PROJECT REPORT

ON

“AN ANALYTICAL STUDY OF THE ISLAMIC BANKING:

WITH SPECIAL REFERENCE TO INDIA”

Submitted towards partial fulfillment of the requirement for the award of the degree of
“Bachelor of Business Administration”

OF

GURU GOBIND SINGH INDRAPASTHA UNIVERSITY

(Session 2009-12)

Submitted to: Submitted by:

Prof. B. Manchanda Arham Shamsi
BBA (3rd Sem.)
10521401709

JAGANNATH INTERNATIONAL MANAGEMENT SCHOOL

Vasant Kunj
New Delhi

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 ACKNOLEDGEMENT
First of all I wish to express my thanks and sense of reverence of my college supervisor and guide

Prof. B.Manchanda for taking pains and also giving his creative suggestions for improvement.

A project of this nature is the product of the ideas and experiences of several persons. So, an

undertaking of a work like this is never the outcome of efforts of a single person, rather it bears the

imprints of a number of persons who are behind the curtain. Though, I am enabling to mention all of

them individually. Yet my debt of gratitude to them is no less.

Last but not the least I wish to thanks my family members, relatives and my friends without their help,

it would not have been possible to complete this project. It gives me great satisfaction to record deep

sense of appreciation of excellent and help provided to me.

Arham Shamsi

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 CERTIFICATE

This is to certify that Arham Shamsi, Enrolment No. 10521401709, BBA 3rd Semester has submitted
his project on “An analytical study of the Islamic banking with special reference to

India”towards partial fulfillment of the requirement for the award of the degree of “Bachelor of
Business Administration” OF GURU GOBIND SINGH INDRAPASTHA UNIVERSITY

Prof. B. Manchanda
(Project Guide)

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 TABLE OF CONTENTS
Serial no. Particulars

1. INTRODUCTON
• Objective of the study
• Focus of the study
• Introduction to Islamic Banking
• Features of Islamic Banking
• Principles of Islamic banking
• Benefits of Islamic banking
• Islamic banking in practice

2. CONCEPTUAL FRAMEWORK OF ISLAMIC BANKING

• Current Practices
• Shortcomings in the current practice
• Comparison of banking frameworks

3. ISLAMIC BANKING IN INDIA

Banking Regulations in India

• RBI Regulation
• Comparative analysis of Islamic Banking and conventional banking
• Constraints and issues

3. DATA ANALYSIS AND INTERPRETATION

4. SUGGESTIONS

5. Limitation of the study

6. BIBLOGRAPHY

7. QUESIONNARIRE

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 OBJECTIVES OF STUDY

(1). To develop a conceptual framework of Islamic Banking.

(2) .To compare the Islamic banking with conventional banking.

(3) .To study its feasibility in Indian context..

FOCUS OF THE STUDY

Interest Free banking, based on Islamic, principles which is in operation in more than 25 countries, has

a strong potential in India like several non-Islamic countries, say Islamic scholars. Once the regulatory

framework is in place, it could offer a viable alternative to the conventional banking system.

Hence the focus of the study is to compare the Islamic banking with conventional banking, and to study

its feasibility in Indian context.

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 INTRODUCTION

Modern banking system was introduced into the Muslim countries at a time when they were politically
and economically at low ebb, in the late 19th century. The main banks in the home countries of the
imperial powers established local branches in the capitals of the subject countries and they catered
mainly to the import export requirements of the foreign businesses. The banks were generally confined
to the capital cities and the local population remained largely untouched by the banking system. The
local trading community avoided the “foreign” banks both for nationalistic as well as religious reasons.
However, as time went on it became difficult to engage in trade and other activities without making use
of commercial banks. Even then many confined their involvement to transaction activities such as
current accounts and money transfers. Borrowing from the banks and depositing their savings with the
bank were strictly avoided in order to keep away from dealing in interest, which is prohibited by
religion.
With the passage of time, however, and other socio-economic forces demanding more involvement in
national economic and financial activities, avoiding the interaction with the banks became impossible.
Local banks were established on the same lines as the interest-based foreign banks for want of another
system and they began to expand within the country bringing the banking system to more local people.
As countries became independent the need to engage in banking activities became unavoidable and
urgent. Governments, businesses and individuals began to transact business with the banks, with or
without liking it.
At the heart of every robust economy is a sound banking system. In its endeavors to help strengthen the
economies of its member countries, the Fund is increasing its emphasis on stronger financial system
surveillance through improved supervisory efforts. Experience has shown that given the close
interrelation between banking system soundness and macroeconomic policy implementation and
performance, a key element of financial system surveillance is effective prudential supervision of the
banking system.

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Islamic banking differs from conventional banking in several important ways. These include the
prohibition of transactions based on a fixed or predetermined rate of interest, and the requirement that
banks' operations be carried out according to certain procedures through the use of certain financial
instruments. However, broadly speaking, in the majority of
Countries where Islamic banks operate the same regulatory framework apply to both conventional and
Islamic banks. This regulatory framework tends to follow standards and
guidelines established by the Basle Committee on Banking Supervision. However, these standards are
not always applicable in an Islamic banking framework in the same way as they are in other banking
systems. Therefore, a fuller understanding of how Islamic banks operate is key to developing an
appropriate and effective regulatory system. Until now the issue of what standards used for
conventional banks should apply to Islamic banks has received little attention, even in countries where
ale banks follow Islamic principles.

Given that there are many variants of Islamic banking practices, it may be useful to reach an
understanding of a paradigm version of Islamic banking and use it as a benchmark against which to
measure current practices. By so doing, effective supervisory norms can be developed to address special
issues that characterize banks operating according to a paradigm version of Islamic banking. This may
prove to be the best course of action because it is always difficult to envisage general prescriptions that
are valid for all countries at all points in time.

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 FUNDAMENTAL FEATURES OF ISLAMIC BANKING
To understand Islamic banking is to realize that its banks and their operations are considered being an
integral part of a complete Islamic economic system, which is based up on the codification of
injunctions outlined in the Koran and the traditions of the Prophet Mohammed, that is the Islamic
Shariah. Key elements of the Islamic economic system include individual rights, property rights,
contracts, work and wealth, and the role of the State. While preserving their key tenets, the rules
established in the Shariah have been elaborated upon and refined over time by Islamic scholars and
economists in order to adapt them to the evolving economic environment. Hence, this section reviews
the fundamental
Features of Islamic banking as they are presented in the literature with a view to defining a paradigm
version of Islamic banking and characteristics of banks operating according to it. The following features
characterize these Islamic banks:

• Prohibition against the payment and receipt of a fixed or predetermined rate of

Interest. This is replaced by profit and loss sharing (PLS) arrangements where the rate of return on
financial assets held in banks is not known and not fixed prior to the undertaking of the transaction. The
actual rate of return can be determined only ex-post, on the basis of actual profits accrued from real
sector activities that are made possible through the productive use of financial assets.

• Requirement to operate through Islamic modes of financing. These modes affect both the assets
and liabilities sides of a bank's balance sheet and can be divided in to two groups: the ones that are
based on the PLS principle (core modes) and the ones that are not (marginal modes). Table 1 provides a
summary description of the main features of both groups.

• Investment deposits. Such deposits are not guaranteed in capital value and do not yield any fixed or
guaranteed rate of return. In the event banks record losses as a result of bad investment decisions,
depositors may lose part or all of their investment deposits. The only contractual agreement between
depositors and banks is the proportion (ratio) according to which profits or losses are to be distributed.

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Demand deposits. Such deposits are guaranteed in capital value, although no returns are paid on them.
The reason to justify the capital value guarantee is the assumption that demand deposits have been
placed as Amanat (i.e., for safekeeping). Hence, they belong at any time to depositors.

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 Principles of Islamic banking

For millions of Muslims, banks are institutions to be avoided. Islam is a religion which keeps Believers
from the teller's window. Their Islamic beliefs prevent them from dealings that involve usury or interest
(Riba). Yet Muslims need banking services as much as anyone and for many purposes: to finance new
business ventures, to buy a house, to buy a car, to facilitate capital investment, to undertake trading
activities, and to offer a safe place for savings. For Muslims are not averse to legitimate profit as Islam
encourages people to use money in Islamically legitimate ventures, not just to keep their funds idle.

1. However, in this fast moving world, more than 1400 years after the Prophet, can Muslims find
room for the principles of their religion? The answer comes with the fact that a global network
of Islamic banks, investment houses and other financial institutions has started to take shape
based on the principles of Islamic finance laid down in the Qur'an and the Prophet's traditions 14
centuries ago. Islamic banking, based on the Qur'anic prohibition of charging interest, has
moved from a theoretical concept to embrace more than 100 banks operating in 40 countries
with multi-billion dollar deposits worldwide. Islamic banking is widely regarded as the fastest
growing sector in the Middle Eastern financial services market. Exploding onto the financial
scene barely thirty years ago, an estimated $US 70 billion worth of funds are now managed
according to Shari'ah. Deposit assets held by Islamic banks were approximately $US5 billion in
1985 but grew over $60 billion in 1994.
2. The best-known feature of Islamic banking is the prohibition on interest. The Qur'an forbids the
charging of Riba on money lent. It is important to understand certain principles of Islam that
underpin Islamic finance. The Shari'ah consists of the Qur'anic commands as laid down in the
Holy Qur'an and the words and deeds of the Prophet Muhammad .The Shari'ah disallows Riba
and there is now a general consensus among Muslim economists that Riba is not restricted to
usury but encompasses interest as well. The Qur'an is clear about the prohibition of Riba, which
is sometimes defined as excessive interest. "O You who believe! Fear Allah and give up that
remains of your demand for usury, if you are indeed believers." Muslim scholars have accepted
the word Riba to mean any fixed or guaranteed interest payment on cash advances or on
deposits. Several Qur'anic passages expressly admonish the faithful to shun interest.

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The rules regarding Islamic finance are quite simple and can be summed up as follows:

a) Any predetermined payment over and above the actual amount of principal is prohibited

Islam allows only one kind of loan and that is qard-el-hassan (literally good loan) whereby the lender
does not charge any interest or additional amount over the money lent. Traditional Muslim jurists have
construed this principle so strictly that, according to one commentator "this prohibition applies to any
advantage or benefits that the lender might secure out of the qard (loan) such as riding the borrower's
mule, eating at his table,

or even taking advantage of the shade of his wall." The principle derived from the quotation emphasizes
that associated or indirect benefits are prohibited.

b) The lender must share in the profits or losses arising out of the enterprise for which the money was
lent

Islam encourages Muslims to invest their money and to become partners in order to share profits and
risks in the business instead of becoming creditors. As defined in the Shari'ah, or Islamic law, Islamic
finance is based on the belief that the provider of capital and the user of capital should equally share the
risk of business ventures, whether those are industries, farms, service companies or simple trade deals.
Translated into banking terms, the depositor, the bank and the borrower should all share the risks and
the rewards of financing business ventures. This is unlike the interest-based commercial banking
system, where all the pressure is on the borrower: he must pay back his loan, with the agreed interest,
regardless of the success or failure of his venture.

The principle, which thereby emerges, is that Islam encourages investments in order that the community
may benefit. However, it is not willing to allow a loophole to exist for those who do not wish to invest
and take risks but rather content with hoarding money or depositing money in a bank in return for
receiving an increase on these funds for no risk (other than the bank becoming insolvent). Accordingly,
under Islam, either people invest with risk or suffer loss through devaluation by inflation by keeping
their money idle. Islam encourages the notion of higher risks and higher returns and promotes it by

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leaving no other avenue available to investors. The objective is that high-risk investments provide a
stimulus to the economy and encourage entrepreneurs to maximize their efforts.

c) Making money from money is not Islamically acceptable

Money is only a medium of exchange, a way of defining the value of a thing; it has no value in itself,
and therefore should not be allowed to give rise to more money, via fixed interest payments, simply by
being put in a bank or lent to someone else. The human effort, initiative, and risk involved in a
productive venture are more important than the money used to finance it. Muslim jurists consider
money as potential capital rather than capital, meaning that money becomes capital only when it is
invested in business. Accordingly, money advanced to a business as a loan is regarded as a debt of the
business and not capital and, as such, it is not entitled to any return (i.e. interest). Muslims are
encouraged to purchase and are discouraged from keeping money idle so that, for instance, hoarding
money is regarded as being unacceptable. In Islam, money represents purchasing power, which is
considered to be the only proper use of money. This purchasing power (money) cannot be used to make
more purchasing power (money) without undergoing the intermediate step of it being used for the
purchase of goods and services.

d) Gharar (Uncertainty, Risk or Speculation) is also prohibited

Under this prohibition any transaction entered into should be free from uncertainty, risk and
speculation. Contracting parties should have perfect knowledge of the counter values intended to be
exchanged as a result of their transactions. Also, parties cannot predetermine a guaranteed profit. This is
based on the principle of 'uncertain gains' which, on a strict interpretation, does not even allow an
undertaking from the customer to repay the borrowed principal plus an amount to take into account
inflation. The rationale behind the prohibition is the wish to protect the weak from exploitation.
Therefore, options and futures are considered as un-Islamic and so are forward foreign exchange
transactions because rates are determined by interest differentials.

A number of Islamic scholars disapprove the indexation of indebtedness to inflation and explain this
prohibition within the framework of qard-el-hassan. According to those scholars, the creditor advances
the loan to win the blessings of Allah and expects to obtain the reward from Allah alone. A number of
transactions are treated as exceptions to the principle of gharar : sales with advanced payment (bai'

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bithaman ajil); contract to manufacture (Istisna); and hire contract (Ijara). However, there are legal
requirements for the conclusion of these contracts to be organised in a way, which minimizes risk.

e) Investments should only support practices or products that are not forbidden

-Or even discouraged- by Islam. Trade in alcohol, for example would not be financed by an Islamic
bank; a real-estate loan could not be made for the construction of a casino; and the bank could not lend
money to other banks at interest.

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 Why Open an Islamic Bank?

1. Billion of Dollars are Sitting Idle in the Current Accounts:

There are billions of dollars lying idle in the current account or in other modes. These
dollars can be brought into the main stream by Islamic banking and Islamic financial products.

2. Reach 70% of the Untapped Market:

According to our estimates, current banking has only reached only 30% of the potential clients
in the Islamic world. Consequently, 70% of clients needs are not being addressed. Due to the
culture and unique value, most people do not go to bank until the point when they feel they do
not have any choice at all.

3. Reach to the grass-roots level:

There is a latent demand from billions of customers for Islamic products, which they can relay
on without compromising their values and belief. In other words banking has not reached to the
grass-roots level in the Islamic world. This is because many banks have tried to implement
western banking model in the Islamic world with little or no modification. With our offering, we
can make Islamic Banking as basic as the need for water and electricity.

4. Conventional Banks’ Sr. Management and Board of Directors Concerns:

How long can the members of Sr. Management tell their boards of directors that this market is
not mature enough? The competition is already making big profits, winning customer loyalty,
and attracting the customers of other conventional banks.
Sr. Management of conventional banks are realizing that if they do not enter into this high
potential and expanding market, they will be left behind.

5. The Best Investment Opportunity:

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 For conventional banks, Islamic Banking will be an investment with one of the highest possible
returns.

6. It’s Already too Late:

It is already too late for conventional banks, which are not yet in the market, to start Islamic
Banking. Customers already ask how long a bank has been in Islamic Banking and want to
know how experienced they are in the field.

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 Islamic Banking: In Practice
Islamic Banks have come into being since early 70s. There are nearly Islamic banks all over the world,
from Africa, Europe to Asia and Australia, and are regulated even within the conventional banking
system. The whole banking system in Iran has moved over to their Islamic system since the early 80s
and even Pakistan is islamising its banking system. A number of Europe and America banks are now
offering Islamic banking products, not only in Muslim countries, but also in developed markets, such as
UK. The concept is also catching up in Malaysia and Dubai.
The first private interest-free bank, the Dubai Islamic Bank, was also set up in 1975 by a group of
Muslim businessmen from several countries. Two more private banks were founded in 1977 under the
name of Faisal Islamic Bank in Egypt and the Sudan. In the same year the Kuwaiti government set up
the Kuwait Finance House.
However, small scale limited scope interest-free banks have been tried before. One in Malaysia in the
mid-forty and another in Pakistan in the late-fifties. In 1962 the Malaysian government set up the
“Pilgrim’s Management Fund” to help prospective pilgrims to save and profit. The savings bank
established in 1963 at Mit-Ghamr in Egypt was very popular and prospered initially and then closed
down for various reasons. However this experiment led to the creation of the Nasser Social Bank in
1972. Though the bank is still active, its objectives are more social than commercial.
In the ten years since the establishment of the first private commercial bank in Dubai, more than 50
interest-free banks have come into being. Though nearly all of them are in Muslim countries, there are
some in Western Europe as well: in Denmark, Luxembourg, Switzerland and the UK. Many banks were
established in 1983 (11) and 1984 (13). The numbers have declined considerably in the following years.
In most countries the establishment of interest-free banking had been by private initiative and were
confined to that bank. In Iran and Pakistan, however, it was by government initiative and covered all
banks in the country. The governments in both these countries took steps in 1981 to introduce interest-
free banking. In Pakistan, effective 1 January 1981 all domestic commercial banks were permitted to
accept deposits on the basis of profit-and-loss sharing (PLS). New steps were introduced on 1 January
1985 to formally transform the banking system over the next six months to one based on no interest.
From 1 July 1985 no banks could accept any interest bearing deposits, and all existing deposits became
subject to PLS rules. Yet some operations were still allowed to continue on the old basis. In Iran, certain
administrative steps were taken in February 1981 to eliminate interest from banking operations. Interest

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on all assets was replaced by a 4 percent maximum service charge and by a 4 to 8 percent ‘profit’ rate
depending on the type of economic activity. Interest on deposits was also converted into a ‘guaranteed
minimum profit.’ In August 1983 the Usury-free Banking Law was introduced and a fourteen-month
change over period began in January 1984. The whole system was converted to an interest-free one in
March 1985.

The last decade

The subject matter of writings and conferences in the eighties have changed from the concepts and
possibilities of interest-free banking to the evaluation of their performance and their impact on the rest
of the economy and the world. Their very titles bear testimony to this and the places indicate the
worldwide interest in the subject. Conference on Islamic Banking: Its impact on world financial and
commercial practices held in London in September 1984, Workshop on Industrial Financing Activities
of Islamic Banks held in Vienna in June 1986, International Conference on Islamic Banking held in
Tehran in June 1986, International Conference on Islamic Banking and Finance: Current issues and
future prospects held in Washington, D.C. in September 1986, Islamic Banking Conference held in
Geneva in October 1986, and Conference ‘Into the 1990’s with Islamic Banking’ held in London in
1988 belong to this category. The most recent one is the Workshop on the Elimination of Riba from the
Economy held in Islamabad in April 1992.
Several articles, books and Ph.D. theses have been written on Islamic Banking during this period.
Special mention must be made of the work by M. Akram Khan in preparing annotated bibliographies of
all published (and some unpublished) works on Islamic Economics (including Islamic Banking) from
1940 and before. It is very useful to students of Islamic Economics and Banking, especially since both
English and Urdu works are included (1983, 1991, 1992). M.N. Siddiqi’s bibliographies include early
works in Arabic, English and Urdu (1980, 1988). Turkish literature is found in Sabahuddin Zaim
(1980).
In India, though there is no full-fledged Islamic bank, there are many non-banking financial
intermediaries in Mumbai and Banglore operating in Islamic principles. There presence in the form of
co-operatives parts of the country has been thee before independence. The Reserve bank of India has
recently appointed a committee headed by a chief general manager to look into the prospects of
introducing certain Islamic products in Indian banks. What is unique is that the products are structured
according to norms prescribed in the ‘shariah.

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 Conceptual Framework of Islamic
Banking

Services

Modes of
Deposit accounts financing Bill
Money
Transfers Collections

Trades in Forex at
Current accounts
Savings accounts Spot exchange rate
Investment account

Investment financing
Trade
financing Lending

Loans with a
Trade
Musharaka service charge Overdrafts
Estimated ratefinancing
of return
Mudarabha
No-cost loans

Mark-up
Leasing Hire-purchase Sell-and-buy-back Letters of Credit

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 CURRENT PRACTICES

Generally speaking, all interest-free banks agree on the basic principles. However, individual banks
differ in their application. These differences are due to several reasons including the laws of the
country, objectives of the different banks, individual bank’s circumstances and experiences, the need to
interact with other interest-based banks, etc. In the following paragraphs, we will describe the salient
features common to all banks.

1 Deposit accounts
All the Islamic banks have three kinds of deposit accounts: current, savings and investment.

Current accounts
Current or demand deposit accounts are virtually the same as in all conventional banks. Deposit is
guaranteed.

Savings accounts
Savings deposit accounts operate in different ways. In some banks, the depositors allow the banks to use
their money but they obtain a guarantee of getting the full amount back from the bank. Banks adopt
several methods of inducing their clients to deposit with them, but no profit is promised. In others,
savings accounts are treated as investment accounts but with less stringent conditions as to withdrawals
and minimum balance. Capital is not guaranteed but the banks take care to invest money from such
accounts in relatively risk-free short-term projects. As such lower profit rates are expected and that too
only on a portion of the average minimum balance on the ground that a high level of reserves needs to
be kept at all times to meet withdrawal demands.

Investment account
Investment deposits are accepted for a fixed or unlimited period of time and the investors agree in
advance to share the profit (or loss) in a given proportion with the bank. Capital is not guaranteed.

2 Modes of financing
Banks adopt several modes of acquiring assets or financing projects. But they can be broadly
categorized into three areas: investment, trade and lending.

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Investment financing
This is done in three main ways:
a) Musharaka where a bank may join another entity to set up a joint venture, both parties
participating in the various aspects of the project in varying degrees. Profit and loss is shared in a
pre-arranged fashion. This is not very different from the joint venture concept. The venture is an
independent legal entity and the bank may withdraw gradually after an initial period.
b) Mudarabha where the bank contributes the finance and the client provides the expertise,
management and labor. Both the partners in a pre-arranged proportion share profits, but when a loss
occurs the total loss is borne by the bank.
c) Financing on the basis of an estimated rate of return. Under this scheme, the bank estimates the
expected rate of return on the specific project it is asked to finance and provides financing on the
understanding that at least that rate is payable to the bank. (Perhaps this rate is negotiable.) If the
project ends up in a profit more than the estimated rate the excess goes to the client. If the profit is
less than the estimate the bank will accept the lower rate. In case a loss is suffered the bank will
take a share in it.

Trade financing
This is also done in several ways. The main ones are:
a) Mark-up where the bank buys an item for a client and the client agrees to repay the bank the
price and an agreed profit later on.
b) Leasing where the bank buys an item for a client and leases it to him for an agreed period and at
the end of that period the lessee pays the balance on the price agreed at the beginning an
becomes the owner of the item.
c) Hire-purchase where the bank buys an item for the client and hires it to him for an agreed rent
and period, and at the end of that period the client automatically becomes the owner of the item.
d) Sell-and-buy-back where a client sells one of his properties to the bank for an agreed price
payable now on condition that he will buy the property back after certain time for an agreed
price.
e) Letters of creditwhere the bank guarantees the import of an item using its own funds for a client,
on the basis of sharing the profit from the sale of this item or on a mark-up basis.

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Lending
Main forms of Lending are:
a) Loans with a service charge where the bank lends money without interest but they cover their
expenses by levying a service charge. This charge may be subject to a maximum set by the
authorities.
b) No-cost loans where each bank is expected to set aside a part of their funds to grant no-cost loans to
needy persons such as small farmers, entrepreneurs, producers, etc. and to needy consumers.
c) Overdraftsalso are to be provided, subject to a certain maximum, free of charge.

3 Services
Other banking services such as money transfers, bill collections, trades in foreigncurrencies at spot rate
etc. where the banks own money is not involved are provided on a commission or charges basis.
TABLE 1. ISLAMIC MODES OF FINANCING

TYPE DESCRIPTION COMMENTS

PLS Modes Profit and loss sharing At the core of Islamic
modes banking
Mudaraba Trustee finance contract Three conditions need to
The bank provides the entire be met:
capital needed for financing
a project, while the 1. The bank should not
entrepreneur offers his labor reduce credit risk by
and expertise. The profits requesting a collateral to
(or losses) from the project this purpose: it bears
are shared between the bank entirely and exclusively
and the entrepreneur at a the financial risk.
certain fixed ratio. Financial Collateral may be
losses are borne exclusively requested to help reduce
by the bank. The liability of moral hazard, e.g., to
the entrepreneur is limited prevent the entrepreneur
only to his time and efforts. from running away.
However, if the negligence
or mismanagement of the 2. The rate of profit has to
entrepreneur can be proven be determined strictly as a
he may be held responsible percentage and not as a
for the financial losses lump sum.
incurred.
8. The entrepreneur has the
absolute freedom to
It is usually employed in manage the business.

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 TYPE DESCRIPTION COMMENTS
investment projects with The bank is entitled to
short gestation periods and receive from the
in trade and commerce. entrepreneur the principal of
the loan at the end of the
period stipulated in the
It affects both assets and contract, if an only if a
liabilities sides of banks* surplus exists. If the
balance sheet. On the enterprise' s books show a
liabilities side, the contract loss, this will not constitute
between the bank and default on the part of the
depositors is known as entrepreneur, except for
unrestricted Mudaraba negligence or
because depositors agree mismanagement.
that their funds be used by
the bank, at its discretion, to
finance an open-ended list of
profitable investment and
expect to share with the
bank the overall profits
accruing to the bank's
business. On the assets side,
the contract between the
bank and the agent-
entrepreneur is known as
restricted Mudaraba because
the bank agrees to finance a
specific project carried out
by a specific agent
entrepreneur and to share the
relative profits according to
a certain percentage.

Musharaka Equity participation Banks can exercise the

contract voting rights corresponding
to their share of the firm's
The bank is not the sole equity capital. Their
provider of funds to finance representatives can sit on
a project. Two or more the firm's board of directors.
partners contribute to the
joint capital All parties invest in varying
of an investment proportions, and have the
right to participate in the
Profits (and losses) are management of the
shared strictly in relation to enterprise.
the respective capital

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 TYPE DESCRIPTION COMMENTS
contributions.

It is usually employed to
finance long-term
investment projects.

Muzar' ah Traditional counterpart of the

Mudaraba contracts in farming.
The harvest is shared
between the bank and the
entrepreneur. The bank may
provide funds or land.
Musaqat Traditional counterpart of the
Musharaka contracts in orchard
keeping.

The harvest is shared among

the partners based on their
respective contributions.
Direct investment The same concept as in Banks can exercise the
voting rights corresponding
conventional banking. The
to their share of the firm's
bank cannot invest in the equity capital: Their
representatives can sit on
production of goods and
the firm's board of directors.
services, which contradict
the value pattern of Islam,
such as gambling.

ISLAMIC MODES OF FINANCING (CONCLUDED)

Non-PLS Modes Non Profit and loss sharing They are used in cases
modes where PLS modes cannot be
implemented, for example
in cases of small-scale
borrowers or for
consumption loans.
Qard al-Hasanah Beneficence loans

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 These are zero-return loans
that the Quran exhorts
Muslimsto make to 'those
who need them." Banks are
allowed to charge the
borrowers a service fee to
cover the administrative
expenses of handling the
loan, provided that the fee is
not related to the amount or
maturity of the loan.
Bai'Mua'jja Deferred payment sales
The seller can sell a product
on the basis of a deferred
payment in installments or
in a lump sum payment.
The price of the product is
agreed upon between the
buyer and the seller at the
time of the sale and cannot
include any charge for
deferring payments.
Bai' Salam or Purchase with deferred
Bai' Salaf delivery
. closely associated with risk
The buyer pays the seller
the full-negotiated price of a
product that the seller
promises to deliver at a
future date. This mode only
applies to products whose
quality and quantity can be
fully specified at the time
the contract is made.
Usually, it applies to
agricultural or
manufactured products.
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Contrary to contracts based
on the PLS principal, modes
such as markup, leasing,
and lease purchase has a
predetermined and fixed
rate of return and is
associated with collateral.
In fact, banks add a certain
percentage to the purchase
price and/or additional costs
associated with these
transactions as a profit
margin, and the purchased
assets serve as a guarantee.
Additionally, banks may
require the client to offer
collateral.
These instruments can be
considered to be more
aversion and they do not
substantially differ from
those used in a conventional
banking system, other than
in their terminology and in
some legal technicalities.
They are considered to
conform to Islamic
principles because the rate
of return is meant to be tied
to each transaction, rather
than to the time dimension.
However, some Muslim
scholars advocate a stricter
 utilization of such a modes
Ijara Lease purchase.
Ijarawaiqtina' A party leases a particular
product for a specific sum
and a specific period of
time. In the case of a lease-
purchase, each payment
includes a portion that goes
toward the final purchase
and transfer of ownership of
the product.
Murabaha Mark-up.
The seller informs the buyer
of his cost of acquiring or
producing a specified
product; then profit margin
(or mark-up) is negotiated
between the buyer and the
seller. The total cost is
usually paid in installments.
Jo'alah Service Charge.
A party undertakes to pay
another party a specified
amount of money as a fee
for rendering a specified
service in accordance to the
terms of the contract
stipulated between the two
parties. This mode usually
applies to transactions such
as consultations and
professional services, fund
placements, and trust
services.

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 SHORTCOMINGS IN CURRENT PRACTICES
In the previous section we listed the current practices under three categories: deposits, modes of
financing (or acquiring assets) and services. There seems to be no problems as far as banking services
are concerned. Islamic banks are able to provide nearly all the services that are available in the
conventional banks. The only exception seems to be in the case of letters of credit where there is a
possibility for interest involvement. However some solutions have been found for this problem --
mainly by having excess liquidity with the foreign bank. On the deposit side, judging by the volume of
deposits both in the countries where both systems are available and in countries where law prohibits any
dealing in interest, the non-payment of interest on deposit accounts seems to be no serious problem.
Customers still seem to deposit their money with interest-free banks.
The main problem, both for the banks and for the customers, seems to be in the area of financing. Bank
lending is still practiced but that is limited to either no-cost loans (mainly consumer loans) including
overdrafts, or loans with service charges only. Both these types of loans bring no income to the banks
and therefore naturally they are not that keen to engage in this activity much. That leaves us with
investment financing and trade financing. Islamic banks are expected to engage in these activities only
on a profit and loss sharing (PLS) basis. This is where the banks’ main income is to come from and this
is also from where the investment account holders are expected to derive their profits. And the latter is
supposed to be the incentive for people to deposit their money with the Islamic banks. And it is
precisely in this PLS scheme that the main problems of the Islamic banks lie. Therefore we will look at
this system more carefully in the following section.

Problems in implementing the PLS scheme

There are four main areas where the Islamic banks find it difficult to finance under the PLS scheme: a)
participating in long-term low-yield projects, b) financing the small businessman, c) granting non-
participating loans to running businesses, and d) financing government borrowing. Let us examine them
in turn.

1 Long-term Projects
The banks are unable or unwilling to participate in long-term projects. This is a very unsatisfactory
situation.

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 The main reason of course is the need to participate in the enterprise on a PLS basis which involves
time consuming complicated assessment procedures and negotiations, requiring expertise and
experience. The banks do not seem to have developed the latter and they seem to be averse to the
former. There are no commonly accepted criteria for project evaluation based on PLS partnerships.
Each single case has to be treated separately with utmost care and each has to be assessed and
negotiated on its own merits. Other obvious reasons are: a) such investments tie up capital for very
long periods, unlike in conventional banking where the capital is recovered in regular installments
almost right from the beginning, and the uncertainty and risk are that much higher, b) the longer the
maturity of the project the longer it takes to realize the returns and the banks therefore cannot pay a
return to their depositors as quick as the conventional banks can. Thus it is no wonder that the banks
are averse to such investments.

2 Small Businesses
Small-scale businesses form a major part of a country’s productive sector. Besides, they form a
greater number of the bank’s clientele. Yet it seems difficult to provide them with the necessary
financing under the PLS scheme, even though there is excess liquidity in the banks. The
observations of Iqbal and Mirakhor is revealing:

Given the comprehensive criteria to be followed in granting loans and monitoring their use by
banks, small-scale enterprises have, in general encountered greater difficulties in obtaining
financing than their large-scale counterparts in the Islamic Republic of Iran. This has been
particularly relevant for the construction and service sectors, which have large share in the gross
domestic product (GDP). The service sector is made up of many small producers for whom the
banking sector has not been able to provide sufficient financing. Many of these small producers,
who traditionally were able to obtain interest-based credit facilities on the basis of collateral, are
now finding it difficult to raise funds for their operations.

3 Running Businesses
Running businesses frequently need short-term capital as well as working capital and ready cash for
miscellaneous on-the-spot purchases and sundry expenses. This is the daily reality in the business
world. Very little thought seems to have been given to this important aspect of the business world’s
requirement. The PLS scheme is not geared to cater to this need. Even if there is complete trust and

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 exchange of information between the bank and the business it is nearly impossible or prohibitively
costly to estimate the contribution of such short-term financing on the return of a given business.
Neither is the much-used mark-up system suitable in this case. It looks unlikely to be able to arrive
at general rules to cover all the different situations.

Added to this are the delays involved in authorizing emergency loans. One staff member of the
Bank of Industry and Mines of Iran has commented:

Often the clients need to have quick access to fresh funds for the immediate needs to prevent
possible delays in the project’s implementation schedule. According to the set regulations, it is not
possible to bridge-finance such requirements and any grant of financial assistance must be made on
the basis of the project’s appraisal to determine type and terms and conditions of the scheme of
financing.

The enormity of the damage or hindrance caused by the inability to provide financing to this sector
will become clear if we realize that running businesses and enterprises are the mainstay of the
country’s very economic survival.

4 Government Borrowing
In all countries the Government accounts for a major component of the demand for credit -- both
short-term and long-term. Unlike business loans these borrowings are not always for investment
purposes, or for investment in productive enterprises. Even when invested in productive enterprises
they are generally of a longer-term type and of low yield. This latter only multiplies the difficulties
in estimating a rate of return on these loans if they are granted under the PLS scheme. In Iran,

... It has been decreed that financial transactions between and among the elements of the public
sector, including Bank Markazi

[the central bank] and commercial banks that are wholly nationalized, can take place on the
basis of a fixed rate of return; such a fixed rate is not viewed as interest. Therefore the
Government can borrow from the nationalized banking system without violating the Law.

While the last claim may be subject to question, there is another serious consequence:

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 Continued borrowing on a fixed rate basis by the Government would inevitably index bank
charges to this rate than to the actual profits of borrowing entities.

COMPARISON OF BANKING FRAMEWORKS

Characteristics Islamic Banking Conventional Banking
Paradigm Version of

Nominal value guarantee of:

Demand deposits Yes

Investment deposits No Yes
Yes
Equity-based system where Yes No
capital is at risk

Rate of return on deposits Uncertain, not guaranteed

Certain and guaranteed
Mechanism to regulate final Depending on banks' Irrespective of banks'
returns on deposits performance performance /profits from
/profits from investment investment

PLS principle is applied Yes No

Use of Islamic modes of

financing:

PLS and non-PLS modes Yes N/A

Use of discretion by banks Possible for reducing moral

with regard to collateral hazard in PLS modes

Yes in non-PLS modes Yes always

Banks' pooling of Yes No

depositors' funds to provide
depositors with professional
investment management.

There are several points that are worth noting. First, Islamic banks guarantee neither the capital value of
nor the return on investment deposits, and these banks basically pool depositors' funds to provide

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depositors with professional investment management. This situation underscores an interesting
similarity between the operation of Islamic banks and investment companies. There is, however, a
fundamental difference between the two thatneeds to be recognized. It lies in the fact that investment
companies sell their capital to the public, while Islamic banks accept deposits from the public. This
implies that shareholders of an investment company own a proportionate part of the company's equity
capital and are entitled to a number of rights, including receiving a regular flow of information on
developments of the company's business and exerting voting rights corresponding to their shares on
important matters, such as changes in investment policy. Hence, they are in a position to take informed
investment decisions, monitor the company's performance, and influence strategic decisions. By
contrast, depositors in an Islamic bank are entitled to share the bank's net profit (or loss) according to
the PLS ratio stipulated in their contracts. Investment deposits cannot be withdrawn at any time, but
only on maturity and, in the best case, at par value. Moreover, depositors have no voting rights because
they do not own any portion of the bank's equity capital. Hence, they cannot influence the bank's
investment policy
(As noted, their relationship with the bank is regulated according to an unrestricted Mudaraba contract,
see Table 1). Second, because of the structure of their balance sheets and the use of profit and loss
sharing arrangements, banks operating according to a paradigm version of Islamic banking appears to
be better poised than conventional banks to absorb external shocks. Indeed, as noted previously, these
Islamic banks have the ability to reduce the capital value of investment deposits in the case of a loss.
Third, Islamic banks are not expected to reduce credit risk by systematically requiring collateral or other
guarantee as a pre-requisite for granting PLS facilities. Fourth, a critical difference between the two
permissible systems of operation needs to be recognized. Islamic banks can use all of their deposits
(demand and investment) for their financing and investment activities in Scheme A, while only
investment deposits can be utilized for such purposes in Scheme B. This makes Scheme A, where
banks' assets and liabilities are fully integrated far riskier than Scheme B, where banks' liabilities are
divided into two windows. Indeed, in Scheme A—given the fact that
(1) Demand deposits are guaranteed in capital value and are redeemable by the depositors on demand.
(2) There is not a mandated specific reserve requirement on demand and investment deposits—an
asset-liability mismatch can occur, leading possibly to negative net worth, or bank insolvency.

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 BANKING REGULATIONS AND ISLAMIC BANKS
IN INDIA: STATUS AND ISSUES

Financial system consisting of financial institutions, financial instruments and financial markets provide
an effective payment and credit supply network and thereby assists in channeling of funds from the
savers (surplus sector) to the investors (deficit sector) in the economy. The task of the financial
institutions or financial intermediaries is to mobilize the savings and ensure efficient allocation of these
savings to high yielding investment projects so that they are in a position to offer attractive returns to
the savers. Non-banking financing companies which work on profit/ loss basis also play an important
role in mobilizing savings and allocate them to productive uses.
According to Islamic principles, interest on borrowing as well as on lending or deposit mobilization is
prohibited and the economic agents as a make investment in financial assets and participate in financing
of real assets on profit and loss basis.
There is a general apprehension about the applicability of profit and loss (interest free) banking in the
economic system. The common question, which is generally raised, is as how the financial system can
operate without interest? The savers in the economy need reward for parting their savings to deficit
units in the economy. According to classical school, interest rate represents the rate of exchange
between present and future goods. The rate of interest signifies the price of a loan of present money in
return for a promise to repay future money. Since the interest is the price of credit, the factors
determining interest rate are rather naturally analyzed in terms of demand and supply of loan able funds.
This school of thought uses productivity and thrift and interest rate as corner stone of theory of finance.
Interest rate does every thing to encourage savings and stimulate demand for savings. This concept is
apparently not compatible with the philosophy of profit and loss based on supply of savings and
demand for it. Another equally important school founded by Keynes has shown some reservations for
the above theory. Keynes insisted that as savings and investment varied directly with the level of
income and in turn they determine extent of aggregate demand and thereby level of income. Thus
interest rate is not a factor in determining economic activity.
It is the profit or loss, which guides economic process. Even in a monetary framework in free market
economy, the banks or the lenders do not determine interest rate independently. They have to keep in
mind demand for funds and supply of funds with them.

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On the other hand expected rate of profit which can be made by the employment of capital and which is
totally independent of the quantity or the volume of the money influences the interest rate structure. If
the profit rate is expected to be lower in future then the existing lending rates, demands for funds
decline and as a result banks have to adjust their lending rates downward depending on the credit rating
of the borrowers. Thus it is the profit and loss and not the interest rate, which determines the demand
for finance and growth of investment and size and degree of other economic activities. Economists on
Islamic financial system have argued that it is an error of modern theory to treat the entrepreneur and
user of funds the second rate citizen and rate financial institutions as the first class citizens working as
locomotive for development and growth. There is a view that finance is not a capital, it is only potential
capital and requires the service of the entrepreneur to transform it into real assets for actual productive
use. The lender has nothing to do with the conversion of money into capital and with using it
productively. The whole risk is thus bond by the user of finance.

In such a system, resource mobilization or creation of liabilities by the Islamic banks on the one hand
and utilization of these resources or financing of assets of other entities by Islamic banks on the other
hand assumes importance. The bulk of liabilities of Islamic banks can be decomposed into current and
investment deposits. The banks guarantee the nominal value of current deposits. In Malaysia, principle
of Al Wadiah (trusteeship) is used for mobilization of demand and saving deposits. These deposits do
not receive any return as banks provide transaction facilities. Investment deposits are accepted on the
basis of Al Mudharabah (trustee profit sharing). In Malaysia, Pakistan and Iran profits are shared
between the depositors and banks. In Pakistan, investment depositors get return on the basis of profits
earned from the projects financed by their deposits. At the same time, the investment account holders or
long term depositors (Malaysia) bear part of the losses if the investment made by the banks is not
profitable. On the assets side, different principles are used for different kinds of financial facilities
offered to customers. For project financing, the principles of Al Mudharabah or Musharakah
(partnership or joint venture with profit sharing) are used. The former works in a manner used in the
case of investment deposits. In this, bank provides the entire capital and the borrower, often an
entrepreneur, provides the management services. The profits shared accordingly to an agreed proportion
while the loss is borne by the bank alone. Under the model of Musharakah, the bank shares the cost of
project with the entrepreneur based on an agreed proportion basis and both parties have the right to

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participate in the management of the projects. The profit from the project is distributed according to an
agreed ratio, which is not necessarily the same as the share in the cost.

As the sharing of risk and loss is the fundamental principle in Islamic banking, model of banking
system provides for accumulation by the banks for loss compensating balances during the phases of
high profits as well as for deposit insurance, asset diversification and monitoring of project to reduce
the risk borne by the investment depositors (long term depositors).

Banking Regulations in India

Now I turn to banking regulations in India briefly and then take up the case of Islamic banks (non-
banking financial companies) working in the country. Indian banks are governed under the Banking
Regulation Act 1949, Reserve Bank of India Act 1934, Negotiating Instruments Act and Co-Operative
Society Act. Banking regulations provide working framework for banking companies, which accept
deposits from public for lending or investment. The deposits are withdrawable on demand or after a
fixed maturity period. Banks’ provide cheque facility, drafts etc. and generates deposits through deposit
multiplier. Thus they create money supply and add to monetary liabilities in the system. Indian banks
have been subjected to a number of banking regulations and guidelines as prescribed by the RBI. Banks
in India have to maintain cash reserves ratio (8.5 per cent at present) of which 3 per cent does not get
interest and remaining 5.5 per cent get interest at the rate of 4 per cent per annum. Statutory Liquidity
Ratio (SLR) is another important condition to be met by the banks. Liquidity assets comprise
investment by the banks in central government securities and other approved securities, which earn
market-determined interest. The Central Bank uses CRR and SLR as instruments of monetary control.
The RBI has used CRR frequently to control the monetary liquidity in the economy. The Central Bank
has used Bank Rate to encourage or discourage bank credit demand in the economy. The above
instruments cannot be used for Islamic banks, as they do not function on the basis of interest. Other sets
of conditions which banks have to meet are capital adequacy, assets classification, provisioning for bad
debts and income recognition norms. Minimum capital base for a bank is Rs.200, which will get raised
to Rs.300 crore and further to Rs.500 crore.

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The issue No.1 which is a permanent eye sore for Islamic banks operating in the countries with interest
based banking is that they cannot function as banks unless powers of issuing cheques are given to them.
They cannot be members of settlement / clearing house unless they accept two conditions regarding
their liabilities and assets like conventional banks who have to keep fractional cash reserve with the
Central Bank and statutory liquid assets in their assets. Thus banks in India have to maintain deposit
account with the Central Bank over which they get interest. The SLR includes Government and
approved securities. A bank licensed by the RBI becomes the part of monetary system, which means it
can create money by deposit generation through deposit acceptance.

Since these assets are interest based, Islamic bank cannot hold them. Consequently, the Central Bank
cannot act as the lender of last resort because such accommodation by the monetary authority is also
interest based. Islamic banks cannot inter-act with conventional banks based on principles of interest. A
silver lining, which is emerging today, is that banks are being subjected to prudential norms, cash
reserve ratio and statutory liquidity ratio . However, statutory liquidity ratio and cash reserve ratio has
been reduced. Interest rate has been decontrolled.
Interest on cash reserves has been substantially reduced.

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Islamic Banks (Non-Banking Financing Companies) in India and RBI
Regulations

Islamic Banks (Non-Banking Financing Companies) in India and RBI Regulations Islamic banks in
India do not function under banking regulations. They are licensed under Non Banking Finance
Companies Reserve Bank Directives 1997 RBI (Amendment) Act 1997, and operate on profit and loss
based on Islamic principles. RBI has introduced compulsory registration system. Only those NBFCs
which have net owned funds equivalent to Rs.50lakhs and above can be registered with the RBI with
the minimum capital of Rs.25 lakhs. Subsequently, in the Monetary and Credit Policy for the year 1999-
2000, it was proposed that in respect of new NBFCs, which seek registration with the Reserve Bank and
commence the business on or after April 21, 1999, the requirement of minimum level of net owned
funds (NOF) will be Rs.2 crore. The RBI (Amendment) Act, 1997 has been the most recent effort to
address the issue of laying down a comprehensive framework for regulating the NBFCs. Exercising the
powers derived under the amended Act, a set of regulatory and supervisory measures was announced by
the Reserve Bank in January 1998. The broad thrust of the new Act has been to provide a greater degree
of comfort and safety to depositors, while, at the same time, fostering the development of a healthy and
diversified financial sector.

Accordingly, entry-level norms for new and existing NBFCs have been laid down. Among the various
measures introduced are compulsory registration of NBFCs engaged in financial inter mediation,
prescription of minimum level of (NOF), maintenance of certain percentage of liquid assets as percent
of public deposits in government bonds, creation of reserve fund and transfer thereto every year a
certain percentage of profits to reserve fund. The regulations also provide for measures like credit rating
for deposits, capital adequacy, income recognition, asset classification, compulsory credit rating
provision for bad and doubtful debts, exposure norms and other measures to keep a check on their
financial solvency and financial reporting. While the regulatory framework has been dovetailed
primarily towards NBFCs accepting / holding public deposits, the supervisory mechanism for NBFCs is
based on three criteria viz. (a) the size of the NBFC, (b) the type of activity performed, and (c) the
acceptance or otherwise of public deposits. Towards this end, a four-pronged supervisory setup
consisting of on-site inspection, off-site surveillance, exception reporting by NBFCs’ statutory auditors
and market intelligence system has been instituted. The NBFCs have also been directed to constitute

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audit committee, consisting of not less than their members of their Board of Directors, if the deposits
exceeds Rs.50 crore. They have been required to follow a uniform accounting.

There are several Baitul Mals working in cities as well as in villages. Only 10 to 15 Islamic banks with
deposits of about Rs. 75 crore operating all over the country in various states. They are actually Non-
Banking Finance Companies, which work on profits/ loss basis. Islamic banks by and large cater to the
needs of local area except a few of them operating across districts or states. Their sources of funds are
limited and as a result these banks have to operate on small scale missing the economies of scale.
Islamic banks in India provide housing loan, on the basis of co-ownership, venture finance on
Mudarabha basis as well as on Musharaka basis and consumers loans. Some banks finance transports
also on the mark up basis via hire purchase. Education finance and skill development finance is also
provided by them. Investments are made in government securities, small savings schemes or units of
mutual funds. Investment in shares of companies is also made by some Islamic banks. Hire purchase
and lease finance is other source of investment.

Islamic banks as referred to in the preceding paragraph face resource constraints and has narrow
financing avenues. Their capital base is small and weak. In order to overcome these problems they can
diversify into equity based financing and resource raising can be done through issue of equity shares.
Islamic banks in India can offer their assets portfolios of primary securities in the form of open ended
mutual funds units / shares for sale to investors. Islamic banks can be identical to open ended mutual
funds that hold only traded on-interest bearing assets. The shares / units of these banks can be used as a
transaction medium because investors can withdraw / transfer / sell such units / shares. The units can be
listed on the stock exchange also and their value can be ascertained in the market. It is perhaps worth
emphasizing that for Islamic banks, resource mobilization and investment through units or equity, need
well functioning equity exchanges market without any tax or penalty on frequent trading. An important
development in Indian financial market is the emerging and widening strong capital market with a
broad-based regulatory system in favor of investors. Now Islamic banks can use two way route they can
mobilize capital resources by issuing equity shares and can invest in equities of corporate and financial
institutions. The setting up of mutual funds is another important route. Islamic banks can float mutual
funds schemes offering dividend on units and these funds can be invested in corporate shares.

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However, Islamic banks functioning on profit-loss basis have developed knowingly or unknowingly a
number of deficiencies. First, they have not developed adequate internal control system; as a result their
accounting system is not very transparent. You may be aware that transparency is the directive of Islam.
A number of times they are not able to follow the directives of regulatory authorities pertaining to
deposit acceptance from public. For instance, they hardly go for credit rating. They are not submitting
required information and data to Reserve Bank of India. Their monitoring system warrants appointment
of technical people familiar with reporting system. It is also observed those accounting practices needs
to be learned by the officials of these banks.
Lack of skilled staff, professionals and infrastructure frustrate their effort to expand and enlarge their
operations. There has been very little effort to provide training facilities. However, there is good news
that government would be permitting NBFCs to accept foreign share holdings even on foreign
partnership basis up to 100 per cent. This relaxation will enable Islamic banks to augment their
resources through foreign holding by foreign investors, consolidate and formalize their operations.
Foreign partners bring with them improved standard of disclosures and better management practices.

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COMPARATIVE ANALYSIS OF ISLAMIC BANKING AND INTEREST BASED
BANKING

There are several benefits of equity based or profit / loss based Islamic banks. The virtues of equity
based banks are more obvious, when we compare them with conventional interest based banks. The
conventional banks are prone to runs; such runs may bring commerce to halt when the banks’ deposits
are the main transaction medium As bulk of their liabilities are fixed in nominal value and are payable
on demand, when bank’s assets which are not liquid or tradable, fall in value due to bad debts or non
performing assets, all the deposits of banks can not be repaid. Even rumors are enough to liquidate the
banks. To summarize, banks’ assets are illiquid and deposit liabilities are fixed in value and can be
withdrawn / converted into other assets of equal value at will. If the run on deposits is high, the banks
need lender of last resort to ensure continued refinance facility. Such help encourages banks to
undertake risky ventures and builds up inflation in the economy. As regards Islamic banks with equity
based resources and assets, need not fear of run on them because holdings of units /shares can be en-
cashed in the market. Here I have made a strong assumption that Islamic banks can develop their own
efficient exchange market.
In Islamic financial system, return to banks liabilities is a direct function of the return to their assets as
several assets are created as partnership contracts. The banks can sell their assets or partnership
contracts. Since the securities markets are becoming efficient and safe, and disclosure norms,
monitoring of banks or firms issuing equity, margins on trading, investors protection norms, settlement
procedures, improved credibility of documents and settlements are being introduced, the equity
investment in corporate has become safe. Islamic banks can invest in corporate equities. Now firms
have to improve their performance in order to be successful in mobilization of resources through issue
of equity. This is not in the case of interest based lending without improving their financing; the
entrepreneurs can borrow huge amounts and divert them to undesirable activities. Interest based banks
suffer from adverse selection weakness. There can be one danger for Islamic banks based on equity
resources / investments or listed equity investment that equity prices may fluctuate. In the phases of rise
in equity prices, there may not be any problem but during the phase of down turn, the Islamic banks
may face fall in the value of investment. These banks will have to adopt the technique of “Mark to
Market”. They may also set up “Risk Funds” to compensate fall in net worth. The investment of

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resources by Islamic banks also can get investors protection environment. A firm issuing equity should
undergo full appraisal of its performance and program and has to obtain credit rating from a credit
rating agency before coming in the market. Islamic banks can invest their resources in these equities. In
a way equity based financing can improve debit equity ratio of companies. More-over, equity based
financing has been considered superior to interest based financing. Besides the institutional advantage
of Islamic banking and financial system as analyzed above, there are social virtues, which occur to the
society.
First we can take deficit financing of Government. Government borrows from the market as well as
from Central Bank of the country. These borrowings are done without having any relation with the level
assets to be created. As such they are inflationary and unproductive, whereas in Islamic system,
Government can not borrow without having partnership of the lender in the assets or projects being
financed with the respective borrowings. As Islamic system would encourage capital formation by the
Government at a higher rate than the interest based borrowings by the Government, there would be a
direct benefit to the society through higher investment, higher growth and more employment. Since
Islamic financing is based on partnership, one has to dispose off the goods or inventories financed, no
one can accumulate the inventories beyond the contract - period with the financing banks.
Islamic banking can eliminate unaccountable economic activities, as every economic activity has to be
financed through legal contract and physical verification of real assets under contract. There is no room
for diversion of funds.
Government borrowings also lead to high interest liabilities, which have to be paid by taxing the people.
It is common knowledge that when Government is run by politicians, they have tendency to resort to
large borrowings and spent the same unproductively with no additional real capacity creation in the
economy. There are losses and losses to be financed by further borrowings. This has resulted in
deprivation of private sector from financial resources. Government borrowings can be project based by
promoting joint ventures between Government and Islamic banks. Islamic banks can participate in India
on “Build, own, operate and transfer” basis.

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ISSUES AND CONSTRAINTS OF ISLAMIC BANKS
As regards partnership by Islamic banks in a firm, the banks has to make sure that the manager does not
shirk his responsibilities or obtain other non-pecuniary benefits at the expense of non-participating
partners and (2) ensure the veracity of the profit statements. This type of monitoring of facts and data on
firms in which Islamic bank invests, could be expensive. Islamic banks, however, need to set up
monitoring cell to keep them informed of the internal function of their joint venture, which they are
financing through partnership. The implication is that banks and entrepreneur have to function very
closely.

For long term investment, Islamic banks should take position only after the technical, economic and
financial viability has been examined and appraised. A professionally equipped Islamic bank needs to
invest in assets providing a return in excess of the cost of the funds tied up and for this purpose it is
important to ascertain the cost of capital which is equivalent to the required rate of return below which a
company may not undertake investment without prejudicing its present net worth and the wealth of its
owners or equity shareholders.
A second issue, which is just on the horizon, is the scale of operations of Islamic banks. The
globalization of financial markets would warrant merger of small banks to bring into shape a big bank
with modern banking infrastructure. Islamic banks being small in size, can merge together to make a
large bank. The induction of trained and professional staff would be a No.1 necessity. Islamic banks
working today have to examine whether they have standardized their functioning. A highly wanted
assurance for the growth of Islamic banking is the establishment of training institutions in the countries
where they are working. The imparting professional training is costly. In India at least they can pool
funds to set up training institutions.
The last but not the least, particularly in India, Islamic banking has been constantly in short term and
medium term operations though some of them are undertaking long-term finance also. It is understood
that inability to evaluate project profitability has tended to act against investment financing. Some
borrowers frustrate the bank appraisal efforts, as they are not reluctant to provide full disclosures of
their business. Moreover, the borrowers do not observe business ethics, which make it difficult to
establish close bank-clientele relationship - a condition for successful Islamic banking. As a result a
result a number of Islamic banks have been closed during the recent years.

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 SUGGESTIONS
1. Islamic banks can implement prudential norms in order to strengthen their quality of functioning and
capital adequacy and asset up gradation should receive focused attention.

2. They can mobilize resources on the basis of “Mutual Funds” model and investment can be equity
based and partnership - contract based. They can promote inter-Islamic banks trading in “Contracts”. If
Islamic banks can make offer to public through capital issues and get listed on stock exchanges then
capital would become marketable and liquid. Inter-bank lending can be set up on the profit sharing
basis.

3. They can diversify instruments of investment on the lines done in some of the countries.

4. Islamic banks can set up “Risk-Funds” to compensate their shareholders or depositors during the
period of losses. They can declare special dividend.

5. They have to enlarge their scale of operation through mergers and can modernize themselves to
compete with other institutions.

6. They can set up training institutions on Islamic banking and can impart training to borrowers and
other public to increase their clientele.

7. They can earmark some funds to finance poor people and can provide them job training so that
they can create employment for themselves. Such experiments are already being done in Tamil
Nadu by English Missionaries. But assisting poor people is not the only objective, this is one of
the objectives.

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 Methodology

The study is mainly based on the basis of the secondary data. Whatever the primary data was collected,
it was collected through the help of questionnaire and personal interview. A sample of 50 people was
surveyed. The selection of samples was based on convenience and these persons are randomly picked at
Delhi.. The data for this study were collected through self-administered questionnaires. A series of
interview with financial institution senior personnel and customers were also conducted. The
questionnaire contains two sections; the first section was designed together information about the
respondents’ personal and demographic characteristics. The profile of the respondent’s characteristics is
shown in Table.

Table : Respondents’ Characteristics

Age No. of Respondents (%)

21-35 years 26 52
36-55 years 17 34
>56 years 07 14
Gender
Female 17 34
Male 33 66
Employment
Non-executive 05 10
Executive 09 18
Professional 10 20
Student 17 34
Unemployed / Retired 04 08
Others* 05 10

Note:
• - Include schools teachers, businessman, non-officer government employees and
agency, religious worker.

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 % of Respondent
According to Age Group

14
21-35 years
52 36-55 years
34 >56 years

% of Respodents based on
Gender
100 66
34
50
0
Fem ale Male

% of Respodents based on
Employment

40 34
30 20
18
20 10 10
8
10
0
Unemployed
Professional
Executive

Student
executive

Others*
/ Retired
Non-

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In the second section of the questionnaire, the respondents were asked to indicate their
knowledge and understanding of Islamic banking and financial products. The approach
was a straightforward method, which asked the respondent to either answer yes or no.
The results of the second section are shown in Table.

Table : Research Findings

Questions Yes (%) No (%) No Answer (%)

Do you know the existence of Islamic 44 56 00
Banking.
Do you know Islamic banking financial 12 88
products?
Do you know what is Al-Mudarabah? 04 84 12
Do you know what is Al-Musyarakah? 08 90 02
Have you used any Islamic Banking
product?

Do you know about Interest Free 40 60

Banking Scheme (IBS)?
Do you know the difference between 42 48 10
IBS and conventional bank financial
product?

From Table, we found that only 44% respondents knew the existence of Islamic banking.
About 12 percent of the respondent says that they know Islamic banking financial
product, but when asked about the meaning of the products, an average of less than 5%
percent able to answer correctly. The findings also highlighted that even though 40%
percent of respondent knew about the Interest-free Banking Scheme (IBS), but more than
60percent could not differentiate between IBS and conventional bank financial products.
This findings escalate the claim made earlier that the knowledge of Islamic
banking is still very less among the customers.

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 Do yo u know the existence of Islamic
Banking.

Yes (%)
44
No (%)
56 No Answer (%)

From the above chart it is quite clear that only 44% people in India are aware of the concept of Islamic
Banking and these 44% people include students, professional, lecturer and banking persons.

Do you know Islamic banking

financial products?

0 12
Yes (%)
No (%)
88 No Answer (%)

Only 12% people in India are acquaintance of the products, which Islamic banking is offering.
Although 44% people are aware of the concept but only a very few people have very depth knowledge
regarding Islamic Banking.

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 Do you know what is Al
-Mudarabah?

4
12 Yes (%)
No (%)
No Answer (%)
84

Mudarabhawhere the bank contributes the finance and the client provides the expertise, management
and labor. Both the partners in a pre-arranged proportion share profits, but when a loss occurs the total
loss is borne by the bank. from the above diagram it is quite clear that only12% people are aware of this
concept in India.

Do you kn ow what is Al
-Musyarakah?

2
8
Yes (%)
No (%)

90 No Answer (%)

Musharakawhere a bank may join another entity to set up a joint venture, both parties participating in
the various aspects of the project in varying degrees. Profit and loss is shared in a pre-arranged fashion.
This is not very different from the joint venture concept. The venture is an independent legal entity and
the bank may withdraw gradually after an initial period. In India 90% people are not aware of this
concept.

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 Do you know the difference b etween
IBS and conventional bank financial
product?

10
Yes (%)
42 No (%)
No Answer (%)
48

From the above char it is quite clear that only 42% people in India can differentiate between Islamic
banking and conventional banking.10% people did not answer and 44% people, during the survey, were
not able to answer.

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 LIMITATION OF THE STUDY

• The respondents were not fully aware of the concept of the Islamic banking.

• Sometime the respondents were not available or were involved their busy schedule.

• Biases on the part of the respondents also took place.

• Due to the time and financial restriction the study may not give the proper result.

• The authenticity of the secondary data depends on its source.

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 BIBLIOGRAPHY

 News paper: Economic Times

 Business magazines

 Direct interviews

 Personal visits

 www.standardchartered.com.

 http://users.bart.nl/~abdul/chap4.html

 www.misysbanking.com/

 www.islamicfinancetraining.com

 www.irti.org/ru1

 www.nber.com

 www.islamic-net.com

 www.rbi.com

 www.ssrn.com

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 QUESTIONNAIRE

Name: Age:

Occupation:

Q.1 Do you know the existence of Islamic Banking?

Yes No No Answer

Q.2 Do you know Islamic banking financial products?

Yes No No Answer

Q.3 Do you know what is Al-Mudarabah?

Yes No No Answer

Q.4 Do you know what is Al-Musyarakah?

Yes No No Answer

Q.5 Do you know about Interest Free Banking Scheme (IBS)?

Yes No No Answer

Q.6 Do you know the difference between IBS and conventional bank financial product?

Yes No No Answer

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