie ins like credit cards, single
                       window internet accounts etc.,
Complexity             Though there is an emotional trust on the products that comes from Shariah
                       approval, excessive complexity may prevent consumer adoption
Trialability           Distribution, reach and low cost are vital for trialability of the products
Observability          Increase in visible benefits and usage may create network effects among consumers
                       who aspire for social status and religious connect by opting for Islamic banking
Uncertainty            Uncertainty in risk and returns of products may prevent consumer adoption of the
                       product


Islamic products also need to be marketed as a universal alternative and not as exclusive for Muslims.
Recent marketing strategies by Indonesian banks reinforce the Islamic products as professional
alternative products for customers who look for mutual benefit between bank and customer than just
calling them in complex Arabic terms- (Exhibit 9).


                                                    +              Consumer Awareness

                                                    +
                                                                    Relative Advantage

                                                    +
               Consumer                                                Compatibility
               adoption of
                                                    -
           Islamic Banking                                               Complexity
                services
                                                    +
                                                                         Trialability
                                                    +
                                                                       Observability


                                                    -                   Uncertainty
Employees
Employees need to be approached without any religious connotation with growth prospects and
performance being the driving force. Increase in personnel and expert requirements can be
compensated by increase in training institutes and movement from NRI Middle East banking personnel
countries who may want to return to India.

Conventional banks
In many countries, not all conventional products are mimicked and implemented by Islamic banking
institutions. Hence conventional products complement Islamic products and bring in more business.
However in banks that offer both, there is possibility of cannibalization of existing products. However
this is a repercussion that cannot be avoided.

Islamic Community
From the interview excerpts of Mr. Abdur Raqueeb, awareness about possibility of Islamic banking
products is actually very low amongst majority of the community. For majority of the people Islamic way
of saving and lending cash is more of religious/charity activity than a normal commercial viability.
Moreover sentiments of religiousness are high and these have to be taken care while coming up with
any product descriptions and advertisements for the products.

Influential and Non Important Stakeholders: - Keep Satisfied

RBI and other Regulators
RBI regulations and issues like capital requirements, reserve requirements etc., have to be strictly
complied with by the Islamic finance institutions along with the compliance to the Shariah board. With
respect to the regulation issues, the changes required and new amendments that may be need were
discussed in the prior section (Amendment requirements). RBI can also collaborate with other central
banking institutions like Malaysia to understand its Islamic banking operations and regulations.



Rating Agencies
Rating agencies can help customers with bringing out the inherent riskiness of a product as well as the
degree of Shariah compliance of the product. Such agencies are prevalent in Middle East. In a new
market like India the role of such agencies would be crucial. A consortium by Islamic banking institutions
can facilitate running such rating agencies for the benefit of customers. This can also be run by existing
rating agencies like CRISIL by extending their rating to compliance testing for Shariah. Increased
transparency and good relationship with such agencies are vital for successful reputation of the product.

Government
Changes in regulatory environment and support for Islamic banking can come through only by
government action. As per the views of Mr. Abdur Raqeeb, (General Secretary, ICIF) even though
government is interested in minority affairs improvement through other minority institutions, and
frameworks, there has been very little incentive for the government to open up for Islamic finance,
unless there is significant political pressure. Unlike other countries where Islamic finance is prevalent
like Malaysia, Indonesia, Middle East etc., whose primary population is Muslims, in India, except Jammu
& Kashmir, primary vote bank is not of Muslims. However recently Kerala (24% Muslims - the second
highest majority) there is an inherent political support and government drive for pushing reforms for
Islamic financial system. The following changes are to be made by the government to accommodate
Islamic banking principles in mainstream banking.
    1) Change laws: The first step in setting up Islamic banking in India has to be taken by the
       government. As explained earlier, there are many laws that prohibit operating banks in Islamic
       way. The government should change the laws appropriately so as to accommodate the Islamic
       principles in banking.
    2) Regulatory framework: A framework for regulating banks and financial institutions should be
       adopted by the government. There are many regulatory authorities set up around the world.
       The Indian government can look at the regulatory frameworks set up by developing countries
       like Egypt and Malaysia to set up its own framework. Best practices from around the world
       should be incorporated while creating the framework.
    3) Academic Institutions: Academic institutions have to be set up to train staff in Islamic banking
       and its principles. There is also a need for certified Shariah scholars who could take part in the
       process of setting up Islamic banks. Islamic banking principles should be integrated in
       conventional banking courses at university level. By involving academicians in this process would
       help us create products customized for the local populations.
    4) Provide Incentives: As we have already explained, Islamic banking would help in inclusive
       growth by uplifting the economically backward Muslim population of India. Also as we have
       seen Islamic banks should be home-grown as foreign banks might not be profitable in Indian
       markets. We have also seen that Islamic banking would attract billions of petro-dollars from the
       rich Gulf countries. Hence, the government should provide incentives and tax rebates to existing
       and new players to set up Islamic banks in the country till the industry is stabilized and is proven
       profitable.
    5) Income Tax: Islamic banking is based on the principle of profit sharing as opposed to interest in
       conventional banking. Under Indian laws, profits are taxable whereas interest is treated as a
       cost item and hence not taxed. This puts Islamic banking at a disadvantage. This has to be
       changed accordingly.
    6) Setting up Islamic Index: An index for share market has to be set up which exclusively includes
       only firms and businesses that have been qualitatively and quantitatively screened and have
       been Shariah approved. Doing so would make information easily available for Islamic investors,
       both Indian and foreign, and would encourage them to invest in these businesses.



IT Products
Technology is one of the key factors for cost advantage,streamlined operations and roll out of Islamic
banking. Infact the majority of Islamic Banking solution providers of the world are present in India especially
Infosys (Finacle), Iflex, TCS and Misys. This closeness can give a great advantage for Indian firms venturing into
Islamic finance can leapfrog in terms of automation and technology. Many other core banking solutions have also
started supporting Islamic finance as an integral part of their solution.



Addressing Institutional voids in India
Tarun Khanna and Krishna Palepu’s “Why Focused Strategies May Be Wrong for Emerging Markets”
gives an interesting perspective about how emerging countries have huge institutional deficiencies that
derail basic business operations. Companies with focussed strategy with impetus on core competence
without addressing these issues may fail to realize their potentials. Conglomerate groups and business
houses were found be able to handle these inefficiencies better than standalone corporates. These
inefficiencies are also addressed by intermediaries that may come up.
Some of the issues identified were,
               1. Dearth of information exchange infrastructure which effectively prevents awareness
                   sharing of products information with each other.
               2. Absence of government watches dogs or rating agencies that can affirm the claims
                   made by sellers.
               3. Absence of practical education and training for work force etc.,
Islamic banking would also be subjected to these effects. Some of the steps that can be taken to address
this are
    1. Collaborate for development of Islamic finance as a subject in university curricula and tie-up
           with specialized institutes for training such requirements. For e.g., Institute of Islamic banking
           and finance which was established recently in Hyderabad, is seeing increasing requests from
           corporates like Infosys and UTI for their training their employees in the area of Islamic finance.
    2. Intermediaries like a consortia or third party rating agencies to verify and certify the products
           can be established. An association of Islamic banking institutions can lobby with regulators and
           push any other reforms they may be necessary etc.,



Conclusion
There is a growing interest amongst Islamic community, as well as businesses and financial institutions
for enabling Islamic finance in India. For the banks that move in first as soon as the regulations are
relaxed, they will have their first mover risks like,


          Educating the customers about the product features
          Training the employees
          Increased turbulence of regulatory changes in the beginning
          Uncertainty amongst customers and inhibitions


Experiences from different countries indicate that an integrated approach of reforms from different
state actors including government, regulators, independent committees as well as finance organizations
are required for successful adoption of Islamic banking in India. Moreover even though three is viability
for certain products like Islamic investment funds or Islamic bonds within the regulatory settings, they
cannot flourish because of lack of secondary trading platform or market development which can only
develop if the commercial Islamic banking starts off, which in turn is unfeasible under current
regulations.




Exhibits

Exhibit 1 Partnership Transactions


                      Cash/Expertise


    Partner 1                                  Partner 2




                                                           Profit /Loss
 Profit/Loss              Project


Exhibit 2: Instalment Credit Sales:



               Supplier
                                                  Purchaser
                                                                                Binding Promise
                                                                                to Purchase at
                          Buy at Spot
                                                                                deferred pay
                                                      Sell at Deferred
    Pay    Goods                                      Payment
    at Spot                    Financier
                               –        owns
                                                      Owns the asset
                               the goods
                                                      – risk remains
                                                      with financier




Exhibit 3: Lease


                                        Step 1: Price Negotiations
        Seller                                                                 Buyer

                                                        Step 4: Delivery of
                                                        Asset to Buyer
                                Step 3: Title
                                transfer       to
                                financier
                                                    Step 5: Lease Contract
                                                                                   Step    6:       Periodic
                                                                                   rentals by buyer. On
      Step     2:   Fixed
                                                                                   completion,      sale of
      Asset Purchase
                                                                                   Asset to buyer
      by Financier
                                           Financier (Bank)



Exhibit 4: Sukuk




                                    Partners


                                                                      Returns & Losses




                                       Shariah
                                       Approved                                Projects
                                       Agreement


              Investment     from                                     Returns & Losses
              investors and Sukuk
              issue by SPV




  Investors                          SPV
                   Profits

Exhibit 5: Best Islamic banks by countryxx




Exhibit 6 – Evolution of Islamic Banking industryxxi
     1963- First Islamic Bank set up in Egypt



            1975 – Islamic Development bank is established in Saudi Arabia. Dubai
            Islamic Bank, the first modern day private Islamic Bank is set up in Dubai


                  1983– Iranian Central bank passes law to mandate Islamic banking and
                  become first country with 100% Islamic banking complaiance


                         1990 - AAOIFI, a non-profit body for accounting, auditing, governance,
                         ethics and Shariah's standards for Islamic financial institutions and the
                         industry is launched


                                2002 - The Islamic Financial Services Board (IFSB) established. The body
                                sets regulatory standards of the industry


    Exhibit 7 - Evolution of Islamic Financial Products




      1970’s                  1980’s                 1990’s                  2000’s                  2005
      •Commercial             • Project              •Equity                 •Sukuk (bonds)          •Liquidity
       Banking                 finance and           •Ijarah (Leasing)       •Structured              Management
                               syndications                                   Alternative             tools
                              •Takaful                                        assets
                               (Insurance)




    Exhibit 8 - Dow Jones Islamic Market Index Screening
    Source: http://www.djindexes.com/islamicmarket/http://www.djindexes.com/islamicmarket/

    To determine their eligibility for the Dow Jones Islamic Market Indexes℠, stocks are screened to ensure that each
    meets the standards set out in the published methodology.

    Industry Screens
     Alcohol
     Pork-related products
     Conventional financial services
     Entertainment
     Tobacco
     Weapons and defence
    Financial Ratio Screens

    All of the following must be less than 33%:
     Total debt divided by trailing 24-month average market capitalization
     The sum of a company’s cash and interest-bearing securities divided by trailing 24-month average market
      capitalization
     Accounts receivables divided by trailing 24-month average market capitalization



    Exhibit 9 - Islamic Finance Deals in India – 2007
    Source: H ABDUR RAQEEB, Convener, National committee on Islamic Banking GS, Indian Centre for Islamic
    Finance (ICIF), New Delhi, www.icif.in


        Date                 Projects                   Obligator              USD            Lead Arranger
                                                                              Million

     December        Economic Development         State of Maharashtra        10,000    Gulf Finance House, Bahrain
       2007               Zone (EDZ)

     November              SREI Projects            SREI Infrastructure         50       HSBC Amananh / Kuwait
       2007                                            Finance Ltd.                          Finance House


       August         Bearys Global Research          Bearys Groups             20           Saudi Economic
                             Triangle                                                     Development Company
        2007
                                                                                                 (SEDCO)

         July          Velcan Hydro Electric      Velcan Energy Holdings       275        National Bank of Dubai
                               Dam
        2007

      October           Energy City of India      State of Maharashtra         2,000    Gulf Finance House, Bahrain

        2007




    Exhibit 10 –Relative Position of Countries in Global Islamic Finance
Exhibit 11 – New age marketing strategy of Islamic Banking products – Indonesia
Source: Bank Indonesia, Directorate of Islamic banking




Exhibit 12 – Growth of world-wide assets managed under Islamic Finance
Exhibit 13 – Porter’s framework analysis for Islamic finance industry


                                 Threat of New Entrants: Low
                                     Untested industry. Success or failure of
                                      products is unknown
                                     Expertise required to operate a bank
                                     Unfavorable govt. policies




   Bargaining power of                Competitors: High                          Buyer Power : High
                                           Competition from                        Low switching costs
   Supplier: Low
                                            conventional banking,                   Customers have other
      Non Existent                         which is Well                            well established
       suppliers                            established , high                       alternatives
      Industry would be                    penetration
       very important to                   Wide variety of
       suppliers                            products cater to all
                                            categories of customer
      Banks and NBFIs can
       set up own training
       centres



                             Threat of Substitutes: High
                                    Many other established substitutes
                                     exists
                                    Chit-funds, pawn brokers, money
                                     lenders etc
                                    Easier to get loans at these alter




Appendix

Basic Sources of Islamic Law / Shariah

Quran: This is the sacred text of Islam (considered as direct and unaltered word of God) and is
taken as the most undisputed source of Islamic principles.
Sunnah: This is Prophet Mohammed’s practices during his life which was taught and preached
by him. It literally means a clear, plain and well-trodden path.

Hadith: Hadith refers to sayings, acts that were approved of (tacitly or explicitly) by Prophet
Mohammed. These run into large collections and are referred to in matters of Islamic law. Their
interpretations are however subject to subjective discrepancies between different groups.

Islamic Finance Products Explained



Murabaha (Cost plus Financing)
Financier acts as middleman. The Financier buys the asset (House/Vehicle etc.,) at price X from the seller
and contracts to selling it at a fixed profit margin to the borrower against deferred payment. Mandating
the borrower to sign the promise to purchase this price offsets the risk of unsold commodity remaining
with the financier. Since the price is clearly contracted during the sale there is no uncertainty involved.

Musharakha (Partnership or Profit / Loss sharing)
Musharakha is Equity financing used for working capital. Financier enters into partnership with
borrower. Basically borrower and bank enter into partnership and buy the house. Borrower makes
payments that are partly rent and partly buyout the bank. The contracts work like a diminishing
partnership. In business financing, each partner may or may not participate in carrying out the business.
A working partner gets a greater profit share compared to a sleeping (non-working) partner. The
difference between Musharaka and Mudaraba is that, in Musharaka, each partner contributes some
capital, whereas in Mudaraba, one partner, e.g. a financial institution provides all the capital and the
other partner, the entrepreneur, provides no capital.

Mudaraba (silent partnership, profit sharing)
Mudaraba is an arrangement or agreement between a capital provider and an entrepreneur, whereby
the entrepreneur can mobilize funds for his business activity. The entrepreneur provides expertise and
management and is referred to as the Mudarib. Any profits made will be shared between the capital
provider and the entrepreneur according to an agreed ratio, where both parties share in profits and only
the capital provider bears all the losses if incurred. The profit sharing continues until the loan is repaid.
The bank is compensated for the time value of its money in the form of a floating interest rate that is
pegged to the debtor's profits.

Istisnaa / Salam (Islamic forwards)
This is a contract where a commodity is transacted before it comes into existence. This is similar to
forward contract. This is like an order to a manufacturer to manufacture a commodity at a specific price.
Either party can cancel the contract before the manufacturing party has begun its work. This is widely
used in construction finance. In general, the sale of non-existent objects is forbidden due to Gharar.
However, to facilitate certain types of business, exceptions were given through those two contracts.
“Whoever enters into a Salam contract let him specify a known volume or weight, and a known term of
deferment”. Thus, he is permitted this trade, where the price is paid in full, and the well-defined object
of the sale is delivered after a specified time. This was agreed by Prophet (pbuh) to allow farmers to
have capital for investing in crops. This pre-payment of the price allowed the farmers to buy seeds,
spend for their own sustenance, etc., in order to be able to produce the fruits. The first price is like
commission to manufacture. The money is paid in instalments as the work progresses in manufacturing
or building any other non-existent object. The price pre-paid in instalments in this case will often be
lower than the cost of purchasing the finished product (if it were to exist), and can therefore be a useful
tool for construction projects.

Ijara (Islamic Leasing)
The bank buys the house or equipment and leases to borrower on a redeemable lease. There are 2
types: Operational and lease purchase. The duration of the lease and rentals are agreed in advance.
Once the lease period is over there is also option for the user to buyout the asset. Thus this product can
be used for housing / vehicle financing.

Tawaruqq
Sale of an asset on deferred payment. The purchaser then sells the asset to third party for cash with a
price lesser than the deferred price, for the purpose of getting access to cash. This is also known as
reverse Mudaraba.

Bai Inah
This is a contract that involves the sale and buy - back transaction of an asset by a seller. The seller will
sell the asset to the buyer on cash basis then immediately buy back the same asset on a deferred
payment basis at a price that is higher (or lower) than the cash price.

Sukuk (Islamic bond)
Series of payments arising from asset based transaction and can be traded at market price. This is also
called as Islamic Bonds.



Takaful (Insurance Sector and Islamic Banking) xxii
Shariah/Islamic Law defines the underlying principles of Takaful which may be summarized as follows:
    i.         Policyholders co-operate among themselves for their common good.
    ii.        Every policyholder pays a part of the contribution as a donation to help those that need
               assistance.
    iii.       Losses are divided and liabilities spread according to the community pooling system.
               Uncertainty is eliminated in respect of subscription and compensation.
    iv.        It does not seek to derive advantage at the cost of others.


Theoretically, Takaful is perceived as “cooperative insurance”, where members contribute a certain sum
of money to a common pool. The purpose of this system is not profits but to uphold the ethical principle
of "bear ye one another's burden." Development of Takaful in India is given in appendix.

Major Islamic Financial Institutions
Most of the major Islamic financial Institutions operate within the Middle Eastern Region and the other
Islamic countries like Malaysia and Indonesia. The Top financial institutions are
          Al Rajhi
          Kuwait Finance House
          Bank Of Islam Malaysia
          Dubai Islamic Bank
          Qatar Islamic Bank
          Boubyan Bank
          Abu Dhabi Islamic Bank
          Qatar International Islamic Bank
          Shamil Bank
          Bank Melli
          Bank Mellat
          Jordan Islamic Bank
          Bank Aljazira
          Bank AlBilad
Over the recent years, almost all Western banks have also been entering this segment with major plans
for expansion. A few major banks with significant Shariah Complaint assets are
          ABN AMRO
          Barclays
          BNP Paribas
          Citi Islamic Investment Bank – A division of Citibank
          Deutsche Bank
          HSBC Amanah
          Lloyds TSB
          Standard Chartered
Analysis of Kerala High court Judgement
Source: http://articles.economictimes.indiatimes.com/2011-02-03/news/28432761_1_islamic-banking-
ksidc-Shariah-compliant
Coming to the substantive questions, the Court first addressed the question of whether Kerala State Industrial Development
Corporation’s (KSIDC) 11% equity in the Al Barakh Financial Services Ltd., a registered non-banking financial company (NBFC)
committed to offering Shariah compliant financial services, constitutes “undue association with a religious activity amounting
to [State] favouring or promoting a religion”. It explained the well-recognized position that the Indian constitution does not
specifically prescribe a wall of separation between religion and state. Not only are specific exceptions to the secular doctrine
made in the Constitution itself (citing Art.30(1) which grants minorities the right to administer educational institutions and
Art.290A which allows for transfer of funds from the consolidated fund of India to certain temples in Tamil Nadu and Kerala for
their maintenance) but State association with religious institutions is ordinarily permissible as well both in education (citing
Art.28(2) and 28(3) which allow the State to administer and/or aid educational institutions set by religious endowments or
trusts where religious education may be imparted) and commercial enterprise (Art.298 which grants broad executive authority
to the state to engage in commercial interactions with no mention of any exception against involvement with religious
denominations) so long as these ventures do not amount to the maintenance or promotion of religion (barred under Art.27).
The Kerala government’s notification makes clear that the purpose here is to raise resources through commercial activity for
developing the state and this does not amount to the maintenance or promotion of religion. Further, interactions between
human beings as prescribed in any religion is required to be treated as a secular aspect of that faith and any association with
such activity cannot be condemned as promoting or aiding the religion. State investment in a commercial venture which is to be
carried out in adherence with the laws of the land would not violate secularism merely because the company in question is
also, in addition, committed to compliance with the Shariah.

Profile Descriptions of Interviewees


Mr. Mufaddal Khumri, Head, Islamic Banking at RAKBANK, United Arab Emirates
He is currently responsible for setting up Islamic banking business at Rakbank. He had headed the team
that set up Islamic Banking division in Abu Dhabi Commercial bank and responsible for bringing it into
operating foray. He has more than 7 years of experience in Islamic banking domain in the Middle East.
Prior to this role he was the Chief Manager, International Banking Group at ICICI Bank India. During his 7
years of tenure at ICICI bank, he had played multiple roles from being an Executive assistant to Head of
Planning and Strategy, setting up ICICI Bank’s NRI Remittance platform, and alliance with ICICI-Emirates
Bank at UAE. Like many of his compatriots he has a dream to set up India's first Islamic Bank on secular
foundations to serve the community as and when the regulatory framework turns favourable.


Mr. H Abdur Raqeeb,
General Secretary, Indian Centre for Islamic Finance, Member Muslim Personal Law Board, Human
welfare foundation, Sahulat Microfinance, Islamic Foundation trust, etc. Presently he is the convenor of
National committee on Islamic Banking. He is businessman from the leather export industry. He has
interacted with Dr. Raghuram Rajan committee on Financial Sector Reforms to recommend Interest Free
Banking and also closely coordinating with Reserve Bank of India for the same.


Interview Excerpts
Interviewee:       Mufaddal Khumri
Head, Islamic Banking at RAKBANK
United Arab Emirates


What are the key operational challenges in setting up Islamic banking?
Regulation: Islamic banking like any other banking is made up of two divisions: Commercial and
Investment banking. For funds to be deemed suitable under the Shariah law it must comply with both
quantitative and qualitative regulations
Qualitative: The funds raised must not be through businesses or sale of products that are not deemed
appropriate in Shariah law.
Quantitative: The debt ratio of the company or business should be under permissible limits.

The most important and popular product in Islamic banking is Sukuk, which is very similar to
conventional bonds. However they are asset-backed and are interest free. While traditional bonds give
ownership to cash-flows, Sukuk gives right to ownership of the asset and the right to collect the funds
raised through selling the asset. In traditional bonds, the business in which the money raised through
bonds need not be explicitly mentioned. However in Sukuk, this has to be mentioned since it has to be
screened both qualitatively and quantitatively. This is not always possible. Also, since Sukuk involves
right to ownership of the asset, this has to be legally documented. According to Indian laws, the
documentation would involve cost and is also taxable as transfer of asset. Since there are no rules in to
avoid the legal document fees and taxation, no company will be willing to raise Sukuk. Also Sukuk makes
it harder for foreign investors to invest in the company since there are no rules or laws to safeguard
their invested money. Hence Sukuk is not possible as of now in India.
Expertise:   Traditional Muslim Shariah law practitioners in India only have religious knowledge;
however, for setting up of Islamic banks, there would be a need for regulators who are well versed with
Shariah law, commercial and banking laws and knowledge of economics. Currently there are no
universities or academic institutions that can train banking staff in Shariah law.
Lack of political will: Muslims form a very minority stake in Indian politics and do not have a controlling
stake politics, except for few sparsely distributed areas. Hence there is no drive at the political end to
adopt Islamic banking.
Acceptance in Muslim world: Islamic banking does not have 100% penetration the Islamic countries. In
our neighbouring countries (Pakistan and Bangladesh) the acceptance rate of Islamic banking has been
very low. The only country with 100% Islamic banking is Iran, but in the current political turmoil, Iran
hardly makes a good example for the potential of Islamic banking. Hence, it gives no compelling reason
for India to set up Islamic banking
Corruption: While originally intended to be a cooperative financing procedure to ensure fair distribution
of wealth (zakat) , Islamic banks have become profit seeking business with significant level of corruption.


Other Challenges
       Low number of educated Muslims especially in Management institutions to set up Islamic
        banking
       It would be a challenge to position Islamic banking as a pure financial system independent of
        religion. Non-Islamic customers would associate it as a religious system and hence will not adopt
        it readily.

Who are best poised to enter Indian Islamic finance market?
Foreign Islamic banks do not have knowledge of the Indian markets. Also banking would also need
setting up of Infrastructure that would involve huge setup costs. Also the Indian laws require banks to
make a deposit which would also raise the fixed costs. All this while the bank is unsure if Islamic banking
would be successful. Hence, Islamic banks should be home-grown at existing banks.
How do you think banks should market Islamic banking in India - focus on Muslims or peg it as
universal products? Are there significant non-Muslims in other countries who opted for Islamic
banking, if so, what where the major reasons which can be marketed in Indian context?
Around the world, many non-Muslims have adopted Islamic banking. However since it is not yet
established in India, the initial adopters would be Muslims. The Islamic banking concept will be backed
by the Shariah boards and Maulanas which would make it easier for Muslims to adopt. Once we are able
to establish the fact that Islamic banking yields higher returns as compared to traditional banking, non-
Muslims customers will be attracted to Islamic banking.
What are major factors behind existing successes of Islamic banking in developing country like
Malaysia? Can India emulate their success?
Islamic banking in Malaysia has been widely accepted due to the support provided by the Government.
Regulatory frameworks have been set for Islamic banking. Islamic banking related courses are offered in
the universities. The regulations make it easier for rolling out Sukuk. About 69% of world’s Sukuk
distribution is done by Malaysia.
What strategy is to be followed while setting up Islamic banks?

Setting up an Islamic bank is very similar to setting up a conventional bank. However regulatory
framework, related legal documentation and a Shariah board for management has to been set
up before setting up the bank

Interviewee: Janab Abdur Raqeeb
General Secretary, Indian Centre for Islamic finance
(www.icif.in)

What has been the RBI approach so far with respect to the Islamic banking? What is the current
standing of RBI and policies with respect to Islamic banking?
We had requested through RTI regarding previous reports prepared by RBI on Islamic banking. In 2005,
Shri Anand Sinha who is the deputy governor at RBI now, had prepared a report on Islamic banking
instruments. They had concluded that unless legal aspects and RBI policies are not amended it is not
possible permit islamic banking in india. However the report done by the ccommittee on financial sector
reforms headed by Dr. Raghu Ram Rajan, prepared during 2008 did not have any recommendations to
start Islamic banking though it suggested interest-free banking would help inclusive banking and bring
vast majority of minorities in to the credit and savings foray. ICIF is currently lobbying and continues to
interact with Deputy Governor for interest free banking. However RBI being only the regulator it gave
the feedback that unless finance ministry or the GOI approves this cannot be done.


What is the current position, is there any thing getting changed?
We have already persisted and lobbied with the finance minister but unless there is political pressure to
change there seems to be very less interest by government towards changing. However there is
continuous change and transfer of secretary of finance ministry. Again one secretary came and we had
discussion, but another transfer took place. Hence we feel unless there is political pressure there is no
incentive for government or regulator to change. Moreover the government is also worried about issues
that may arise on the uniform civil code, if differential banking privileges are given for a religious
community.


Can there be a stream lined Shariah board in India for review of products.?
Islamic banking has got several products and each and every customer may end up taking highly
personalized products, unlike established standards products in conventional banking. Hence the
Shariah board’s role may become more complicated when it takes in to account local community and
geographical conditions into account.


Why do you think islamic banking will take off?
According to one of the RBI reports, there is some 42,000 crores of interest accrued by muslim accounts
not being taken and sitting idle especially in states like Kerala. Moreover there are many who buy gold
and other non-banking assets and cash, instead of bank accounts and products. Hence there is a big
opportunity from both religiously inclined as well as others who see status symbol by opening islamic
accounts.


Don’t you think we need to have proper controls, checks and balances so that issues like Parsoli
corporation fraud does not take place?
Frauds happen in any type of business regardless of whether islamic or not. Even the biggest banks like
Citibank, Lehmann brothers were bailed out due to mismanagement of funds. And in India especially if
there is no established systems and regulations in place for this industry, it will only breed opportunistic
people who take advantage of religious sentiments and create fraudulent businesses. That is why there
is all the more need for regulations and standardinzation of practices. Even many other funds actually
put up islamic funds based on a limited screening of criteria amongst equity securities most of which are
not strictly compliant.




Islamic Banking Terms
TERM                  DEFINITION
Quran                 Revelations from God
Sunnah                Authenticated sayings and actions of Prophet
Hadith                Individual sayings
Riba                  Money has no intrinsic value. Hence no interest for its use. Basically avoids rate of
                      return on investment.
Gharar                Similar to consumer protection laws to prevent ambiguity or uncertainty.
Halaal                Permitted
Haraam                Forbidden
Zakat                 Process of Tax to be set aside for charitable purposes
Fiqh                  Fiqh is collection of interpretations/rulings/precepts based on Quran and Sunnah

Sukuk                 Certificates (Securitised Assets)
Ijarah                Rent
Fatwa                 Edict, opinion or judgement based on religious sources scholarly discussion




i
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Technology, Bastara, Karnal, Haryana
ii
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iii
    Microfinance and Islamic Finance – A Perfect Match, Dr. Linda Eagle, Founder & President of The Edcomm Group
Banker's Academy
iv
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v
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vi
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vii
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viii
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ix
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26/09/2011
x
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xi
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xii
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xiii
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xiv
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xv
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xvi
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http://www.globalislamicfinancemagazine.com/index.php?com=news_list&nid=1758
xvii
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xviii
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xix
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xxi
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xxii
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accessed on 26/09/2011

				
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