Explainer: Deconstructing Islamic Finance & what it means for us

Moneycontrol Bureau

The Reserve Bank of India (RBI) has said it will work with the government to introduce interest-free banking, as part of its efforts to improve financial inclusion. This is expected to appeal to communities like Islam, which frowns on the concept of interest, be it payment or receipt. In short, the RBI’s proposal paves the way for introduction of Islamic finance in India.

Moneycontrol tries to answer some of the commonly asked questions relating to Islamic finance.

How is Islamic finance/banking different from conventional banking?

In traditional banks, a depositor gets interest on his capital and a borrower pays interest on loans. The difference between the two rates is the profit earned by the banks.

Islamic banks earn their money from profit and loss sharing, trading, leasing, charging fees for services, etc. which are guided by the principles of the Shari’ah.

What are some of the common financial contracts in Islamic banking?

Equity participation (Musharakah)

A partnership agreement between the bank and the customer where equity is contributed jointly, either in cash or assets, and profits and losses are shared.

Leasing (Ijarah)

The bank (lessor) buys and leases out an asset or equipment required by its clients (lessee) for a rental fee.

Cost-plus financing (Murabahah)

The bank (seller) purchases goods from a third-party and then resells them to the borrower (buyer) at an agreed mark-up. The total cost is usually paid in instalments and the product belongs to the seller until the last instalment is paid.

What is the RBI’s view on interest-free banking?

For long, the RBI’s stance was that Islamic finance could be offered through non-bank channels such as investment funds or cooperatives.

The Committee on Medium-term Path on Financial Inclusion, in its report to the RBI in December 2015, made the following recommendation:

Commercial banks wanting to test the potential of interest-free banking may open interest-free windows, through which they can conduct business utilising only Shariah-compatible instruments.

Is Islamic banking a new concept in India?

No. Kerala experimented with the Islamic finance back in 2000. The Alternative Investments and Credits (AICL), which started operation in Kochi then, is defunct now.

Cheraman Financial Services—a non-banking finance company--promoted by the Kerala State Industrial Development  Corporation and NRIs which started operations in Kochi, follow Islamic banking principles.

Are there any Islamic financial products in India currently?

Some asset management companies like Taurus Mutual Fund and Tata Mutual Fund offer equity schemes that are Shariah compliant. These funds are marketed as ‘Ethical funds’ so as to make them attractive to non-Islamic investors as well. These funds do not invest in companies associated with alcohol, tobacco, gambling and pork products. They also don’t invest in companies that profit from charging interest.

Also, there are portfolio management schemes which follow Shariah rules in their selection of stocks.

Have there been any controversies around Shariah funds?

In March 2015, State Bank of India (SBI) deferred the launch of a Shariah-compliant equity mutual fund at the last moment despite having got the green signal from SEBI. SBI maintained that the decision was a commercial call, but there was speculation that the decision could have had to do with political pressure.

Senior BJP leader Subramanian Swamy is among the most vocal critics of Islamic finance, arguing that it could encourage religious conversion and also open channels for terrorist organisations to channel money into India.