The Indian Economy Blog

September 14, 2007

“Islamic Banking” And Banking For Muslims In India

Filed under: Banking,Business,Capital markets — Prashant @ 9:00 pm

A friend of IEB who wishes to remain anonymous, The Graduate has sent us a great post on Islamic banking in India.

The Graduate is a recently minted MBA who is currently employed with a foreign bank’s business banking operations. He does not consider himself an expert on banking, he hopes to bring lay readers an inside perspective and further insight on finance in India.


This Great Indian Mutiny post on Islamic banking in India has prompted me to write about some aspects of both Islamic banking and banking for Muslims in India.

A few caveats: I have only a little more than a year’s experience in banking, and I’m no expert, but I would hopefully have a greater degree of insight than the lay reader. Also, this post does not have any central theme, but is more a collection of responses to the points raised in the blogpost, as well as some additional points on the subject I thought would be worth raising.

Let’s address the points raised in the blogpost first:

I’ve known many Muslims who invest in mutual funds, shares and traditional non-Shariah compliant banking products. Most Muslims in India who would go on to bank tend to think with a secular starting point.

The reality is a little more complex. I’m currently working in small business banking, and several of my customers are Muslim-owned partnerships who are borrowing crores. So Sandil’s point that there are Indian Muslims who have no compunctions about dealing with debt and interest is valid. However, I was working in personal banking for a while. Over there, me and my colleagues had to deal with a number of other Muslim customers who had a more orthodox approach. They would deal with the prohibition on interest and insurance in a variety of ways, including:

1. Not investing in mutual funds with a debt component
2. Donating the interest on their salary savings account to charity
3. Using a zero-interest current account instead of a savings account

Obviously, I would never have come into contact with Muslims who were so orthodox that they did not utilise banking services at all. The size of that market is anybody’s guess.

It would be best if existing retail banks offer Islamic products within their current schemes and carry out their ledger-separation, overlooked by a Shariah authority, who can certify that the profit is indeed separated. Besides, it offers a more legitimate front – the Sena would have to think twice before attacking at a larger and more ‘legitimate’ organization like ICICI, Stancy, HDFC or HSBC.

Existing retail banks, including my employer are in fact anxious to do exactly this. Malaysia and the UAE are the laboratory where domestic and foreign banks are concurrently running Shariah and non-Shariah compliant products. HSBC’s Islamic mortgage in Malaysia has apparently been quite a success, and Standard Chartered has recently launched a Shariah-compliant credit card in the UAE.

The Islamic REIT
However, with or without banks jumping in, Indian Muslims have already been making their own Shariah-compliant financial products.

When I was working in personal banking, I had to investigate a transaction that showed up on the money-laundering alerts. A current account which had been lying dormant for almost three years suddenly had a huge sum credited to it. I went to meet the customer.

When I got there, it turned out that the customer was a trust representing a number of local Muslims. They had pooled in money four years ago, used it to invest in real estate, develop it, and had now sold the property. The sales proceeds had been deposited into the account, and would be distributed again to the contributors. They had done this because they felt that this was more moral then investing in debt (interest prohibited), or in equity (too much akin to gambling).

This is quite fascinating. Long before REITs had been permitted by the Indian state, a group of Bombay Muslims had gone ahead and created a synthetic-REIT on their own. The diversification and risk management was much lower than a real-REIT, but there is a lesson here: marketing to Muslims who worry about the ethics of their financial product does not necessarily need an Islamic banking label.

Is Shariah Compliance the Biggest Hurdle?
Is Islamic banking the magic bullet which will pull India’s Muslims into the financial system and enable them to access credit and secure their savings?


A much bigger problem faced by India’s Muslims is that the majority of them are too poor to be targeted by the banking system as serious customers. Financial exclusion of the poor is a much bigger worry for them than the absence of Islamic banking. And of course there’s the whole issue of ‘negative areas’, which I’ll address shortly.

When my employer was conducting market research on Islamic banking in Pakistan and the Gulf, it discovered that Shariah-compliance was ‘sufficient but not necessary’. Customers would readily use traditional banking services, but if they were offered an alternative which was Shariah-compliant, they would feel happier with that and switch to it. If the same insights hold good in India, it’s clear that bringing Muslims into the financial system requires financial inclusion rather than Islamic banking.

The ‘Negative Area’ Trap
It’s an open secret that when it comes to retail lending, Muslims find it difficult to get credit cards or personal loans.

This difficulty arises not because of actual negative scoring for Muslims, but because the neighbourhoods which are classified as negative, no-lending areas, are usually ones which have high Muslim or Dalit populations.

Honestly, I’m not sure why this is. My employer is committed to diversity, opposed to discrimination, and also operates in several Muslim countries. At least at a global level, it doesn’t have anything against Muslims. So why does the credit policy fail Muslims in India? There are three possible reasons:

1. A complete mismatch between the global office and the country office. Everyone in the country top management is conspiring against Muslims. Unlikely, but possible. What makes it more unlikely is that this would be a conspiracy perpetrated by the top management of all banks in the country, who all have the same negative areas.
2. Plain laziness. The list of negative areas was drawn up a long time ago by the first bank to do retail lending, and then copied by all other banks, none of whom bothered to test it against actual experience. This is possible.
3. Negative areas are drawn up by banks in consultation with collections agencies. Collections agencies are not willing to work in ghettoised areas, because the people here who are creditworthy enough to borrow, are also probably politically well-connected. If they default, and a collection effort is made, it can be responded to with violence with impunity. I think this is the most likely reason.

So, at the end of this, where are we?
1. Islamic banking makes Muslim customers feel good. So banks could adopt it as a differentiating strategy. This makes more sense in countries like the UAE and Malaysia where there are many high net worth Muslim individuals than in India. But there might still be enough of a market in India.
2. India’s poor Muslims face a real problem in accessing organised financial services, and this is the same problem that the rest of India’s poor face. Greater financial inclusion, such as no-frills-banking accounts, and higher banking outreach will fix this. The fastest way to do this is enhancing competition.
3. India’s poor Muslims face an additional problem over other poor people in that they live in ghettos, and so have trouble accessing credit. The solution to this probably can’t come from the banking system, but from NBFIs, subprime borrowers, or community finance institutions. If these institutions could be plugged into a credit grading system, it would help.
4. Tweaking financial products to make them Shariah-compliant is not very hard. However, as the Percy Mistry report has pointed out, the way the RBI conducts regulation makes developing any new product hard. This is a separate challenge, and worth many blogposts.

Sidebar from Prashant: As we’ve said earlier, IEB’s always looking for new contributors.


  1. [...] A great post on the Indian economy blog on the various facets of Islamic banking,   Is Islamic banking the magic bullet which will pull India’s Muslims into the financial system and enable them to access credit and secure their savings? [...]

    Pingback by Islamic Banking | DesiPundit — September 15, 2007 @ 1:18 am

  2. hope you have heard of the Ahmedabad-based Parsoli finance company. they are looking to launch a shariah-compliant mutual fund targetted at Middle Eastern investors looking to invest in India. Obviously, there is a wall of money waiting to enter the Indian markets under the shariah-compliant banner.

    Comment by Shiv Kumar — September 15, 2007 @ 10:37 am

  3. Some great points on here that I did not know of. Definitely worth a few discussions on here.

    Prashanth, I would think the “negative trap” need not stereotype the typical basthi communities of lower income muslims. In any case this would be a separate discussion altogether as I would imagine even low income Hindus, Christians etc would have a hard time getting credit worthiness.

    I would be interested to know more how wealthy muslims operate. Most prime properties all over India are largely owned by the muslim community. Real estate in Bandra & Khar in Mumbai or Cunningham Road and the old Cox Towns and Fraser Towns of East Bangalore are all now largely muslim owned real estate. Negative stereotypes aside these guys move huge amounts of money period.

    Comment by Nikhil Nayak — September 15, 2007 @ 8:39 pm

  4. Test comment. Trying with HashCash on.

    Comment by MadMan — September 16, 2007 @ 12:12 am

  5. Waw It’s great post on Indian Economy. I think Indian economy is second fatest growing economy after China. The savings of Muslims also increase this rate it is my hope.

    Thaks for sharing this post…

    Comment by Prashant Vikram — September 16, 2007 @ 2:10 am

  6. Why are we writing about this here? I always thought the posts here are of “secular” nature, but within no time we are talking about Sharia laws and banking, you might as well change the name of this blog to
    Is India and Indians so poor that they have to attract funds from so called Sharia banks and funds?

    Comment by Dissenter — September 16, 2007 @ 7:53 pm

  7. Great post! And great insight into the issue by blogger! Keep it going!

    Comment by Vijay — September 17, 2007 @ 9:02 am

  8. Bank is bank, why one has to place an “Islamic” label in front? As in the case of India, the racial harmony is always a major issue, labeling banking activities as “Islamic” might carry a real potential risk for misunderstanding or subtle segregation of communities and commercial activities. You rarely hear such terms in esat asia and north america.

    Comment by thecupgr — September 18, 2007 @ 8:41 am

  9. we can have tamil, telugu, marati , gujarathi etc banks also. they will be limited to respective people and let them create some more discrimination among people live aound. we already have states, we can have districts and cities also language and cast wise, that we groups can grow in groups and become like frogs in well.

    Try to think everyone like human first, then write about this kind of nonsence blogs.

    Comment by madavi — September 18, 2007 @ 8:33 pm

  10. I’m pretty surprized to see some of the comments above that are blindly passionate and didnt respond to the artilce, per se. For good or bad, Islam has a separate law wrt handling money, and instead of questioning on why they have such a law, it is more prudent to utilize that from a pure economical perspective. A lot of wealthy customers with big bucks from Middle east can be brought more closely to the banking system and the money could be used more productively which could otherwise end up in questionable activities like Hawala, Money laundering or even go into indirectly funding terrorists without the participants knowing about.

    Its always dangerous to have money lurking around in non-official forms, and Islamic banking would enable atleast a part of the money to enter official channels. The banks could also benefit by 0 or low interest deposits from those customers and a bigger client-base. Its a win-win for everybody, and the concerned parties must engage the general public and convince them that this is not surrender to minority interests.

    Comment by Balaji Viswanathan — September 19, 2007 @ 7:26 am

  11. I’m shocked at some of the comments and surprised that readers of the Indian Economy blog would react such.

    It takes skimming of the article to see that Islamic Banking has nothing to do with religion or favoritism towards Muslims; all it does is have a banking system which tweaks itself to Shariat laws … according to which interest is not paid, as mentioned Muslims get by in regular savings account by donating the interest accrued to them to charity. Even Shariat Funds are mostly such that do not invest in Businesses such as Alcohol, gambling etc. Very similar to Green Funds and Christian Funds.

    The comments just expose the very deep rooted prejudices against Muslims even in urban and well-educated India. I also sincerely believe and hope that these people are in a minority.

    Comment by Keya Rai — September 19, 2007 @ 11:58 am

  12. I think this blog gave us a nice perspective on showing that ‘Islamic banking’ may be a good tool for banks to use from a marketing perspective. In markets where we already have Muslims using banking services, this tool can give some banks an edge over the others since they ‘seem’ to comply with the Islamic laws, and hence will be more preferred. From a new product development and launch perspective it may be useful in markets where there are a lot of wealthy Muslims, and key influencer to purchase might be religious sentiments, like some middle eastern countries, which are keeping these Muslims from buying financial products and servicing. However, in India, I agree that what is most important, and more profitable for banks in the long run, is to understand that this is a financial inclusion issue.

    Comment by Kamini Kinger — September 19, 2007 @ 11:59 am

  13. Dear friends, I see some of you shocked at just reading the comments written by others, but that may be reality. Shariat laws may be applicable somewhere where lot of rich people are their where they may not need interest on savings account. But do you think same thing can be done in india too?. ok even if it is done what about the poor hard working Muslims are they not deserved to get interest earned from savings when they bank with such bank?. how ideal is this to assume that rich people will put their money in banks than putting somewhere else?
    without even existence of a bank like this, if some rich person really want to donate to charity he will do that anyway. i don’t understand in what way will it benefit by opening labeled banks like this.

    Comment by Lokesh — September 19, 2007 @ 9:04 pm

  14. Dear Keya Rai & Balaji,
    I am surprised by your naivete.
    If you want sharia laws, why restrict it to banking per se? You can have the whole thing! You have to understand that Islam is a complete belief system, you cannot be part-islamic. Either you have Sharia or you have secular laws, you cannot have both. For more information please do some research before supporting dimwits like “name withheld” and his idiotic “banking” ideas. For more inspiration of similar ideas do a reality check on certain middle eastern countries & the sharia systems there.

    Comment by Dissenter — September 20, 2007 @ 7:11 pm

  15. Dissenter

    If you have issues with the ideas presented in the post, let\’s hear them. No need to get into gaali-shaali… [grin]


    Comment by Prashant — September 21, 2007 @ 3:10 am

  16. Dissenter, Madavi;

    you are correct. I now realise my mistake. Setting up enterprises which follow the dictates of one particular religion or other is sure to cause divisiveness and unrest. Yes, we cannot allow Islamic Banking.

    We must also shut down halal slaughterhouses. Either you have halal slaughter or secular slaughter. You cannot have both.

    And vaishnav dhabas and Brahmin darshinis must also be demolished. A restaurant is a restaurant, why should it pander to one particular religion?

    Comment by The Graduate — September 21, 2007 @ 8:04 am

  17. personally i think islamic banking, i.e. a banking system sans ‘interest’, is merely a concept used to satisfy ones morals. wats the point when the bank ends up making money from you and does call it interest but through concepts like ‘murbaha’.

    i think its unwise and a bit silly to mix religion with economics.

    Comment by Ravi — September 21, 2007 @ 6:30 pm

  18. sorry type,

    ‘does not call it interest but through concepts like murbaha’

    Comment by Ravi — September 21, 2007 @ 6:31 pm

  19. Well, if the problem some people feel is with the term “Islamic Banking”, I’m sure it can be tweaked to give it a more “secular” feel. Nevertheless, more than the actual terminology, what is important is the strategy and the concept of Islamic banking. Banks can use it to attract greater investment, nothing to do with religion. As Indian banks start operating outside, they realise that if they have to cater to the Islamic markets, they would have to introduce such products.

    Working in the core banking implementation field, I have come across so many banks who want Islamic banking in our product. Since the clients require it, we try to deliver this, without too much fuss. Of course, I’m not too sure whether the concept will work in India.

    It’s also unfortuante that readers like Dissenter should start getting abusive in what is only a discussion. C’mon folks, can’t we just be a bit more tolearnt of each other’s views??? Grow up…

    Comment by E Pradeep — September 22, 2007 @ 9:40 am

  20. Graduate,
    Sorry if you have got offended.
    A “bramhin darshini” is a very very small business, opening a new one or closing an existing one will not have any consequences. On the other hand we are talking about billions of dollars here, which may be floating around in the Sharia funds. As it is, there is a growing unease among many sections (and rightly so) about the sources and uses of these funds that come, mainly from the middle east, who may be inmical to Indian interests. After the US and western countries tightened their banking laws, a lot of unsavoury funds have started making their appearances in these forms in the Asian markets.
    Secondly, money is a commodity which has a rent, which we call “interest”. If interest is “bad” due to religious diktats, then some religious banks will simply levy it but will not call it by that name.
    If not, then the lending by the bank, is similar to a venture capital fund financing a client, or buying shares in the clients company. There is nothing called Sharia in this whole exercise. Thirdly interest paid on loans is tax deductible in most countries, for businesses and on certain loans like housing loans for individuals. How do you propose that the banks that offer Sharia funds to borrowers will deal with this? Pay more tax? Pay dividend tax?
    Or let the client pay more as “service charges”?

    Comment by Dissenter — September 23, 2007 @ 11:25 am

  21. Dissenter,

    I think you were much more offended than I was. :)

    I think I missed out two things in the post. First, that I’m not suggesting that Islamic banking substitute regular banking, but just that it be added to the product portfolio of existing banks. Second, I am in no way suggesting that Muslims be compelled to use only Islamic banks.

    As to your points,

    1. If Islamic banking is offered as such, by existing banks, then they will have to apply existing standards of customer due diligence, anti-money laundering, and know-your-customer norms. While the effectiveness of these standards and the compliance to them can be argued over, it is surely preferable to have money flowing through the banking system than through shadier avenues like hawala or film financing/ property dealing.

    2. Levying interest and calling it by another name – true, the net cashflows are indistinguishable from normal interest payments, and it is largely jugglery in the structuring of the legal contract. But if it makes customers happy, why not offer it?

    3. The interest is deductible on the borrower’s income, not the bank’s income. I’m not proposing anything, but allowing deductions on equivalent interest/ service charges is not impossible. Or, if Sharia-compliance is that important to Muslim borrowers, perhaps they would be willing to forgo the tax deduction.

    Comment by The Graduate — September 23, 2007 @ 11:58 am

  22. Unfortunately, although “Islamic” banks may make Muslims feel good, they only perpetuate a fixation with religion governing all aspects of life.
    We all know it can not work that way if we want to have long term gains, financial and societal.
    Think of the losses. How many westerners would utilize a bank called by that name?

    Comment by Athena Smith — September 24, 2007 @ 5:53 am

  23. [...] Sobre este tema, vale a pena registrar, também, que, conforme indicado em matéria do Indian Economy Blog (ver aqui), há um público preocupado em usar produtos financeiros que sejam compatíveis com a Sharia (são os produtos e serviços chamados "Shariah-compliant"). Segundo a matéria do Indian Economy Blog, há muitos clientes de bancos na India que fazem questão de respeitar a proibição islâmica da cobrança de juros. E o fazem de várias maneiras, dentre as quais: [...]

    Pingback by Cartão de crédito islâmico « Direito - Economia - Sociedade — September 29, 2007 @ 3:26 am

  24. As we all know, in the developing world there is increasing realization that the
    interest-based system of the capitalist West has failed to solve the problem
    of poverty and economic disparity.

    The feeling is that the minds are overwhelmed with the Western thoughts and
    the vested interests siege the World Banking system, which are
    engaged in poisoning minds and shaking the feet of the weak minded people.
    The need is to break the idols inhabiting the minds and the way of the
    submission of the mind and vision to God’s commandments should be adopted.

    Many feel quite strongly about the idea of interest-free banking and this
    common bond goes a long way towards encouraging good behaviour.

    It provides affordable and responsible finance, and enables its members to
    have a say in where their money is invested. I have no doubt it will
    continue to be true to its purpose and values while exploring new frontiers
    in ethical finance.

    The goals of socio-economic justice and equitable distribution of income and wealth are integral parts of the moral philosophy of Islam. However, one of the socio-economic reforms made by Islam was the prohibition of riba (interest). About the efficacy and usefulness of the prohibition of interest in Islam, Muslim economists have tried to provide the juridical clarity and support based on reason, as opposed to mere belief.

    interest free Islamic banking (not only investment), that is different with similarities, has the potential of changing the conditions
    Islamic tenets strictly ban interest. Instead, lenders are supposed to invest in their clients’ ventures and share in the profit or loss.

    Unlike their counterparts elsewhere, Islamic bankers do not expect to advance money and receive a predetermined sum on a fixed date in the future. Under the Shariah, the bedrock of the Islamic faith, they are instead responsible for ensuring that money is invested in viable projects, with reliable borrowers. If the project succeeds the banker shares in the profit. If it fails he suffers the losses.

    The Shariah, requires that reward comes from risk sharing. Profit must be justified through the creation of value that the banker brings to complement the value of the borrower’s efforts and skills.

    Against a background of rapid growth in Middle Eastern economies over the last 20 years and a desire to increasingly compete internationally, Islamic banks have begun to change and develop to provide a range of alternative financial products

    In order to provide a competitive range of alternative financing vehicles, banks will need to work together to develop and adopt the standards of disclosure and risk management that are expected in the international markets, and to educate westernized borrowers in the use of Islamic finance.

    Regulatory issues need to be sorted out before Islamic banking can be introduced and its benefits can be enjoyed to the fullest and its fruits felt and shared in other parts of South Asia to begin with.

    Islamic banks can provide housing loan, on the basis of co-ownership, venture finance on Mudarabah basis as well as on Musharaka basis and consumer loans, finance purchase of automobiles on a hire-purchase basis. Education and skill development finance. Investments can be made in government securities, small savings schemes or units of mutual funds. These banks can also invest in shares of companies. Hire-purchase and lease finance are other source of investments.

    To have a smooth functioning of these financial institutions law of the land will be always paramount and there are no two opinions about this, legalities, transparency and respect for the local law are the basics of Islamic Shariah in the mean time the government should devise an efficient legal system to safeguard the interest-free banking practice against any misuse.

    Comment by manzoor — October 3, 2007 @ 4:18 am

  25. Manzoor, I like what you have written but it wasn’t necessary to dig at the “interest system of the capitalist west”. You have some good points to say but you have to be more neutral on here in your opinions no matter how strongly you believe in them.

    Mind you following the recent US sub-prime crisis there may be quite a few who would appreciate Islamic banking. And only a command from the heavens would get me to completely trash the concept of interest or the price of credit. But it is a concept worth spending time on … and I did.

    It is not only Islam that abhors credit. Medieval Christian thinking treated time as the property of God. Therefore charging interest was to do commerce with God’s property. Things have changed since in the Christian world of course but notable proponents were people like Thomas Aquinas a leading Catholic thinker.

    Comment by Nikhil Nayak — October 4, 2007 @ 12:24 am

  26. As a practitioner and deep believer in Islamic Finance who hails from a Hindu Brahmin Family I do think the trail of comments in this post has revealed a deep seated ignorance and prejudice that we have towards Muslims in India.

    Firstly, it was an excellent piece by Graduate. The Islamic view on Interest is by no means an exclusive one, as Nikhil has noted – medieval christianity, judaism and classical greeks all viewed ‘usury’ as a henious sin. Although in modern parlance, the word ‘usury’ has been dressed up to be extorniate interest, an etymological look at the word would reveal that it was interest at any rate. The reason why individuals like Thomas Aquinas were Aristotle adamant that money ‘NOT’ be treated as a commodity in and of itself – I would say has borne fruit in the current world.

    I would refer all readers to the following book, the ‘future of money’, by Bernard Lietar – where he expertly highlights the intrinsic dangers of interest and then mentions how Islam (whether) you agree with it or not – has admirably represented the last bastion of resistance. He illsutrates how interest is a direct cause of inflation, wealth imbalance contributing to the rich getting richer and the poor getting poorer.

    Comment by Sumit Jha — October 5, 2007 @ 6:58 pm

  27. Sumit,
    Can you try to be not so condescending to Indians and their “deep seated” prejudices for muslims or any one else ? The points raised by Dissenter about large amouunt of money flowing in from the Middle East under the guise of Islamic banking is a very valid one – it could very easily be used as a conduit for terrorists.

    The very concept of a bank exists because of interest rates. The civilized world would not be able to operate if there is no reliable cash supply/flow and interest rates have a huge bearing on this area.

    You seem to have an anti capitalist/communist mindset when you throw around words like wealth imbalance. It may come as a big surprise for you but there is no requirement in this country or any other democratic state that every one should be equally wealthy. Wealth is what you create based on your talents, smarts and your hard work. As long as people have equal opportunities to come up in life and create wealth for themsleves, we should all be happy.

    Communism and Socialism made terrible efforts to “correct” this imbalance and did so at the enormous expense of personal liberty and freedom. Poor becoming poorer was a phenomenon in communist countries that was even worse than in any other capitalist economy.

    May be you should see if the oil rich Arab countries take the profits that they earn from the West through energy supply and put it entirely into an Islamic banking account backed by Sharia laws before trying to enlighten the rest of us.

    Comment by NS — October 6, 2007 @ 2:09 am

  28. Manzoor,
    You have written that Shariah funds also invest in Government securities. How do they earn a return on them, if interest is not paid? Since most governments have large deficits, there is no possibility of them ever making a profit on any public venture nowadays. Secondly, you say that the Islamic Banker loses his investment, if the venture into which the money has invested, fails. This means it is possible in an Islamic Banking system that all assets can be wiped off because the banker made a poor decision. Also since the borrower is under no obligation to pay interest, he may not be really keen, to even return the principal amount. If this happens, what happens then? Or do they get punished under other Shariah laws? Imagine pension funds being invested in this way.
    You say that the subprime crisis would not have happened under an Interest free regime. I beg to disagree.In fact if there was no obligation for borrowers to pay any interest, the subprime crisis would have been not just worse, much more worse. People would have bought 10 houses instead of just 1-2 with cheap (interest free funds) and kept on speculating under the whole economy collapsed.
    Interest on money is not just a rent on money, it also encourages borrowers to borrow only when they are confident of getting a superior return on the money which covers the interest. Just as vey high interest rates are bad for the economy, very low (such as zero) are worse, because you are essentially giving away free money.

    Comment by Dissenter — October 6, 2007 @ 9:04 pm

  29. I’m with Keya Rai, quote.

    Comment by chat — October 8, 2007 @ 7:53 am

  30. Wow. Huge amounts of ignorance here. Very embarrassing. First, there are three components of “interest”: rent, risk, and inflation. When somebody gives up use of their money, it is just like giving up use of their house, so they expect to be paid a rent for the use of their money. Same thing for the risk of harm: that’s why loans usually have collateral and flat rents usually require first and last month’s rent. But a component of the interest will cover the risk that the collateral doesn’t cover. And when the central bank inflates the currency, money later is worth less than money now, so a loan may require higher repayments with neither rent nor risk, but only to cover inflation.

    Second, there is no single “Islamic” interpretation of the ban on interest. Some Muslims are comfortable with a modest rate of interest. Some Muslims think that interest without risk is what the Koran inveighs against — in other words, they won’t accept any rent on their money, but they’ll accept risk and inflation payments. And other Muslims are willing to accept the loss of their money’s value in return for what they believe to be strict compliance with Islamic law. Gosh, Muslims disagree about what God wants! Wotta surprise! Muslims are people too!

    And yes, various religions have wailed against interest, but that doesn’t make it right. Spirituality comes from God; religions come from man; and man is biased against profit. See _The Myth of the Rational Voter_, by Bryan Caplan.

    Comment by Russell Nelson — October 21, 2007 @ 9:03 pm

  31. NS,

    Without meaning to highlight, “deep seated” prejudices for any group..

    You mentioned:
    “The points raised by Dissenter about large amouunt of money flowing in from the Middle East under the guise of Islamic banking is a very valid one – it could very easily be used as a conduit for terrorists.”

    I say:
    Islamic Finance is purely a mode of financing, it is the mode that is of concern to Islamically inclined investors – the underlying investments would be those funds, businesses who would just need to streamline their activities and operations in accordance with the financial requirements – as is similar to ethical investing.

    How does this equate to financing terrorits – except perhaps for someone whose mind is already accustomed to equate the word Islam with terrorism. I simply dont understand how Islamic banking is linked as a conduit for terrorists, do you think if someone wants to destroy the infrastructure of a country they are going to be obsessed with how they finance it ?! Due to the added strings of Islamic Finance and diligence/compliance/attention required it would be more difficult for any terrorist financing where anonymity is the order of the day…so forgive me for assuming some prejudices here.

    You also say;
    ‘The very concept of a bank exists because of interest rates. The civilized world would not be able to operate if there is no reliable cash supply/flow and interest rates have a huge bearing on this area.’

    Not all Banks operate on Interest rates – venture capitalist and equity financing dont..and reliable cash flows do not simply come through charging ‘rent’ on money as advocated by another commenter – all that does is make the rich, richer and the poor, poorer. Just to clear the air..I am not a socialist, I think the idea of everyone earning the same irrelevant of effort and action is flawed and history proved so, but I not an unbridled capitalist either. The current banking system and interest being the main culprit has grossly imbalanced wealth in the world – which is why 250 people of the richest people in the world have more than 2.5 billion of the rest of the world. This is what Bernard Lietar points out in his book, that Interest amplifies wealth distortion – a recent report commissioned by the World Bank itself concluded that not one of the nominal interest loans proved beneficial in the ultimate sense for the economies they were forwarded to.

    The only argument for interest exists on the micro level as far as Im concerned (*micro finance) and that is because there is the problem of not being able to adequately book keep as to allow for profit distribution.

    Finally, the word ‘bank’ in the parlance you ascribe is a financial intermidiary – ‘Islamic Banks’ are more Investment Banks akin to Venture Capitalist Financing.

    Comment by Sumit Jha — October 29, 2007 @ 7:09 pm

  32. The following story illustrates one of the deeper causes of the endless quest for growth that underpins our modern consumer society – INTEREST. The story and adapted comments are from the book The Future of Money (pp. 50 – 53) by Bernard Lietar. Your thoughts, comments and discussion are welcomed and appreciated.


    The Eleventh Round

    Once upon a time, in a small village in the Outback, people used to barter for all their transactions. On every market day, people walked around with chickens, eggs, hams and breads, and engaged in prolonged negotiations among themselves to exchange what they needed. At key periods of the year, like harvests or whenever someone’s barn needed repairs after a big storm, people recalled the tradition of helping each other out that they had brought from the old country. They knew that if they had a problem some day, others would aid them in return.

    One market day, a stranger with shiny black shoes and an elegant white hat came by and observed the whole process with a sardonic smile. When he saw one farmer running around to corral the six chickens he wanted to exchange for a big ham, he could not refrain from laughing. “Poor people” he said. “So primitive.” The farmer’s wife overhead him and challenged the stranger, “Do you think you can do a better job handling chickens?” “Chickens, no,” responded the stranger. “But there is a much better way to eliminate all that hassle.” “Oh yes, how so?” asked the woman. “See that tree there?” the stranger replied. “Well, I will go wait there for one of you to bring me one large cowhide. Then have every family come visit me. I’ll explain the better way.”

    And so it happened. He took the cowhide, and cut perfect leather rounds in it, and put an elaborate and graceful little stamp on each round. Then he gave to each family ten rounds, and explained that each represented the value of one chicken. “Now you can trade and bargain with the rounds instead of the unwieldy chickens,” he explained.

    It made sense. Everyone was impressed with the man with the shiny shoes and inspiring hat.

    “Oh, by the way,” he added after every family had received their ten rounds, “in a year’s time, I will come back and sit under the same tree. I want you each to bring me back 11 rounds. That 11th round is a token of appreciation for the technological improvement I just made possible in your lives.” “But where will the 11th round come from?” asked the farmer with the six chickens. “You’ll see,” said the man with a reassuring smile.


    Assuming that the population and its annual production remain exactly the same during the next year, what do you think had to happen? Remember that the 11th round was never created. Therefore, bottom line, one of each 11 families will have to lose all its rounds, even if everyone managed his affairs well, in order to provide the 11th round to ten others.

    So when a storm threatened the crop of one of the families, people became less generous with their time to help bring it in before disaster struck. While it was much more convenient to exchange the rounds instead of the chickens on market days, the new game also had the unintended side effect of actively discouraging the spontaneous cooperation that was traditional in the village. Instead, the new money game was generating a systemic undertow of competition among all the participants.


    This is how today’s money system pits participants in the economy against each other. The story isolates the role of interest – the eleventh round – as part of the money creation process, and its impact on the participants. When the bank creates money by providing you with your $100,000 mortgage, it creates only the principal. However, it expects you to bring back $200,000 over the next twenty years or so. If you don’t, you’ll lose your house. Your bank does not create the interest; it sends you out into the world to battle against everyone else to bring back the second $100,000. Since all the other banks do exactly the same thing, the system requires that some participants go bankrupt in order to provide you with this additional $100,000. To put it simply, when you pay back interest on your loan, you are using someone else’s principal.

    In other words, the device used to create the scarcity indispensable for a bank-debt system to function involves having people compete for money that has not been created, and penalizes them with bankruptcy whenever they do not succeed. . . No wonder ‘it is a tough world out there.’

    In reality, we do not live in a world of zero growth population, output or money supply (as in the story). In the real world, there is typically some growth over time in all these variables…This dynamic makes it much harder than in the Eleventh Round story to notice what is actually going on. With this dynamic view, the money system is like a treadmill that requires continuous economic growth, even if the real standard of living remains stagnant. . . . This need for perpetual growth is another fact of life that we tend to take for granted in modern societies, and one that we usually do not associate with either interest or our money system.

    Adapted from pp.50 – 54 of The Future of Money, © Bernard Lietar.

    Comment by Sumit Jha — October 30, 2007 @ 7:17 pm

  33. Sumit, nice story but I lost the plot a little – are you saying constant economic growth is the other side of the same coin namely interest?

    Russ Nelson & others, have you heard of “paradigm shifts”? Its the stuff that causes revolutions or massive change. When the world was flat, Kepler caused a paradigm shift with the planetary model. We all understand the concept of interest but what if we challenge the premise when problems occur as they certainly have very recently.

    Just ask Merrill Lynch of their $8 billion problem. Soon others are going to follow suit. Merrill Lynch is just the first to bite the bullet. Citigroup who invented the whole thing with Structured Investment Vehicles (SIVs) may be next. There is about $400 billion worth of “investments” out there for which demand has mostly dried up.

    Folks like Merrill’s recently fired CMD, Stan O’Neal and others are likely to be begging for consideration of “non-economic concepts” like mercy, forgiveness, compassion etc. And why not. After all they are as real as anything else in economics. It’s just that they haven’t been tied to economics or attached with any amount of significance.

    This is where Islamic banking or any other name for a similar system holds interest for me. Can we consider alternate ways to address the concept of the cost of money?

    Comment by Nikhil Nayak — November 1, 2007 @ 1:13 am

  34. Hi,

    Islamic Banking is not required until the banking sector assures us that they are not involving our funds and giving us the profit from Haram elements like Alcohol, Pubs, lending money on intrest etc… Rather we are ready to put our hard earned money if they are investing on infratructure, pharma, education, realestate etc…

    I being a salaried person earning 45k permonth have a large problem to save my money without intrest think about other who earn more and more.. i could just count some 1500 person in my 2 KM area who will be open to invest the next day it start. can u have a count in india.

    Were as donating money by intrest amount.. Please we any how have to do it at anycost every year as Zakat, Fitra, Sadqa … which is to help for poor.


    Comment by Siddiqui — November 10, 2007 @ 1:14 am

  35. Few questions:

    what bank offers in saving account is nominal interest rate. so real interest rate may be zero depending on the inflation. Which part is prohibated as per Islamic laws?

    since such account wont be paying interest to the depositor, so will banks charge less money when lending them out? There is a possibility that banks site higher transaction costs for these accounts (seperate ledger, monitoring of investment, etc) and charge same LR on them.

    In todays economy how is it practically possible to monitor how the fund is utilised? Say banks stay loyal to their promise and invested only in acceptable funds first hand. But in second hand it may go to some unacceptable activity. And the return bank gates is a mix of two.
    My guess is that since money spins and money got a velocity it is never practically possible to ensure safe funds for islamic or any money.

    Islamic banking may turn out another ad campaign profiting on money of religiously sensitive people. Also for a country like India we have very few people like Siddiqui, most are poor and they should get a return on their investment over inflation rate to maintain and improve their standard of living.My final question how islamic banking is expected to improve the financial strength of the depositor except providing him some securty.

    Comment by Raj — November 10, 2007 @ 5:08 pm

  36. What are the chances that “islamic banking” would have gained greater acceptance without the I word ? If people can invest in “green funds” and other such dedicated avenues, why not “interest-free banking” ?

    @Siddiqui – theres a snowballs chance in hell anyone is going to give you the assurances you want. Remember, its the taxes of alcohol and ciggies that keeps our creaking infrastructure going. And if you really want to be sharia compliant look at one of the Tata Equity Funds- i’m told one of them is S-C.
    Besides, smoking and any other such “vices” doesnt make SRK a bad muslim only a potential cancer patient so i dont think muslims as a whole are perturbed by alcohol or ciggie companies !

    Comment by ambik — November 11, 2007 @ 9:39 am

  37. Hi All,

    Just to respond to some of the previous posts…

    Nikhil said:
    *Sumit, nice story but I lost the plot a little – are you saying constant economic growth is the other side of the same coin namely interest?*

    The story was used by Bernard Lietar to illustrate how interest as a mechanism, creates a debt that doesnt exist – with the effect that somebody has to suffer (i.e. lose their money or go bankrupt) to pay off the interest. You illustrate some interesting points about ‘interest’ (sorry about the pun, somebody had to do it) and the concept of money. It is precisely about the concept of money, which is why Interest(called usury) has been forbidden in almost all traditional cultures -money was never viewed as an asset itself but rather a conduit, a means of exchange (as most traditional ecoonmies were Barter economoies). Amongst prominent names Aristotle, Thomas Aquinas and Imam Ghazali wrote extensively about the dangers of viewing money as an asset itself (thereby justifying the chargaing of rent – which is amongst the dominant justifications of interest).

    Of course this is where we stop, because we know that conventional finance views money as an asset. It is proven through numerous studies that asset and equity financing is a better performer than debt financaing, this is in essence what Islamic finance is.

    There are alternative systems of economics being expoused based on the Islamic paradigm by people who arent Muslims – please do a wikipedia search on Binary Economics and Rodney Shakespeare.

    Dear Siddiqui – I think the Tata Equity Fund sounds good(though I havent seen the Fund), there is the Mahendra Fund, Parsoli Equity Fund, the State Bank has an Islamic Fund coming soon…Im sure if you look around you will find lots of stuff.

    Raj said:*what bank offers in saving account is nominal interest rate. so real interest rate may be zero depending on the inflation. Which part is prohibated as per Islamic laws?*

    Well thats a valid point, the econmic effect of interest in terms of being at par with inflation would mean the money is not growing – but the reason why interest is prohibited in Islam is because it is an abuse of the function of money itself – so compound, nominal, fixed, floating and all other types of interest are forbidden. Infact interest as illustrated by many economists is the primary cause of our inflation driven environment to justyfiy intrest because of inflation is a circular argument. In an asset back currency such as Gold, the buying power should stay the same – although one would note that the price of Gold has changed over time, it is not because of Gold’s intrinsic value changing but because of the fact that currency is no longer of any value except in percpetion and the so the amount of gold bought by our paper changes . Post Bretton Woods, even the dollar is not pegged to Gold…so your money actually is simply a promise to pay what doesnt exist and only represents value as long as people accept it..if we all rushed a bank at the same time..that would crash the economy. Islamic Finance in its ideal is about real money (preferably Gold and Silver), real investments and asset backed finance.

    Raj also said:

    *What are the chances that “islamic banking” would have gained greater acceptance without the I word ? If people can invest in “green funds” and other such dedicated avenues, why not “interest-free banking” ?*

    Yes, the ‘I’ word lends terrible connoations in the non ‘I’ word, especially post 11th. The issue is that the Finance world has to demaracte it – it doesnt fit in with interest free banking (because there are many ethical injuctions) and it doesnt fit in with contemporary ethical banking (because most eithical funds do not regard investing in pork and interest as wrong or unethical). Efforts are underway to create some sort of paradigm between ethical and Islamic Banking as there is huge overlap barring some areas. Of course, some people take exception to ernaming Islamic Banking as ethical banking as they feel that may lend a holier than thou attitide, implying that others arent. It was felt that the name best fitted as its primary market would always be people concerned about Islamic injuctions towards finance and econopmics. Of course, you can agree with the philiosophy and passionately believe it proposes an alternative to the current system without being a Muslim – but often that requires a need to think beyond a tribalist mindset and looking beyond the ‘I’ word.

    Comment by Sumit Jha — November 14, 2007 @ 4:18 pm

  38. A Few words from a very close friend adressing the role of money as a commodity and inflation:

    * Why does Islam forbid interest when money is just another commodity that comes at a price? *

    Unlike an actual commodity (like gold, which has traditionally been the standard of measure for currencies), money has no intrinsic value. It
    derives its value from something other than itself, namely, market demand.

    So interest actually creates nothing. By creating money from nothing, we bloat economies with asset-less, service-less pieces of paper. And we all know what happens when the supply of anything, even
    money, exceeds its demand. Its price drops. And when the “price” of money drops, we get inflation; the money in our pocket becomes worth less today than it was yesterday. However simplified and stylised this
    description, it accurately illustrates the macroeconomic debilitation of interest. Because interest serves the interest (coincidence?) of
    capital owners like banks, governments, “development” agencies, corporations and wealthy individuals, it is unlikely to go away.

    The treatment of money has a commodity is partly responsible for burgeoning world poverty. (By forcing poor countries to allocate increasing amount
    of capital away from social services, like health care and education, towards debt servicing) and increased market volatility (by widening the gap between the supply of money and the creation of real assets).
    It is often asked how we would live in a world without interest.

    We might instead begin asking how should we be expected in a world with interest?

    *If Islam forbids fixed-income interest, what’s wrong with floating-rate interest? Doesn’t it allow raise and fall like profit? *

    Islam does not forbid fixation. It is permissible to fix profits (in percentage, not absolute, terms), prices, rents and instalment plans,to name a few measure. But it is forbidden to exchange money for a
    larger amount of money (unless the currency is different, in which case it is permissible at spot). The unlike exchange of like moneys creates
    riba. But exchanging assets or services for money and money for assets and services is entirely permissible. So the problem does not relate to whether an interest rate is fixed or floating, but to the interest itself.

    *Where should I keep my money? Islamic banking
    doesn’t adequately addresses the inflation problem and then you say interest banking is forbidden. If today’s $1 is going to be worth 90 cents next year because of inflation, why cant I charge interest to compensate for the loss? *

    The short answer: because interest from an Islamic perspective is still wrong. Charging interest to compensate for interest is analogous to terrorising civilians to compensate for global injustice: two wrongs do not make a right.

    In order to compensate for inflation, Islamic banks provide plenty of instruments that mimic the security and liquidity of an ordinary savings account while also providing a reasonable interest-free return (Meezan Bank’s monthly Musharaka certificate is just one example, but all major banks, including
    non-Muslim banks that sell permissible Islamic products, offer basic consumer accounts).

    If making a long-term personal loan, for
    instance, one might consider denominating the amount in gold (e.g. an individual lends $100 cash today and tells a borrower that he would like gold equivalent amount back in 3 years; $100 buys X grams of gold
    today; at the time of repayment 3 years later, X grams of gold buys $120; the borrower returns the lender the lender $120 cash).

    *Stocks are like gambling, but Islam permits stocks and forbids gambling. Why? *

    This returns to the basic principle of asset and service backing. Stocks invest in real assets (a company’s property, plant and equipment) and
    actual services (a company’s management expertise). Gambling invests in nothing.

    Even if a lottery funds charities or finances public works, the money with which it does so is still invested underlyingly in nothing – a number,a ticket, etc.

    Stocks provide risk-based returns based on publicly available information. Gambling provides only uncertainty and the distance prospect of huge gains based entirely on chance.

    To the casual observer “buying low and
    selling high” resembles gambling, but because there is no Islamic stipulation on the price at which something is sold and the duration of which it is held, the primary concern relates to what is actually
    bought and sold. Provided the main business of the company is permissible, the company owns some illiquid assets, and the investor removes the proportion of his profits that correspond to the company’s
    interest earnings. Then purchasing the stock is permissible Islamically.

    Questions are adapted answers from Atif Khan.

    About Atif Khan:
    Atif Khan writes on Islamic economic and finance. He studied ecomonic development at Harvard University and has worked as an investment banker with Morgan Stanley in New York and London.

    Comment by Sumit Jha — November 15, 2007 @ 11:38 am

  39. Some very good points have been highlighted here.

    Few things to keep in mind.

    -Islamic banking is referred to as a banking system. In my opinion many organizations market the name of their company as if it were for Islamic related transactions only, therefore, they are shooting themselves on the foot. I know quite a few wealthy folks who are “Angel Investors” or a mini-version of venture capitalist. The idea behind Islamic Banking relies primarily on the ability to gain wealth by the means of sweat and hard work rather than obtaining “rent” on the money.

    Also if someone is truly seeking to get funding there are many options available. Venture capitalists, Angel investors just to name a few.

    Comment by Adil — December 26, 2007 @ 2:38 pm

  40. 1.Whether a muslim can work in Central bank of a country(for example RBI india)
    2.Whether a muslim can have an account in a bank

    Comment by Shamseer — December 31, 2007 @ 9:50 pm

  41. Sumit,

    I think you are way to impressed by that book of yours. It has some decent points to make, but it fails to acknowledge that money supplies liquidity. It is not just junk paper. Some sovereign govt. backs this paper saying that it should buy some real commodity (rice, grains, clothes, etc.). The barter system had the most direct value (chicken for pork, etc.), but it was still unwieldy. Example – if I wanted to buy a home, how many chickens would I have to grow and barter? Economics has evolved, just like many things.

    You seem very impressed with Islamic finance, and it is okay for you to be impressed. But my understanding of Vedic texts tells me that nothing has the potential to be more sacred than the human mind. If the mind is sacred, everything else is. It doesn’t matter if I am taking interest or giving interest or whatever. Since money or asset or whatever you are to call it is only to sustain my physical existence anyway. Not my soul. If a human being knows how to control his/her mind, then the battle of existence on this planet is won anyway. I don’t need some sharia law written millenias back to tell me how to treat my mode of sustenance aka money/asset/et al.

    My problem with Islamic banking, and with entire Islam (and evangelical Christianity) is that they govern people’s lives way too much! Eat this way, dress this way, treat your women this way, treat your money this way, think of God this way, think of evolution this way, et cetera, et cetera. It never ends. I believe in total freedom of my physical self and of my mental and spiritual self. You can see how someone like me would have a problem with the I-banking.

    It is time that someone tells these Islamic proponents that a religion’s job is to lead people towards true spirituality and not to govern their lives.

    No dis respect meant to Muslims. I am just giving a valid criticism of how I think of their culture and religion as an outsider.

    Comment by R. — January 4, 2008 @ 4:16 pm

  42. I agree with Nelson

    First, there are three components of “interest”: rent, risk, and inflation. When somebody gives up use of their money, it is just like giving up use of their house, so they expect to be paid a rent for the use of their money. Same thing for the risk of harm: that’s why loans usually have collateral and flat rents usually require first and last month’s rent. But a component of the interest will cover the risk that the collateral doesn’t cover. And when the central bank inflates the currency, money later is worth less than money now, so a loan may require higher repayments with neither rent nor risk, but only to cover inflation.

    Second, there is no single “Islamic” interpretation of the ban on interest. Some Muslims are comfortable with a modest rate of interest. Some Muslims think that interest without risk is what the Koran inveighs against — in other words, they won’t accept any rent on their money, but they’ll accept risk and inflation payments. And other Muslims are willing to accept the loss of their money’s value in return for what they believe to be strict compliance with Islamic law. Gosh, Muslims disagree about what God wants! Wotta surprise! Muslims are people too!

    And yes, various religions have wailed against interest, but that doesn’t make it right. Spirituality comes from God; religions come from man; and man is biased against profit. See _The Myth of the Rational Voter_, by Bryan Caplan.

    Comment by chat — January 20, 2008 @ 2:22 pm

  43. Dear R. and all others,

    Islam per se is not a religion, it is a philosophy, a way to lead life. Or rather an ideal way to lead life.

    Islamic Banking, Finance and all ‘rules’ that Islam has, are a subset of this philosophy. Ask the many businessmen who would fly in the air if there were no interest charged on their loans, in exchange for a share in the business by the bank.

    I would earnestly request you’ll to avoid senseless critcism and do good research before commenting on a topic. Also avoid abuses. This is a thread not a wrestling ring.


    Ezaz, India

    Comment by Ezaz — March 22, 2008 @ 9:10 pm

  44. Financial Sector Reforms has a long way to go
    Syed Zahid Ahmad

    The CFSR (the High Level Committee on Financial Sector Reforms) has almost received all public comments over their draft report and may be busy in preparation of the final report, which may be submitted to the planning commission of India somewhere in the month of September 2008. It is possible that CFSR may miss some issues related to economic justice and financial stability of the nation. The approach of CFSR was not to arch the financial structure for inclusive growth; rather it was to promote the businesses of existing financial enterprises. Majority of the commentators over CFSR draft report were intended to snatch economic advantage from possible reforms and majority were basically guided by corporate forces. They are interesting to resolve their constraints compared to resolve the financial constraints restricting inclusive growth of India.

    If CFSR is sincerely making the reform proposals, I would just like to know some facts related to following issues.

    1. What is the share of Indian financial resources to organized and unorganized sector?
    2. What proposal it has made to ensure flow of more financial resources towards stock market to accelerate investment through equity participation?
    3. What proposal is there to ensure sustainable growth and stability in the stock market?
    4. What is the proposed structure for providing equity finance to unorganized sector?
    5. What is the scope of opening up of Islamic Banking and Finance in India, which is bypassing conventional banking in many countries?
    6. What are the real term financial constraints restricting inclusive growth of India?
    7. Which specific banking or financial problems associated to the unorganized sector is taken up under consideration by CFSR?
    8. What proposals are there to minimize economic disparity in India?
    9. What is future financial product for farmers and artisans to avoid suicide cases?, and
    10. What are the expected benefits of CFSR recommendations to achieve inclusive growth?

    The database and information sources are not available to general people; otherwise we would have drawn up the sketch of our financial sector reforms. Nevertheless, it is expected that still 60% Indians are deprived of formal sector banking and financial services, and just not more than 10% of national savings are transformed into capital by stock markets. The financial and economic plight of unorganized sector workers need serious and sincere efforts by our planners and policy makers because despite 60 years of independence, our financial sector and ministries are governed by few capitalists from corporate sector. Hardly have we seen any representation of the unorganized sector in making reforms processes.

    Now if we really desire inclusive growth of India, we have to focus our efforts to resolve the problems associated with the unorganized sector where around 94% Indian workers are making their livelihood. Moreover, we have to ensure that our maximum savings should be converted into capital through investments in equities. Moreover we have to adopt some practices to ensure fair trade in stock market and prevent ditching game by speculators.

    Without financial sector reforms in the unorganized sector we may not be able to help majority of Indians. If we have to see India grow in inclusive manner, we need to help the unorganized sector worker which is just possible through reforms for the unorganized sector. The reforms in formal sector will not help reduce poverty and income disparity.

    Comment by Syed Zahid Ahamd — July 14, 2008 @ 8:36 pm

  45. RBI may just ruin the Indian economy
    Syed Zahid Ahmad

    The present trend of recession in US and prevailed uncertainty in petroleum nations had provided an opportunity for India to pull capital resources from US and Gulf countries, but the practical approach of RBI has converted the opportunities into challenges as the liquidity and inflation is certainly not under control of the RBI who is attempting to freeze the liquidity by increasing the interest rate and cost of credits. Interest is a factor for liquidity and credit, but all cares should be taken up while we handle this instrument because if liquidity and credits influences inflation, are also necessary for growth and development. Increased cost of credits not only increases the cost of output, but also creates shortage of supply. This increases the prices levels further up. However the depositor gets higher rate of interest over their deposits and this inflates their purchasing power, thus boosts inflation. FICCI and the corporate sector have already disagreed with RBI recent announcement to increase the rate of interest.

    With recent trend of increased capital inflow into India the aggregate deposits by Scheduled Commercial Banks (SCBs) has increased from 80.7% in 2005-06 (Rs. 21,09,049 crores) to 102% (Rs. 31,96,939 crores) of GDP at factor cost by 2007-08. With increased deposits, the bank credits has also increased from Rs. 15,07,077 crores in 2005-06 to Rs. 23,61,914 crores by 2007-08 reflecting 75.6% of GDP at factor cost in 2007-08 as credit against 57.7% in 2005-06. This indeed is a situation, where our economists, financial sector regulators and bankers need to review the policy and practices adopted by RBI as we take interest as a major tool to control liquidity but we hardly evaluate the far reaching consequences of interest in our economic process.

    Our real term GDP growth rate (= GDP growth rate at factor cost – rate of inflation) has considerably declined from 5.2% in 2005-06 to 2.9% by 2006-07 and fell down to1.6% by 2007-08. As the interest increases the cost of credit and output, even the GDP value is inflated through interest. Thus the higher GDP growth rate like 9% just reflects 1.6% real term GDP growth rate if inflation rate is 7.4%. The liquidity theory of J. M. Keynes is failed here to guide RBI optimize these opportunities. The practical approach of RBI to curb the rate of inflation by increasing the rate of interest may not control inflation and might lead towards stagflation as the prices are continue to increase along with purchasing power of the depositors, but the expenditure, investment and net GDP growth rate is falling due to costlier credit and interest based deposit schemes.

    By increasing the rate of interest, liquidity might be controlled for shorter period, but with increased cost of credit, the GDP value will increase that leads to inflation. Interestingly the interest income to SCBs was Rs. 1,85,384.9 crores in 2005-06 which increased to Rs. 2,37,271.14 crores by 2006-07. It means by 2006-07 total interest income to SCBs was 7.1% of GDP at factor cost. It simply means that the interest income to SCBs has inflated the value of GDP at factor cost by 7.1%.

    With increase in rate of interest, the aggregate deposits might increase and SCBs may need to pays more interest over increased deposits. Total Interest expended by SCBs over deposits was Rs. 89,742 crores in 2005-06 which increased to Rs. 1,20,261.08 crores by 2006-07 showing a net annual increase of 34%. This growth is inflationary as it increases the buying capacity of the depositors. By 2006-07, the interest expended over deposits was around 4.20% of GDP at factor cost.

    If we add the interest income of SCBs to interest expended over deposits, it stands for around 12.5% of GDP at factor cost and 8.6% of GDP at market prices in 2006-07. Considering the impact of interest on inflation, we may need to add interest income of SCBs through investments / commercial credits with interest expended by SCBs over deposits. This amounts to approximately 9% of GDP at factor cost and 5% of GDP at market prices in the year 2006-07 while annual rate of inflation was 6.7%. It reflects that basically inflation is a result of interest charged on credits expanded by SCBs and interest expended over deposits. The interest charged by SCBs increases the cost of GDP and the price levels, while the interest paid by SCBs over deposits increases the purchasing power of the depositors. Both ways the interest is increasing the price level and causing inflation. Since RBI regulates the banking business in India, by increasing rate of interest it is increasing the inflation and decreasing the real term growth rates.

    Further to note that RBI is increasing the rate of interest for over one year to control the inflation which ultimately increasing the cost of GDP showing higher GDP value and increasing inflation instead of controlling it. Our total final consumption expenditure as % of GDP at market prices is already declining from 67.8% in 2005-06 to 65.5% by 2007-08. This decline along with inflation cannot be controlled by increase in interest rate. This economic tendency may leads to stagflation which is more dangerous for economic stability and growth. The unemployment rates in increasing, the investment rate is also declining; so RBI should review its policies and practices to monitor liquidity, credit and inflation, if we have to combat inflation and attain desirable growth rate.

    Islamic economic ethics suggests mechanisms for stable and anti inflationary monetary system which should be adopted by RBI to make our monetary system more stable and anti inflationary. Hope the RBI will consider these ethics as measure to combat inflation and stagflation. Islamic Banking principles and practices will not only increase the equity deposits and finances but also promote capitalization and investments. It will help increase employment and business opportunities which are must for inclusive and foster growth of India at a time where world is eying upon Indian economy for making more investments. Otherwise consistent approach of RBI to control inflation through interest rate may let the UPA government face cruel failures in capitalizing the investment and growth opportunities with worst off inflation and stagflation.

    Wish all the best for Indian economy, the general Indians, RBI and the UPA government.

    Comment by Syed Zahid Ahamd — August 2, 2008 @ 9:22 pm

  46. I fully support an agree with the analysis given by Mr. Syed Zahid Ahmad.

    Ali Hashmi

    Comment by Ali Hashmi — August 3, 2008 @ 7:36 pm

  47. Readers may kindly note that the following section has been deleted from the actual article, so kindly do not consider those portion as part of the original article.

    “Our real term GDP growth rate (= GDP growth rate at factor cost – rate of inflation) has considerably declined from 5.2% in 2005-06 to 2.9% by 2006-07 and fell down to1.6% by 2007-08. As the interest increases the cost of credit and output, even the GDP value is inflated through interest. Thus the higher GDP growth rate like 9% just reflects 1.6% real term GDP growth rate if inflation rate is 7.4%. “

    Comment by Syed Zahid Ahmad — August 10, 2008 @ 9:54 pm

  48. Economics of Islamic Banking in India
    Syed Zahid Ahmad

    With silent debates on Islamic Banking in India among Indian Muslims, some of our financial sector players and political leaders, time has come that besides considering the religious, social, political and diplomatic dimensions, we should understand the economics of Islamic banking for Indian economy.

    Financial Sector Reforms and Islamic Banking:
    Though the draft report was silent about Islamic Banking, it is expected that the final report by the Committee on Financial Sector Reforms (CFSR) will add some note about Islamic banking because the issue was raised during the seminar at Mumbai on 12th June 2008 where the committee members assured to consider it in the final report. The recent growth trend of Islamic investment funds worldwide has made some financial sector players feel that it was like a lost wisdom to miss Islamic banking so far which has some post modern financial products / services. Recently Zee news and the statesman have published projecting high potentials for Islamic banking in India. And latest with statement of Mr. Amar Singh (Samajwadi Party) on 1st September 2008 to pitch for Islamic banking, this issue has got some more attention in India. So, before it become a political agenda, it is better to evaluate its economic value for India.

    Silver Lining for Islamic Banking in India:
    In recent years the Islamic Investment business is gaining considerable grounds and companies like McKinsey & Company Inc. and Bearys Group are already dealing big businesses through Shariah Investments funds. East wind launched Islamic Index; and Reliance Money and Religare have launched Shariah Complaint Portfolio Management Services. As a result Indian Stock market is also observing some better trends in Shariah complaint stocks. With increased market of Shariah investments world wide, if China is going for Islamic banking to pool Islamic Investment Funds, why India should not allow Islamic banking with 150 millions Muslim who may help us pool around one trillion dollars Islamic investment funds from Gulf countries that too on equity base which keep our national current account and fiscal deficit under control.

    Facts and fictions about Islamic banking in India:
    It is unfortunate that our financial sector regulators have crisis of professional experts to visualize the prospects of Islamic Banking in India, that’s why RBI or any other committee have yet to visualize the scope of Islamic banking in India. So far Islamic banking has been considered as a mere religious matter for Indian Muslims and thus it is not allowed with a fear of financial segregation, a threat of parallel banking system for RBI along with any hidden fear for SCBs to loose Muslim depositors. There has never been any public committee analyzing the impact of Islamic banking in India because Muslims of India were never so evocative about features of Islamic banking in India while the other community members had no background to conceive this concept to required level for projecting its utility for Indian economy. Off Course the concept of Islamic banking is driven by ethics of Islam, but it has more economic utility compared to its religious vigour which needs some genuine study by professionals having basic knowledge of Islamic banking and expertise on Indian economy because Islamic banking carries more advantageous features to boost real sector economy compared to financial sector. It is a need of the hour that Indian government should constitute a committee on public domain to study and analyze the economic significances of Islamic banking for the Indian economy.

    Economic analysis of Islamic Banking in India:
    Islamic banking may not be allowed just for a community as a religion based banking business, but it should be allowed after thorough study of its potential to resolve our real economic problems. The report by Sinha Committee was incomplete and thereafter still we have to find any report on economic viability of Islamic banking and its impact on inclusive growth. We have to remove the prejudices about Islamic banking and need to study it as a core economic issue irrespective of its base driven form Islam.

    Future leaders of Islamic banking in India:
    There might be a prejudice among top bankers that since Islamic banking originates from Islam, Muslims might take a lead in Islamic banking and their supremacy in banking sector may not be sure after Islamic banking. However the reality may be far different from the fiction. Hardly Indian Muslims are capable to hold major shares of Islamic banking business in India as they lack required infrastructure, financial depth, banking creditability to attract the general depositors and investors under Islamic Banking. Islamic banking is not a children’s game. It requires even better professional expertise compared to conventional banking because it deals more with commercial projects than mere monetary credit and debit transactions. Indian Muslims may feel privileged in terms of Islamic ethics required for Islamic banking but they certainly lack professional efficiency to manage modern commercial banking on Islamic ethics. Our leading nationalized bank (SBI) is somehow reaching to that expertise which is required to manage Islamic banking, but they have to hire services of experts on ‘Islamic Banking’. The RBI code of conduct to SCBs putting thrust on SMEs is reflecting the need of advanced commercial banking in India which would be focus under Islamic Banking. SBI performance has been best among nationalized banks to lend commercial credits. But still majority of unorganized sector workers who are non-bankable due to collateral problems are actually needing equity finance instead of debt finance. All the difference among nationalized bank’s operation and Islamic banking is the mechanism of credit and deposits. Under Islamic banking mechanism thrust would be on equity deposits and credits while interest charged would be replaced by profit margins on commercial credits and interest expended over deposits would be replaced by dividend on equity finance with deposits mobilized as equity deposits by banks.

    It is expected that with introduction of Islamic banking in India, the first choice of depositors and investors would be nationalized banks as despite contradiction of interest, Indian Muslims have a confidence in nationalized banks. To ensure security of deposits majority of Muslims depositors would prefer to join Islamic banking managed by nationalized banks. However it is expected that Foreign Investors looking to invest in India through Islamic banking, would prefer to have services of foreign banks. As far Indian Muslims are concerned, they have to make hard efforts to find their place in managing Islamic banking in India because they lack required financial depth; infrastructure and more importantly they have poor credibility among the depositors and investors due to some past failures of financial institutions.

    Beside to take political, social, religious and diplomatic advantages, Islamic banking is more desired for Inclusive growth of India. It is all important to evaluate probable impact of Islamic banking in different segments of Indian economy. Every segment is expected to enjoy its benefits.

    • The 150 millions Indian Muslims would enjoy their religious rights in banking sector with provision to get rid of interest which is strictly prohibited in Islam.
    • With introduction of Islamic banking, the UPA government may get advantage to please the second largest community of India who are somehow uncomfortable with linking of recent terrorist attacks with only Muslim community or in other words by hearing the terminology of Islamic terrorism.
    • With introduction of Islamic banking, Indian government will gain diplomatic advantages to make financial dealings with Muslim dominated nations especially to attract trillion dollars of equity finance from gulf countries.
    • The operation of Islamic banking will allow the Muslims to work with majority community in banking sector which is not found in proportion to their population share so far, because RBI has just 0.78% Muslims and SCBs have just 2.2% Muslim employees. Similarly Muslims have a poor employment rate in NABARD and SIDBI because every where financial institutions are dealing with interest and Muslims do not like to work with interest based banking and financial institutions. It is a major factor causing financial exclusion of Indian Muslims. With Islamic banking this exclusion may be removed and it would definitely help us build civil society economy.

    Islamic Banking is rated as one of the urgent needs of Indian economy as it is the only banking mechanism which seems to arrest the liquidity and inflation problem along with allowing GDP growth with adequate share in all segments. The increased percentage share in GDP by agriculture or manufacturing industry, or per capita income growth is just not indicative of true inclusive growth. For real inclusive growth, we have to ensure increase in income and employment status of workers at all segments. Empirical evidences reflects that though India has registered better growth rate in recent years, the number of poor living below poverty line has increased in our country. It may be noted that the household consumption is directly related to household income which has declined in recent years; while corporate savings are directly related to income of corporate sector which has increased. Thus we may conclude that with better GDP growth rate in recent years, our corporate sector has snatched the fruits of growth, while majority of work force have failed to enjoy the fruits of development.

    Similarly if we analyze the share of financial sector in GDP growth, we may find that in recent years the growth rate of financial sector has been better which indicate that share of deposits and credits to GDP has increased. Since our SCBs extend debt finance, these credits put interest cost as part of GDP cost which causes inflation. While under equity finance since the credit cost is zero, the growth of credit share to GDP cannot add cost of GDP thus cannot create inflation. On the contrary the dividend shared by depositors on equity finance help equitable distribution of income generated through financial sector, thus instead of concentration of credit to corporate sector, the generated income will be shared by household sector which would increase level of consumption, pushing the economy on faster growth track. This is the basic difference of debt and equity credit which needs our financial sector regulators attention. The prime economic advantages of Islamic banking could be as following –

    Islamic Banking and Financial Inclusion
    Though we do not have any survey to compare community wise financial exclusion in India, the primary study of data available through Sachar Committee report reflects that still around 50% Muslims are financially excluded and banking is inversely related to concentration of Muslim Population. The reason is just prohibition of interest in Islam and thus wherever Muslims are concentrated; they find means practicing interest free banking through societies and NBFCs. With inception of Islamic banking it is expected that Muslims will join Islamic banks which will remove their financial exclusion.

    The Indian Muslims have a share of 7.4% in saving deposits while just get 4.7% of credit in terms of PSAs. If we consider this as a standard proportion in national aggregate deposits with and credits maintained by SCBs, Indian Muslims annually loose around Rs. 66,700 crores because Muslims have a credit deposit ratio of 47% against national average of 74%. It shows that Muslims of India loose around 27% of their deposits by not availing as credits. After Islamic banking this deficit may be removed to curb financial loss to Indian Muslims because with 31% Muslims living below poverty line and 40% Muslim workers as own account workers, the deficit of credit is like economic assassination of the community. Muslims avail just 4% and mere 0.48% credits from special financial institutions like NABARD and SIDBI respectively because there also the community has to indulge in interest which is strictly prohibited in Islam.

    Business of nationalized banks would be increased:
    So Indian Muslims are looking for Interest free banking to avail much needed credits for development which is possible through introduction of Islamic Banking in India. This may add at least approximately 60 millions Muslims to formal financial sector. Through this financial inclusion of Indian Muslims to formal sector Islamic Banks, it is expected that Indian nationalized banks may see additional savings worth 1,00,000 crores and credit worth over Rs. 2,00,000 crores which may help banks to gain higher rate of profits compared to their SLR. After successful operation of Islamic banks by our nationalized banks, private banks may also enter into dealing with Islamic banking. It is not rational to presume that only Muslims will deal with Islamic banking, but approximately 25% of non Muslims may also deal with Islamic Banking as in case of Malaysia.

    Stock Market Capitalization
    Since Islamic banking focus on equity deposits and finance, it is expected that Stock market will be the most preferred avenue for investments by Islamic banks of India because currently it is our stock market which is attracting new investments under Shariah Finance schemes. With advanced art of technology for investment with liquidity and profitability, it is expected that majority of deposits with Islamic banks in India will be preferably canalised to stock market. It would be the safest and fasted mode of deploying equity funds. Thus Islamic Banks may add additional 6 million new D mat accounts with expected capital gain of Rs. 60,000 crores from domestic market and around 1 trillion US $ through Islamic Banks managed by foreign bankers in India.

    Formal Sector Economic Agents
    Under Islamic banking the formal sector economic agents like corporate firms listed with stock markets would be the first likely beneficiary of Islamic banking because their shares would be subscribed through investors at Islamic banks. All the companies listed in stock markets will have additional potential subscribers to genuinely subscribe their shares instead of mere trading stocks to gain for speculation.

    Islamic banking will bring Revolution:
    Islamic banking will allow the manufacturing and retail enterprise of unorganized sector and agriculture to obtain equity finance which would bring revolution in Indian economy because our majority of poor and vulnerable workers are associated to agriculture and unorganized sector that are not in a position to afford financial risks for capitalization which affects their productivity and income levels. Their financial background is not encouraging SCBs to extend debt finance to them in lack of collaterals. While in case of Islamic banking the inadequate capital ratio in unorganized sector could be resolved through equity finance which might be a revolution is our agriculture and unorganized sector. With improved capital ratio, our poor and vulnerable workers associated with agriculture and unorganized sector might be able to compete with the formal sector workers with their enhanced productivity. This might allow our leaders to substitute grants and subsidies with financial institutions focussing on equity finance because self reliability is more important for growth which never comes through grant and subsidies but with successful utilization of equity finance. The stabilization fund for poor farmers and artisans may be utilized to experiment such finance with Islamic banking.

    Islamic Banking and Public Finance:
    Islamic banking may further help us mobilize capitals on equity base to meet the investment needs for irrigation, dams, roads, electricity, and communication projects along with other infrastructure where public finance is insufficient and debt finance may be cause deficit to the government. With Islamic banking raising equity funds would be easier for banks. We must not forget that over 50% of our rain fed lands need irrigation which need equity finance to reduce the credit costs. The total investment in infrastructure, in 2006–07 was estimated to be around 5% of GDP. It has to be 9% of GDP by 2011-12, it means that we would require Rs. 2,07,291 crores in 2006-07 and Rs. 5,74,096 crores by 2011-12 to finance our infrastructure. The total investment amounts to Rs 20,56,150 crore for the 11th five year plan. Of which Rs. 14,36,559 crores is supposed to be met from Public Investment wile Rs. 6,19,591 from private investments. Islamic banking through promoting equity finance from national and international markets may reduce this burden effectively with keeping public finance well under control and probably we may need not to worry about fiscal deficit as well.

    Since Islamic banks may also have managerial control over commercial financing, government might use banking units as source to mobilize taxes as well which might reduce mobilization costs for public revenue and increase margins for governments.

    Islamic Banking and Indian Economy:
    Viewing the probable multi dimensional positive impacts of Islamic banking on Indian economy, there are many reasons to smile for Islamic banking in India. It is helping our financial sector maintaining stability while helping real economic sector attain inclusive growth. The public finance would be much benefited through Islamic banking by generating investment funds on equity basis. Thus Islamic banking should be considered as a core economic need of the economy instead of viewing it as a religious matter for Indian Muslims. By any projections, it is expected that Islamic banking may help us mobilize business up to 5% our GDP with making due corrections in financial and real markets. Therefore it should be considered as a genuine economic need of the nation instead of considering it as religious, social or political issue. Hope all patriot Indians will flag green signal to Islamic banking as it is opening the doors towards faster and more inclusive growth – An approach to 11th five year plan of India.

    Since we have no project or viability report on this issue, it would be better to form a committee on public domain to analyze Islamic banking and its impact on Indian economy before we take any action in this regard because a delay but careful step is far better than any hasty move with prejudice.

    Comment by Syed Zahid Ahmad — September 6, 2008 @ 12:14 am

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