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*Shariq Nisar, Ph.D. Economics, is Joint Editor Islamic Economics Bulletin, India and
works as consultant. He has worked in the banking sector in various capacities.
E:shariqnisar@yahoo.com; M;91-9980355403
*Syed Kamran Razvi, Legal consultant, and is also Director, Miftah Advisory India P
Ltd. e: skrazvi@gmail.com m:91-9810078799 f: 91-11-41734987 a: Flat No.7,137B/12,
Zakir Nagar, New Delhi-25
Regulating Islamic Finance in Secular Countries:
A Case Study of India
By Dr.Shariq Nisar and Syed Kamran Razvi
ABSTRACT
Indian Muslims have always been trying to manage their economic affairs within the
framework of Shariah. Their struggle against usury practices has been both religious
and financial struggle. This paper aims to highlight the attempts made by Indian
Muslims in this regard and how some of the recent developments since opening of
Banking and financial sectors and FDI cap from 74% to 100% in various categories
of banking and provides opportunity and poses regulatory challenge in establishing
Islamic Finance and Sharia compliant-products affecting their functioning. The paper
focuses on opportunities, events and regulatory changes facilitate and pose new and
additional challenges to new entrants. It examines the potential segments including
NBFCs,FII, Micro Finance and Mutual Funds as new source of proliferation in India
and the regulatory mechanism existing and requisite for functioning at large scale.
The paper also relates the causes of failures in past by the depressed economic
scenario in early 1990s and the highly changing regulatory environment in the late
1990s. Some prominent Islamic NBFCs and new initiatives by UTI and others in
India are taken for detailed case studies to identify the future aspects in the topic of
the paper.
Terms;
Lac: One hundred thousand
Crore: 10 Million.
1: Introduction
Financial arrangements constitute an integral part of the process of economic
development. A growing economy requires a progressively rising volume of savings
and adequate institutional arrangements for the mobilisation and allocation of savings.
These arrangements must not only extend and expand but also adapt to the growing
and varying financial needs of the economy. A well-developed and efficient capital
market is an indispensable prerequisite for the effective allocation of savings in an
economy. A financial system1 consisting of financial institutions, instruments and
markets provides an effective payment and credit supply network and thereby assists
in channeling of funds from savers to the investors in the economy. The task of the
financial institutions or intermediaries is to mobilise the savings and ensure efficient
allocation of these savings to high yielding investment project so that they are in a
position to offer attractive returns to the savers.
1
Annxr.1 to paper
Islam’s teachings are not confined to the religious spheres but extend and
control every aspect of human endeavors including the economic activity. Islam
provides guidelines to regulate the economy and seeks to curb the unbridled race for
material pursuit. Concern for equity and justice, halal and haram and a sense of
responsibility towards the weaker sections of society and the need to share the
economic resources with them, are some of the principles which guide and control the
economic activity in Islam.
Keeping in view the Islamic aspirations, Indian Muslims have always been
trying to manage their economic affairs within the framework of the Shariah. The
present paper seeks to highlight the attempts made by Indian Muslims in this regard
and how some of the later developments in the form of changing regulatory
environment has affected their functioning.
Besides being the world’s second most populous country India also is Asia’s
third largest and one of the fastest growing economy. It has a huge Muslim population
between 150-200 million.2 There are several places where Muslims constitute
majority of the total population (Bagsiraj, 2002). There are a number of industries in
which Muslims traditionally have major stakes3.
Since the last two decades, India has continuously managed an average saving
rate at above 20 percent of the GDP (Bhandari, & Aiyar, 1999, p.29). Considering
their relative economic backwardness even 15 percent saving rates for Muslims would
fetch an enormous amount of annual savings to the community. Besides, there are
properties worth billions of Rupees lying in the form of Awqaf. Zakah potential of the
Indian Muslims still largely remains untapped and under utilized.
4
The Concept of priority sector lending was proposed by Prof. Gadgil Study Group (1967). Later on
the Ghosh Committee (1981) recommended a target of 40 percent of the total credit to priority sector
including 18 percent to Agriculture and 10 percent to weaker section.
5
By the end of 1992-93, 171 Regional Rural Banks out of 196 were loss making.
3: Non-Banking Financial Institutions in India
Non Banking Financial Institutions in India comprise of Non Banking Financial
Companies (NBFCs), Mutual Funds, Insurance Companies and Developmental
Institutions. According to the nature of their business, NBFCs are further classified as
Equipment Leasing (EL), Hire Purchase (HP), Merchant Banking, Investment
Companies, and Mutual Benefits Companies etc.
A new set of companies called the Asset Finance Companies (AFC) has been
added to this classification, these are further sub-divided into those accepting deposits
and not accepting deposits.
Developmental institutions are mainly created to serve special purposes like
agriculture development, investments and export promotion etc. They are mainly
promoted and run by the Government and its maintained institutions. On the other
hand the insurance sector, which has recently been opened for the private sector, is
still beyond the reach of small capital holders. Entry norms and regulatory framework
makes it further difficult for the small capital owners to think entering this field.
Mutual funds are open to the private players. But they too are beyond the reach of
small capital holders. Besides the initial requirements of large capital and some other
stringent requirements are well beyond the reach of Islamic financial institutions.6
In short anybody going for Islamic alternatives in finance has the option of
choosing only the Non Banking Financial Companies format for its easy entry norms,
low capital requirements, lower regulations and flexibility in registration and
functioning.
However two newer option can be through the route of FII and Micro Finance.
4: Non-Banking Financial Companies (NBFCs)
The Non Banking Financial Corporations or Companies (interchangeably used in this
paper) are defined by the RBI Amendment Act, 1997 as financial institutions which
are registered as companies and which have as their principal business the receiving
6
The Tata Mutual Fund made a pioneering attempt when, at the instance of the Barkat and some other
Islamic financial group, it launched Tata Core Sector Equity Fund in 1996 (IEB, 1996a). This scheme
was specially tailored keeping in view the Muslims inhibition of dealing with interest bearing and
haram investments. This scheme surprised many by being able to raise Rs. 230 million from the public.
After initial hiccups the scheme did well for three years. After that the nomenclature was changed to
the ‘Tata IT sector Fund’ (IEB, 2000a).
of deposits under any scheme or arrangement or in any other manner and lending in
any manner (http//: www.rbi.org.in).
In India, the Non Banking Financial Corporations (NBFCs) play an important
role in the mobilization and the deployment of financial resources. NBFCs are
popular because of their added advantage over banking institutions in terms of high
customer orientation, lower transaction costs, quick decision-making, easy
registrations, lesser regulations and higher flexibility. Flexibility in their structure also
allows NBFCs to un-bundle services provided by banks and market the components
on a competitive basis. These distinctive features armed with economic liberalization
contributed to great proliferation of NBFCs activities in India. The significant
increase in the domain of activities of NBFCs is evident by the fact that the share of
non-bank deposits (in gross financial assets of household sector) increased from a low
of 2.2 percent in 1990-91 to 13.6 percent by 1996-97.
Table 1 shows the growth of NBFCs during 1981 to 2003. The total number of
NBFCs in 1981 was merely 7063, which increased to 15358 in 1985 and by the year
1995 it jumped to over 55000 NBFCs. However, after the new regulations came into
force in 1998 the number of NBFCs drastically reduced to 7855 in 1999. Even after
five years of the new regulations the number NBFCs could only rose to 13849 in 2003
with only about 700 companies allowed to accept deposits from the public.
7
NOF: Net Owned Fund is the aggregate of the paid-up capital and free reserves, reduced by the
amount of accumulated balance of loss, deferred revenue expenditure and other intangible assets, if
any, and further reduced by investments in shares and loans, and advances to subsidiaries, companies in
the same group and other NBFCs in excess of 10 percent of owned fund.
3. Creation of reserve funds by transferring a minimum of 20 percent of the
net profit every year.
Besides, some other stringent provisions, those violating the regulations were
not allowed to access public deposits. Simultaneously, new set of regulatory measures
was announced in January 1998 (further amended in December, 1998) bringing an
entirely new set of regulations and supervision over the activities of NBFCs. Now the
NBFCs were broadly classified into three:
1) Those accepting public deposits; they were the subject of the entire gamut of
new regulations. The regulatory attention was specifically focused on this
category,
2) Those not accepting public deposits but engaged in financial business were
proposed to be regulated in a limited manner, and
3) The Core investment companies holding at least 90 percent of their assets as
investments in the securities of their groups/holding/subsidiary companies.
Since the major focus of these regulatory changes was on companies accepting
public deposits, Islamic NBFCs were among those affected most severely by the new
and sudden regulatory changes that mainly focused on the following:
Reducing the period of deposit between 12-60 months, from 24-120 months,
Barkat Leasing and Financial Services Ltd. (BLFSL) returns on capital shows
that the strategy had worked except for the year 1997-98 when its net return on
working capital was down by 7.23 percent (Table 6) and its net return to investment
by 6.99 percent. That was the year of heavy regulatory changes brought in the NBFCs
sector in India.
New regulatory changes enforced in April 1997 completely banned all firms
involved in investment activities from accepting any fresh deposits. This led to a one-
way flow of funds (outflow) from the firms in the group causing tremendous pressure
on the already trembling operations. Barkat’s commitment to Shariah forced it not to
access the usual avenues available to others for addressing its liquidity needs. Had this
not been the case, temporary liquidity from conventional banks might have sufficed
its liquidity needs. Since there were no Shariah complaint options available or lender
of the last resort, Barkat kept waiting for some sort of external assistance either from
within or outside the country, which never reached and finally one of the very
promising Islamic NBFC in India was closed in May 2000. (IEB, 2000b, 2002).
Computer software 25 29 30 40 51
Drugs &
15 16 21 30 34
pharmaceuticals
Automobile
2* 6 14 17 21
ancillaries
Cosmetics, toiletries,
6 5 6 6 6#
soaps & detergents
Top four’s
Contribution in 40.00 40.88 38.38 39.24 36.12
Total Qualifying (%)
FII in India are desired to be registered under the SEBI8 laws, they can also
create sub-accounts. FIIs are permitted to have their own brokers operate with
condition of account being maintained by custodian bank and transactions by the local
Stock-broker. Countries with whom, India has DTAA are advantaged in terms of tax
benefits which the investors can enjoy. However the most favourable DTAA structure
that India has is with Mauritius. Last two years have seen DTAA signing with UAE
and some other emerging economies in Middle East. The potential really lies in the
fact post 9/11, wherein the Gulf money has been craving for as alternative investment
destination to US. The investment opportunity in fast growing fairly well regulated
and organized Indian market is seen and duly recognized by many of the Islamic
Banks and Financial institutions. Sharia Complaint products (stocks and others like
real estate, infrastructure,etc) in India after deducting the interest component are
readily available. Indexing has been done by co-author Dr.Shariq Nisar and one of the
new entity Miftah Advisory India P Ltd, who is initiating this Index at BSE or NSE.
8
Securities Exchange Board of India body through enactment in 1992, regulator for Financial markets
but in case of NBFC it shares as cross-regulator with RBI, the Central Bank in India. It has power to
frame regulations. www.sebi.gov.in.
(Rs. crore) (Rs. crore) (Rs. crore) (US $ mn.) (US $ mn.)
1 2 3 4 5 6
1992-93 17 4 13 4 4
1993-94 5593 466 5126 1634 1638
1994-95 7631 2835 4796 1528 3167
1995-96 9694 2752 6942 2036 5202
1996-97 15554 6979 8574 2432 7634
1997-98 18695 12737 5957 1650 9284
1998-99 16115 17699 -1584 -386 8898
1999-00 56856 46734 10122 2339 11237
2000-01 74051 64116 9934 2159 13396
2001-02 49920 41165 8755 1846 15242
2002-03 47061 44373 2689 562 15804
2003-04 144858 99094 45765 9950 25755
2004-05 216953 171072 45881 10172 35927
2005-06 346978 305512 41467 9332 45259
The report in India times dtd.30 May 2007 is illustrative and is summarized below9:
"FIIs from Gulf countries should actively look at investing in the Indian stock
markets," Union Commerce Minister Kamal Nath said in a presentation at the
valedictory function of the 3rd India-Gulf Cooperation Council Industrial Forum.
India's stock markets were booming and registering as FIIs here would help Gulf
banks deliver benefits to their high net-worth clients.
These are the indicative trends that what second wave of Islamic Investments would
be. Although at least three FII from Gulf, like Taib Bank and others have tried to float
the Sharia Compliant Mutual Fund, but there progress in terms of launching in India
for more than one year has been partly challenged by regulations/regulators there.
Local Players:
There is raise in expectations by the Indian local players, who already have strong business
presence in Middle East and launch of some Indian insurance companies in Middle East
insurance sector are adding to expectations. It may be too early to predict the trends.
The biggest stumbling block for Sharia Compliant funds has been a specific mention for such
products in Equity markets which is considered by regulators as community specific and too
sensitive to handle.
9
http://timesofindia.indiatimes.com/articleshow/2086728.cms
By this circular RBI11 has issued instructions to controlling offices, branch offices
advising them to specially monitor the credit flow to minorities in these 121 districts
thereby ensuring that the minority communities receive an equitable portion of the
credit within the overall target of the priority sector. The above requirement is to be
kept in view for the purpose of earmarking of targets and location of development
projects under the Prime Ministers New 15 Point Programme for the Welfare of the
Minorities.
This circular itself is a major shift in terms of the way Indian Banking policy will be
governed. This has not happened in the past 70 years of Indian independence.
In addition to this Micro Finance Bill of 2007 if and when passed by the Parliament can be
another thrust area for Community Development initiative. The principles enumerated can be
beneficial to direct entry for Islamic financial products.
RBI more recently, has agreed to the initiative by the Finance Ministry to directly permit the
acceptance of ECB by those institutions who are already established in the field of micro-
lending and help establish small enterprises. Institutions like IDB and other such development
funds from Islamic Nations can gain entry to Indian finance market through this route without
much changes warranted to their principles, as is in the existing Indian financial (including
Banking) and tax laws and regulations therein.
In this sense it may widen the area of entry Islamic Financial products in Indian market.
8: Conclusion
The decade of 1980s and 1990s saw proliferation of Islamic NBFCs. India’s decision
to introduce large-scale regulatory changes in the non-banking financial sector at a
time when most of the South Asian countries were passing through severe economic
recession did not augur well for the non-banking finance sector. More so Islamic
NBFCs appears to have suffered more because of the distinct nature of their business
and other religious constraints like not being able to avail the conventional avenues
available to other financial institutions. In a fast changing regulatory environment like
this, a conventional NBFC would prefer keeping its money in commercial banks than
to go with risk associated ventures that are part and parcel of Islamic financial
institutions. On the other hand small size of Islamic NBFCs and a lack of the lender of
last resort besides naive and complacent attitude towards the regulation also had a fair
share in their failures. Perhaps the recessionary economic phase could have easily
been tackled had the management been more alert and investors more informed.
10
This issue was debated in one of the constituent assembly debates and was also part of scheme of
governance for muslims under Government of India Act of 1935.
11
Reserve Bank of India Act of 1934 but it became functional in 1935. Its existence pre-dates Indian
independence in 1947 and becoming of Indian Republic in 1950.
The decades of 2000 onwards may be facilitating entry for Islamic financial Products
in India through Stock market, investments, Venture Capital finance, micro-
credit/finance and lastly Sukuks.
9: Suggestions and Recommendations
Experiences of the Islamic NBFCs in India underscore at least two points: (i)
Internally, Islamic NBFCs should be well capital adequate besides being highly
cautious in their business operations and (ii) In a secular democratic country like India
there is need for some sort of advocacy groups that work quietly in creating soothing
conditions for Islamic oriented businesses.
Islamic financial institutions constantly need to diversify their investment
basket through innovations and improvement in technology. In a secular country like
India it could be difficult due to non-recognition of Islamic principles but nevertheless
they are important and need to be conveyed to the regulators through all the legal
means.
Self imposed moratorium on certain qualified modes of finance by certain
Islamic finance house instead of increasing the reputation led to isolation and lopsided
investments. Therefore, more flexibility is needed to cope with the changing business
environment. Lack of the lender of last resort has been a major cause of concern for
Islamic financial institutions the worldwide. Therefore, the establishment of any such
institutions that could act as the lender of last resort should be the topmost priority by
Islamic economists and policy makers.
Another issue that needs immediate attention of the policy makers is to put a
check on tainted profit seekers who just fore the sake of their small profit vitiate the
whole environment for genuine concerns. Many institutions that operate on the basis
of interest disguising them as an Islamic financial alternative, either overtly or
covertly, only help in creating a crisis of confidence. People also need to be informed
about the Islamic finance principles so that at the time of crises they do not create
unnecessary panic and rumors leading to contagion.
****
*Shariq Nisar, Ph.D. Economics, is Joint Editor Islamic Economics Bulletin, India and
works as consultant. He has worked in the banking sector in various capacities.
E:shariqnisar@yahoo.com; M;91-9980355403
*Syed Kamran Razvi, Legal consultant, and is also Director, Miftah Advisory India P
Ltd. e: skrazvi@gmail.com m:91-9810078799 f: 91-11-41734987 a: Flat No.7,137B/12,
Zakir Nagar, New Delhi-25
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