Islamic Banking

Author: Kunal Singh

Modern banking system was introduced into the Muslim countries at a time when they were politically and economically at the lowest ebb in the late 19th century. The main banks in the home countries of the imperial powers established local branches in the capitals of the subject countries and they catered mainly to the import-export requirements of the foreign businesses. The banks were generally confined to the capital cities and the local population remained largely untouched by the banking system. The local trading community avoided the “foreign” banks both for nationalistic as well as religious reasons. However, as time went on it became difficult to engage in trade and other activities without making use of commercial banks. Even then many confined their involvement to transaction activities such as current accounts and money transfers. Borrowing from the banks and depositing their savings with the bank were strictly avoided in order to keep away from dealing in interest which is prohibited by religion.

With the passage of time, however, and other socio-economic forces demanding more involvement in national economic and financial activities, avoiding the interaction with the banks became impossible. Local banks were established on the same lines as the interest-based foreign banks for want of another system and they began to expand within the country bringing the banking system to more local people. As countries became independent the need to engage in banking activities became unavoidable and urgent. Governments, businesses and individuals began to transact business with the banks, with or without liking it. This state of affairs drew the attention and concern of Muslim intellectuals. The story of interest-free or Islamic banking begins here.


It seems that the history of interest-free banking could be divided into two parts. First, when it still remained an idea and second, when it became a reality – by private initiative in some countries and by law in others. The last decade has seen a marked decline in the establishment of new Islamic banks and the established banks seem to have failed to live up to the expectations. The literature of the period begins with evaluations and ends with attempts at finding ways and means of correcting and overcoming the problems encountered by the existing banks.

Interest-free banking as an idea: Interest-free banking seems to be of very recent origin. The earliest references to the reorganisation of banking on the basis of profit sharing rather than interest are found in Anwar Qureshi (1946), Naiem Siddique (1948) and Mahmud Ahmad (1952) in the late 1940s, followed by a more elaborate exposition by Mawdudi in 1950s. Muhammad Hamidullah’s 1944, 1955, 1957 and 1962 writings too should be included in this category. They have all recognised the need for commercial banks and the evil of interest in that enterprise, and have proposed a banking system based on the concept of Mudarabha – profit and loss sharing.

In the next two decades interest-free banking attracted more attention, partly because of the political interest it created in Pakistan and partly because of the emergence of young Muslim economists. Works specifically devoted to this subject began to appear in this period. The first such work is that of Muhammad Uzair (1955). Another set of works emerged in the late sixties and early seventies. Abdullah al-Araby (1967), Nejatullah Siddiqi (1961, 1969), al-Najjar (1971) and Baqir al-Sadr (1961, 1974) were the main contributors.

Early seventies saw the institutional involvement. Conference of the Finance Ministers of the Islamic Countries held in Karachi in 1970, the Egyptian study in 1972, First International Conference on Islamic Economics in Mecca in 1976, International Economic Conference in London in 1977 were the result of such involvement. The involvement of institutions and governments led to the application of theory to practice and resulted in the establishment of the first interest-free banks. The Islamic Development Bank, an inter-governmental bank established in 1975, was born of this process.

The coming into being of interest-free banks: The first private interest-free bank, the Dubai Islamic Bank, was set up in 1975 by a group of Muslim businessmen from several countries. Two more private banks were founded in 1977 under the name of Faisal Islamic Bank in Egypt and the Sudan Islamic Bank in Sudan. In the same year the Kuwaiti government set up the Kuwait Finance House.

However, small scale limited scope interest-free banks have been tried before. One in Malaysia in the mid-forties and another in Pakistan in the late-fifties. Neither survived. In 1962 the Malaysian government set up the “Pilgrim’s Management Fund” to help prospective pilgrims to save and profit. The savings bank established in 1963 at Mit-Ghamr in Egypt was very popular and prospered initially and then closed down for various reasons. However this experiment led to the creation of the Nasser Social Bank in 1972. Though the bank is still active, its objectives are more social than commercial.

In the ten years since the establishment of the first private commercial bank in Dubai, more than 50 interest-free banks have come into being. Though nearly all of them are in Muslim countries, there are some in Western Europe as well: in Denmark, Luxembourg, Switzerland and the UK. Many banks were established in 1983 (11) and 1984 (13). The numbers have declined considerably in the following years.

In most countries the establishment of interest-free banking had been by private initiative and were confined to that bank. In Iran and Pakistan, however, it was by government initiative and covered all banks in the country. The governments in both these countries took steps in 1981 to introduce interest-free banking. In Pakistan, effective 1 January 1981 all domestic commercial banks were permitted to accept deposits on the basis of profit-and-loss sharing (PLS). New steps were introduced on 1 January 1985 to formally transform the banking system over the next six months to one based on no interest. From 1 July 1985 no banks could accept any interest bearing deposits, and all existing deposits became subject to PLS rules. Yet some operations were still allowed to continue on the old basis. In Iran, certain administrative steps were taken in February 1981 to eliminate interest from banking operations. Interest on all assets was replaced by a 4 percent maximum service charge and by a 4 to 8 percent ‘profit’ rate depending on the type of economic activity. Interest on deposits was also converted into a ‘guaranteed minimum profit.’ In August 1983 the Usury-free Banking Law was introduced and a fourteen-month change over period began in January 1984. The whole system was converted to an interest-free one in March 1985.

The subject matter of writings and conferences in the eighties have changed from the concepts and possibilities of interest-free banking to the evaluation of their performance and their impact on the rest of the economy and the world. Their very titles bear testimony to this and the places indicate the world-wide interest in the subject. Conference on Islamic Banking: Its impact on world financial and commercial practices held in London in September 1984, Workshop on Industrial Financing Activities of Islamic Banks held in Vienna in June 1986, International Conference on Islamic Banking held in Tehran in June 1986, International Conference on Islamic Banking and Finance: Current issues and future prospects held in Washington, D.C. in September 1986, Islamic Banking Conference held in Geneva in October 1986, and Conference ‘Into the 1990’s with Islamic Banking’ held in London in 1988 belong to this category. The most recent one is the Workshop on the Elimination of Riba from the Economy held in Islamabad in April 1992.

Generally speaking, all interest-free banks agree on the basic principles. However, individual banks differ in their application. These differences are due to several reasons including the laws of the country, objectives of the different banks, individual bank’s circumstances and experiences, the need to interact with other interest-based banks, etc. In the following paragraphs,


There seems to be no problems as far as banking services are concerned. Islamic banks are able to provide nearly all the services that are available in the conventional banks. The only exception seems to be in the case of letters of credit where there is a possibility for interest involvement. However some solutions have been found for this problem – mainly by having excess liquidity with the foreign bank. On the deposit side, judging by the volume of deposits both in the countries where both systems are available and in countries where law prohibits any dealing in interest, the non-payment of interest on deposit accounts seems to be no serious problem. Customers still seem to deposit their money with interest-free banks.

The main problem, both for the banks and for the customers, seem to be in the area of financing. Bank lending is still practised but that is limited to either no-cost loans (mainly consumer loans) including overdrafts, or loans with service charges only. Both these types of loans bring no income to the banks and therefore naturally they are not that keen to engage in this activity much. That leaves us with investment financing and trade financing. Islamic banks are expected to engage in these activities only on a profit and loss sharing (PLS) basis. This is where the banks’ main income is to come from and this is also from where the investment account holders are expected to derive their profits from. And the latter is supposed to be the incentive for people to deposit their money with the Islamic banks. And it is precisely in this PLS scheme that the main problems of the Islamic banks lie.


MUSLIMS constitute over 15 per cent of the population in India but they hold only 12 per cent of the accounts in the 27 public sector banks as far as priority sector advances are concerned. The share of other minority communities, which form roughly 6 per cent of the population, is 8 per cent. This is the average for the period between March 31, 2001, and March 31, 2005. Statistics available for the same period with regard to priority sector lending by the 29 private sector banks reveal that Muslims held over 11 per cent of the accounts, while the other minorities held 10.5 per cent.

The figures become even more disappointing in the 44 minority-dominated districts in the country. Muslims, who form over 33 per cent of the population there, hold only 21 per cent of all public sector bank accounts, while other minorities, who form only 2 per cent of the population, hold 5 per cent of all accounts. In the private sector banks, Muslims hold over 20 per cent of all accounts, while other minorities hold 15 per cent.

These are figures painstakingly compiled by the Sachar Committee, which studied the socio-economic conditions of Muslims in India vis-a-vis other minority communities.

The committee’s report has established beyond doubt that a huge section of the Muslim population has been left out of the ambit of banking services for various reasons. In its chapter titled “Access to bank credit”, it has shown clearly that the access of Muslims to formal banking facilities is much lower than that of other minorities, and this is true for both private and public sector banks. In its detailed analysis, the committee has noted that “the percentage share of accounts, total amount outstanding and amount outstanding per account of Muslims remains disappointing”.

The committee has summed up its findings thus:

“The access of Muslims to bank credit, including priority sector advances, is low and inadequate. The average size of credit is also meagre and low compared with other socio-religious communities both in public sector and private sector banks. The position is similar with respect to finances from specialised institutions like the SIDBI and NABARD. Census 2001 data show that the percentage of households availing themselves of banking facilities is much lower in villages where the share of Muslim population is high…. The financial exclusion of Muslims has far-reaching implications for their socio-economic and educational uplift.”

This financial exclusion could be because of a certain mindset prevailing in the banking sector, which has categorised Muslims and Muslim-dominated areas as “negative zones” (this is documented in the Sachar report), and also for reasons of faith.


For the first time a debate over real economic issues concerning the Muslim community is taking place and a demand is gradually emerging that the government should take specific measures to introduce Shariah-compliant banking products so that a vast section of Muslims who fail to access banking services for reasons of faith can avail themselves of these services and improve their lot. The demand for what is popularly called Islamic banking, which is essentially interest-free banking, has started emerging from within the community. A forum of Muslim intellectuals, parliamentarians and bankers and Islamic scholars, called the Indian Centre for Islamic Finance (ICIF), is spearheading the demand, which is slowly taking the shape of a popular movement.

The fact that Muslims are being left out of the ambit of banking services has been spelt out in the Raghuram Rajan Committee report on financial sector reforms, which is considered the most comprehensive report of its kind so far.

In his report submitted to the Government of India in 2006, Raghuram Rajan, former chief economist of the International Monetary Fund (IMF), has observed that “certain faiths prohibit the use of financial instrument that pays interest. The non-availability of interest-free banking products 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.”

What this actually means is that a vast section of the Muslim population in India simply does not approach banks because no interest-free banking product is available at present, and giving or receiving interest is prohibited in Islam.

“If interest-free banking can be introduced in India, it will revolutionise the economic scenario, unleashing massive financial resources, which are at present lying dormant because of the non-availability of a suitable environment,” says H. Abdur Raqeeb, convener of the national committee on Islamic banking of the ICIF. What, however, is interesting about this banking practice is that it is open to all, irrespective of faith, and in the present high-interest rate regime, if financing is available without the burden of the ever-increasing interest rates, it will be welcomed by all, advocates of the concept argue.

Obviously, the United Progressive Alliance (UPA) government did see some merit in this argument and is actively working on evolving such a model, in conjunction with the Reserve Bank of India. In the RBI, there is already a strong opinion in favour of allowing such a mechanism. A report published in the April-June 2005 issue of RBI Legal News and Views outlines the fact that interest-free banking is an attractive proposition gaining currency all over the world and so it was time India introduced it.

The report describes the existing situation in India in these words: “It is reported that in India thousands of crores earned in interest is kept in suspended accounts as believers do not claim it. The assets controlled by Muslims are estimated to be $1.5 trillion and growing at 15 per cent a year. In Kerala alone, it is reported that this money could be above Rs.40000 crores. Research reveals that a handsome bulk of money in India owned by believers is lying idle, which, if invested in profit-sharing basis and utilised properly, can have a major impact on the Indian economy.” The report further points out that such banking can be initiated in India through a single window in some banks.

The UPA government, in keeping with its policy of inclusive growth, took the initiative in 2005 and asked the RBI to explore ways to introduce Islamic banking in India.
The RBI appointed a committee headed by Anand Sinha, Chief General Manager, Department of Banking Operations and Development. The committee examined the issue in detail and came to the conclusion that in view of the current statutory and regulatory framework it would not be feasible for banks in India to undertake Islamic banking activities or for branches of Indian banks abroad to undertake Islamic banking outside India. It submitted its report in 2006.

In the wake of this report, there has been a growing demand from the Muslim community for amending the Banking Regulation Act. An ICIF delegation called on RBI Deputy Governor Dr K.C. Chakroborty on September 11, 2009, and submitted a memorandum demanding the introduction of Shariah-compliant banking practices in India, pointing out that “if London, Singapore, Tokyo and Hong Kong can become the hub and home of Islamic finance and banking, why not Mumbai and Cochin [Kochi]?”

It now appears that Islamic banking could become a reality. A senior RBI official told Frontline recently: “Yes, we are taking a look at this proposal along with various other proposals. We are in the midst of consideration for bringing in comprehensive reforms in the financial sector and will consider all proposals in front of us.” Significantly, the Indian Banks’ Association (IBA), the representative body of all public sector banks, has already expressed itself in favour of this concept.

At an international conference on participatory banking held in August 2007, former IBA Chairman M.B.N. Rao said, “Islamic banking is an idea whose time has come. The IBA will study the concept, but will wait for the regulatory framework by the RBI to run it.”
If Muslim parliamentarians and other Islamic banking scholars are to be believed, this regulatory framework is in the offing. Prime Minister Manmohan Singh personally favours this concept and has asked the Deputy Chairman of the Rajya Sabha, Rehman Khan, who has been advocating the concept, to mobilise other Members of Parliament in favour of Islamic banking and suggest measures for implementing it. Rehman Khan constituted a group of MPs, which reiterated that the Islamic banking concept could be introduced in India without cumbersome changes in the law. The group presented an alternative model to the Prime Minister as a test case before such full-fledged banking is started. This model, based on Tabung Haji of Malaysia, is basically about setting up an institution to manage the Hajj.

The committee, which was headed by Rehman Khan himself, suggested in its report submitted to the Prime Minister in January 2006 that an institution where Muslims can park their savings could be set up in India. The institution, in turn, would provide them services for performing the Hajj and invest the surplus money in other projects as per the rules laid down in the Shariah.

The committee also recommended that once such an institution was set up, the government should withdraw the Hajj subsidy, which in any case is not appreciated by devout Muslims as performing the Hajj with government dole is considered unIslamic.

Highlighting the benefits of such an institution, the report said: “The present structure of the Hajj Committee will not permit to undertake this function. The proposal is to create an institution on the lines of Tabung Haji, which can mobilise the savings of prospective Hajj pilgrims and invest in projects and instruments which are permissible in Shariah. It can also invest in infrastructure for the Hajj travel, like purchasing or leasing aircraft, accommodation for pilgrims both in India and Saudi Arabia, negotiate and make long-term arrangement for chartering of aircraft at economical fares.”

A measure of the interest shown by the Prime Minister towards this concept is evident from the fact that he constituted a committee of Secretaries, headed by the Cabinet Secretary, to look into the suggestions. This committee is yet to submit its report.

According to Rehman Khan, “this institution can be set up as a test case and if it succeeds, then full-fledged Islamic banking can be introduced”. He says Islamic banking has tremendous potential in India as even modest calculations show that the country has 180 million Muslims.

“If the proposed institution targets even 10 per cent of the population it can reach over 15 million investors and, on an average, if saving per investor is around Rs.25,000, then it can aim to mobilise savings to the extent of over Rs.30,000 crore in the course of three to five years. This can change the face of the minority community in India. If a tiny country like Malaysia, which has a 15 million Muslim population, can try and succeed in this, why can’t we?” he says. He told Frontline that the majority of parliamentarians and even clerics with whom he had interacted had approved of the proposal and it was only a matter of time before the Prime Minister took it up with him.

At another level, a group of Lok Sabha members are mobilising MPs to seek their support in getting a Bill passed in the winter session of Parliament. Asaduddin Owaisi of the All-India Majlis-E-Ittehadul-Muslimeen (MIM) will bring in a private member’s Bill in this connection. “I have spoken to a whole lot of people cutting across party lines and there is massive support for such a move,” he told this correspondent. “Why should we look at this from the prism of Islam, why not look at it as an alternative mode of banking for which there is a massive need,” he said.

He said he was aware of the fact that in many savings accounts held by Muslims the interest money is lying defunct as receiving interest is considered haraam [forbidden] in the Shariah. “Why should we not do something to mobilise this dormant resource?” he asks, adding that Islamic banking has become a runaway success even in non-Islamic countries such as the United Kingdom and the United States and is functioning well in Malaysia, Singapore, Japan and Indonesia.

Abdul Rehman, a Dravida Munnetra Kazhagam (DMK) MP from Vellore and a former banker, says the issue must not be linked with Islam as essentially it is all about introducing interest-free banking (as in the case of mutual funds), which has additional benefits as it can cater to the specific needs of Muslims as well. “This kind of banking is not at all religion-specific because non-Muslims constitute the majority of customers in such banks in other countries.” What this can achieve, he says, is that it will save gullible Muslim customers who park their money with not-so-credible non-banking institutions. “If the government gives the legislative sanction for such an institution, then Muslims will not only be able to put their savings in safe accounts but also be able to take loans for various purposes [based not on interest but on profit/risk sharing basis] and improve their socio-economic lot.”

“Though no specific amount can be pointed out for the country as a whole, yet it is a fact that thousands of crores of rupees is lying in suspended accounts in banks across India, unclaimed for reasons of faith. If only the government did something to unlock this money, the face of the minority community in India will change for ever,” says Abdur Raqeeb. Facilitating such an institution will not only unlock dormant money in India but open the doors to massive investment from abroad as well, he says.

According to unconfirmed estimates, over $40 trillion from oil-rich Gulf countries is waiting to be invested in India post-9/11. “Post-9/11 oil money has stopped being invested in the U.S. and is looking for a safe investment destination and India could well be that destination, given its safe economic scenario, huge market and good growth rate,” says Abdur Raqeeb, quoting from a report by GRAIL Research, a U.S. market intelligence and data analysis provider. The report says that “India has the potential of emerging a significant market for Islamic banking provided there is a favourable change in the regulatory environment and increased awareness among Muslims and India as a whole”.

With parties such as the Communist Party of India (Marxist), the Samajwadi Party, the Rashtriya Janata Dal, the Nationalist Congress Party and the DMK having already expressed their support for Islamic banking, the concept could materialise earlier than imagined.


Islamic banking is a very young concept. Yet it has already been implemented as the only system in two Muslim countries; there are Islamic banks in many Muslim countries, and a few in non-Muslim countries as well. Despite the successful acceptance there are problems. These problems are mainly in the area of financing.

With only minor changes in their practices, Islamic banks can get rid of all their cumbersome, burdensome and sometimes doubtful forms of financing and offer a clean and efficient interest-free banking. All the necessary ingredients are already there. The modified system will make use of only two forms of financing — loans with a service charge and Mudaraba participatory financing — both of which are fully accepted by all Muslim writers on the subject.

Such a system will offer an effective banking system where Islamic banking is obligatory and a powerful alternative to conventional banking where both co-exist. Additionally, such a system will have no problem in obtaining authorisation to operate in non-Muslim countries.

Participatory financing is a unique feature of Islamic banking, and can offer responsible financing to socially and economically relevant development projects. This is an additional service Islamic banks offer over and above the traditional services provided by conventional commercial banks.

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