ISLAMIC BANKING system seems to be catching up in many parts of the world. Perhaps, it is time India should also welcome the concept of Islamic banking, which seems to adequately address the issue of solid economic growth. 

First, let’s understand the concept of Islamic banking: Islamic banking refers to a system of banking or banking activity that is consistent with the principles of Islamic law (Sharia). Sharia prohibits the payment of fees for the renting of money (riba, usury) for specific terms, as well as investing in businesses that provide goods or services considered contrary to its principles (haraam, forbidden). All forms of interest is prohibited, whether it is simple or compound, low or high rate, personal or institutional, private or public. The question obviously which would arise is how then is the bank going to make a profit if it is not going to charge any interest based on Sharia!

To avoid interest or riba, Islamic banks have introduced instrument such as Mudaharba and Musharka. Mudaharba means that bank as a rab-ul-mal will provide the funds to an entrepreneur to do business.

But the bank has no right to interfere in the business. The entrepreneur has responsibility to run business and provide whole information to bank. In this kind of contract the bank will share the profit of business according to percentage fixed in contract. In case of loss the bank will bear all loss. In Musharka, both will share the loss and profit. This type of contract is called partnership.

A few special characteristics of an Islamic bank are as follows:

a) Firstly, Islamic finance involves a system of equity sharing and stake-taking. It works on the principle of a variable return depending on the actual productivity and how well theproject performs. The project can be in different forms such as specific or general, individual or institutional, private or public. However, the Islamic principle remains of equity and reward sharing unlike the western concept of loan-interest relationship.

b) Social and ethical aspects are a part of the Islamic economic system. It will ask question such as: What are the objectives for which money is being acquired? Will it benefit individuals, society and humanity? Will it lead to the establishment of a just, honourable, sustainable society; or will it result in exploitation, moral degeneration, social tensions and inequalities? These questions will be as relevant as the profitability and economic viability of the project in the Islamic system.

c) Islamic banking is entrepreneurial driven. It is directed not just towards financial expansion but also towards physical expansion of economic production and services. In the Islamic economy money will not produce money; it is expected to finance talent, innovation and new ideas, skills and opportunities. Whereas, conventional banking operates predominantly on the basis of financial collateral, therefore the more money you have, the more you can get. This means that the viability of a project mainly depends on the financial worth of the borrower; meaning that low collateral can reduce the chance of getting a loan, even if the project is viable and the person has impeccable character.

In the Islamic system collateral is not ignored but it is reduced, through the trustworthiness of the person, the viability and usefulness of the project; which is more important than the financial worth of the borrower. This means in the Islamic system emphasis is placed on human needs such as fair distribution, equity, community and individual development. The result being small savers, investors, traders and producers become more important. Islamic banking is more oriented towards the community, talent and entrepreneurship.

With the passage of time, the interpretation of Islamic bank concept has broadened to catch up with those countries which are not Islamic states. In the West also Islamic banking is flourishing. People in the business offer valuable comments like (a) Shari’a-compliant banking is fast moving from niche to mainstream, (b) But while continuing growth seems certain, challenges remain.

The following are chief extracts on the goodness of Islamic banking concept:

• In January this year when the UAE’s Sharjah Electricity and Water Authority (SEWA) needed cash to construct a power generation and desalination plant in the town of Hamriyah; it was Islamic finance that provided the answer. The utility raised $ 350 m by issuing its first ever ‘sukuk’ – asset-backed bonds that comply with Shari’a, the Islamic legal code that prohibits interest.
• By no means is SEWA alone in venturing into the Islamic capital markets. Corporate ‘sukuk’ issuance leapt from $ 0.4 billion in 2000 to $ 24.5 billion in 2006, according to International Islamic Financial Market (IIFM), an industry association. Growth topped 122 percent in 2006 alone. “Islamic finance is no longer a niche market,” says David Pace, CFO of Bahrain-based Unicorn Investment Bank (UIB), a Shari’a-compliant house. It is increasingly a mainstream component of the global banking system.”
• To be sure, while the world’s first Islamic bank was founded back in 1975, it is only in the last five years or so that Islamic finance has surged. Sniffing opportunity, conventional banks are now scrambling to set up Shari’a - compliant operations; and there has been a flurry of all-Islamic start-ups, from full-service investment banks to specialist advisory firms.

Products have moved beyond lending, insurance and investment funds to include ‘sukuk’, hedge funds, currency swaps, and more.

Buoyed by good cash generation, many regional governments are planning ambitious infrastructure programmes:

Indonesia alone expects $ 110 billion of expenditure in the five years to end-2010; and consulting firm McKinsey estimates the GCC will invest $ 200 billion in the same period. Much of this spending is already being financed by sukuk – and the volume is set to balloon: Following its successful ‘sukuk’ issue, SEWA hopes to raise another $ 2.7 billion. And in neighbouring Dubai, the electricity and water authority is eyeing a debut ‘sukuk’ issue, with plans to raise $ 2.5 billion.

-   With ever-stronger foundations in the Middle East and Asia, Islamic finance is now starting to take hold in London, too. The UK’s first standalone Shari’a-compliant bank opened its doors in 2004; two others have followed; another is on the way. (All are backed by Middle Eastern institutions.) And in April this year the London Stock Exchange listed its maiden ‘sukuk’, adding much-needed depth and liquidity to the market. Another milestone is in sight: The UK government is mulling its first sovereign ‘sukuk’ issue, perhaps as soon as early-2008.

-   But challenges remain. If Islamic finance is to move deeper into mainstream global finance, the industry needs to improve transparency and foster credibility by harmonising standards and practices. Not least, Shari’a interpretation varies between regions and even institutions. Regulatory oversight need to be sharpened as well. These measures – and others – could be critical in broadening the appeal of Islamic finance and bridging the gap between Islamic and conventional financial systems.

-   For certain, industry practitioners are making progress. Earlier this year the International Capital Market Association and the IIFM agreed to develop standard contracts and common best practice for secondary trading of ‘sukuk’ and other Islamic instruments. And it may help, too,that global banking giants are putting their weight behind Islamic finance. (Deutsche Bank, Barclays Capital).

While concluding, it is suggested that introducing the above concept in a secular state
like India can bring in rewarding benefits to all sections of the populace. Policy-makers need to plan out with leading banks to introduce the above system which seem to be full of promise for taking the economy to higher platforms.