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CAN ISLAMIC FINANCE RESCUE CURRENT FINANCIAL SYSTEM? – VIEW OF AN INQUISITIVE MIND 

SUMIT KUMAR JALAN

The article begins with a simplified description of the current financial system to present the case for need of critically reviewing fundamentals of the system and initiating a wider discussion about novel approach(es) that can be adopted to improve the system.

Current financial system

In the current financial system, money multiplies leading to growth. One man’s expense is another’s income. He/She saves, savings are invested, goods/services produced, consumption expenditure takes places. This is a simplified view of the circular flow of money. Therefore, in the current financial system credit/lending is integral for economic growth. Banks as we know today play an important role as financial intermediaries. It accepts deposits and provides credit. Since, generally, deposits are for short term and credit for long term, there is need for prudence in lending. Further, prudence is necessary as deposits can be sought any time by the depositor. This prudence is reflected in stipulations such as reserve ratios by Central Bank and guidelines relating to capital adequacy in form of Basel norms. Such regulation has to balance between prudence and credit supply in economy necessary for growth. In similar spirit, national government also require credit for pursuing investments in their country for growth of the economy.

Economic crisis

The economic crisis was mostly attributed to unchecked lending. Further exotic financial products were developed based on loan portfolios for investors who expected windfall gains. This unbridled lending took place due to insufficient regulation and incentives attached to lending / selling such products for the executives dealing in it. Executives were in the business of portraying maximum returns to their investors in form of interest and / or wind-fall gains and in turn maximise their own salaries. When banks or financial institutions fail on a large scale, that is their health of loan portfolio is exposed and defaults occur, the entire economy is at stake because the significant flow of money is in danger. Depositors may not get their deposits, with fall in sentiments, they will hoard money, leading to reduction in not only savings (and hence investments) but also consumption. This is may lead to a halt in economic growth and / or recession. Therefore government has to pitch in and if Government’s borrowing is itself in precarious position then the crisis escalates. Ultimate recourse (as in current discourse) is of debt restructuring and bail-out. Bail-out of banks by national government or bail-out of national government itself by international financial institutions or other countries (such in case of Ireland / Greece).

Essence of current financial system and role of Islamic finance

In the above description of current financial system, one thing to note is the principal incentive for banks to be in business of financial intermediation? It is interest. It is the want of interest income which led to unbridled lending, derivative developed based on loan portfolio, so that more money was available for deployment. One may argue that fee-based services of financial intermediaries have gained significance in recent times, but this again is delinked from equity participation. This is where principles of Islamic finance – most distinctly interest-free lending may play a role. Islamic Finance is governed by the Shariah (Islamic Law), sourced from the Quran and the Sunnah. The Islamic law (Shariah) prohibits taking or giving interest (Riba) which is the most essential feature of Islamic banking. Islamic finance is asset-based banking with profit sharing and equity participation principles.

As per Indian Centre for Islamic Finance, Islamic banking can be possible alternative to the conventional banking because of the following reasons. As discussed later, some of these are vindicated by findings of a committee setup by Government of India.

Islamic banking

• Is based on ethical and socially responsible investments (SRI)
• Aims at equity and justice and leads to poverty alleviation and
• Acts to new dimension to assets and actual projects aiming to support real economic growth instead of financial engineering
• Provides services to under banked populations ignored by conventional banks

There are more than 300 Islamic Financial Institutions in approximately 50 countries with total assets and funds under management (AUM) exceeding USD 300 billion. They operate in various dimensions of financial services – debt and capital markets including mutual funds, insurance, asset management, structured and project financing. These institutions are already recognized or gaining acceptance in countries such as Britain, Singapore, Hong Kong, Japan, U.S.A., France, China, Thailand, Australia, Sri Lanka, Korea, and Belgium.

Grail Research (2007) in their ‘Overview of Islamic Finance’ classifies the countries world over as primary, secondary or tertiary area of Islamic Finance. Some of the countries are mentioned in the following table across each category.

Islamic finance and India
In 2005, Government of India asked Reserve Bank of India to examine Islamic banking instruments and constituted a working group headed by Mr. Anand Sinha, Chief Manager, Department of Banking and Operation and Development along with senior bankers. Further, in August 2007, Govt. of India under the Planning Commission constituted a high level Committee on Financial Sector Reforms (CFSR) under the chairmanship of Dr. Raghuram Rajan, former chief economist, IMF. CFSR submitted its final report in Sept. 2008 to Prime Minister with the specific recommendation of interest free banking in the country –

“Another area that falls broadly in the ambit of financial infrastructure for inclusion is the provision of interest-free banking. Certain faiths prohibit the use of financial instruments that pay interest. The non-availability of interest-free banking products (where the return to the investor is tied to the bearing of risk, in accordance with the principles of that faith) results in some Indians, including those in the economically disadvantaged strata of society, not being able to access banking products and services due to reasons of faith. This non-availability also denies India access to substantial sources of savings from other countries in the region.

While interest-free banking is provided in a limited manner through NBFCs and cooperatives, the Committee recommends that measures be taken to permit the delivery of interest-free finance on a larger scale, including through the banking system. This is in consonance with the objectives of inclusion and growth through innovation. The Committee believes that it would be possible, through appropriate measures, to create a framework for such products without any adverse systemic risk impact.”

Conclusion

Through the above discussion, it is argued that it is high time to critically re-look at fundamentals of current financial system. Alternatives like interest free banking need to be studied in detail to understand whether it can lead to betterment of the financial system and save nations and its citizens from financial distress. Also deliberations need to take place on ways in which interest free banking can be conducted – through Islamic finance or otherwise. To this end, a wider discussion among public at large needs to initiated to challenge the very fundamentals of current financial system and deliberate upon contribution, novel ways such interest free banking can make and how such novelties can be promoted.

References

1. Raqeeb Abdur H. (2010) ‘Problems and Prospects of Islamic Banking in India – Road Map ahead,’ Indian Centre for Islamic Finance (ICIF) New Delhi URL: http://www.icif.in/presentation.php?event=dl
2. Grail Research (2007) ‘Overview of Islamic Finance’ URL:
http://grailresearch.com/PDF/ContenPodsPdf/Islamic_Finance_Overview.pdf
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PRM 30 participant, Email: p30104@irma.ac.in