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The first model, relying on the concept of profit-sharing, integrates assets and liability side based on a principal called the two-tier Mudarabah. This model envisages depositors entering into a contract with a banking firm to share the profits accruing to the bank’s business. The bank, on its asset side, enters into another contract with an agent entrepreneur who is searching for investible funds and who agrees to share his profit with the bank in accordance with a predetermined percentage stipulated in the contract. The bank’s earnings from all its activities are pooled and are then shared with its depositors and share holders according to the terms of their contract. Thus in the profits model, the banks are allowed to accept demand deposits that earn no profit and may be subjected to a service charge. This model, though requiring that the current deposits must be paid on the demand of the depositors, has no specific reserve requirement. It further stipulates that the bank is obligated to grant very short-term interest-free loans (Qard Hasan) to the extent of a part of the total current deposits.
The second model divides the liability side of the bank balance sheet into two windows, one for demand deposits (transactions balances) and the other for investment balances. The choice of the window would be left to the depositors. This model requires a 100 percent reserve for the demand deposits but stipulates no reserve requirement for the second window. This is based on the presumption that the money deposited as demand deposits is placed as Amana (safe-keeping) and must be backed by 100 percent reserve, because these balances belonging to the depositors do not carry with them the innate right for the bank to use them as the basis for money creation through fractional reserves. Money deposited in investment accounts, on the other hand, is placed with depositor’s full knowledge that his deposits will be invested in risk-bearing projects; therefore, no guarantee is justified. In this model, too, the depositors may be charged a service fee for the provision of the safe-keeping services performed by the bank. Provisions of interest-free loans have to be limited to the fund deposited in such accounts by the depositors who may consider that the banks may be better equipped for this purpose. No portion of the deposits in current accounts or investment accounts will be required to be used for this purpose.” 2
A critical analysis of the perception of the commercial banking and its Islamic alternative reveals that the former relies on earning ‘interest’ and the latter relies on ‘trade profit.’ To explore the possibility of practising Islamic banking in India we need an affirmative answer to the question. “Is trading permitted for banks under the existing Indian Law?”
M.L. Tannan has given an answer to the question in negative. “For the beginning of the accidental banking in India we must go back to the Calcutta Agency Houses, the trading firms, which undertook the banking operations for the benefit of their constituents. Prominent among these were Messers Alexender & Co. and Messers Fergusson & Co. Both firms combined banking with other kind of business, and both were predecessors of the early joint stock banks in India. The bank of Hindustan, a mere appendage of the former, was the earliest bank started under Euroupean direction in India.
Fatal Combination of Banking with commercial enterprise- That banking is incompatible with any other kind of business, was illustrated by the commercial disaster of 1829-32. Banking needs to be run with great caution, while adventure to a certain extent is necessary for other kinds of business eg. Industry & Commerce. Reckless speculation and a policy of placing profits before safety were responsible for the failure of the agency houses, which also involved a collapse of their banking departments. Having successfully withstood three severe runs on it, the Bank of Hindustan could not survive the failure of its parent firm in 1832. Even in the case of Sholapur Bank Ltd which went into liquidation in 1918, the failure was attributed to this fatal combination. Besides the usual banking business, this bank had the powers to do the business of “merchants or capitalists either as principal or agents”. The then Chief Justice of Bombay, passed very strong strictures on such a practice (Govind V. Ramnath, 32 Bom. L. R. 232) and suggested the legal prohibition of combining banking business with other commercial enterprise could have made what happened more difficult, if not impossible. The Indian legislation recognized the principle of separation of banking business from any other kind of commercial undertaking”3.
Thus the Indian legislation had, inadvertently, adopted a policy which would go against the concept of Islamic banking much before its emergence.
Various provisions of Banking Regulation Act 1949, Reserve Bank of India Act 1934 and credit policy decisions of RBI which come in the way of Islamic banking are being reproduced below. Certain suggestions regarding amendments in the Indian Banking Law and in the model of Islamic banking to make them compatible with each other have also been made.
BANKING REGULATION ACT 1949:
Business of Banking Companies:
Sec (6) Forms of business in which banking companies may engage – (1) In addition to the business of banking, a banking company may engage in any one or more of the following forms of business, namely: (a)-----(n).
(The complete text is available hereinafter under ‘the concept of banking’ in the contemplation of law-the Indian law).
Comments:
Clauses (a) to (n) of sub section (1) of Sec. (6) describe various forms of business but do not include trading of goods. However, clause (0) of sub section (1) of sec. (6) provides that any other form of business, which the Central Government may, by notification in the official Gazzette specify as a form of business in which it is lawful for a banking company to engage.
Sec 6 (2) says that no banking company shall engage in any form of business other than those referred to in the sub section (1)
Prohibition of Trading:
Sec (8) Notwithstanding any thing contained in Sec 6 or in any contract, no banking company shall directly or indirectly deal in the buying or selling or bartering of goods, except in connection with the realization of security given to or held by it, or engage in any trade, or buy, sell or barter goods for others otherwise than in connection with bills of exchange received for collection or negotiation or with such of its business as is referred to in clause (i) of sub section (1) of section (6).
[Provided that this section shall not apply to any such business as is specified in pursuance of clause (o) of sub-section (1) of section (6).]
Explanation - For the purpose of this section, “goods” means every kind of movable property, other than actionable claims, stocks, shares, money, bullion and specie, and all instruments referred to the clause (a) of sub-section (1) of section 6.
Comments
The above provisions of the law are contrary to and strike at the basic contracts of Islamic banking like Mudarabah, Musharaka, Murabaha (sale with a markup), Bai Salam (payment is made against deferred delivery) etc. on the assets side.
An Islamic Bank under these contracts has to deal, directly or indirectly, in buying or selling or bartering of goods.
Similarly there is no provision under the law for banks to accept deposits on investment account ie Mudarabah deposits on the liabilities side. These deposits are akine to equity while bank deposits are merely debts. Even if, the bank does not pay any interest on the money deposited, it continues to be customer’s debtor. (Official Liquidator, Hanuman Bank Ltd. V. K.P.T Nadar and others, 26 comp. Cas. 81).
Suggestions
The above shortcomings can be made good by the Central Government, by virtue of the powers vested in it by clause (o) of sub-sec (1) of sec (6), through a notification in official Gazette to expand the list of forms of business in which a banking company may engage, in addition to the business of banking, to include investment deposits, trading of goods, Mudarabah, Musharakah, Murabaha, Bai Salam etc. This does not require any legal amendment. (The full text of clause (o) of sub section (1) of section (6) is available hereinafter under “concept of banking in the contemplation of law–the Indian Law”)
However, issuing of a notification may not be a healthy proposition for the reasons; firstly combination of banking with trading has been found to be fatal as stated above and secondly Musharakah and Mudarabah contracts of models of Islamic banking appeared to be non - feasible as explained in the latter part of this paper.
Sec (9) Disposal of non-banking assets -
Notwithstanding any thing contained in Sec 6, no banking company shall hold any immovable property howsoever required, except such as required for its own use, for any period exceeding seven years from the acquisition there of or from the commencement of this Act, whichever is later or any extension of such period as in this section provided, and such property shall be disposed of within such period or extended period as the case may be:
Provided that the banking company may, within the period of seven years as aforesaid, deal or trade in any such property for the purpose of facilitating the disposal thereof:
Provided further that the Reserve Bank may in any particular case extend the aforesaid period of seven years by such period not exceeding five years where it is satisfied that such extension would be in the interests of the depositors of the banking company.
Comments
An Islamic bank is supposed to hold immovable property in its name for a period more than the prescribed limit. As such these provisions of Indian banking law restrict the scope of Islamic banking in the matter of “Leasing”, “Ijara”. But we do not propose an amendment in the law as Sec. 19 (1) provides sufficient relief in the matter.
Sec (17) Reserve Fund – (1)
Every banking company incorporated in India shall create a reserve fund, and shall, out of the balance of profit each year as disclosed in the profit and loss account, prepared under section 29 and before any dividend is declared, transfer to reserve fund a sum equivalent to not less than twenty percent of such profit (RBI now directed banks to transfer not less than 25% of net profit to reserve fund w.e.t March 31, 2001).
[(1A) Notwithstanding anything contained in sub-section(1), the Central Government may, on the recommendation of the Reserve Bank and having regard to the adequacy of the paid-up capital and reserves of a banking company in relation to its deposit liabilities, declare by order in writing that the provisions of sub-section (1) shall not apply to the banking company for such a period as may be specified in the order:
Provided that no such order shall be made unless, at the time it is made, the amount in the reserve fund under sub-section (1), together with the amount in the share premium account is not less than the paid-up capital of the banking company]
Comments
The above provision on one hand restricts the freedom of Islamic bank in the distribution of dividend which is the only source of income on investment in Islamic bank. On the other hand this strengthens, presumably, the meager capital base of Islamic bank. We do not think this provision warrants an amendment in the law. It will not be out of place to mention here that the Govt of Malaysia has also incorporated a provision for creation of such a reserve for Islamic banks. 4
Restriction on nature of subsidiary companies:
Sec 19 (1) provides that a banking company shall not form any subsidiary company except a subsidiary company formed for one or more purposes namely.
(a) the undertaking of any business which under clause (a) to (o) of sub-section (1) of section 6 is permissible for a banking company to undertake or
(b) with the permission in writing of the Reserve Bank, the carrying on of the business exclusive outside India or
(c) the undertaking of such other business, which the Reserve Bank may, with the prior approval of the Central Government, consider to be conducive to the spread of banking in India or to be otherwise useful or necessary in the public interest.
Explanation – for the purpose of Section 8, a banking company shall not be deemed, by reason of its forming or having a subsidiary company, to be engaged in the ‘business’ carried on by such subsidiary company.
Comments
The Reserve Bank has already permitted banks during 1991 to form subsidiary companies for the purpose of ‘leasing’ but at the same time it has put a cap on the total exposure of bank in leasing upto 10 percent of its total advances. This cap may be removed by RBI for the Islamic banks as they are not supposed to use depositors’ money in any kind of business. Thus Indian banking law is quite flexible for ‘Ijarah’ of Islamic banking.
(2) Save as provided in the sub-section (1), no banking company shall hold shares in any company whether as pledgee, mortgagee or absolute owner of an amount exceeding thirty percent of the paid up share capital of that company or thirty percent of its own paid up share capital and reserves which ever is less-----------.
Comments:
This is the maximum limit for investment in shares of a particular company. This does not mean that a banking company can not hold the shares of a large number of companies of an amount exceeding 30 percent of its own paid up capital and reserves. In view of diversification of investment the restriction is not bad. No amendment of law is required in this respect.
Sec (36) Further powers and functions of Reserve Bank – (1) The Reserve Bank may -
(a) caution or prohibit banking companies generally or a banking company in particular against entering into a particular transaction or class of transactions and generally give advice to any banking company,--------------
Comments
By virtue of powers vested in it, Reserve Bank may issue guidelines for banks. Certain guidelines may not be in conformity with Shariah. The issue, if any, arises may be sorted out through dialogue. Therefore no amendment in law in this respect is required.
Ceiling on exposure to capital markets:
In terms of revised Reserve Bank guidelines effective from May 11, 2001 there is a ceiling of 5 percent (of total advances) on investments in capital markets. This ceiling is applied to the total exposure of a banking company to stock market (including loans and advances to corporates and stock brokers for investment in shares and debentures etc).5
Comments & Suggestions
Islamic banks are not supposed to invest depositors’ money in the capital market. There should be no restrictions on investment of shareholders’ funds of Islamic banks in capital market. The Reserve Bank may exempt Islamic banks from following the above guideline. This is a policy matter and does not require any amendment of law.
Mandatory nature of the below mentioned provisions and forced involvement of banking company in the business of “interest”:
Following are the two provisions of banking law, which force a banking company to involve itself, directly or indirectly, in the business of “interest”.
1-Statutory liquidity requirement:
24. Maintenance of a percentage of assets––[(2A)(a) Notwithstanding anything contained in sub-section (1) or in sub-section (2), after the expiry of two years from the commencement of the Banking Companies (Amendment) Act, 1962 (36 of 1962),––
(i) a scheduled bank, in addition to the average daily balance which it is, or may be, required to maintain under section 42 of the Reserve Bank of India Act, 1934 (2 of 1934), and
(ii) every other banking company, in addition to the cash reserve which it is required to maintain under section 18.
[shall main in India,––
(A) in cash, or
(B) in gold valued at a price not exceeding the current market price or in unencumbered approved securities valued at a price determined in accordance with such one or more of, or combination of, the following methods of valuation, namely, valuation with reference to cost price, market price, book value or face value, as may be specified by the Reserve Bank from time to time, an amount which shall not, at the close of business on any day, be less than twenty-five per cent or such other percentage not exceeding forty per cent, as the Reserve Bank may, from time to time, by notification in the Official Gazette, specify, of the total of its demand and time liabilities in India, as on the last Friday of the second preceding fortnight;]
Comments:
Now RBI has got a free hand on SLR, (The Economic Times dated 12-01-2007). Presently this is 25% w.e.f. 22-10-1997.6
Reserve Bank of India Act, 1934.
Sec (42) Cash Reserves of scheduled banks to be kept with the Bank -
[(1) Every bank included in the second schedule shall maintain with the bank an average daily balance the amount of which shall not be less than three percent of the total of the demand and time liabilities in India of such bank as shown in the return referred to in sub – section (2).
[Provided that the Bank may, by notification in the Gazette of India, increase the said rate to such higher rate as may be specified in the notification so however that the rate shall not be more than fifteen percent of the total of the demand and time liabilities].
The RBI is also empowered to pay or not to pay any interest on these balances.
(with effect from Jan 21, 1991 the RBI is empowered to increase this to 20%. Presently the CRR is 8.75% w.e.f 19-07-2008.)7
Comments:
Balances with RBI or with any other bank:
If the depositee bank pays interest on these balances, there is direct involvement of the Islamic bank in the business of interest. Even if no interest is paid on these balances, the deposits are to be utilized by the depositee bank in the business of ‘interest’ resulting in indirect involvement of Islamic bank in or supporting the business of ‘interest’.
Other venues for SLR:
Keeping funds in the form of cash is not desirable due to security concerns. Investment in gold carries physical and market risks. Moreover keeping the funds idle in the form of cash or gold is akin to Kinz, a prohibited act in Shariah. The Government securities are interest-bearing instruments. Thus the situation warrants amendment of the relevant provisions so as to ensure the compatibility of Islamic banking with the conventional banking.
The purpose behind these two provisions is to ensure availability of short-term and long-term liquidity for banks. This can be well achieved by a provision of 100% reserve requirement as envisaged by the aforesaid second model of Islamic banking.
Instead of keeping these funds of Islamic banks in current account with RBI or with any other bank it may be more advisable to allow Islamic banks to keep the funds in the form of cash and in the current account of the Central Government, (comprised of sub-accounts of individual Islamic bank) with RBI or any other specified bank. For receipt and withdrawal requirements Islamic bank should have an authority to operate the sub-account. The float available to the Central Government should be utilized by it in reducing its interest-based borrowings, making interest free loans to the weakest of the weaker sections of society and other Islamically permissible activities. Islamic banks should be paid a commission by the Central Government on cost-plus basis as is done in the case of Public Provident Fund (PPF) accounts maintained by the banks. The Central Government should also provide free insurance cover to the cash-in-transit and in the branch of Islamic banks and other operational risks.
In view of above proposed 100% reserve requirement, Islamic banking may be exempted from the application of Sec 42 (1) of Reserve Bank of India Act 1934.
Therefore section 42(1) should be amended to read as under:
Sec. (42) Cash Reserve of scheduled banks to be kept with the Bank. (This shall not apply to the business of interest free banking.)
[(1) Every bank included in the second schedule shall maintain with the bank an average daily balance the amount of which shall not be less than three percent of the total of the demand and time liabilities in India of such bank as shown in the return referred to in sub-section (2).
[Provided that the Bank may, by notification in the Gazette of India, increase the said rate to such higher rate as may be specified in the notification so however that the rate shall not be more than fifteen percent of the total of the demand and time liabilities].
However sec. 24 (2A)(a) of the Banking Regulation Act, 1949 may be amended to read as under:
24. Maintenance of a percentage of assets––[(2A)(a) Notwithstanding anything contained in sub-section (1) or in sub-section (2), after the expiry of two years from the commencement of the Banking Companies (Amendment) Act, 1962 (36 of 1962),––
(i) a scheduled bank, in addition to the average daily balance which it is, or may be, required to maintain under section 42 of the Reserve Bank of India Act, 1934 (2 of 1934), and
(ii) every other banking company, in addition to the cash reserve which it is required to maintain under section 18.
[shall maintain in India,––
(A) in cash, or
(B) in gold valued at a price not exceeding the current market price or in unencumbered approved securities valued at a price determined in accordance with such one or more of, or combination of, the following methods of valuation, namely, valuation with reference to cost price, market price, book value or face value, as may be specified by the Reserve Bank from time to time, an amount which shall not, at the close of business on any day, be less than twenty-five per cent or such other percentage not exceeding forty per cent, as the Reserve Bank may, from time to time, by notification in the Official Gazette, specify, of the total of its demand and time liabilities in India, as on the last Friday of the second preceding fortnight;]
(b) ………………………and
(c) Every bank practicing interest-free banking shall maintain in India (a) in cash or (b) in its sub-account of current account of Central Government with Reserve Bank of India or any other bank specified by the Reserve Bank an amount not less than hundred percent of its liabilities in respect of interest-free banking on daily basis.
Thus the savings of the public shall be utilized in the interest of the nation and not for the monetary gain of shareholders of the banks. In this way creation of money through deposit multiplier and credit creation can also be checked to lower the rate of inflation. Thus Islamic banking is not for the exclusive benefit of the Muslims but it is in the interest of the nation. Faridi has correctly said, “Islamic economics is neither the parochial nor sectarian. It should not and can not be construed as Muslim economics that is an economics that seeks the amelioration and upliftment of Muslim community to the exclusive of all nor does it correspond to the socialist goal of economic welfare of the proletariat only. Islamic economics seeks the universal welfare of mankind’8.
The idea of 100% reserve requirement against bank deposits may not be looked at as a privilege of Islamic banking. Some economists, notably Milton Friedman have already advocated such a system.9
Harsh RBI guidelines for opening new banks in private sector:
The following provisions of RBI guidelines 1993 as amended upto date are found as deterring the opening of Islamic bank in India. We, therefore, propose suitable amendments.
1- The minimum paid up capital requirement for such a bank is Rs 200 crore to be increased to Rs. 300 crore within three years of commencement of business.10 The promoters quota shall be a minimum 40% of the paid up capital of the bank at any point of time, which can go upto 74%. 11
Comments
The higher requirement of paid up capital as also the promoters’ quota have been fixed in view of the highly leveraged position of the banks which Islamic bank is not supposed to assume. The poor economic condition of Muslims and their meager appearance in capital market suggest that the above norms are too high to be adhered to by Islamic banks.
Suggestions
Islamic banks may be exempted from the application of the above provisions. It is, therefore, suggested that in this respect only the provisions of company law 1956 and Securities And Exchange Board of India (SEBI) guidelines may be applied to Islamic banks.
These relaxations may not be found to be quite unique for Islamic banks. The local area banks, in view of their low exposure to risks are already enjoying some relaxations in this respect. For them minimum capital requirement is Rs 2500 Lacs (raised from Rs 500 Lacs during Sep 2003).12
2- A new bank shall not be allowed to set up subsidiary or Mutual Fund at least upto three years of its establishment. The aggregate of such investments in the subsidiaries and mutual funds (if and when set up) and portfolio investments in other companies shall not exceed 20 percent of the bank’s own paid up capital and reserves.13
Comments
The above provisions have been introduced to protect the interest of the depositors as also to allow time to new banks to gain experience in the field of innovative business. This is once again made clear that Islamic banks are not supposed to use borrowed capital in their business. As against the financial intermediation on the basis of interest, Islamic banks are to function as merchant banks or investment banks. Any restriction on Islamic banks in setting up mutual funds or subsidiaries shall defeat one of the main objectives of Islamic banking.
Suggestions
It is, therefore, suggested that Islamic banks may be exempted from application of the above guideline of RBI. However, guidelines issued by SEBI in this respect may be applied to Islamic banks too.
3- The holding of such a bank in equity of other companies shall be governed by existing provisions applicable to other banks viz.
(a) 30% of the banks or investee company’s capital funds, whichever is less, as set out under Banking Regulation Act, 1949 and
(b) 1.5% of incremental deposits of the bank during a year. 14
Comments & Suggestions
In respect of (a) above there is no objection but in respect of (b) there should be no restriction on Islamic banks to invest the share holders funds ie. capital plus free reserves in equity of other companies.
The proposed amendments in the Indian Banking Law and RBI guidelines may not be taken in the spirit of political appeasement of a particular religious community in a secular state. But they should be seen as conducive to the spread of banking in India as also useful and necessary in public interest. The financial inclusion of the society is not possible without making above amendments in the law.
Now we have to study the model of Islamic banking and suggest some amendments within the limitations of Shariah to make the model compatible with Indian Banking Law. But before proceeding further in the matter, we have to discuss various constituents of Indian Banking Law, its nature and the concept of “banking” in the contemplation of law.
Constituents of Law of Banking:
The Law of Contract, the law of Tort and other branches of commercial and civil law are applicable to banks as to others. However, Bankers’ Books Evidence Act, 1891, Reserve Bank of India Act, 1934, and Banking Regulation Act, 1949 are known to be enacted for bankers alone.
Nature of Law of Banking:
The English Banking Law during the post industrial development period was largely judge made law, based on the recognition of certain customs of advanced European countries. In India courts generally applied English Law relating to negotiable instruments, when the contesting parties were Europeans but in the case of Hindus and Muslims their respective personal laws and usages were made applicable.15
This is to be noted here that merely recognition of the customs and usages of different communities while framing a law may not be considered as a communal act.
Concept of ‘Banking’ in the contemplation of the law:
On account of multifarious functions and services of the modern banks no satisfactory definition of ‘banking’ has so far been framed by the legislators. Even the English Law has failed to provide us the satisfactory definition of the terms ‘banker’ and ‘customer’.16
The English Law:
Dr. Herbert L. Hart, the Author of the well known treatise, Law of Banking says, “A banker is one who in the ordinary course of business, honours cheques drawn upon him by persons from and for whom he receives money on current accounts”
According to this view the expression “bank” shall be considered so as to include only those institutions where a substantial part of business consists of the receipts of money on current account to be drawn upon by cheques, (Banker & Customer by SE Thomas).17
In the words of Halsbury: “An individual partnership or corporation whose sole predominating business is banking, that is the receipt of money on current account and the payment of cheques drawn by and the collection of cheques paid in by a customer”.18
The Indian Law:
The Banking Regulation Act 1949 Sec 5(c), defines banking company: “as a company which transacts the business of banking in India”.
Sec 5 (b) defines “Banking” as “accepting” for the purpose of lending or investment, of deposits of money from the public, repayable on demand or otherwise, and withdrawal by cheque, draft, order or otherwise.”
Section 6, describes the forms of business in which banking companies may engage:
(1) In addition to the business of banking, a banking company may engage in any one or more of the following forms of business, namely:
(a) The borrowing, raising, or taking up of money; the lending or advancing of money either upon or without security; the drawing, making, accepting, discounting, buying, selling, collecting and dealing in bills of exchange, hundis, promissory notes, coupons, drafts, bills of lading, railway receipts, warrants, debentures, certificates, scrips and other instruments, and securities whether transferable or negotiable or not; the granting and issuing of letters of credit, travellers’ cheques and circular notes; the buying selling and dealing in bullion and specie; the buying and selling of foreign exchange including foreign bank notes, the acquiring, holding, issuing on commission, underwriting and dealing in stocks, funds, shares, debentures, debenture stock, bonds, obligations, securities and investments of all kinds; the purchasing and selling of bonds, scrips or other form of securities on behalf of constituents or others, the negotiating of loans and advances; the receiving of all kinds of bonds, scrips or valuables on deposits or for safe custody or otherwise; the providing of safe deposit vaults; the collecting and transmitting of money and securities;.
(b) acting as agents for any Government or local authority or any other person or persons; the carrying on of agency business of any description including the clearing and forwarding of goods, giving of receipts and discharges and otherwise acting as an attorney on behalf of customers, but excluding the business of a managing agent or secretary and treasurer of a company;
(c) contracting for public and private loans and negotiating and issuing the same;
(d) the effecting, insuring, guaranteeing, underwriting, participating in managing and carrying out of any issue, public or private, of State municipal or other loans or of shares, stock, debentures, or debenture stock of any company, corporation or association and the lending of money for the purpose of any such issue;
(e) carrying on and transacting every kind of guarantee and indemnity business;
(f) managing, selling and realizing any property which may come into the possession of the company in satisfaction or part satisfaction of any of its claims;
(g) acquiring and holding and generally dealing with any property or any right, title or interest in any such property which may form the security or part of the security for any loans or advances or which may be connected with any such security;
(h) undertaking and executing trusts;
(i) undertaking the administration of estates as executor, trustee or otherwise;
(j) establishing and supporting or aiding in the establishment and support of associations, institutions, funds, trusts and conveniences calculated to benefit employees or ex-employees of the company or the dependents or connections or such persons, granting pensions and allowances and making payments towards insurance; subscribing to or guaranteeing money for charitable or benevolent objects or for any exhibition or for any public, general or useful object;
(k) the acquisition, construction, maintenance and alteration of any building or works necessary or convenient for the purposes of the company;
(I) selling, improving, managing, developing, exchanging, leasing, mortgaging, disposing of or turning into account or otherwise dealing with all or any part of the property and rights of the company;
(m) acquiring and undertaking the whole or any part of the business of any person or company, when such business is of a nature enumerated or described in this sub- section;
(n) doing all such other things as are incidental or conducive to the promotion or advancement of the business of the company;
(o) any other form of business which the Central Government may, by notification in the Official Gazette, specify as a form of business in which it is lawful for a banking company to engage.
(2) No banking company shall engage in any form of business other than those referred to in subsec (1).
Accepting deposits on current account, the primary characteristic of banking:
If we analyse section 5 (b) of the Banking Regulation Act 1949, then it becomes clear that receiving money on current accounts from the customers and honouring their cheques is an essential characteristic of banking. This fact has also been established in the following court case:
In Karuppan Chittiar V Somasundaram Chettiar (1961, 31 Comp Cas 378) Jagadisan J. said, “The essence of the relationship of banker and customer is the affording of the facility to the customer to draw funds from the bank by issuing cheques. This is primary characteristic of a banking business. Without it the business is not of banking as known and understood in the English Law”.
Lending of money, no distinguish phase of banking:
We can obtain the same result from Sec 6 (1) of Banking Regulation Act, 1949 which provides that in addition to the business of the banking a banking company may engage in any one or more of the different kinds of business specified in the various clauses of sub section (1) of section 6. This also means that there is an essential business as stated in section 5 (b) which is the real business but banking companies are permitted to carry on other forms of business as well which are auxiliary or incidental to the main business. This is further, confirmed by sec 6 (2) which lays down that no banking company shall carry on any business other than those referred to in sub section (1) of section 6. Thus interest- based borrowing and lending of money which are commonly known to be essentials of banking are not its distinguish features. Gupta has rightly said, “Lending of money may be a phase of banking business but it is not the main phase or the distinguish phase”.19
Profit motive is not necessary for banking:
This fact has been established in the following court case:
In Irinjalakudh Bank Ltd. V Poruthussary Panchayat, Sobramaniam Potti, J. of Kerala High Court, said, “I do not think that the view that business of banking must necessarily be one which is run for profit is consistent with the present day concept of banking. English cases which are relied on by Madras High Court also do not appear to support the view that the running of the banking business must be for profit or that profit motive is one of the elements necessary to constitute the business one of banking --- banking, as it is understood today, need not necessarily be a business run with a profit motive’’. The learned judge held a treasury to be a banker in so for as it maintained banking accounts for certain panchayats [(1970) 40 Comp. Cas 767)].
Moreover under negotiable instruments act 1881 ‘banker’ includes any person acting as a banker and any post-office savings Bank is also a banker (preliminary clause 4). The balances of post-office savings accounts are withdrawable by cheques subject to certain conditions.
Lawful name of Banking Company:
In order to distinguish a banking company from any other company Banking Regulation Act 1949 insists upon banking company and prohibits any other company to use the word ‘bank’ ‘banker’ or ‘banking’ along with its name.
Therefore Sec 7 (1) says that no company other than a banking company shall use as part of its name (or in connection with its business) any of the words “bank”, “banker” or “banking” and no company shall carry on the business of banking in India unless it uses as part of its name at least one of such words.
Implications of Section 5 (b), and Section 7 on Islamic Banks
The ‘business of banking’ as defined earlier is to accept deposits on current accounts withdrawable by cheque. In order to use any of the above words as part of its name Islamic bank has to accept deposit on current accounts. Fortunately this business is common in both the aforesaid models of Islamic banks.
Other Banking Services, Islamic Bank can provide
In addition to the above main banking service the Indian Law provides a wide array of fee based Shariah compliant services, for example letter of credit (backed by 100% cash margin), letter of guarantee (backed by 100% cash margin), safe keeping of documents and valuables, collection of bills, transfer of funds, hiring of safe deposit boxes, administration of property estates and wills & share brokerage, mutual insurance (Takaful) etc. The Islamic bank can also offer these services without requiring any amendments in law.
Islamic Financial Services on behalf of Government:
On behalf of the Government, Islamic banks can provide interest free loans to the weakest of the weaker sections of the society subject to the recovery of actual administrative cost from the borrowers. Under Bai Salam (payment of price against deferred delivery) contract of Islamic banking, Islamic banks on behalf of Govt may make advance payment of price, to the farmers, for the agriculture produce to be procured under minimum support price mechanism.
Islamic Bank as Source of Income for Government:
The Govt. can quote two rates for agricultural produce; the lower rates for deferred delivery and higher rates for spot delivery. The difference is the revenue for Govt. In this way Govt can recover much of the cost of operation of current accounts incurred as commission paid to the Islamic banks and free insurance cover provided to them.
Involvement of Islamic banks in Mudarabah and Musharakah:
As an alternate to indirect finance or financial intermediation on fixed return basis the models of Islamic banking envisage the concept of two tier Mudarabah.
There is no provision in Indian Banking law for a bank to accept investment deposits (Mudarabah deposits) on the liability side and provide the funds to the seekers on Mudarabah or Musharakah, profit/loss sharing basis because these contracts involve direct or indirect ‘trading’ which has prohibited for banks. Still no amendment in the law of banking has been suggested to accommodate these contracts in banking on certain valid grounds as discussed below.
The combination of trading with banking under Mudarabah or Musharakah as envisaged by the models of Islamic banking is nothing more than a hypothesis. Even after a lapse of a period of more than three decades we do not find even a single successful story of Islamic banking based on these contracts. This fact has been well recognized even by the Islamic economists.
Usmani says:
“It is true that there are practical prolems in using Musharakah as a mode of financing, especially in the present atmosphere where Islamic banks are working in isolation, and mostly without the support of their respective governments. The fact, however, remains that Islamic banks should have advanced towards Musharakah in gradual phases and should have increased the size of Musharakah financing. Unfortunately the Islamic banks have overlooked this basic requirement of Islamic banking and there are no visible efforts to progress towards this transaction even in a gradual manner, even on selective basis.”20
Needless to say that Musharakah could not occupy a seat on the centre stage of the transactions of Islamic banking supported by government in Malaysia.
In the words of Ahmad, “The basic trouble with Islamic finance at a theoretical plane is that contemporary theory of finance in the western world deals with real world situations while theory of Islamic finance deals with a world that is not yet in existence. Within the era of Islamic finance, there is again a hiatus between theory and practice. The theory deals with a normative world, but the hiatus between theory and practice takes place in the real world in which the norms are far removed from the theoretical models”.21
As discussed earlier, prohibition on trading by banks has been imposed by the law on account of fatal consequences of such a combination experienced by the banks in the past. A hypothetical case of Islamic banking in this respect cannot be recommended against an empirical study.
Even under the existing US banking law, profit and loss sharing (PLS) arrangements such as Musharaka and Mudarabah may difficult to implement since commercial banks in United States are restricted from entering partnership or taking equity stakes. 22
In UK Islamic Bank of Britain accepts deposits on the basis of Mudarabah and Wakalah but deploys funds on the basis of Murabaha, Ijarah and Tawarruq. Even in the case Mudrabah the depositors are protected against loss as deposits are guaranteed by law through a deposit protection scheme in full upto £ 20000 and proportionately above that amount. This goes against the shariah maxim ‘profit goes with the responsibility for loss.’
“To get around the legal position investment depositors with the Islamic Bank of Britain are asked to sign a waiver foregoing their rights in the interests of Shariah compliance, although they can not be obliged to sign. In practice the majority have been writing to sign for this opt out.”23
This is pertinent to mention here that this type of waiver could not be implemented in case of a loss making Islamic Financial Institutions in India. Hasib and Dalvi say “while this is true as far as sharing of losses with depositors or concern, there are legal hurdles and pit falls, in implementing the understanding.24
The waiver signed by the depositors of Islamic bank of Britain is likely to meet the similar fate when it comes to share the loss.
The efficacy of contracts of Musharakah and Mudarabah:
Musharakah and Mudarabah in their original forms are very efficient financial products in a limited society only. The reason is that they contain rights and liabilities of the partner’s intersee. Each partner acts as an agent of other partners. The liability of each partner is unlimited. For the success of partnership it is necessary that each partner should know the other partners well. Similarly each partner has a veto power in the partnership, the consensus of opinion of all partners in business mattes is necessary. Each partner has a right to come out of partnership resulting in the dissolution of the firm. This mode of business organization is very much successful for venture-to-venture and project-to-project business in partnership of a limited number of persons. However for a large number of partners who do not know each other contributing to huge capital for large and long lasting business the contemporary world has provided a much mature form of business organization in the shape of Ltd. company!
On the basis of above logic the Indian Law made provisions that the maximum number of partners in a firm carrying on banking business can be 10 and in any other business 20. The maximum number of members in a private company is 50, there is no limit to the maximum number in case of a public company (Section 11 of Companies Act 1956).
Scope of Musharaka and Mudarabah under the existing Banking Law
This does not mean that there is no scope for Mudarabah and Musharakah under the modern banking system. Even now Mudarabah or Musharakah is an inevitable part of the modern financial system. The basis of entire commercial investment can be broadly categorized into two parts namely ‘Equity’ and ‘Debt’. Equity which represents Mudarabah or Musharakah is an inevitable part of the investment. The only thing is that the banks are not allowed to involve themselves in these contracts directly or indirectly except in a limited quantity. However banks can act as facilitators to establish this relationship between the owners of funds and the users of funds. This is categorically, known as investment banking or merchant banking.
Merchant Banking
Merchant banking stands for providing various services relating to capital market and finance to corporate sector. This includes not only the activities for the above purpose in the country but at times arranging funds from outside the country as also investment abroad. A commercial bank has funds with it which it mobilizes through deposits and borrowings or other ways and deploys or lends these funds, whereas a merchant bank does not have any funds in its own but it has the expertise and access to various sources of funds as per needs of the client.
The prominent multinationals which practice commercial banking combined with investment banking are ABN Amro, BNP Paribas, and Deutche Bank etc. There are also some multinational independent investment banks like Goldman Sachs, Merril Lynch, Morgan Stanely etc.
In India Kotak Mahindra Bank Ltd, ICICI Bank Ltd, and State Bank of India, through their investment banking companies, are the active players in this field.
Non-Interest business of banks in India; A Source of Income of Islamic Banks:
Since second half of 1990s Indian banks have been adopting universal structure. Consequently Indian banks are diversifying their operations to generate income from non-interest sources viz fee based sources, income from financial services, security trading, foreign exchange etc. No doubt, interest income still remains their major source of revenue but non-interest income is gaining significance against the declining trend of interest income in the total income of banks.
The following table shows, on an average, increasing trend of non-interest income.
Share of non-interest income as percentage of total income.25
Banks/year 2000 2001 2002 2003 2004 2005 2006
Nationalized Bank 12 11 15 17 20 16 14
SBI & Associates 14 13 13 17 17 18 17
New Private Banks 23 19 23 19 19 23 24
Foreign Banks 21 22 26 26 26 31 29
Interestingly foreign banks with low deposit base have an edge on Indian banks in the matter of growth in non-interest income. Same is true in respect of new private sector banks as compared with public sector banks.
In the light of the above analysis, it can safely be said that Islamic banks without any deposit base can compete with other banks in generating income from non-interest sources.
Merchant Banking Services in India
As a substitute of financial intermediation between the lenders and the borrows on the basis of the ‘interest’, performed by a modern commercial bank, Islamic bank under its Merchant Banking Division can provide services like project counselling, technology tie ups, collection of funds from capital markets, portfolio management, mutual funds, venture capital funds, private equity fund, gold exchange traded funds, real estate investment trusts, collective investment schemes of collective investment management companies, bought out deals, rehabilitation of sick units, over the counter (OTC) market operations, mergers and amalgamations etc. All of the above activities belong to different kinds of business specified in clauses (a) to (n) of sub-section (1) of section 6 or Sec (19), of Banking Regulation Act 1949 at the same time they can be made Shariah-compliant too.
The major apprehension in respect of 100% equity-based company is that the taxation policy over the world has a bias against equity in favour of debt. This reduces the competitive strength of 100% equity-based company in competition with a debt-equity mix company. This is true only during the period when the rate of profit on funds employed remains higher than the rate of interest on borrowed funds. In fact in case of many business units rate of interest remains higher than the rate of profit. In such a case 100% equity company has an edge over the debt-equity-mix company. Moreover one should not ignore the fact that very often highly leveraged position of a business entity leads to its bankruptcy.
Blueprint of Model of Islamic Banking
In the light of proposed amendments in Banking Law, RBI guidelines and the model of Islamic banking, the following proposals can be considered as blueprint of model of Islamic banking.
1. It can be a for-profit Islamic banking company, carrying on the Shariah compliant activities of banking.
2. It can be a company under section 25 of Indian Companies Act 1956 non-profit company to increase the efficiency of financial markets in general and financial inclusion of Muslims in particular.
3. Islamic banking can be carried out by the post-offices upto the extent of accepting deposits in savings bank account by providing an option to the account holders to forego the interest and maintaining 100% reserves in the government’s account against their deposits. There is good scope for selling Islamic financial products by post-offices.
4. Islamic banking can be carried out by the local and foreign commercial banks & cooperative banks as an add-on business and through dedicated branches in accepting deposits in current account with 100% reserves to be maintained in Govt. account. The banks should be paid commission on cost plus basis by the Govt. The commercial banks under their merchant banking operations can create Shariah compliant investment avenues and sell Shariah compliant products. Cooperative banks can also sell Islamic financial products and accept deposits in current account in the way as explained above.
In view of forgoing we may say that the Muslim parliamentarians, in their representation before Prime Minister Manmohan Singh and UPA Chairperson Sonia Gandhi, have rightly underlined that Islamic banking can be easily introduced without disturbing the basic fabric of Indian financial system.26
Conclusion
The most important function of the modern commercial banks is financial intermediation between the lenders and the borrowers on the basis of ‘interest’. However Islamic economists claim that an alternative banking system can be evolved without interest on the basis of Musharakah and Mudarabah. A critical perception of the commercial banking and its Islamic alternative reveals that the former relies on earning ‘interest’ and the latter relies on ‘trade profit’. However a combination of banking with ‘trade’ has been proved fatal for banking in the past. Therefore the Indian legislation had, inadvertently, adopted a policy of separation of ‘trading’ from banking much before the emergence of the concept of Islamic banking. As such a number of provisions of Indian banking law come in the way of contracts of Musharakah and Mudarabah based on trading. This shortcoming can be removed by the Central Government without making an amendment in the law. The Central Government is empowered by law to notify any form of business as a business in which a banking company may engage. But we do not recommend issuing of such a notification by the Central Government to include Musharakah and Mudarabah in the list of forms of business in which a banking company may engage for two reasons– firstly the combination of banking with ‘trading’ has been proved fatal for banking and secondly we do not find a successful story of Islamic banking based on Musharakah and Mudarabah. Therefore a hypothesis can not be advocated against an empirical study.
However there are two provisions of law that force a banking company to involve itself, directly or indirectly, in the business of ‘interest’–Sec. (42) of Reserve Bank of India 1934 and Sec. 24 (A) of Banking Regulation Act 1949 force a banking company to keep a portion of its liabilities in interest-bearing accounts / instruments. Thus there is a genuine need of Islamic banking for an amendment of law in this respect.
The purpose behind these provisions of law is to ensure short-term and long-term liquidity for banks. This can be well achieved by Islamic bank through 100 percent reserve requirement as against the proportionate reserve requirement according to the said provisions of law. Therefore it is recommended that these provisions of law should not apply to the business of interest free banking. Further it is proposed that 100 percent reserve against liabilities of banks in respect of interest-free banking should be kept in (a) cash and (b) the current account of Central Government with Reserve Bank. The Central Government should, in turn, ensure to utilize the float available to it in reducing its interest-based liabilities and in all other Halal purposes. The Government should also provide free insurance to cover the security and operational risks of banks and pay them a service charge on cost-plus basis for this service.
Certain amendment in the model of Islamic banking are also required to make it compatible with Indian Banking Law. But before recommending such amendments, it is necessary to describe the salient features of banking in the contemplation of law as under:
• Accepting deposits on current account is the primary characteristic of banking.
• Lending of money is not a distinguish phase of banking.
• Profit motive is not necessary for a bank.
In view of the above features of banking more particularly the ‘lending of money is not a distinguish phase of banking’ Islamic economists should not make Musharakah and Mudarabah obligatory (Fard) for Islamic banking.
This should not mean that there is no scope for Musharakah and Mudarabah contracts in the Indian Banking Law. The only thing is that the banks can not involve themselves, directly or indirectly in these contracts. However there is ample scope for banks to act as facilitator to bring together the owners of funds and the users of funds through these contracts. For this purpose banks can provide merchant banking services like raising funds from capital markets in the form of equities, establishment and management of Mutual Funds, Private Equities, Venture Capital Funds, Real Estate Funds, Real Estate Investment Trusts, Gold Exchange Traded Funds, Portfolio management etc.
Thus practising of Islamic banking, subject to minor amendments in law and in the model of Islamic banking, in India is possible by accepting deposits on current account and providing all Halal auxiliary banking services most importantly through merchant banking products akin to Musharakah or Mudarabah without disturbing the main financial fabric of the country.
References:
1.1 Maududi Syed Abul Ala ‘Sood’ (in Urdu) 2004, New Delhi, Markazi Maktaba Islami Publication, pp. 91 to 93,155.156.
1.2 Siddiqui Nejatullah, Preface, Banking without interest, Delhi, 1979, Markazi Maktaba Islami, Page X.
1.3 Usman Justice M. Taq,i Islam Aur Jadid Maishat –0-Tijarat (in Urdu), 1996, Delhi, Darul Ish’at pp. 115,135.
1.4 Obaidullah Mohammad, Islamic Financial Services, http:// islamiccentre.kau.edu.sa/ english/ publication/ obaidullah/ifs/html, pp. 40,47,48.
2. Khiyar Abdalla Khiyar, The Rize & Development of Interest Free Banking– 2005, New Delhi, Institute of Objective Studies, pp. 159-160.
3. Tannan M. L., Tannan’s Banking Law and Practice in India, 2004, New Delhi, Indian Law House, pp. 12-13.
4. See Section 15 of Malaysia Islamic Banking Act 1983.
5. See http://www.rbi.org.in/scripts- RBI Press Release July 10, 2001.
6. The ‘Economics Times’ January 12, 2007.
7. The Economics Times June 25, 2008.
8. Faridi, F.R.- The universal concern of Islamic economics-Islamic banking in India, scopes & Challenges, edited by Javed Ahmad Khan, 2003, New Delhi, Institute of Objective Studies, p. 41.
9. See ‘A 100 reserve system’ – http://wfhummel.cnchost.com/alt money html.
10. See http://www.rbi.org.in.
11. Toor N.S., Hand-book of Banking Information, 2005, New Delhi, Skylark publication, p. 1.21.
12. Ibid, p. 1.22.
13. Tannan M. L., Tannan’s Banking Law and Practice in India, 2004, New Delhi, Indian Law House, p. 194.
14. Ibid.
15. Ibid. pp. 64-65.
16. Ibid p. 210
17. Ibid p. 211.
18. Halsbury’s laws of England 4th Edition Vol – 3, p. 31 as quoted by M.L. Tannan in Tannan’s Banking Law and Practice in India, 2004, New Delhi, Indian Law House, p. 211.
19. Gupta S. N. Banking Law in theory & practice, 2005, Delhi, Universal Law Publishing Company, Vol-1, p. 54.
20. Usmani Mohammad Taqi The performance of the Islamic banks – A realistic evaluation – An introduction to Islamic Finance, Maktaba Maariful Quran, 2004, Karachi, pp. 240-241.
21. Ahmad Ausaf - A review on the book “An Introduction to Islamic Finance: Theory and practice”: By Zamir Iqbal and Abbas Miskhar: Singapore Jon Wiley & Sons Asia 2007. Forthcoming.
22. Thomas C. Baxter, Jr. Executive Vice president and General Counsel, The Federal Reserve Bank of New York. Inter net;/ D:/ Islamic Banking – Remarks before the seminar on legal issues in the Islamic Finance, March2, 2005.
23. Wilson Rodney, Experiences of Interest free Banking in the United Kingdom, a paper presented in the International Conference on ‘Participatory Banking’-August 31, September 1, 2007 at India International Centre, New Delhi.
24. Hasib, A. and A Wahab Dalvi-Islamic Banking in the context of changing conventional banking system, Islamic Banking in India, scopes and challenges, edited by Javed Ahmad, 2003, New Delhi, Institute of Objective Studies, p. 116.
25. Sangeeta Arora & Shubhpreet Kaur, Declining interest in Interest Income, The Indian Banker, The Monthly Journal of The Indian Bank’s Association, Mumbai, Vol. II, No-9, Sep 2007, p. 41.
26. Latest developments, The Journal of Banking Studies, Bankers’ College, New Delhi, Sep 2006, p.16.
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