One of the most important themes to which Indian scholars have made pioneering contribution is the area of Islamic Economics. The present paper attempts to attempt to bring on the record postindependence India's contribution to Islamic economics.Islamic Economics; Indian Economics;

Islahi, Abdul Azim

English

Research Papers in Economics

Obstacles in the way of Islamic banking and 
finance in India 
 
Abdul Azim Islahi* 
 
The present paper aims to give a brief account of the main difficulties 
faced by the movement of Islamic banking and finance in India. Some 
of these obstacles may not be special to Indian case. However, their 
intensity becomes many folds due to prevailing condition of suspicion 
or indifference and absence of executive and enforcing power. The 
purpose of highlighting these issues is to draw the attention of 
scholars and business activists to think over the measures that may be 
adopted to overcome these difficulties.  
 
The modern history of Islamic banking and finance in India originated 
in the wake of controversy that arose in the second quarter of the 20th 
century regarding the legitimacy or otherwise of bank interest and 
which developed into consensus like opinion on its prohibition.
1  This 
led to the discussion of finding the alternative arrangement based on 
Islamic principles. As a result some valuable academic works 
appeared which were also the first and pioneering writings in the 
development of modern Islamic economic theory.
2 But no worth 
mentioning institution of Islamic finance could be established in the 
first half of twentieth century. The second half saw forthcoming of a 
chain of Islamic financial institutions either in the form of interest free 
lending societies or interest free participatory investment and finance 
houses. However, a full-fledged Islamic bank remained still a dream 
for Indian Muslims. Even the interest free non-banking financial 
institutions could not present any bright record or successful story due 
to various obstacles discussed below. 
 
The first and the foremost obstacle in the establishment of Islamic banking in 
India is the legal hindrance. The very law of banking in India does not permit 
to establish a bank without interest. Section 17 of RBI Act 1934 and section 
24 of the Banking Regulation Act 1949 require the commercial banks to 
invest a portion of their deposits in interest bearing government and public 
sector securities. At one time the legal reserve and forced investment under 
cash reserve ratio (CRR) and statutory liquidity ratio (SLR) amounted more 
than 50% of banks' deposits. Now they have been drastically reduced. But 
simply removal of legal hindrance will not ensure establishment of a 
successful competitive Islamic bank. There are a number of other obstacles, 
discussed below, in the way of Islamic banking and financial companies that 
have to be removed.   
 
                 It may be noted that the existing government rules could have been used to 
establish interest free investment companies under the category of non-
banking financial companies (NBFCs) on Islamic lines of varying degrees. 
The Islamic business activists noted it only lately and made certain 
experiments.
3 But the growth and performance of interest free financial 
institutions has not been satisfactory due to various constraints.  
 
The frequent changes, though for genuine reasons, in to regulatory 
framework of Indian .financial sector become an important obstacle. 
while some of these changes were in favour of Islamic financial 
institutions, a majority of them hindered their advancement. Earlier NBFCs were governed by Companies Act 1956, which did not even 
contain the definition of a finance company. The registration of these 
companies with RBI was made compulsory during April 1993 to 
March 1995. The government enacted RBI (Amendment) Act 1997, 
which conferred, wide ranging powers on RBI for controlling the 
functions of NBFCs. The latest amendments to NBFCs guidelines 
state that "An NBFC having certificate of registration and otherwise 
entitled to accept public deposits is allowed to open its branch/office 
or allow its agents to operate for mobilization of public deposits 
within the state where its registered office is situated if its NOF (not owned 
fund) is up to Rs. 50 crore and anywhere in India if its NOF is more than Rs. 
50 crore and its fixed deposits programmes have been rated by one of the 
approved credit rating agencies at 'AA' or above.
4  These amendments clip 
the wings of all Islamic financial companies (and they are already few) as 
none of them qualifies to operate beyond the state of its registered office.  
 
Another trouble comes due to unequal treatment of debt and equity fund. The 
capital of Islamic financial companies is equity-based operating through 
profit and loss sharing. Under the existing government rules profit is taxed 
while interest is exempted from tax on the ground that it is a cost item. This 
puts the Islamic financial institutions in the disadvantaged position. In the 
annual budget of 2000-2001 the rate of tax on dividends has been increased 
from 10% to 20%. 
 
 Islamic financial institutions in India are working in an environment which is 
secular and interest-based. It is but natural in such circumstances to be 
deprived of official sympathy and patronage. Due to this fact, it is sometimes 
very difficult to get certain provisions of Islamic banking and finance 
executed and arising disputes resolved. 
 
While conventional commercial banks and cooperative societies have the 
facility of deposit insurance and credit guarantee, no such facility is available 
for Islamic banking and financial institutions which develops sense of 
insecurity and lack of confidence. 
 
In addition to non-availability of Islamic insurance schemes, lack of interest 
free instruments, undeveloped Islamic primary market and non-existence of 
secondary marker for Islamic product are some other serious problems of 
Islamic banking and finance in India. It may be noted that conventional banks 
have various types of financial products for investment. But the Islamic   
institutions have only a few traditional avenue of investment which limits 
their competitive capability. 
 
The Islamic spirit requires that the institutions operating on interest 
free basis should work in coordination and cooperation of each other. 
But the business interests and occupational rivalry very often make 
them indifferent and non-cooperative to each other. Thus, the benefits 
of joint venture, research and experiments, formation of block, 
institutional lending, etc. which could have strengthened them are not 
enjoyed by them. 
 
Again the transparency in profit distribution, proper documentation, 
regular balance sheet, trained personnels, financial expertise, standard 
accounting procedure, compliance to existing government rules, along 
with the Shar`iah principles are necessary elements to promote and 
restore' the confidence of investors. Unfortunately on all 'these issues, 
Islamic financial institutions in India have shown a mere failure. 
 Since under profit and loss sharing partnership of  mudarabah, the 
capital loss is always borne by the investor, there is always fear that 
the entrepreneur may give misstatement about the loss or under-report 
the profit as the moral and ethical condition of  people is not very 
reliable. Unless a mechanism is evolved to check such happenings, the 
investor's confidence cannot be fully secured and an atmosphere of 
suspicion will be surrounding him. 
 
Interest based-advances and credits have built-in provision for 
penalizing the defaulters or late payers. Islam exhorts its followers to 
give time to a poor, till he is able to return his debt. But there is no 
clear guidance about dealing with the rich defaulters. It is generally 
complained that this provision has been misused by the rich and 
wealthy debtors, which slows down the operational capacity of the 
interest free institutions. In the opinions of some contemporary 
scholars, the rich defaulters should be fined but the amount should be 
spent on charity.
5 The issue needs further analysis and discussion to 
reach a consensus. 
 
Last but not the least. There are several agencies to rate credit worthiness of 
interest based financial companies. But there is no such arrangement on the 
part of Islamic institutions. Due to this many foul and fraudulent 
companies entered the Islamic milieu and with crores of rupees fled 
by night. In many cases they presented the best example of hypocrisy 
and dichotomy by challenging the institution of interest and at the 
same time practicing the interest themselves. 
 
There is also lack of qualified Shari`ah experts who could understand the 
intricacies of modern business styles. Sometimes these companies keep a 
traditional alim (religious scholar) in the board of their directors only to 
befool the public and encash his popularity. 
 
To end the paper on an optimistic note I would like to submit that 
most of the obstacles mentioned above are already subject of concern 
for Islamic economists in India and abroad. And where there is will, 
there is a way. However, the main challenge facing Islamic banking in 
India is how to communicate the idea to decision makers as a viable 
alternative. Done effectively, this, in a democratic country, may 
eventually pave the way for wider acceptance of interest free banking 
which is currently perceived as something 'needed' by Muslims alone. 
As a matter of fact, reaching out to the general Indian population with 
the message 'that Islamic interest free banking is more conducive to 
efficiency, stability and social justice is necessary for the realization 
of the full potential of Islamic banks in India. The democratic set-up 
of the country and its recent policies in favour of globalization, 
liberalization, etc. provide suitable environment to establish such a 
bank with or without collaboration of foreign Islamic banks. 
 
Another front, which demands our immediate attention, is formation 
of Islamic rating agency so that vested interest may be eliminated. 
They want to hijack the movement of Islamic banking and finance for 
their selfish ends and ultimately defeat the very purpose of the 
movement. There is urgent need to increase the research and 
investigation to remove the hurdles in the way of Islamic banking and finance and expose those who exploit the sentiments under the guise of 
practicing interest-free system while in reality they are not. 
 
 
NOTES AND REFERENCES 
 
1. For a description of this controversy one may refer to Fazlur Rahman, 'Tijarti Sud 
Tarikhi aur Fiqhi Nuqta-e- Nazar Se" (Commercial Interest from the stand point of 
History and Islamic Law) (Urdu), Aligarh Muslim University, 1967. 
 
2 Although a number of works appeared around the mid 20
th century in which 
Mudarabah was suggested as an alternative to interest based banking system, the first 
clear exposition of the theory of Islamic banking was drafted by Dr. M. Uzair - a 
graduate of Allahabad University. See, Uzair, Muhammad, "An Outline of Interest-
less Banking': Karachi/Dacca, Raihan Publications, 1955. 
 
3. In one of his articles Mr. M. H. Khatkhatay expressed his grief over the Islamic 
financial institutions for not being able to exploit opportunities available in India for 
many decades after independence. Khatkhatay, M.H. "Islamic Investment Activities in  
India': Paper presented at the second conference on Islamic Banking and Finance, 
Toronto, Canada, June 1997, Mimeo, p. 2. 
 
4. The Journal of Banking, New Delhi, Vol. 19, No.4,  April 2000,  p. 10. 
 
5. Usmani, Muhammad Taqi, An Introduction to Islamic Finance, Karachi,  Idaratul 
Ma'arif. 1998, pp. 132-139. 
 
References 
1.  Fazlur Rahman,  'Tijarti Sud Tarikhi aur Fiqhi Nuqta-e- Nazar Se" 
(Commercial Interest from the stand point of History and Islamic Law) 
(Urdu), Aligarh Muslim University, 1967 
 
2.  Uzair, Muhammad, "An Outline of Interest-less Banking': Karachi/Dacca, 
Raihan Publications, 1955. 
 
3.  Khatkhatay, M.H. "Islamic Investment Activities in India': Paper presented 
at the second conference on Islamic Banking and Finance, Toronto, Canada, 
June 1997, Mimeo, p. 2. 
 
4.  The Journal of Banking, New Delhi, Vol. 19, No.4,  April  2000,  p. 
10. 
 
5.  Usmani, Muhammad Taqi,  An Introduction to Islamic Finance, Karachi,  
Idaratul Ma'arif. 1998, pp. 132-139. 
 
 
 

An Outline of Interest-less Banking':

Islamic Investment Activities in India': Paper presented at the second conference on Islamic Banking and Finance,

Taqi, An Introduction to Islamic Finance, Karachi, Idaratul Ma'arif.

Tijarti Sud Tarikhi aur Fiqhi Nuqta-e- Nazar Se&quot; (Commercial Interest from the stand point of History and Islamic Law) (Urdu), Aligarh Muslim University,

Post Independence India's contribution to Islamic Economics

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