Muslim Financial Institutions in India (MFIs): Analysis and Scope of their Islamicity Under the Current Financial Reforms Abstract There are a large number of financial institutions in India run by Muslims with the aims to relieve the poor Muslims from the bane of Riba and to introduce Islamic financing techniques in their business. Backed by the Ulama and religious organizations, these institutions have been quite successful in creating awareness about the need for such ventures that provide Muslims an alternative to avoid Riba. More importantly, these institutions have been successful in inducing saving habits among the lower and middle classes of society in general and the Muslim community in particular. This study aims to focus on two important aspects of these MFIs: (i) to analyze the state of their Islamicity under the current legal format of the country and (ii) to analyze the scope of their Islamicity under the recently initiated privatization, liberalization and globalization scenario. In view the current changes it is our opinion that these MFIs can effectively extend their arms in the area of equity financing, mutual funds, venture capital and insurance sectors which will improve their Islamicity besides strengthening their current legal format. These changes, together with the possible cooperation of Islamic banks working outside the country, will go a long way in augmenting the business prospects of these MFIs.
2 Muslim Financial Institutions in India (MFIs): Analysis and Scope of their Islamicity Under the Current Financial Reforms I: Introduction With the emergence of Islamic banking and finance at the global level the Islamic finance in India is catching the imagination of Muslim investors and finance practitioners. Islamic finance companies and welfare societies have substantially expanded their activities during the last couple of decades. Although, their forms, sizes and numbers are still relatively very small as compared to the conventional interest-based financial institutions in the country. Because of some legal regulatory hurdles, MFIs have not been able to exert any significant impact on the Indian financial market, otherwise they could have attracted the large potential market of Muslim investors and borrowers who have shown increasing interest in the Islamic line of investment and financing in recent years. Due to various legal hurdles the Islamic financial institutions have not been able to run their business and financing purely on the Shariah principles. Whatever deposits/ funds they raise, could not be invested in manner other than those interest-bearing instruments. The major regulatory changes in India took place in early 1990s, the Islamic financial institutions in India have been unable to quickly adapt to these changes and consequently facing recurring failure, one after other. 1 The basic issues, which these Islamic finance companies are facing presently, are their lack of adequate capital and reserve funds to meet any future contingency. These are the issues which Ulama, economists, and Islamic financial experts need to ponder upon and find out solution to make the Islamic financial institutions a viable alternate in the Indian environment. Under this framework, the paper firstly focuses on the development of Islamic finance in India, which is followed by some case studies of Muslim Funds in India. Section four deals with the problem of Islamicity facing these MFIs and section five explores the future of Islamic finance in the country. The last section provides the conclusions of the study.
3 II: The Development of Islamic Finance in India The history of Islamic finance in the country goes back to the struggle of Muslims against the colonial forces. In fact a few researchers are of the opinion that the discipline of Islamic economics itself grew as a manifestation of a distinct identity stressed by Muslims during their struggle for independence. 2 The situation, however, significantly changed after partition of the country in 1947. Since then major initiatives in this regard could be taken by the religious bodies like Jamat-e- Islami (Hind) and the Jamiet-e- Ulama-e-Hind. The Jamiet-e-Ulama-e-Hind has been successful in establishing a series of Muslim Funds in its influential belt of northern India, especially western Uttar Pradesh. Jamat-e- Islami (Hind) on the other hand could make its presence felt in the southern part of the country where it is successfully running a few charitable institutions mainly engaged in interest free lending. A major source of their funding is donation and Zakah collected from sympathizers. These kinds of institutions are commercially nonviable. Therefore we shall not discuss them in detail. During the decade of 1970s and in early 1980s, a few Islamic finance companies were established either to capture the niche market or out of concern by wealthy and committed individuals. Most of this kind of institutions have been facing horrendous times since the new Non Banking Finance Companies (NBFCs) regulations came into effect in the late 1990s. In fact most of them have either closed already or facing doomed future. 3 In all the cases, the declared aim of these concerns was to relieve the poor Muslims from the clutches of indigenous moneylenders and the government owned interest based financial institutions. Establishment of the Federation of Interest Free Organization (FIFO) was a valiant attempt in this regard to create a central bank type institution which would guide, help and provide liquidity to its members at the time of need and would also represent the common interest of its members before the government and its maintained institutions. Cooperative Financial Institutions are legally strong and viable options. However, for various reasons Muslims have not yet been able to explore them at large. On the other hand though Muslim Funds are legally not a very strong option, but at present they are the only format freely practiced by Muslims. Perhaps they are handier in running these kinds of institutions.
4 In our survey we chose five representative Muslim Funds to assess their financial strengths, the size of deposits and advances made by them and more importantly, the level of Islamicity practiced by these institutions. Of these, four are located in the district Bijnore of Uttar Pradesh which has average Muslim population of about 20 percent. The other one the Muslim Fund Deoband falls in the district Saharanpur of Uttar Pradesh which has a Muslim population between 15-20 percent. This Fund is chosen for being the oldest one operating in the country. The two Funds in our sample are the largest Muslim Funds in the country while the rest three are moderate in size (in terms of deposits as well as number of branches). The next section deals these Muslim Funds in some detail. III: Muslim Funds in India The Jamiet-e-Ulma-e-Hind took major initiative in establishing these Funds. The first of these was established in the year 1961. At present there are more than 130 Muslim Funds scattered in different parts of the country. Of these, thirty Muslim Funds are the permanent members of the FIFO. A cumulative figure of their deposits and advances are not clearly known as no comprehensive study has been conducted on them so far. Our survey, however, does suggest that their deposit figure must be crossing a billion Indian rupees. This shows the vast potentials of Muslim Funds in the country. One of the most striking features of these Funds is their remarkable success in inducing saving habits among the poorest class of the society. They have also been successful in providing low cost loans to the poor against the collaterals of ornaments and other valuables. A glance at the Table 1 reflects the financial strengths of Muslims Funds under the survey. Table 1 about here Table 1 depicts a picture of the financial strengths of the selected Muslim Funds deposits and advances positions during the last five years (1998-2002). As can be seen, the increasing deposits by the Muslims shows their inclination towards these Funds. The amount of total deposits of these selected Muslim Funds has increased from 246.36 million in 1998 to 476.54 million in the year 2002. Likewise, the advances made by them have also gone up from 88.1 million in 1998 to 148.68 million in the year 2002. The high
5 growth of deposits and advances is significant in the sense that these are remarkably higher than the growth achieved by the conventional interest-based financial institutions in India. This is explained more explicitly in the figure 1 below, showing that the advances as percentage of the total deposits vary between 31 to 35 during the period of the survey. Another important aspect to be noted here is that the deposits in these Funds are growing at the rate of 15 20 percent per annum, while advances are growing between 12 and 18 percent except in the year 2001 when it grew little over 8 percent. Average annual growth in deposits is 17.95 percent while the same for advances is 14.04 percent. The average of advances of the total deposits during the period of study stood at 33.29 percent. Figure 1 Muslim Funds in India Deposits Advances Deposits & Advances (Rs. million) 600 500 400 300 200 100 0 1998 1999 2000 2001 2002 Years In the following section we attempt to explain as to why these Muslim Funds need to keep some 35 to 30 percent of the idle deposits in the commercial banks. In fact, this issue is more associated with their diversification and utilization of funds under the Islamic modes of finance, namely Mudarabah, Musharakah, Murabahah or Ijarah etc
6 IV: The Problem of Islamicity The problem of Islamicity of Islamic financial institutions in India is basically related to the legal hurdles in applying Islamic financial instruments. In the survey we found that the Muslim Funds were aware of the Islamic financing techniques such as Mudarabah, Musharakah, Ijarah etc. However, the managers of these funds were unwilling to practice them for they were concerned about the legal tangles arising due to Islamic financial contracts which are still not recognized in the country s present legal format. Another important difficulty hindering the implementation of these techniques is the weak capital base of these Muslim Funds. Since the Muslim Funds are either registered as charities or trusts, they cannot raise equity capital. Under such a climate, as one Islamic finance practitioner points out, without a strong capital base, no banking or Islamic financial institutions worth its name irrespective of its form and size, can survive for a long time and compete with others. 4 On the assets side, Muslim Funds are apprehensive against introducing the Islamic financing techniques because of agency problems 5 (Moral hazard and adverse selection). Through experience they have come to conclusion that no loans would get repaid if lent without sufficient and proper collateral. They are also well aware about the prevailing malpractices in the accounting practices and procedures. On the liability side, no financial institution is allowed to accept deposits on profit and loss basis. As far as the current practices of Muslim Funds are concerned, the issue of Islamicity arises only on the assets side. On the liability side Muslim Funds accept interest free deposits from the public which is returnable on demand. There are deposit collectors appointed by the Muslim Funds reaching door-to-door to collect deposits. These deposits have three uses (i) a part of the total deposits would be loaned to the public, (ii) another part is kept for day-to-day transaction and (iii) the third is idle or has no use at present. The figure 2 shows the uses of these deposits by Muslim Funds. After keeping aside the day-to-day required liquidity of about 25-30 percents, Muslim Funds are left with the remaining 70 percent of their deposits. When the average advances of 33.29 percent are excluded the Muslim Funds are still left with the unused 36.71 percent of their deposits.
7 Figure 2 Uses of Deposits Idle Cash 37% Advances 33% Liquidity for daily transaction 30% So far as the current practices of Muslim Funds are concerned we shall discuss their Islamicity from the following angles. Deposits from the public. Advances to the public. Uses of liquidity needed for daily transaction. Uses of the remaining deposit not utilized under advances or liquidity. Regarding the deposits from the public there is no problem of Islamicity as the deposits are 100 percent interest free withdrawable on demand. Advances, on the other hand, as our figure 2 shows comprise about 33 percent of the total deposits which is lent against the collateral of ornaments with a sufficient margin between the value of the pledge and the amount of loan granted. A service charge between 2.5-3 percent is levied for each quarter upon all these loans. This predetermined, time bound service charge has been the subject of heated debate among the scholars. For example, Islamic Fiqh Academy has unequivocally declared that Muslim Funds cannot charge anything over and above the principal amount. If they do so they would indulge in Riba. 6 The moral fabric of the society is such that if Muslim Funds do not charge anything for the advances the loans would seldom get repaid on time, if at all. If Muslim
8 Funds realize the loans by selling the pledges of borrowers then they would be seen as crueler than moneylenders who at least never sell their collaterals. Another problem with Muslim Funds is that they require a high proportion of their deposits for daily transaction which in our survey was found to be as high as 30 percent (figure 2) of the total deposits. A major portion of this requirement is kept by the Muslim Funds at their offices and the rest being kept in the current accounts of conventional banks, where they do not receive any income. If Muslim Funds charge anything other than the principal then it comes under the scrutiny of Shariah. However, if they do not, about 60 percent of their deposits produce nothing. This raises a genuine question of the viability of Muslim Funds. Another imperative question for the Muslim Funds is what to do with the amount left after loaning and fulfilling the daily requirements? In the survey we found that the cost incurred by the Muslim Funds on deposits collection is substantially high as compared to the conventional banks. The major reason behind this is that unlike conventional banks Muslim Funds collect deposits from door to door. Another reason increasing the cost of deposits for Muslim Funds is the smallness of the size of their deposits. Muslim Funds accept deposits from the public in small denomination as low as Rs. 2. On the other hand, we seldom find anybody going to deposit even Rs. 100 in a bank account. Besides these, the other factor that raises the cost of deposits by Muslim Funds is the socio economic condition of their clientele. The segments of population served by Muslim Funds are those that cannot afford to open an account in conventional banks that require minimum balance of Rs. 500 as compared to Muslim Funds that require as low as Rs. 10 or 20 as the minimum balance. All these factors accompanied by high uncertainties associated with Muslim Funds, in the wake of their being loosely regulated in comparison to conventional banks, force the depositors to withdraw money on frequent intervals. We have seen in the above paragraphs that though Muslim Funds do not pay any returns to their depositors, their cost of deposits is substantially high. On the other hand, for various reasons, they realize lower charges from the loanees. This brings a negative spread to Muslim Funds which becomes a sort of annual liability on them. Together with this, Muslim Funds maintain good numbers of employees and also spend considerable
9 amounts on social welfare activities like education and health. From where does all this money come? Muslim Funds keep the third portion of their deposits (36.71 percent, figure 2) in conventional banks and meet all their expenses through the interest income received on that. For this un-islamic practice, the managements of Muslim Funds explains their logic in the guise of Dar-al-Harb and Dar-al-Islam. However, the Islamic Fiqh Academy in its resolution has categorized this activity as un-islamic. 7 V: Scope of Islamicity in the Liberalized Financial Market To assess the issue of Islamicity under the current economic scenario a survey was conducted among some topmost economists, policy makers and the Islamic financial experts. 8 Unfortunately, most of them do not foresee bright future of Islamic finance in the country. Though reasons for this pessimism also included issues other than economics but the crux of the survey was that the future of Islamic finance is not very promising at least in the near future. A former Managing Director of India s once largest Islamic financial institutions in an interview expressed, It is the eighties and nineties that were the best and most opportune period for Islamic finance in India. It was during this period that govt. threw open the fields of mutual funds, banking and insurance. Since then regulations have been made more stringent and thresholds have been raised. Then many niche areas, which were accessible earlier due to changed regulatory condition, either closed to us or will now involve bigger compromises with Islamic stipulations. 9 When asked the same question a former high ranking Reserve Bank (India s Central Bank) officer categorically said, Honestly, I do not believe the prospects to be bright unless Islamic banking is successfully introduced in at least one Muslim country. However, the former Senior Economic Advisor to the Security and Exchange Board of India (SEBI, India s capital market regulator) Dr. Khan was of the opinion that globalization, privatization and liberalization combined well to reflect the economic philosophy of Islam. Islamic financial institutions have, therefore, tremendous scope to grow under such an environment. He further said that in future institution like mutual funds, pension funds, venture capital, leasing would grow; so MFIs can also enter in these areas.
10 The reason behind the pessimism expressed by most of our respondents may be consideration of the fact that India has now entered the second generation economic reforms where stable consolidation has already taken place in the changing regulations. The stringent norms are now stipulated for registration and for accessing public deposits. On the other hand, the scenario for new MFIs also looks no better as the entry threshold for MFIs in the form of companies, has been raised steeply to a level of net owned funds of Rs. 20 million. The definition of "Public Deposits" has been broadened to plug virtually all avenues of raising funds from the public other than as share capital & public deposits. And it is now mandatory to pay a pre-specified rate on deposits. Thus for existing as well as new companies technically equity is the only legally feasible instrument which can lead to a profit sharing operation. But equity is costly and its mobilization is a discreet and discontinuous process for raising finance. VI: Conclusion In this paper we discussed the issue of Islamicity faced by Muslim Funds in India. We have come to the conclusion that the present practices of Muslim Funds desire much to be achieved as far as the issue of Islamicity is concerned. At the same time, it may be added that the problems faced by Muslim Funds are genuine and serious and therefore, must be seen in proper context of socio, political, economic and legal environment under which they operate. As far the future prospects of Islamicity are concerned the future, indeed looks hazy if not doomed as expressed by our respondents. However, we firmly believe that all is not loss yet. Despite the fact that India has entered the second generation of its economic reforms there are still many areas that are being opened for new entrants. Moreover, some of the older options have also not dried up yet. For example, the mutual funds, venture capital and a number of likely instruments based on equity financing are considered to be identical to Islamic principles of profit and loss sharing. They are being widely accepted in Indian capital market. Especially, the market for mutual funds has significantly grown during the last decade from total assets under management of Rs 68.19 billion to Rs 109.3 billion as on March 2003. 10 Muslim Funds could develop necessary expertise and may venture into the market that is growing healthy. In fact during mid 1990s, a prominent business house of India launched a mutual fund scheme
11 especially suited to Muslims from Shariah point of view. Many Muslim Funds took advantage of the scheme. Although many of them did suffer some loss due to their lack of expertise. At that time the practical difficulties in running such establishment, especially among the Indian Muslims, have been discussed at length. 11 Another area that may augment the future prospects of MFIs is the entry of foreign Islamic banks in the country either through capital market or through joint venture partnership with some Indian counterparts. The entry of foreign players may help loosening the regulatory grip as India is in dire need of external finance. This will also help in increasing the capital base of Indian MFIs besides bringing the attraction attached to it. It now depends on the entrepreneurs and investors as to how best they can utilize the existing framework of India s liberalized financial market.
12 Notes and References: 1 See, M. H. Khatkhatay, The Future of Islamic Finance in India Islamic Economics Bulletin, Vol. 12 No. 5, 2002. And Nisar, Shariq. The State of Islamic Finance in India: Strengths and Weaknesses, Review of Islamic Economics, No. 12, 2002. 2 See Kuran, Timur, Islamic Discipline of Economics Emerged in Late Colonial India, Islamic Economics Bulletin, (Aligarh, India), November-December 2002. A large volume of literature and writers produced by the subcontinent also give credential to this assertion, See M.N. Siddiqi, Muslim Economic Thinking, Leicester, UK: The Islamic Foundation, 1981. 3 For a perceptive analysis of this issue, See M. H. Khatkhatay, Islamic Banking in Indian Context Journal of Objective Studies (New Delhi, India), Vol.9, No.2, 1997, pp.83-110. 4 Dalvi A. Wahab M., Economic and legal Challenges to Islamic baking system in India, paper presented at the seminar on Islamic Economics: Issues and Challenges, held at Jamia Millia Islamia, New Delhi, on October 25-26, 1999. 5 Agency problems refer to moral hazard and adverse selection. Moral hazard arises due to hidden action when one party has the incentive to shift the risk onto another uninformed party. Adverse selection is due to hidden information, when one party has access to more information. 6 Shafiq A Mazhari, Banking Without Interest, in: Proceedings of Third Fiqhi Seminar on Bay rights, Murabaha and Islamic Banking, held at Bangalaore, India, on June 8, 1990, Islamic Fiqh Academy, New Delhi, India, n.d. pp.602-607. 7 Ibid. 8 See, Nisar, Shariq. Muslim Financial Institutions in India: A Survey Report, Islamic Economics Bulletin (Aligarh, India), Vol. 13, No. 4, July - August 2003. 9 Khatkhatay, op. cit. 2002, p. 3. 10 The Times of India, August 18, 2003. 11 Mohammad Obaidullah, Investment Products for Indian Muslims, Journal of Objective Studies (New Delhi, India), Vol.8 No. 1 1996, pp. 74-83, also, Masood Hasan, Islamic Modes of Investment: Its Relevance to India, Journal of Objective Studies (New Delhi, India), Vol.5, N0.2, 1993, pp.147-169.