Islamic finance – steady amid chaos


Reviewed by Robert E Looney

In 1936 in the depths of a world-wide economic depression, John Maynard Keynes described the decline of the world’s financial markets as a result of playing at a casino: “Short-term speculation with little regard to fundamentals.” A cursory examination of the current global financial crisis suggests little has changed since Keynes’ day – the conventional financial system, despite various patches and fixes over the years, is still prone to periods of extreme instability and abuse.

Unfortunately, the economics profession has provided little in the way of constructive input in re-designing a more stable financial architecture. Mainstream neo-classical equilibrium economic analysis has not systematically incorporated elements that would account for the conventional system’s instability, let alone provide a framework for predicting the occasional bouts of extreme instability.

Liberal-minded neo-Keynesians have done a bit better in identifying some important precursors of the crisis, in particular, the destabilizing role of huge private sector financial deficits in countries with large external deficits, such as the US. The Keynesian view certainly played a big part in the post-crisis response (fiscal stimulus) of many developed and emerging countries.

On the conservative side, monetarists certainly raised doubts about the Federal Reserve’s abnormally low interest rates and expansive monetary creation in the years preceding the crisis. Yet, at best, this line of analysis does not go very far beyond the warning of an impending bubble and likely bout of inflationary pressures.

No doubt a leading monetarist, Milton Friedman, if alive today, would reaffirm a firm belief in Say’s Law of the smooth functioning of unimpeded (free) markets. Those going down this road contend the current financial instability is wholly the fault of too much government. As Friedman often observed, “The Great Depression, like most other periods of severe unemployment, was produced by government mismanagement rather than by any inherent instability of the private economy”. Lax money and credit policy of US Federal Reserve under Alan Greenspan would be the focus of his ire today.

Monetarist offshoots such as the Rational Expectations School, while producing good explanations of the stagflation experience of the 1970s, have not been able to systematically incorporate irrational behavior into their models. The lemming or investor-herd mentalities observed in recent years remain well beyond their comprehension.

As Martin Wolf of the Financial Times has noted, of the Western interpretations of the global financial crisis, it appears those economists working in the Austrian tradition were more nearly right than anybody else. In particular, they have argued that: central bank inflation-targeting is inherently destabilizing; that fractional reserve banking creates unmanageable credit booms; and that the resulting pattern of investment, linked not to the marginal efficiency of capital but rather to financial returns, explains the subsequent financial crash.

The best non-Western explanation of the global financial crisis is presented in the book under review, The Stability of Islamic Finance: Creating a Resilient Financial Environment for a Secure Future by Hossein Askari, Zamir Iqbal, Noureddine Krichene and Abbas Mirakhor. However, this book is much more than just an alternative explanation of the current depressed state of the world economy – it is an elegant, sophisticated assessment of Islamic finance as a viable, realistic alternative to the current conventional system. Perhaps to the surprise of many, the author’s assessment finds a number of similarities between the core elements of Islamic finance and that of the Austrian School.

Certainly Islamic finance and banking institutions are thriving relative to conventional finance. The Banker’s 2009 survey of Islamic finance found the volume of sharia-compliant assets of the Top 500 grew by an extremely healthy 28.6%, rising to US$822 billion from $639 billion, in 2008 (forecasts are that this figure will top $1 trillion in 2010). At a time when asset growth in the Top 1,000 world banks slumped to 6.8% from 21.6% the previous year, Islamic institutions were able to maintain the 28% annual compound growth achieved in the past three years.

The industry also continued to expand, with 20 new entrants bringing the number of sharia-compliant institutions to 435, with a further 191 conventional banks having sharia windows. The Islamic banking geographies are stretching beyond the existing strongholds of Iran, Saudi Arabia, Bahrain, Malaysia and the UAE to Europe, South Africa, Kenya and Indonesia.

Advocates claim Islamic finance has been immune because sharia-compliant institutions are focused on the fundamentals, with simple products bearing robust mechanisms for risk mitigation. Market analysts have stressed the correlation between asset quality in Islamic institutions and their conservative approach to risk as an insulating factor. Many conventional bankers contend the success of Islamic finance in riding out the financial storm can be attributed to the fact it is underpinned by tangible assets such as real estate.

Askari et al incorporate all of these considerations into their demonstration of the advantages of the Islamic alternative, but they also go several steps further than most previous assessments. Prior examinations of Islamic finance have devoted most of their attention to its ethical side – prohibition of interest and the ban on lending for certain activities – gambling, alcohol production and so forth. As its title suggests, The Stability of Islamic Finance demonstrates, in addition to Islamic finance’s usual virtues, its relative stability with regard to the conventional system.

As the authors note (p 209), conventional banks fail to meet inherent stability conditions even in the presence of prudential regulations. First, credit losses from debt default to the depreciation of assets may create a large divergence in relation to the liabilities that remain fixed in nominal value. Second, bank credit has no fixed relation to real capital in the economy and bears no direct relation to the real rate of return. Unbaked credit expansion through the credit multiplier and further leveraging is a fundamental feature of conventional banks. Cash flow could fall short of expectations and force large income losses on banks, especially when the cost of funds is fixed through a predetermined interest rate.

Third, banks caught in a credit freeze, with a drying up of liquidity. may default on their payments. Fourth, banks are fully interconnected with each other through a complex debt structure; in particular, the assets of one bank instantaneously become liabilities of another, leading to fast credit multiplication. A credit crash causes a dramatic contagion and a domino effect that may impair even the soundest banks.

While their analysis is much too rich to detail here, suffice to say they demonstrate that an Islamic system overcomes many of these limitations. In particular, in an economy governed by the principles of Islamic finance, the rate of return on equities is determined by the marginal efficiency of capital and time preference, and is positive in a growing economy. This implies that Islamic banks are always profitable provided that real economic growth is positive. This establishes a basic difference between Islamic banking where profitability is fully secured by real economic growth and conventional banking where profitability is not driven primarily by the real sector.

A critical feature noted by the authors, and one consistent with the Austrian ideal for banking, is the fact that the Islamic system operates on a 100% reserve requirement. In this system, investment banking operates on a risk/profit sharing basis, with an overall rate of return that is positive and determined by the real economic growth rate.

Islamic banks do not create and destroy money; consequently, the money multiplier, defined by the savings rate in the economy, is much lower in the Islamic system than in the conventional system, providing a basis for strong financial stability, greater price stability and sustained economic growth.

In short, the requirements of Islamic finance – lower proportions of debt to equity, a condition that the lender share profits and losses with the borrower, and a focus on transactions based on tangible assets – mean that Islamic banks have not become entangled in the toxic-debt instruments that have laid waste to many of the conventional banking giants.

In sum, The Stability of Islamic Finance has many strengths. Perhaps the greatest one is the ability of the authors to bridge the gap between the conventional and increasingly sophisticated global financial system and that represented by Islamic finance. Previous attempts at contrasting the systems largely failed because authors were strong in one area but lacked the expertise to provide an in-depth critique of the other system. Professor Askari is an acknowledged world-class expert in both systems and combined with his three co-authors anchors an analytical team uniquely capable of integrating the workings of an Islamic system into the increasingly complex global context.

Still, there are many problems confronting a wider based adoption of Islamic financial systems. In addition to the usual West-Islamic differences over interest, ethical roles of business etc, a number of fundamental changes would have to take place in the way Western governments manage their economies. For one thing, the adoption of popular Keynesian stimuluses during recessions would be much more difficult than is currently the case. Central bank discretionary policy would have to be abandoned for strict rules on monetary expansion. Reserve requirements of 100% on banks would fundamentally alter the banking business – the list goes on.

Having shown its inherent advantages over the current system, hopefully the authors will collaborate on a follow-on book detailing how the Islamic financial system can transition outside of its current narrow confines to be a viable alternative to the conventional system.

The Stability of Islamic Finance: Creating a Resilient Financial Environment for a Secure Future by Hossein Askari, Zamir Iqbal, Noureddine Krichene and Abbas Mirakhor. John Wiley & Sons, Singapore (2010). ISBN: 978-0-470-82519-80. Price US$49.95, 256 pages.

Robert Looney is a professor of national security affairs, and associate chairman of instruction, Department of National Security Affairs, at the Naval Postgraduate School, California.

Why in India Islamic Finance is Nipped in the Bud

The recent stay order passed by the Kerala High court against the incorporation of an Islamic finance company needs to be critically reviewed and also the contents of the writ petition filed by Dr. Subramanian Swamy to understand why Islamic finance is generally nipped in the bud in India.

In this article I will be mainly analyzing the content of the writ petition and briefly cover the judgment of the Kerala High Court.

An excerpt from the petition of Dr. Subramanian Swamy

5) The Shariah is the canon law of Muslims. A financial services company set up with government participation which would follow the canon law of a particular religion, is clear instance of the state favoring a particular religion.

B) It is clear from Exhibit P1, P2 and P3 that the proposed Islamic financial company is to be set up strictly in accordance with the Shariah, the canon law of Muslims. Exhibit P3 implies the setting up of a Shariah Advisory Board. As it is stated in Exhibit P3 that the CEO of the proposed company is required to report to the Shariah Advisory Board, this makes it clear that the board will have some measure of supervision over the proposed Islamic Financial Services Company.

It needs to clearly emphasized that the company is being set up strictly in accordance with the Indian companies act as a non banking financial company and not in accordance with Shariah. No doubt in the articles of association the shareholders agree to conduct the business of the company in accordance with Shariah. The companies act provides freedom to the share holders to agree upon financial methodologies of the company provided they do not violate any existing regulation.

Therefore in this particular case if share holders have agreed to conduct their business in accordance with Shariah then the company has not violated any regulation and further this company is not the first company in India wherein the share holders have decided to conduct their business in accordance with Shariah.

Shariah Advisory Board would be an advisory body advising the CEO of the company on the Shariah compliance matters of the products and the services of the company. The CEO of the company reports to the Shariah Advisory Board on how the products and financial services are being implemented within the advised principles of the Shariah Advisory Board.

As the share holders of the company have agreed to conduct the business of the company in accordance with the principles of Shariah then it becomes pertinent that Shariah experts advice the company on the principles of Shariah. This being an internal matter of the company and being done within the parameters of the over all legal frame work should not raise any legal concern. The company is not a religious organization but a full fledged commercial financial entity which conducts its business based on certain principles.

The articles of association of the company does not mention that it would cater to any specific religious community but on the contrary it would as any other registered financial entity would not discriminate its clientele based on their religion.

An excerpt from the petition:

E) In M.P Goplakrishnan Nair v. State of Kerala, (2005) 11 SCC 45, the Hon’ble Supreme Court held that, ‘The state is not only prohibited to establish any religion of its own but is also prohibited to identify with or favoring any particular religion’. Hence Exhibit P1 is liable to be struck down on the ground of violation of Art .14 and 25.

Article 25, Freedom of conscience and free profession, practice and propagation of religion of the Indian constitution clarifies that, ‘Subject to public order, morality and health and to the other provisions, all persons are equally entitled to freedom of conscience and the right freely to profess, practice and propagate religion.

As Islam is a complete way of life, therefore there are also clear principles laid out in the religion on how the financial transactions should be conducted by Muslims. Therefore if the state creates an ambience wherein Muslims have an opportunity to profess and practice their Islamic financial principles that in-fact reiterates the fact that the state is upholding Article 25 of the Indian constitution.

If a state establishes a commercial legal entity and takes a minority stake in it and this entity internally has guidelines on its investment strategy based on Shariah, Islamic law, then it no way should mean that the state has established or embraced any specific religion and neither that it is identifying or favoring any particular religion.

The state by its action wants Article 25 to be exercised and create a vibrant economic environment which helps in building infrastructure and job opportunities in the state for people at large without being discriminatory to any particular religious community. It should be understood that the action of the state should not be construed in a parochial manner by any citizen.

In accordance with Article 14 of the Indian Constitution, Equality before law, which states that ‘the State shall not deny to any person equality before the law or the equal protection of the laws within the territory of India.’

The state of Kerala is on the contrary to the charge levied by the petitioner in his petition is upholding Article 14 of the Indian constitution by offering financial services through the company to the citizens at large without discriminating them on the basis of cast, creed and religion.

An excerpt from the petition:

F) The operation of the proposed company in a Shariah-compliant manner would mean that prohibitions of the Shariah will also be complied with. One of the basic principles of financial dealings under Shariah is the prohibition of riba or intetest. The prohibitions contained in the Shariah will also cover articles such as alcohol and pork which are considered haram (meaning prohibited in Arabic) for Muslims. The prohibitions contained in the Shariah may also extend to entertainment, including cinema and music

It is should be understood that no legislation in India mandates that a financial company should only structure financial products which are based on ‘interest’. There are innumerable financial products which are not based on interest, for e.g. equity funds. Not engaging in the business of alcohol and pork should again be not questionable as both have a clear track record of having negative impact on health.

Deaths because of consumption of alcohol and swine flu are clear indications to this. In case of entertainment the prohibition is more so towards obscenity and pornography which in fact is also not permissible under the existing legal structure. We humbly would like to emphasize that the financial policies of the company are indeed in the interest of the general public and not to the contrary as charged by the petitioner.

The law clearly allows the share holders of a financial company to make its decisions internally on how its financial products should be structured and offered to the customers there fore no one has any legal right to question how a legally registered financial company manages its internal policies.

It should be emphasized that the incorporation of the company has in no way violated Article 14, 15, 16, 19(1) g , 19 (6) and 25 of the Indian constitution. On the other hand it has strengthened the practice of Article 14 and 25.

The incorporation of the company also should not be interpreted as though it has favored any particular religion. By incorporating a legally registered financial company which has its own internal policies and which will offer its products and services without discriminating the religion of the recipients, it is clear that it does not violate any rule in the book.

The judgment of the Kerala High Court on the above writ petition should not be viewed in complete negative light as the judge has sought views on the incorporation of Islamic finance company from the Union of India, represented by the Secretary in the Department of Finance and Industry and by the Reserve Bank of India being represented by its governor. It would have been really helpful if the judgment would have been more comprehensive and would have realized the positives attached to Islamic finance.

We hope that this judgment will not derail the establishment of financial institutions in India which do not base their products and services based on ‘interest’. Banking which is asset based and not linked to interest should not be considered just as a religious urge of Muslims but it should be also be considered as another type of banking which may surely provide some solutions to the present ailments in the banking sector.

Islamic finance can do wonders, particularly in a country like India

Prasoon S. Majumdar

Editor, Economic Affairs

The Sunday Indian

It is reported that the Kerala state government is all set to tap the investments from the Middle-East region through the Islamic finance route. It is also reported that the centre has yet not given a nod for Islamic banking, though it has been under deliberation for long.

Though there are challenges in creating an enabling framework for Islamic banking, given the conventional banking regulations, but then some kind of proactive thinking is required for opening doors for Islamic finance, knowing well that it has done wonders in the other parts of the world.

It is a known fact that Islamic finance is governed by Sharia, and is known to be conservative with its philosophy. Under Sharia, interest income is not permitted and along with that the funds cannot be used for speculation, alcohol and a few other sectors.

This is still fine, but the biggest diversion of Islamic banking from the conventional Indian banking is that the former does not just lend, but becomes an equity partner in the project, sharing both the profits and losses, whatever might be the case. Another activity which defines Islamic banking is that the banks can engage in trading, purchase and resale of properties and investment and various other activities, which is not permissible under the Indian Banking Regulation Act, 1949.

Along with this, there are constraints as the bank rate — maintenance of Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) as per the provisions of Banking Regulation Act, 1949, involve the concept of interest, which is not permissible under Sharia Act.

All in all, there are challenges but then just like there are separate regulations for Non-Banking Financial Companies (popularly known as NBFCs) in India, similar provisions can be created to cull out Islamic banking and finance within the country.

But then — as per few experts opinion, if being conservative is an issue then in that case the scheduled commercial banks in India are no less. That is the reason probably that the current NPA or the Nonperforming Assets of most banks on an average is almost negligible and that is also the reason that Indian banks are by far immune to global crises.

But then with the growing needs from Indian industry and overall infrastructural development, Indian banks can only do that much. Knowing the fact that how Islamic finance have done wonders to economies like Malaysia and Indonesia.

Not just that, Islamic banking is popular in the US too — so much so that as of 2009, it has been home to at least 19 odd providers of Islamic banking products and services including retail banking, investment banking, mortgages services, to name a few.

The fact is, Islamic finance can do wonders, particularly in a country like India.

As such culturally, the Sharia philosophy is not much departed from Indian ethos, but more than that if India can go ahead and create provisions for Islamic funds then, the later would find an worthy investment destination, as India has a huge investment appetite for years to come and more than that returns on investment are relatively higher when compared to other parts of the world.

Moreover, Indian industrial borrowers’ mindset has been attuned to conservative borrowing which makes the investment/lending option even safer. Not just this, with growing political and financial unrest in the Middle-East region, Islamic finance can find a safe heaven within India.

In addition to all this, provisioning of Islamic banking would also open a window of opportunity for Indian banks, as they can then mobilise funds from regions like Middle-East and invest in India, which  is currently nor permitted.

It is my own personal experience that there are a lot of investors who are sitting on the fence, across the Middle-East region, eager to invest in India, particularly the Indian real estate, but then they are waiting for an able partner who can effectively mobilise their funds through the Islamic banking route.

It is needless to state that Islamic finance pose a huge opportunity and we should be proactively thinking in provisioning the same within the country. Post 9/11, petro-dollars are actively eyeing for a safe investment destination as they have been extremely apprehensive about investing in the US.

And this is the opportunity that India should avail, given the fact that as a destination its economic scenario is not just safe but vibrant. It has been reported that France has already amended its laws to issue sukuk (Islamic bond) of one billion euro. Also Indonesia has launched its dollar sukuk earlier this year, which was hugely successful.

And lastly if most developed countries like UK, Japan, Singapore and Hong Kong have embraced Islamic finance and banking, then what are we waiting for?

When London, Tokya, Singapore and Hong Kong can become hub of Islamic Finance, Why not Mumbai or Cochin?

H Abdur Raqeeb explains finer points of Islamic Banking to Mr Naro Naramain Meena. At left is Engr Md Saleem
A delegation concisting of Engineer Muhammed Saleem, President, Jamaat e Islami Hind, Rajasthan and Mr. H Abdur Raqeeb, General Secretary, Indian Centre for Islamic Finance met Naro Naramain Meena, Ministry of State for Finance in New Delhi to discuss the feasibility of Interest Free Islamic Banking in India.

Mr. Engineer Saleem submitted a Memorandum on behalf of Rajasthan Muslim Forum, which is an umbrella organisation consisting of Jamaat e Islami Hind, Mansuri Panchayath, All India Majlise Mushawara, Progressive Muslim Front, Indian Union Muslim League, Association for Protection of Civil Rights and host of other organisations and associations. Memorandum requested to accept the recommendation of Dr. Raghuram Rajan, Chairman, Committee on Financial Sector Reforms to create a framework for Interest Free banking in our great country.

Mr. Saleem urged in the Memorandum that Islamic banking is not only for Muslim but also helpful for Minorities and Marginalised and shared the recent statement of MS Swaminathan, Father of Green revolution that Islamic Banking can be solution for farmer’s suicide in Vidarbha.

Mr. H Abdur Raqeeb added that 40% customer of Malaysia and 20 % customer of Islamic bank Britain are Non Muslims.

Mr. H Abdur Raqeeb also submitted the important documents related to the methods and techniques adopted by the Modern and Secular countries to create level playing field for conventional and Islamic Banking and argued that when London, Tokya Singapore and Hong Kong can become hub and house of Islamic Finance why not Mumbai or Cochin?

The honourable Minister assured that he would go through the documents in detail and will have discussion with his officials and higher authorities regarding the issue.

Mohammed Sadath, Office executive,  Indian Center for Islamic Finance

Islamic Finance in India

Islamic Finance in India

Conventional Banking is a part of the financial system. It is not a complete financial system but when we talk about Islamic Banking we wish that all Shariah permissible financial activities should be carried out by a bank.

The basic difference between profitable mode of investment in banking and Islamic finance is that trading is prohibited for the former and it is must for the later.

There are some reasons for this prohibitions. There was a time when banking in combination of trading was practiced by bankers who happened to be merchants also. During the economic disaster of 1929-32 this combination of banking with trading proved to be fatal for a number of banks.

Since then banking laws, over the world were amended to restrict banking activities to risk-free interest base lending. As such trading is now strictly prohibited for a bank. Instead of ignoring this historical fact we should take a lesson from it.

In case of Islamic finance any kind of involvement in interest base lending is strictly prohibited. Therefore for an Islamic financial institution trading is the only option for making profitable investment.

In view of the above clash of fundamentals of the two Islamic banking is not possible without bringing about a drastic change in the legal framework and the same is not expected in a secular and pluralistic society like India.

To achieve our goals we should think in terms of Islamic financial system of which banking forms an important part. We should not insist on combination of trading with the banking when both the ends can be achieved separately.

In the presence of such a clash of fundamentals where a trade-off is not possible Islamic banking shall remain restricted up to the activities which do not violate banking law such as mobilizing deposits in current accounts, making interest-free advances on actual service charge basis, collection of bills and cheques, safe deposits vaults, transfer of funds, agency services like payment of bills, payment of pension, collection of taxes etc.

But the viability of Islamic bank on above fee based income where minimum capital requirement is Rs. 100cr and mobilization of minimum deposits of Rs. 1000cr within a year of its establishment looks doubtful.

Under the circumstances as explained above we may propose following alternatives:

In view of strong prohibition against any kind of involvement in interest, in Islam, a pious Muslim is reluctant to keep his savings even in current account with a bank which would utilize his funds for earning interest.

In order to make deposits in current account fully compatible with Shariah we may suggest that deposits moblized from Muslims in current accounts by a bank should be utilized in making interest-free loans preferably to Muslims and the government. Deposits in these accounts should be treated by the dealing bank as government business like PPF.

Since quarterly turn-over in comparison of balance outstanding is deemed to be quiet high, the turn-over commission  for dealing this type of business may be separately negotiated by the government with the dealing banks.

The necessary liquidity reserve as is applicable to the conventional bank deposits in terms of Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) may be kept in government account as interest-free loan.

Rest of the amount may be disbursed to public in general and Muslims in particular as interest free loans. The cost of operations for deposits and advances may be shared by government and borrowers proportionately.

Security for Advance

Interest-free loans to the individuals may be made against sufficient collateral / personal guarantee. Post dated cheques may also be taken according to repayment schedule.


The loans to the public may be covered under state governments recovery act wherever applicable. All the dues should be treated as government dues and preference should be given in the matter of hearing in recovery suits as also in case of action taken against bouncing of cheques.

Provision for Bad-debts

In the light of the experience of the banks in the matter of defaults in such type of loans, sufficient provision should made by creating a benevolent fund contributed by the government and the borrowers proportionately.

As regards the mobilization of savings for investment on profit or loss sharing (PLS) basis, a number of opportunities are available out side the banking sector. The format of private fund manager suits most to this type of business.

Existing public and private mutual funds may also adopt Islamic financial practices subject to relaxation in the rules governing their business. The funds can easily, be mobilized in the form of securities like units issued by the fund manager for various schemes tailored to suit the requirement of investors.

Collection of funds may also be made in lump sum are in recurring installments (under systematic investment plan). Similarly the repayment of principal +- Profit or Loss (PL) may be made in lump sum are installment (under systematic withdrawal plan).

Proposal can be made to government for extending the status of mutual funds to the business of fund managers. Mutual funds should be allowed to access commodity exchange, foreign exchange financing of government projects and public and private industrial and housing projects.

In the matter of PLS financing efficient deployment rather mobilization of funds is a difficult task. To overcome this difficulty suggestions can be made to government for financing their different projects through Islamic modes under its recent policy “Public-Private-Partnership (PPP)”.

Various government projects can be financed through Musharaka, Murabaha, Istisna, Ijarah modes in a win-win situation. Crop loan to farmers and purchase of farm products at minimum support price (MSP) minus return on funds under administrative price mechanism (APM) can be made through Salam.

Similarly food credit to the government can be made available on cost + mark-up basis through Murabaha.

To encourage Islamic financial system involvement of representative of experts of Islamic finance, investors, fund manager including public and private mutual funds, banks, farmers, industrialists and specialized project financing institutions seems to be inevitable.

Wide discussions among all the perspective parties with regard to their requirements, expectations and constraints in the matter of mobilization of funds and their efficient deployment to exploit all the opportunities in different markets like capital market, commodity exchange, foreign exchange and government projects should be held before submitting a concrete proposal to the government for establishment and development of Islamic financial system.

Ahsanul Haq

Joint Director (Hony.), Islamic Banking Finance & Economics, Institute of Objective Studies

New Delhi, India.