Regulating Islamic Finance in Secular Countries: A Case Study of India

By Dr.Shariq Nisar and Syed Kamran Razvi

*Shariq Nisar, Ph.D. Economics, is Joint Editor Islamic Economics Bulletin, India and works as consultant. He has worked in the banking sector in various capacities. E:shariqnisar@yahoo.com; M;91-9980355403

*Syed Kamran Razvi, Legal consultant, and is also Director, Miftah Advisory India P Ltd. e: skrazvi@gmail.com m:91-9810078799 f: 91-11-41734987 a: Flat No.7,137B/12, Zakir Nagar, New Delhi-25

Regulating Islamic Finance in Secular Countries: A Case Study of India

By Dr.Shariq Nisar and Syed Kamran Razvi ABSTRACT
Indian Muslims have always been trying to manage their economic affairs within the framework of Shariah. Their struggle against usury practices has been both religious and financial struggle. This paper aims to highlight the attempts made by Indian Muslims in this regard and how some of the recent developments since opening of Banking and financial sectors and FDI cap from 74% to 100% in various categories of banking and provides opportunity and poses regulatory challenge in establishing Islamic Finance and Sharia compliant-products affecting their functioning. The paper focuses on opportunities, events and regulatory changes facilitate and pose new and additional challenges to new entrants. It examines the potential segments including NBFCs,FII, Micro Finance and Mutual Funds as new source of proliferation in India and the regulatory mechanism existing and requisite for functioning at large scale. The paper also relates the causes of failures in past by the depressed economic scenario in early 1990s and the highly changing regulatory environment in the late 1990s. Some prominent Islamic NBFCs and new initiatives by UTI and others in India are taken for detailed case studies to identify the future aspects in the topic of the paper. Terms; Lac: One hundred thousand Crore: 10 Million. 1: Introduction Financial arrangements constitute an integral part of the process of economic development. A growing economy requires a progressively rising volume of savings and adequate institutional arrangements for the mobilisation and allocation of savings. These arrangements must not only extend and expand but also adapt to the growing and varying financial needs of the economy. A well-developed and efficient capital market is an indispensable prerequisite for the effective allocation of savings in an economy. A financial system1 consisting of financial institutions, instruments and markets provides an effective payment and credit supply network and thereby assists in channeling of funds from savers to the investors in the economy. The task of the financial institutions or intermediaries is to mobilise the savings and ensure efficient allocation of these savings to high yielding investment project so that they are in a position to offer attractive returns to the savers.
1

Annxr.1 to paper

Islams teachings are not confined to the religious spheres but extend and control every aspect of human endeavors including the economic activity. Islam provides guidelines to regulate the economy and seeks to curb the unbridled race for material pursuit. Concern for equity and justice, halal and haram and a sense of responsibility towards the weaker sections of society and the need to share the economic resources with them, are some of the principles which guide and control the economic activity in Islam. Keeping in view the Islamic aspirations, Indian Muslims have always been trying to manage their economic affairs within the framework of the Shariah. The present paper seeks to highlight the attempts made by Indian Muslims in this regard and how some of the later developments in the form of changing regulatory environment has affected their functioning. Besides being the worlds second most populous country India also is Asias third largest and one of the fastest growing economy. It has a huge Muslim population between 150-200 million.2 There are several places where Muslims constitute majority of the total population (Bagsiraj, 2002). There are a number of industries in which Muslims traditionally have major stakes3. Since the last two decades, India has continuously managed an average saving rate at above 20 percent of the GDP (Bhandari, & Aiyar, 1999, p.29). Considering their relative economic backwardness even 15 percent saving rates for Muslims would fetch an enormous amount of annual savings to the community. Besides, there are properties worth billions of Rupees lying in the form of Awqaf. Zakah potential of the Indian Muslims still largely remains untapped and under utilized.

2: Non-feasibility of Islamic Banking in India Indian banking laws do not explicitly prohibit Islamic banking but there are provisions that put Islamic banking almost an unviable option. As the financial institutions in India comprises of Banks and Non Bank Financial Institutions. Banks in India are governed through Banking Regulation Act 1949, Reserve Bank of India Act 1934, Negotiable Instruments Act 1881, and Co-operative Societies Act 1961.
2

Even a conservative estimate by Syed Shahabuddin in Muslim India puts Muslim population as 133.54 million in the year 2001. For details please see, www.milligazette.com/Archives/15092001/29.htm 3 Like leather, cotton, bronze, lock, sari, carpet, etc.

Despite these acts being amended several times, one of the distinguishable features that still remain unaffected is that they define Banking in such a way that Banks can accept deposits from public only for further lending. For example, Section 5 (b) and 5 (c) of the Banking Regulation Act, 1949 prohibit the banks to invest on PLS basis (BR Act, 1949, 1999, pp. 6-7). Further, section 8 of the Banking Regulations Act (BR Act, 1949, 1999, p. 12) reads, No banking company shall directly or indirectly deal in buying or selling or bartering of goods . Besides India is among the countries that explicitly provides guarantee to its depositors. Deposits of each account up to the value of Rs. 0.1 million are guaranteed through the Deposit Insurance and Credit Guarantee Corporation (DICGC), a subsidiary of the Reserve Bank of India established in 1962. Moreover, government also interferes at the assets side by asking banks to provide concessional credit to certain priority sector.4 Above all the Government of India explicitly clarified its position with respect to the permissibility of Islamic banking in the country. Minister of State for Finance Mr. Zulfiqarullah, informed the Indian parliament that the Government is not in favour of its own or permitting the private sector to open an Islamic bank (Dalvi, 1999). Some other factors that help stealing the shine of Islamic banking is governments policy of large-scale pre-emption of banks resources through Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) requirements. These together eat up over 35 percent of the banks total deposits. Counting another 40 percent of banks resources directed towards the priority sector leaves banks with very little capital at their own disposal. Also, to increase the banking habit among people and for the purpose of extending banking facilities to the larger sections of the population, banks are asked to open branches in the rural and semi rural areas that mostly are economically nonviable5 (Kanta, 1996, p.24). Some of the other issues are stamp duty rates, Income Tax on income by Financial institutions.

The Concept of priority sector lending was proposed by Prof. Gadgil Study Group (1967). Later on the Ghosh Committee (1981) recommended a target of 40 percent of the total credit to priority sector including 18 percent to Agriculture and 10 percent to weaker section. 5 By the end of 1992-93, 171 Regional Rural Banks out of 196 were loss making.

3: Non-Banking Financial Institutions in India Non Banking Financial Institutions in India comprise of Non Banking Financial Companies (NBFCs), Mutual Funds, Insurance Companies and Developmental Institutions. According to the nature of their business, NBFCs are further classified as Equipment Leasing (EL), Hire Purchase (HP), Merchant Banking, Investment Companies, and Mutual Benefits Companies etc. A new set of companies called the Asset Finance Companies (AFC) has been added to this classification, these are further sub-divided into those accepting deposits and not accepting deposits. Developmental institutions are mainly created to serve special purposes like agriculture development, investments and export promotion etc. They are mainly promoted and run by the Government and its maintained institutions. On the other hand the insurance sector, which has recently been opened for the private sector, is still beyond the reach of small capital holders. Entry norms and regulatory framework makes it further difficult for the small capital owners to think entering this field. Mutual funds are open to the private players. But they too are beyond the reach of small capital holders. Besides the initial requirements of large capital and some other stringent requirements are well beyond the reach of Islamic financial institutions.6 In short anybody going for Islamic alternatives in finance has the option of choosing only the Non Banking Financial Companies format for its easy entry norms, low capital requirements, lower regulations and flexibility in registration and functioning. However two newer option can be through the route of FII and Micro Finance. 4: Non-Banking Financial Companies (NBFCs) The Non Banking Financial Corporations or Companies (interchangeably used in this paper) are defined by the RBI Amendment Act, 1997 as financial institutions which are registered as companies and which have as their principal business the receiving
6

The Tata Mutual Fund made a pioneering attempt when, at the instance of the Barkat and some other Islamic financial group, it launched Tata Core Sector Equity Fund in 1996 (IEB, 1996a). This scheme was specially tailored keeping in view the Muslims inhibition of dealing with interest bearing and haram investments. This scheme surprised many by being able to raise Rs. 230 million from the public. After initial hiccups the scheme did well for three years. After that the nomenclature was changed to the Tata IT sector Fund (IEB, 2000a).

of deposits under any scheme or arrangement or in any other manner and lending in any manner (http//: www.rbi.org.in). In India, the Non Banking Financial Corporations (NBFCs) play an important role in the mobilization and the deployment of financial resources. NBFCs are popular because of their added advantage over banking institutions in terms of high customer orientation, lower transaction costs, quick decision-making, easy registrations, lesser regulations and higher flexibility. Flexibility in their structure also allows NBFCs to un-bundle services provided by banks and market the components on a competitive basis. These distinctive features armed with economic liberalization contributed to great proliferation of NBFCs activities in India. The significant increase in the domain of activities of NBFCs is evident by the fact that the share of non-bank deposits (in gross financial assets of household sector) increased from a low of 2.2 percent in 1990-91 to 13.6 percent by 1996-97. Table 1 shows the growth of NBFCs during 1981 to 2003. The total number of NBFCs in 1981 was merely 7063, which increased to 15358 in 1985 and by the year 1995 it jumped to over 55000 NBFCs. However, after the new regulations came into force in 1998 the number of NBFCs drastically reduced to 7855 in 1999. Even after five years of the new regulations the number NBFCs could only rose to 13849 in 2003 with only about 700 companies allowed to accept deposits from the public. Table 1: NBFCs Position in India Year Number of NBFCs
1981 1985 1990 1995 1999 2003 7063 15358 24009 55995 7855 13849

Source: Reserve Bank of India Bulletin, August 97, p.591 and RBI Report, 2003.

In December 2006, NBFCs have been permitted to distribute and market Mutual Funds, this has been permitted by RBI for two years subjected to certain conditions including financial worth (NOF) of Rs.100 Crores. However, it is no longer easy to take CoR( Certificate of Registration) and to run as Deposit taking NBFC as Table 1A illustrates.

Table 1A: Status of NBFCs as on March 2007 March 2007 CATEGORY A Deposit Taking Non Deposit taking Banned in Delhi+Mumbai+Kolkata Applications rejected as on All over India NBFC+RNBC October 1,2006

Total Numbers 403 748 238 20080

5: Islamic Financial Institutions in India A Brief History Even a cursory look at the economic history of Indian Muslims highlights the fact that Muslims have always been conscious about the need to operate financial institutions on Islamic pattern. Hamidullah (1944) traces back such efforts to the end of nineteenth century. Another notable effort that still continues its operation was made in 1938 in the form of Pattani Cooperative Credit Society at Surat, Gujrat (Bagsiraj, 2002). However, the Bait-un-Nasr of Mumbai, established in 1973, still remains one of the most successful attempts so far. The history of Muslim Funds (a very popular format devised by the Jamiat-eUlema-e-Hind) is also as old as 1940 when the first Muslim Fund in the country was established at the Rampur State of North India (Nasir, 1997). Partition of the country in 1947 halted these efforts for almost one and half decade. After that the first major attempt could be made possible in the form of Muslim Fund Deoband in the year 1961. These Funds are arguably the most popular format adopted by Muslims in India specially in the highly concentrated Muslim belt of North. According to a list prepared by the Federation of Interest Free Organization (FIFO), there are more than 130 Muslim Funds in the country. Of them, thirty Muslim Funds as well as some others are the founding members of the Federation of Interest Free Organizations established in 1986. FIFO acts as an apex body of the member organisations for policy making, liquidity arrangements, staff training and representing to the Government. Jamaat-i-Islami Hind also attempted, particularly in the southern states of India, to establish welfare societies. The main purpose was to financially help the poor and needy on Islamic principles. Bagsiraj (2002) reports about 200 such institutions.

Muslim Funds, cooperative credit societies and welfare societies are all nonprofit institutions and have started either out of the need to rescue people from the ruthless moneylenders or out of a concern for the economically backward and downtrodden. By 1980s, Muslims started venturing into profit oriented business as well. This was made possible for three reasons; firstly, by that time, Indian Muslims had gained some financial expertise through successful running of non-profit financial businesses; secondly, the Islamic financial movement started in late seventies had gained momentum throughout the Islamic world giving an impetus to the Indian Muslims as well; lastly, the new economic policy initiated in early 1990s focussing on privatisation, liberalisation and globalisation from the old controlled regime provided new opportunities for the overall growth of the business. The first NBFC claiming to do business on Islamic principles called Al-Mizan was started in 1980 at Madras (Bagsiraj, 2002). This was a loose constituent of many small partnership firms engaged in leather trading. This effort miserably failed in 1984-85. Some other notable NBFCs established in India since then are as follows.

Table 2: Prominent Islamic NBFCs in India Name of Institution

1. Barkat Investment Group 2. Al-Amin Islamic Financial & Investment Corporation of India 3. Al-Barr Finance House Ltd. 4. Syed Shariyat Finance 5. Assalam Finance & Investment Ltd. 6. Baitul Islam Finance Ltd. Source: Nisar, S. (1999, p.27)

Year of Establishment
1983 1986 1989 1989 1990 1990

6: Changing Regulatory framework for NBFCs in India After more than four and a half decades of planned economy, India opted for a market friendly economy when it faced a severe economic crisis in the early 1990s. These policy changes were partly brought about out of the IMF/World Bank compulsion and partly due to changing domestic politics. Large-scale policy and institutional changes were brought in to make the country integrate with the global economy. Hence the period witnessed large-scale regulatory changes in the entire financial system.

Regulations governing NBFCs were an integral part of these overall policy changes. We would like to begin with the start of these regulations. NBFCs regulation in India began in 1963 with a declared aim of safeguarding depositors interest and to ensure healthy functioning of the NBFC sector. To begin with, a new chapter, IIIB, was inserted in the RBI Act, 1934 to enable the central bank to effectively supervise, regulate and control these institutions. Initially the directions were restricted to the liability side of the balance sheet and that too, solely to the deposit acceptance activities. However, after the reports of several expert committees examining the functioning of NBFCs, the Chakravarty Committee (1985) recommended a licensing based system for NBFCs. Narasimham Committee (1991) outlined a detailed framework for streamlining the functioning of NBFCs and setting up of a separate specialised department under the aegis of the RBI to control and supervise the activities of NBFCs. Later on, Shah Working Group, 1992 (RBI, 199899, p. 157), was appointed to make an in depth study of the role of NBFCs and to suggest regulatory and control measures to ensure healthy growth of these companies. Based on the recommendations of this group, the RBI initiated a series of measures that included: a. b. Widening the definition of regulated deposits; Compulsory registration of NBFCs having Net Owned Funds7 of Rs. 5 million and above; c. Guidelines on prudential norms to regulate the assets side of the NBFCs as well. To empower the RBI to enforce these regulations, the RBI Act, 1934 was further amended in March 1997. Major highlights of the amendments were: 1. An entry norm of Rs. 2.5 million as minimum NOF (this was later raised to Rs. 20 million), 2. Compulsory registration with the RBI and maintaining certain minimum percentage of liquid assets,

NOF: Net Owned Fund is the aggregate of the paid-up capital and free reserves, reduced by the amount of accumulated balance of loss, deferred revenue expenditure and other intangible assets, if any, and further reduced by investments in shares and loans, and advances to subsidiaries, companies in the same group and other NBFCs in excess of 10 percent of owned fund.

3.

Creation of reserve funds by transferring a minimum of 20 percent of the net profit every year.

Besides, some other stringent provisions, those violating the regulations were not allowed to access public deposits. Simultaneously, new set of regulatory measures was announced in January 1998 (further amended in December, 1998) bringing an entirely new set of regulations and supervision over the activities of NBFCs. Now the NBFCs were broadly classified into three: 1) Those accepting public deposits; they were the subject of the entire gamut of new regulations. The regulatory attention was specifically focused on this category, 2) Those not accepting public deposits but engaged in financial business were proposed to be regulated in a limited manner, and 3) The Core investment companies holding at least 90 percent of their assets as investments in the securities of their groups/holding/subsidiary companies. Since the major focus of these regulatory changes was on companies accepting public deposits, Islamic NBFCs were among those affected most severely by the new and sudden regulatory changes that mainly focused on the following: Linking the quantum of deposit to Net Owned Fund (NOF), Reducing the period of deposit between 12-60 months, from 24-120 months, Ceiling on the rate of return not exceeding 16 percent. Ceiling on brokerage fee and commission not exceeding 2 percent of the deposit. Changes in the content of application form as well as the advertisement patterns for soliciting deposits only helped in tightening the situation. The companies accepting public deposits were now asked to comply with all the prudential norms of income recognition, assets classifications, accounting standards, provisioning for bad and doubtful assets, capital adequacy, credit, and investment concentration norms etc. The classification of assets and provisioning of accounts have been laid down as follows: (Shah 1996, p.763) Substandard: Bad and doubtful: 10 percent of the total outstanding. Up to 1 year-20 percent of the outstanding.

1-3 years-30 percent of the outstanding. Bad and doubtful uncovered-100 percent of the outstanding Total loss- 100 percent of the outstanding The minimum capital adequacy ratio had been fixed at 12 percent while the credit and investment concentration was fixed at 15 and 25 percent of the owned funds to single borrower and group respectively. The total loans and investments were subject to a ceiling of 25 and 40 percent of the NOF respectively for exposure to single party or an industry group. Those soliciting public deposits were now asked to specify their rating in the advertisements. Mobilizing public deposits was fixed not more than 1.5 times of its NOF or Rs. 100 million whichever was lower. Prohibiting NBFCs to invest more than 10 percent of NOF in real estate and asking them not to invest in unquoted shares badly hampered the investment opportunities of Islamic NBFCs. Moreover the companies were now required to maintain liquid assets of not less than 15 percent of their public deposits into commercial banks. Table 3: Position of NBFCs for issue of Certificate of Registration
Criteria 1. Total number of applications received 2. Number of NBFCs having NOF of Rs. 2.5 million and above (i.e., fulfilling primary eligibility criteria) 3. Number of approved applications: Number of NBFCs permitted to hold/accept public deposits 4. Number of rejections 5. Number of NBFCs whose applications are under process 6. Number of NBFCs having NOF below Rs. 2.5 million Source: RBI, 1998-99, p. 163. Note: Position as on August 31, 1999. Number 37,390 10, 486 7,855 624 1,167 1,464 26,904

As is obvious from the table 3 that after the implementation of new regulations, business prospects of NBFCs in the country including those of Islamic were badly hurt. As per the direction for compulsory registration, the RBI received 37,390 applications. Out of these, 7,855 were approved and 11, 67 were rejected. Rest of the applications were pending at different stages of processing. Strikingly only 624 of the total approved NBFCs, have been permitted to accept/hold public deposits.

7: Effects of Regulatory Changes on Islamic NBFCs In the early liberalization phase, Islamic NBFCs like others grew rapidly. Major factors responsible for this pull, besides the Islamic tag or interest-free, were their highly customer oriented services and high returns made possible mainly due to the bullish stock market and spiraling real estate prices, especially in the metros like Mumbai, Delhi, Bangalore, and Hyderabad, etc. By 1995, both the stock market and real estate had started crashing. These two put a brake on the returns offered to the depositors who till now had been receiving very handsome returns. Sliding economic conditions at a time of fast changing regulatory requirements proved too much too soon for many of the Islamic NBFCs. In a nutshell, shrinking business opportunities, increasing competition and highly changing regulations culminated in closing down few very promising Islamic NBFCs in the country. Following sub-sections attempt to find out the effect of these regulations on some of the selected Islamic NBFCs like Barkat, BUN, Al-Najib and the Al-Barr. These four though come under the purview of the provisions of law governing and regulating NBFCs but each company follows a different business format like Barkat, a leasing company, Baitun Nasr a cooperative, Al Najib a Mutual Benefits Company and Al Barr engaged in merchant and investment banking activities.

7.1: Barkat Investment Group (BIG) Arguably it has been one of the brightest and most trusted Islamic financial institutions in the country. Since the Bait-un-Nasr Urban Cooperative Credit Society Ltd (BUN), Bombay was prohibited to invest its deposits under the Islamic option it floated two partnership firms called Falah Investments Ltd. and Ittefaq Investments Ltd. in 1983. These two later on were joined together to form the Barkat Investment Group in 1988. In 1991, Barkat floated its flag bearing organization the Barkat Leasing and Financial Services Ltd. (BLFSL) The total funds under its management increased from about Rs. 1.6 million in March 1989 to about Rs. 270 million in March 1997. During all these years its returns to deposits remained a positive figure between 10 to 25 percent (Table 4), except one of its schemes Barkat Stocks that incurred

losses of 8.56 and 5.85 percent during the financial year 1995-96 and 1996-97. Due to limited business options other than trading in stock and real estates all the schemes of Barkat incurred losses of about 25 percent in the year 1997-98. The total loss to the company was to the tune of Rs. 32.8 million which did not appear quite high in comparison to Brakats past performance and the present financial standing. But eventually it proved too much for the company. After two years of frenzy the Barkat was finally closed by the government in May 2000. Liquidation of Barkat at a time when it had assets worth Rs. 170 million (Table 5) was a major blow to the Islamic financial activities in India. As mentioned earlier that Barkat had heavily invested in the real estate and the stock market. This was mainly because Islamically Barkat had little other options and moreover the past performance of these two sectors had made Barkat able to meet the expectations of its depositors. By the time the slump started in stock market in 1995, Barkat had already invested a substantial part of its funds in the stock market. Tight liquidity in the market had its impact on the Barkat which was forced to divest its high performing shares at depressed prices. Recovery in the stock market by 1999 was too late for the Barkat. On the other hand real estate market also went into an unprecedented recession in 1996 that only helped increasing the despair. Table 4: Summary of the Financial Performance of Barkat Investment Group (1988-1998- Rs. In Lakhs)
Year 1988-89 1989-90 Gross Profit 8.88 13.141 Expenses 5.131 6.7 Net Profit 3.749 6.441 Depositors Share 1.874 4.831 Deposits Mobilized 9.865 27.6.5 BIC 19 Stocks Leasing Retained Fund 1.875 Add/Less Retained 0 Fund b/d Net Retained Fund 1.875 Source: (Balance Sheets) 17.5 1990-91 1991-92 1992-93 1993-94 27.833 56.512 79.358 158.76 7.478 15.766 26.777 48.78 20.355 40.746 52.581 109.98 15.267 30.56 42.065 93.29 85.96 151.58 262.317 567.75 Returns to Depositors 17.75 20 16 6 10.516 18.759 29.275 16.25 25 13.64 16.69 29.275 45.965 1994-95 286.378 104.178 182.2 150.373 970.664 14 14 15.23 31.827 45.965 77.792 1995-96 1996-97 313.433 401.241 149.457 232.456 163.98 168.79 139.857 253.225 1807.027 2262.484 12 -8.56 15 24.119 77.792 101.91 10 -5.85 10.45 -84.44 101.911 17.471 1997-98 -60.356 257.326 -317.68 27.969 1,135.38 -25.45 -25.45 0 -345.651 17.471 -328.18

1.61 1.875 3.485

5.088 3.485 8.573

10.186 8.573 18.759

Table 5: Assets Held by Barkat Investment Group as on 30th September 1998

1= Real Estate Properties (Total 34 Properties) 2= Other Assets 116,834,341

Fixed Leased Investments in Shares Real Estate Receivables PLS investments Barkat Fisheries Deposits Other Receivables Total 1+ 2 Source: Barkats Assets List

2,389,792 24,407,095 2,685,000 12,608,075 3,730,000 3,200,000 2,015,000 2,967,000 170,836,303

Barkats self-imposed moratorium on Murabahah only added to its already existing list of woes by limiting its investment basket. Though during later years Barkat did try albeit unsuccessfully, to expand its investment portfolio by increasing its presence in leasing based (Ijarah) activities. Table 6: Returns on Working Capital and Total Investments of Barkat Leasing and Financial Services Ltd. during 1991-98
Year 1991-92 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 Gross Returns on Working Capital % 2.71 11.64 1.77 17.97 14.35 15.81 5.3 Net Returns on Working Capital % 0.43 3.2 3.49 1.73 1.09 0.75 - 7.23 Gross Returns on Investment % 5 13.94 8.72 16.8 13.61 13.4 5.13 Net Returns on Investment % 0.81 3.83 2.83 1.62 1.04 0.64 - 6.99

Source: Bagsiraj, M. I. (2000, p. 548)

Barkat Leasing and Financial Services Ltd. (BLFSL) returns on capital shows that the strategy had worked except for the year 1997-98 when its net return on working capital was down by 7.23 percent (Table 6) and its net return to investment by 6.99 percent. That was the year of heavy regulatory changes brought in the NBFCs sector in India. New regulatory changes enforced in April 1997 completely banned all firms involved in investment activities from accepting any fresh deposits. This led to a oneway flow of funds (outflow) from the firms in the group causing tremendous pressure on the already trembling operations. Barkats commitment to Shariah forced it not to access the usual avenues available to others for addressing its liquidity needs. Had this not been the case, temporary liquidity from conventional banks might have sufficed its liquidity needs. Since there were no Shariah complaint options available or lender of the last resort, Barkat kept waiting for some sort of external assistance either from

within or outside the country, which never reached and finally one of the very promising Islamic NBFC in India was closed in May 2000. (IEB, 2000b, 2002).

7.2: Baitun Nasr Urban Cooperative Credit Society (BUN) Started on a trial basis in 1973, it was regularized in 1976 as an Urban Cooperative Credit Society under the Maharashtra Cooperative Credit Societies Act. The main purpose of the society was to provide banking facility to its members on Islamic lines. It accepted deposits from its members on interest free basis and extended it to the same on actual service charges. Table 7 shows its financial performance from beginning till 1999. Since September 2001 BUN has been forced to suspend its operation due to its close association with the Barkat group. Table 7: Financial Performance of Baitun Nasr (1977-1999). Share Capital, Total Deposits, Loan Turnover and Total Assets are in Rs. 000
Years Branches Members Share Capital Total Deposits Loan Turnover Total Assets 1977 1 654 26 36 49 0 1982 4 6820 126 171 3062 13 1987 7 20356 584 6191 15977 705 1992 12 47186 2862 26302 58088 5497 1997 18 120510 13035 108580 278995 25760 1998 18 137797 12993 119184 324950 30405 1999 20 155050 12762 124159 364810 34598

Source: (Balance Sheets)

Starting with a meager fund of Rs. 12000 the society became one of the most successful Islamic societies in India with 20 branches in the city of Mumbai. Membership of the society increased to more than 150,000. Total deposits of the society also reached Rs. 120 million. It is pity that the BUN was not closed for any bad investments (as it was not allowed at all) but because it had, once upon a time, floated Barkat Investment Group (Nisar: 2003). It was a classic case of rumor and contagion effect taking its toll on an otherwise smoothly functioning institution. BUN, in fact, has purely been engaged in banking activities, accepting deposits from the public (members) and lending it to the same. All its lending were secured by property, gold and silver. The society had developed a scientific system of calculation of service charges and all its 20 branches were computerized to keep pace with the changing technological developments and keep overheads low.

The only solace for the society is that despite it being closed for so long, its depositors, by taking a lesson from Barkat, have not taken the case to the court. Till date, the society is in a dormant state.

7.3: Al-Najib Milli Mutual Benefits Limited (AMMB) This is the largest financial institution in the country managed by Muslims. With 41 branches mainly spread in the northern India the company has deposits over Rs. 200 million. As far the Islamicity is concern its operation are ambiguous beyond any doubt. The company, in fact, avoids calling itself an Islamic financial institution. The prestigious Muslim Fund, Najibabad floated AMMB in 1993 (Nasir, 1997). Since AMMB was notified as the Mutual Benefit Finance Companies (Under Section 620 A) of the Non Banking Financial Companies Act, hence it was kept outside the purview of most of the new regulations. Because of this, even during the recessionary years, it kept growing, albeit a bit slowly. This shows that even the worse economic condition could have successfully been averted had there not been the sudden regulatory changes. Another factor that provided greater flexibility to AMMBs operations was its mother organization MFN which is incorporated as a trust through separate Act. Since the businesses of AMMB and MFN were run from the same offices it gave the group a privilege of cross shifting its employees, assets and liabilities. Because of this operational flexibility the group was able to promptly counter some of the regulatory changes that might have affected its business prospects. Moreover the AMMB also follows a policy of putting a large chunk of its deposits in commercial banks, which provides the company a solid source of revenue besides giving it a good cushion during the time of crisis. Table 8 shows the financial position of AMMB, which is getting stronger by the day.
Table 8: Financial Performance of Al-Najib Milli Mutual Benefits Limited (1993-99) (Figures in Rs. 000) Year 1993 1994 1995 1996 1997 1998 1999 Deposits 53,635.44 66,953.61 91,050.83 112,307.37 120,763.01 140,330.79 161,718.97 Loan 28,623.45 37,306.80 44,834.90 53,401.38 66,568.84 72922.46 78,062.76 Investments 352.60 1072.60 1339.20 1674.90 1874.50 5660.15 16,495.65 Profit after Tax 2.18 3.55 34.07 29.54 52.18 96.41 103.63

2000

193,285.05

80,518.04

15,875.50

51.71

Source: Annual Reports, 1992-93 to 1999-2000.

7.4: Al-Barr Finance House Ltd. (ABFL) Formerly known as Al-Baraka Finance House Ltd. It was promoted by the Dallah Al Baraka group in 1989. This is the only Islamic financial institution in the country with a foreign stake. Throughout 1990s it was low profiled and largely unknown to the public. However, since inception of the new regulations in 1998, it has succeeded in accelerating its activities. It is registered under the NFBCs Act and unlike many other Islamic NBFCs in the country it has thrived since the new regulations. The strongest reason that seems to have favored this company during the new regulation was its lower stretch. At the time of new regulations it operated with a very few branches and with small public deposits. A foreign holding of 51 percent proved to be its major source of strength, besides helping it earns a credit rating of adequate safety (IEB, 1999). Table 9 shows the financial highlights of the company during 1990 to 1998. A substantial part of companies resources are invested in short term Murabahah and at the time of exigency the company is not hesitant in approaching interest based commercial institutions. The total income of the company increased from merely 12 lakh in 1990 to 715 lakh by 1999. Specially the period since 1997 saw greater proliferation in its total income. Irrespective of the economic condition the company has managed to distribute dividend at the rate of 12 percent since 1996. Despite share capital being constant since 1997 reserve surpluses of the company has increased constantly. Fixed assets too witnessed greater jump since the new regulation. Table 9: Financial Highlights of Al-Barr Finance House Ltd. (1990-1999) (Figures in Rs. 100,000)
Year 1990 1991 Total 12.43 15.66 Income Profit 0.06 2.92 Dividend 14 Fixed 0.38 0.75 Assets Share 15.00 21.56 Capital Reserves 0.06 0.60 and Surplus Source: Balance Sheets 1992 85.65 17.39 15 45.72 300.00 5.15 1993 145.34 41.29 12 180.60 300.00 12.87 1994 186.93 45.98 10 193.82 400.00 25.17 1995 288.26 100.02 11 433.53 400.00 81.19 1996 434.65 115.92 12 743.55 400.00 149.10 1997 604.39 106.33 12 959.56 430.00 233.18 1998 657.59 80.44 12 1232.35 430.00 261.26 1999 715.21 85.23 12 1197.1 8 430.00 289.40

8: Second Wave of Islamic Finance and Financial Institutions:

The possible second wave of Islamic Financial Institutions is not in the Banking Sector or NBFC but in the stock market or investment driven through the medium of FII, who are now attempting to register Mutual Funds, Real Estate investments,etc. This has permitted the entry without meeting out the challenge which RBI, the central Banker has posed for Shariah compliant products or interest free products. Table 10: NSE Top Four Shariah Compliant Sectors

NSE Top Four Shariah Compliant Sectors

Year Mar-20 02 Mar-2 0 03 Mar-2 004 Mar-2 00 5 Dec-005

FII in India

Computer software Drugs & pharmaceuticals Automobile ancillaries Cosmetics, toiletries, soaps & detergents Total Qualifying Top fours Contribution in Total Qualifying (%)

25 15 2* 6 115 40.00

29 16 6 5 137 40.88

30 21 14 6 185 38.38

40 30 17 6 237 39.24

51 34 21 6# 335 36.12

FII in India are desired to be registered under the SEBI 8 laws, they can also create sub-accounts. FIIs are permitted to have their own brokers operate with condition of account being maintained by custodian bank and transactions by the local Stock-broker. Countries with whom, India has DTAA are advantaged in terms of tax benefits which the investors can enjoy. However the most favourable DTAA structure that India has is with Mauritius. Last two years have seen DTAA signing with UAE and some other emerging economies in Middle East. The potential really lies in the fact post 9/11, wherein the Gulf money has been craving for as alternative investment destination to US. The investment opportunity in fast growing fairly well regulated and organized Indian market is seen and duly recognized by many of the Islamic Banks and Financial institutions. Sharia Complaint products (stocks and others like real estate, infrastructure,etc) in India after deducting the interest component are readily available. Indexing has been done by co-author Dr.Shariq Nisar and one of the new entity Miftah Advisory India P Ltd, who is initiating this Index at BSE or NSE. TABLE 11: FOREIGN INVESTMENT INFLOWS
Year 1 1990-91 1991-92 1992-93 1993-94 1994-95 1995-96 * 1996-97 * 1997-98 * 1998-99 * 1999-00 * 2000-01 * 2001-02 * 2002-03 * 2003-04 * 2004-05* P 2005-06* P P: Provisional. * Includes acquisition of shares of Indian companies by non-residents under Section 6 of FEMA,1999. Data on such acquisitions are included as part of FDI since January 1996. Note: 1. Data on FDI have been revised since 2000-01 with expanded coverage to approach international best practices. Data from 2000-01 onwards are not comparable with FDI data for earlier years. 2. Negative (-) sign indicates outflow. Source: RBI.
8

A. Direct Investment (Rs. crore) (US $ Million) 2 3 174 97 316 129 965 315 1838 586 4126 1314 7172 2144 10015 2821 13220 3557 10358 2462 9338 2155 18406 4029 29235 6130 24367 5035 19860 4322 25395 5652 34316 7751

B.Portfolio Investment (Rs. crore) (US $ Million) 4 5 11 6 10 4 748 244 11188 3567 12007 3824 9192 2748 11758 3312 6696 1828 -257 -61 13112 3026 12609 2760 9639 2021 4738 979 52279 11377 41854 9315 55307 12492

Total (A + B) (Rs. crore) (US $ Million) 6 7 185 103 326 133 1713 559 13026 4153 16133 5138 16364 4892 21773 6133 19916 5385 10101 2401 22450 5181 31015 6789 38874 8151 29105 6014 72139 15699 67249 14967 89623 20243

Securities Exchange Board of India body through enactment in 1992, regulator for Financial markets but in case of NBFC it shares as cross-regulator with RBI, the Central Bank in India. It has power to frame regulations. www.sebi.gov.in.

TABLE 12: TRENDS IN FII INVESTMENT

Year 1 Gross Purchases (Rs. crore) 2 Gross Sales (Rs. crore) 3 4 466 2835 2752 6979 12737 17699 46734 64116 41165 44373 99094 171072 305512 Net Investment (Rs. crore) 4 13 5126 4796 6942 8574 5957 -1584 10122 9934 8755 2689 45765 45881 41467 Net Cumulative Investment** (US $ mn.) 5 4 1634 1528 2036 2432 1650 -386 2339 2159 1846 562 9950 10172 9332 Net Investment** (US $ mn.) 6 4 1638 3167 5202 7634 9284 8898 11237 13396 15242 15804 25755 35927 45259

1992-93 17 1993-94 5593 1994-95 7631 1995-96 9694 1996-97 15554 1997-98 18695 1998-99 16115 1999-00 56856 2000-01 74051 2001-02 49920 2002-03 47061 2003-04 144858 2004-05 216953 2005-06 346978

** Net Investment in US $ mn. at monthly exchange rate. Source: RBI.

The report in India times dtd.30 May 2007 is illustrative and is summarized below 9:

"FIIs from Gulf countries should actively look at investing in the Indian stock markets," Union Commerce Minister Kamal Nath said in a presentation at the valedictory function of the 3rd India-Gulf Cooperation Council Industrial Forum. India's stock markets were booming and registering as FIIs here would help Gulf banks deliver benefits to their high net-worth clients. These are the indicative trends that what second wave of Islamic Investments would be. Although at least three FII from Gulf, like Taib Bank and others have tried to float the Sharia Compliant Mutual Fund, but there progress in terms of launching in India for more than one year has been partly challenged by regulations/regulators there. Local Players:
There is raise in expectations by the Indian local players, who already have strong business presence in Middle East and launch of some Indian insurance companies in Middle East insurance sector are adding to expectations. It may be too early to predict the trends. The biggest stumbling block for Sharia Compliant funds has been a specific mention for such products in Equity markets which is considered by regulators as community specific and too sensitive to handle. However this perception or limitation imposed on Sharia compliant products by Indian regulators may be waning, if this circular by RBI is any indication which must be credited to Manmohan Singhs government.

http://timesofindia.indiatimes.com/articleshow/2086728.cms

Vide Circular UBD.PCB.No.17/09.09.001/2006-07 dated October 17, 2006 on Prime Ministers 15 Point Programme for the Welfare of Minorities. In this connection a list of 121 Minority Concentrated Districts has been identified by Government of India10. By this circular RBI11 has issued instructions to controlling offices, branch offices advising them to specially monitor the credit flow to minorities in these 121 districts thereby ensuring that the minority communities receive an equitable portion of the credit within the overall target of the priority sector. The above requirement is to be kept in view for the purpose of earmarking of targets and location of development projects under the Prime Ministers New 15 Point Programme for the Welfare of the Minorities. This circular itself is a major shift in terms of the way Indian Banking policy will be governed. This has not happened in the past 70 years of Indian independence.
In addition to this Micro Finance Bill of 2007 if and when passed by the Parliament can be another thrust area for Community Development initiative. The principles enumerated can be beneficial to direct entry for Islamic financial products. RBI more recently, has agreed to the initiative by the Finance Ministry to directly permit the acceptance of ECB by those institutions who are already established in the field of microlending and help establish small enterprises. Institutions like IDB and other such development funds from Islamic Nations can gain entry to Indian finance market through this route without much changes warranted to their principles, as is in the existing Indian financial (including Banking) and tax laws and regulations therein. In this sense it may widen the area of entry Islamic Financial products in Indian market.

8: Conclusion The decade of 1980s and 1990s saw proliferation of Islamic NBFCs. Indias decision to introduce large-scale regulatory changes in the non-banking financial sector at a time when most of the South Asian countries were passing through severe economic recession did not augur well for the non-banking finance sector. More so Islamic NBFCs appears to have suffered more because of the distinct nature of their business and other religious constraints like not being able to avail the conventional avenues available to other financial institutions. In a fast changing regulatory environment like this, a conventional NBFC would prefer keeping its money in commercial banks than to go with risk associated ventures that are part and parcel of Islamic financial institutions. On the other hand small size of Islamic NBFCs and a lack of the lender of last resort besides naive and complacent attitude towards the regulation also had a fair
10

This issue was debated in one of the constituent assembly debates and was also part of scheme of governance for muslims under Government of India Act of 1935. 11 Reserve Bank of India Act of 1934 but it became functional in 1935. Its existence pre-dates Indian independence in 1947 and becoming of Indian Republic in 1950.

share in their failures. Perhaps the recessionary economic phase could have easily been tackled had the management been more alert and investors more informed. The decades of 2000 onwards may be facilitating entry for Islamic financial Products in India through Stock market, investments, Venture Capital finance, microcredit/finance and lastly Sukuks. 9: Suggestions and Recommendations Experiences of the Islamic NBFCs in India underscore at least two points: (i) Internally, Islamic NBFCs should be well capital adequate besides being highly cautious in their business operations and (ii) In a secular democratic country like India there is need for some sort of advocacy groups that work quietly in creating soothing conditions for Islamic oriented businesses. Islamic financial institutions constantly need to diversify their investment basket through innovations and improvement in technology. In a secular country like India it could be difficult due to non-recognition of Islamic principles but nevertheless they are important and need to be conveyed to the regulators through all the legal means. Self imposed moratorium on certain qualified modes of finance by certain Islamic finance house instead of increasing the reputation led to isolation and lopsided investments. Therefore, more flexibility is needed to cope with the changing business environment. Lack of the lender of last resort has been a major cause of concern for Islamic financial institutions the worldwide. Therefore, the establishment of any such institutions that could act as the lender of last resort should be the topmost priority by Islamic economists and policy makers. Another issue that needs immediate attention of the policy makers is to put a check on tainted profit seekers who just fore the sake of their small profit vitiate the whole environment for genuine concerns. Many institutions that operate on the basis of interest disguising them as an Islamic financial alternative, either overtly or covertly, only help in creating a crisis of confidence. People also need to be informed about the Islamic finance principles so that at the time of crises they do not create unnecessary panic and rumors leading to contagion. ****

*Shariq Nisar, Ph.D. Economics, is Joint Editor Islamic Economics Bulletin, India and works as consultant. He has worked in the banking sector in various capacities. E:shariqnisar@yahoo.com; M;91-9980355403 *Syed Kamran Razvi, Legal consultant, and is also Director, Miftah Advisory India P Ltd. e: skrazvi@gmail.com m:91-9810078799 f: 91-11-41734987 a: Flat No.7,137B/12, Zakir Nagar, New Delhi-25

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