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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
Islam’s 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 world’s second most populous country India also is Asia’s
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.

4
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 7063
1985 15358
1990 24009
1995 55995
1999 7855
2003 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 Total Numbers
‘A’ Deposit Taking 403
Non Deposit taking 748
Banned in 238
Delhi+Mumbai+Kolkata
Applications rejected as on All over India NBFC+RNBC 20080
October 1,2006

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-e-
Ulema-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 non-
profit 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 Year of Establishment
1. Barkat Investment Group 1983
2. Al-Amin Islamic Financial & Investment Corporation of India 1986
3. Al-Barr Finance House Ltd. 1989
4. Syed Shariyat Finance 1989
5. Assalam Finance & Investment Ltd. 1990
6. Baitul Islam Finance Ltd. 1990
Source: Nisar, S. (1999, p.27)

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, 1998-
99, 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. Widening the definition of regulated deposits;
b. 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,

7
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: 10 percent of the total outstanding.
Bad and doubtful: 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 Number
1. Total number of applications received 37,390
2. Number of NBFCs having NOF of Rs. 2.5 million and above 10, 486
(i.e., fulfilling primary eligibility criteria)
3. Number of approved applications: 7,855
Number of NBFCs permitted to hold/accept public deposits 624
4. Number of rejections 1,167
5. Number of NBFCs whose applications are under process 1,464
6. Number of NBFCs having NOF below Rs. 2.5 million 26,904
Source: RBI, 1998-99, p. 163.
Note: Position as on August 31, 1999.
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 Brakat’s 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 1990-91 1991-92 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98
Gross Profit 8.88 13.141 27.833 56.512 79.358 158.76 286.378 313.433 401.241 -60.356
Expenses 5.131 6.7 7.478 15.766 26.777 48.78 104.178 149.457 232.456 257.326
Net Profit 3.749 6.441 20.355 40.746 52.581 109.98 182.2 163.98 168.79 -317.68
Depositors Share 1.874 4.831 15.267 30.56 42.065 93.29 150.373 139.857 253.225 27.969
Deposits Mobilized 9.865 27.6.5 85.96 151.58 262.317 567.75 970.664 1807.027 2262.484 1,135.38
Returns to Depositors
BIC 19 17.5 17.75 20 16 16.25 14 12 10 -25.45
Stocks 25 14 -8.56 -5.85 -25.45
Leasing 6 13.64 15.23 15 10.45 0
Retained Fund 1.875 1.61 5.088 10.186 10.516 16.69 31.827 24.119 -84.44 -345.651
Add/Less Retained
0 1.875 3.485 8.573 18.759 29.275 45.965 77.792 101.911 17.471
Fund b/d
Net Retained Fund 1.875 3.485 8.573 18.759 29.275 45.965 77.792 101.91 17.471 -328.18
Source: (Balance Sheets)

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


1= Real Estate Properties (Total 34 Properties) 116,834,341
2= Other Assets
Fixed 2,389,792
Leased 24,407,095
Investments in Shares 2,685,000
Real Estate Receivables 12,608,075
PLS investments 3,730,000
Barkat Fisheries 3,200,000
Deposits 2,015,000
Other Receivables 2,967,000
Total 1+ 2 170,836,303
Source: Barkat’s Assets List

Barkat’s 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
Gross Returns on Net Returns on Gross Returns Net Returns on
Year
Working Capital Working Capital on Investment Investment
% % % %
1991-92 2.71 0.43 5 0.81
1992-93 11.64 3.2 13.94 3.83
1993-94 1.77 3.49 8.72 2.83
1994-95 17.97 1.73 16.8 1.62
1995-96 14.35 1.09 13.61 1.04
1996-97 15.81 0.75 13.4 0.64
1997-98 5.3 - 7.23 5.13 - 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 one-
way flow of funds (outflow) from the firms in the group causing tremendous pressure
on the already trembling operations. Barkat’s 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 1977 1982 1987 1992 1997 1998 1999
Branches 1 4 7 12 18 18 20
Members 654 6820 20356 47186 120510 137797 155050
Share Capital 26 126 584 2862 13035 12993 12762
Total Deposits 36 171 6191 26302 108580 119184 124159
Loan Turnover 49 3062 15977 58088 278995 324950 364810
Total Assets 0 13 705 5497 25760 30405 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
AMMB’s 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 Deposits Loan Investments Profit after Tax
1993 53,635.44 28,623.45 352.60 2.18
1994 66,953.61 37,306.80 1072.60 3.55
1995 91,050.83 44,834.90 1339.20 34.07
1996 112,307.37 53,401.38 1674.90 29.54
1997 120,763.01 66,568.84 1874.50 52.18
1998 140,330.79 72922.46 5660.15 96.41
1999 161,718.97 78,062.76 16,495.65 103.63
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 1992 1993 1994 1995 1996 1997 1998 1999
Total
12.43 15.66 85.65 145.34 186.93 288.26 434.65 604.39 657.59 715.21
Income
Profit 0.06 2.92 17.39 41.29 45.98 100.02 115.92 106.33 80.44 85.23
Dividend 14 15 12 10 11 12 12 12 12
Fixed 1197.1
0.38 0.75 45.72 180.60 193.82 433.53 743.55 959.56 1232.35
Assets 8
Share
15.00 21.56 300.00 300.00 400.00 400.00 400.00 430.00 430.00 430.00
Capital
Reserves
0.06 0.60 5.15 12.87 25.17 81.19 149.10 233.18 261.26 289.40
and Surplus
Source: Balance Sheets
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 FII in


India
Year Mar-2002 Mar-2003 Mar-2004 Mar-2005 Dec-005

Computer software 25 29 30 40 51

Drugs &
15 16 21 30 34
pharmaceuticals

Automobile
2* 6 14 17 21
ancillaries

Cosmetics, toiletries,
6 5 6 6 6#
soaps & detergents

Total Qualifying 115 137 185 237 335

Top four’s
Contribution in 40.00 40.88 38.38 39.24 36.12
Total Qualifying (%)
FII in India are desired to be registered under the SEBI8 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 A. Direct Investment B.Portfolio Investment Total (A + B)
(Rs. crore) (US $ Million) (Rs. crore) (US $ Million) (Rs. crore) (US $ Million)
1 2 3 4 5 6 7
1990-91 174 97 11 6 185 103
1991-92 316 129 10 4 326 133
1992-93 965 315 748 244 1713 559
1993-94 1838 586 11188 3567 13026 4153
1994-95 4126 1314 12007 3824 16133 5138
1995-96 * 7172 2144 9192 2748 16364 4892
1996-97 * 10015 2821 11758 3312 21773 6133
1997-98 * 13220 3557 6696 1828 19916 5385
1998-99 * 10358 2462 -257 -61 10101 2401
1999-00 * 9338 2155 13112 3026 22450 5181
2000-01 * 18406 4029 12609 2760 31015 6789
2001-02 * 29235 6130 9639 2021 38874 8151
2002-03 * 24367 5035 4738 979 29105 6014
2003-04 * 19860 4322 52279 11377 72139 15699
2004-05* P 25395 5652 41854 9315 67249 14967
2005-06* P 34316 7751 55307 12492 89623 20243
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.

TABLE 12: TRENDS IN FII INVESTMENT


Year Gross Gross Net Net Cumulative
Purchases Sales Investment Investment** Net Investment**

8
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.
(Rs. crore) (Rs. crore) (Rs. crore) (US $ mn.) (US $ mn.)
1 2 3 4 5 6

1992-93 17 4 13 4 4
1993-94 5593 466 5126 1634 1638
1994-95 7631 2835 4796 1528 3167
1995-96 9694 2752 6942 2036 5202
1996-97 15554 6979 8574 2432 7634
1997-98 18695 12737 5957 1650 9284
1998-99 16115 17699 -1584 -386 8898
1999-00 56856 46734 10122 2339 11237
2000-01 74051 64116 9934 2159 13396
2001-02 49920 41165 8755 1846 15242
2002-03 47061 44373 2689 562 15804
2003-04 144858 99094 45765 9950 25755
2004-05 216953 171072 45881 10172 35927
2005-06 346978 305512 41467 9332 45259

** 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 below9:

"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 Singh’s government.

Vide Circular UBD.PCB.No.17/09.09.001/2006-07 dated October 17, 2006 on ‘Prime


Minister’s 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.

9
http://timesofindia.indiatimes.com/articleshow/2086728.cms
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 micro-
lending 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. India’s 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
share in their failures. Perhaps the recessionary economic phase could have easily
been tackled had the management been more alert and investors more informed.

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.
The decades of 2000 onwards may be facilitating entry for Islamic financial Products
in India through Stock market, investments, Venture Capital finance, micro-
credit/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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