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Corporate Nov 23, 2012

Islamic banking is a myth; RBI is right to reject it

By R Jagannathan

Reserve Bank Governor D Subbarao has done well to reject the idea of Islamic banking in India. Though he has left a window open in case the government makes legislative changes to enable Islamic banking, he also seemed to suggest that Islam's injunctions can be met not through banking, but other financial options.

He said: "Islamic banking is not possible. There are some legal problems. We have studied the issue. We appreciate the objectives behind the request. But there are some legal problems. It can be got around not through banking, but other vehicles."

He's partly right. But the fact is even he is partly wrong. Islamic banking is not possible even though an enabling legislation, for the whole idea is a myth and cannot be introduced in a country where normal banking exists, and which claims to be secular.

To create a legislation which allows no interest to be paid or received would mean subjecting ordinary savers to enormous risks - which surely cannot be the intention of Islamic banking. If Islamic banks cannot invest in bonds, T-bills, and commercial paper, or lend to finance inventory or projects for interest, it defeats the whole purpose of banking.

Even in Muslim countries, what is called Islamic banking is - to put it in the dismissive words of one western critic - "normal banking sprinkled with holy water." At best, Islamic banking is a way to deny the existence of interest and make it easier for Muslims to accept the idea of banking since the Koran includes strong injunctions against the giving or taking of "riba" - interest.

Islamic banking as advocated by the Prophet would be close to venture capital or even a mutual fund - where the investor earns nothing if his money makes a business loss. Reuters

Before we explain why Islamic banking is a myth, let's understand something basic about money and investment. There are only two basic forms of saving or investing - equity and debt. If you give somebody money and the borrower is not expected to pay interest, but only share profits, you are investing in equity. If the borrower is expected to pay interest, it is debt.

There can be hybrid instruments that are part equity and part debt, but since the objection is to avoid interest-bearing debt, hybrids need not be considered Islamic instruments at all. The only exception would be zero-interest bearing convertible bonds; if Islamists are happy with them, maybe Indian companies should offer more of such instruments. There would be no need to invent Islamic banking.

Let's understand, equity is risk. The returns are priced based on the risk undertaken. Debt is meant to avoid risk, and is the price payable for the time value of money.

Why did the Prophet of Islam forbid interest-based banking? I am no expert on Islam or the Koran, but taking a commonsense view of his intentions, it is likely that he did not want usury - he didn't want rich moneylenders to fleece the poor.

In its intended form, Islamic banking as advocated by the Prophet would be close to venture capital or even a mutual fund - where the investor earns nothing if his money makes a business loss. He gets a share of profit or dividends if the venture or underlying investment makes a profit.

Now consider what an Islamic bank would have to do if it were to take Koranic ideas to their logical end: since a bank's primary purpose is to bring savers and investors to a common platform, an Islamic bank would have to invite depositors to take up equity. An Islamic bank would thus have an ever-expanding equity base, reduced occasionally whenever it has to write down equity to write off losses. Depositors should thus get dividends, whenever the business makes a profit.

On the borrowing side, since the funds do not carry interest, the borrower would have to declare his profits and share it with the bank in some predetermined manner.

In theory, this is fine. But in practice, this is simply not viable when both depositors and borrowers have alternatives.

If I am a depositor, and the bank tells me it may or may not give me a return, I have a choice: if I don't want to take a risk, I would opt for a traditional bank which promises me a clear return at no risk. Very few people, even Muslims, may want to take this risk, unless theologians frighten them enough with hell and damnation.

If I am a borrower, why would I agree to share a proportion of my profits unless they are so low that borrowing from a normal bank would be costlier? In fact, only projects that are inherently losers would want to take money from an Islamic bank.

In practice, thus, few people would bank with an Islamic bank when they have other options and are not forced by religious-minded clerics to shun normal banks.

In the real world, Islamic banks have to compete with normal banks. They thus create instruments which mirror the returns that are close to current market interest rates in order to retain business. They are thus pulling wool over the eyes of true believers where interest will be disguised as dividend, and borrowing as purchase of assets by the bank. A loan returned would be classified as the repurchase of the same asset by the same person or company.

In a paper by Dr Nimrod Raphaeli produced for the Middle East Media Research Institute (Memri), he quotes a Kuwaiti banker as saying that conventional banks are more straightforward than Islamic banks. In an article titled "The non-usury deception", the Kuwaiti banker, Ahmad Al-Sarraf, quotes a cleric, Prof Hamid Al-'Ali, as saying that "Islamic banks disguise usury by inventing documents that appear on the surface as sales documents, but that are actually interest-bearing loans. Therefore, anyone who distinguishes between traditional and Islamic banks is ignorant."

Raphaeli's paper quotes Al-Sarraf as saying that "most of the Islamic banks are guided by well-paid clerics who are employed by the bank, and issue rulings according to the bank's needs. The entire corpus of paperwork created by these Islamic banks, Al-Sarraf concludes, is in violation of the rules of the sharia and is inherently deceptive."

In India, the Bombay Stock Exchange has a Shariah Index where the leading stock is Reliance with a weight of 18 percent. Reliance, which is one of the biggest cash-generating machines in India, invests a huge amount of its funds in interest-bearing deposits and securities - and it is supposed to be Shariah-complaint. Tata Consultancy, which also has surplus cash and invests in bank deposits, is another top member of the Shariah index.

Clearly, Islamic investment and banking are little more than fig-leaves to give Muslims an excuse to adopt relabelled normal banking.

Wonder if the Prophet would have liked such deceptive practices. Wouldn't Muslims be better off accepting normal banking in a secular country?

Islamic banking is a bad idea intended to fool Muslims. Only a government trying to woo a sectarian vote would even think of legislating such a law. The RBI Governor should tell the government this is no uncertain terms.

by R Jagannathan

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