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‘Interest-Free’ In Islamic Finance Is A Myth

The official clarification that the move for the introduction of Islamic banking in India, mooted by former RBI Governor Raghuram Rajan, stands abandoned has given rise to speculation that the decision is based on political considerations, given that the current dispensation in India is held unlikely to do anything that would promote the Islamic way of doing things, including banking.

Some media commentaries have sought to describe the decision as motivated by politics as, according to their authors, this would have brought thousands of crores of additional money into the banking system from devout Muslims, who shun riba, the Arabic term for interest.

But most of these responses are borne out of a total lack of understanding about how Islamic banking is conducted in comparison to the normal banking practices. Islamic banking, as is widely understood, does not allow charging of interest on one’s money because such earnings are supposed to be sinful as the holder does not take any risk or contribute anything for the growth of that capital. So charging interest will amount to exploiting the helplessness of the borrower.

But having watched Islamic banking from close quarters for over two decades, including the points in which the Middle Eastern concepts differ from those practiced by Malaysia and by institutions in London, a major centre contributing to the growth of Islamic banking operations, until jurisdictions such as Dubai and Bahrain started asserting their rightful claim to be the major domains for the development of Islamic banking and finance, it can be stated with a lot of conviction that interest-free Islamic banking is a misnomer and a myth perpetuated over time. It is true that in Islamic banking the term interest is not used, because it is unIslamic, but in practice, this is substituted by the term ‘profit, which is determined on the basis of prevailing interest rates. So, the profit rates will keep fluctuating with the changes in interest rates.

It is essential to understand that Islamic banking has evolved as an alternative system that can be used by faithful followers of Islam without pricking their conscience and at the same time giving them the opportunity to grow their capital. While the means to the end are different, the end is the same: how to multiply one’s money. And in doing this, Islamic banking has evolved ingenious mechanisms that will help achieve the objective of capital appreciation, which will camouflage interest earning in its simplest form of deposit, at the same time assuring the depositor an equal or higher return compared to the prevailing market norms.

The most popular method of doing this is by the bank undertaking a commodity transaction on behalf of the depositor. The idea is that the depositor risks his capital, for which a reward is justifiable and ceases to be haram, which essentially means unethical. This is followed by a number of subsequent transactions of buying and selling, which keep generating profits as these are mere paper transactions without any real commodity changing hands and have little downside risks because both seller and the buyer are notional entities. After the bank’s charges and management fees etc are deducted, which will again be in accordance with the practices in conventional banking, the difference is added to the original deposit.

So Islamic banking can mimic almost every activity in conventional banking through this commodity-trading and the industry makes it a point to develop alternatives for every product introduced by the normal banking channels from time to time. These are variously known as Ijara for leasing, Murabaha for credit financing, Mudaraba for trust financing, Musharaka for equity participation, Sukuk, which is an Islamic bond etc.

So when an auto loan customer approaches an Islamic bank for financing a car purchase, the bank purchases the car on behalf of the customer and sells it him or her for a higher price, which would be equivalent to the principal and interest charged on it in the conventional system. In the process, the bank has earned a profit, but without charging interest! The car remains hypothecated to the bank as in the rest of the cases, but there are certain assets such as a house that cannot be dispossessed of a Muslim, which adds to the lender’s risk and as such the cost of the product. So in effect, although Islamic banking has a comparable variant for every product introduced in the conventional banking system, the cost actually works out higher. That is why in most cases, Islamic banking products cost higher, a fact that inhibits the popularity of some of the products, although Islamic banking itself has been growing at a much higher rate than conventional banking for a number of years. According to an Ernst & Young report, Islamic banking assets are expected to record a compound annual growth rate of 14 percent through 2015-20, with total assets reaching US$1.8 trillion across its nine important markets.

In India, there is widespread misconception about Islamic finance as many people, including some of the so-called experts, believe that that money comes cost-free. Kerala Finance Minister Dr Thomas Issac, whose credentials as an economist have been assiduously promoted by his supporters, had in fact flaunted a virtual trump card in one of his early media appearances after assuming his current stint in the form of interest-free Islamic finance to fund the state’s infrastructure investment needs.

He even secured the go-ahead from the RBI in July for a cooperative based on the principles of Islamic banking, called Cheraman Financial Services Limited, named after a provincial king who embraced Islam in its early days in India, with an initial corpus of Rs 250 crore, contributed by the Kerala State Industrial Development Corporation (KSIDC) and Gulf-based NRIs. Nothing much has been heard about it since then, strengthening the fears that his idea of cost-free Islamic finance to fund Kerala’s development needs will ever remain a pipe dream. (IPA Service)

The writer K Raveendran has lived and worked in Dubai for over two decades.

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