Politics, laws weigh on Islamic finance in India

India's tiny Islamic finance industry is hoping to expand by developing products that would work around the country's ban on sharia-compliant banking. But political and legal obstacles mean progress is likely to be slow.

An estimated 177 million Muslims in India, the largest Muslim minority population in the world, are unable to use Islamic banks because laws covering the sector require banking to be based on interest, which is forbidden in Islam.

This policy has persisted since 2005, when the Reserve Bank of India set up a committee to study Islamic finance.

"The Reserve Bank's position has been that the current Banking Regulation Act does not permit Islamic banking because interest rate is an important component of banking in India," RBI governor Duvvuri Subbarao told reporters in October.

Last month, the governor added that some Islamic financial services could be delivered through vehicles other than banks -- a comment which is encouraging some firms to look at developing sharia-compliant products outside the banking sector.

"It can be got around not through banking, but other vehicles," Indian media quoted Subbarao as saying.

Shariq Nisar, director of research and operations at Mumbai-based Taqwaa Advisory and Shariah Investment Solutions, an advisory firm, said of Subbarao's statement: "This is a good thing -- it is the first time the RBI is saying that Islamic banking is possible through other mechanisms.

"The message is to try out other things."

Because Islamic banks pay depositors based on the returns earned by pooled investment funds, equity- and investment-related products might to some extent mimic the operations of Islamic banks and fill the gap left by the ban on them, the products' proponents hope.

Saif Ahmed, managing partner at Bengaluru-based Infinity Consultants, said: "The RBI's comments will enable a more creative approach to developing Islamic finance in the country, by getting people to critically think through ways they can introduce Islamic finance under the present regulations."

Innovation

The 2006 Sachar Committee report, commissioned by the state to examine the social, economic and educational conditions of India's Muslim communities, recommended steps be taken to improve Muslims' access to credit, which it called inadequate.

Muslims across all income categories in India are shunning conventional banks because of Islam's ban on interest, said Ahmed.

"Access to sharia-compliant credit is the biggest issue, followed by access to sharia-compliant investment options."

The issue of investment options looks easiest to resolve.

Some capital market products, regulated by the Securities and Exchange Board of India, are already based on Islamic equity indexes, such as one launched in 2010 by TASIS and the Bombay Stock Exchange; Islamic indexes exclude firms involved in areas forbidden by the religion, such as alcohol and gambling.

In May, Sebi introduced guidelines for alternative investment funds which allow the pooling of capital from local and foreign investors.

"We expect sharia-compliant funds to be registered under the AIF regulations," and to invest in permissible assets such as real estate, said H. Jayesh, founding partner of Mumbai-based law firm Juris Corp.

Both Infinity and the Bengaluru-based Amana Group have developed savings schemes known as chit funds which they say comply with Islamic finance principles.

In chit funds, subscribers pool their money; members can then obtain temporary use of the funds through a bidding process.

"Our schemes have been approved by major sharia institutions. . .along with prominent scholars. This can promote Islamic banking in the country more wisely," said Asifulla Khan, founder and partner at

Amana.

Credit

But providing any form of credit in India under Islamic principles appears much more difficult, and would probably require regulatory changes.

A handful of politicians, particularly Muslim leaders such as Vice President Mohammad Hamid Ansari, has been lobbying for years to start Islamic banking in India.

Politicians from the southwestern state of Kerala, where there is a large Muslim population, have raised the issue many times in parliament.

They have met strong opposition from bureaucrats in the finance ministry and banking circles.

Some politicians, especially from the main opposition Bharatiya Janata Party, say they fear Islamic banking could be used by militants and might strengthen the hold of clergy over India's Muslim community.

Also, the government is struggling to shut down channels for illicit flows of funds from the country, which are used by businessmen, politicians and bureaucrats to evade taxes.

For these reasons, India seems unlikely in the foreseeable future to permit any form of Islamic banking.

Nisar at TASIS said that one possibility, which would not require amendments to the banking act, would be for the RBI to issue an order allowing non-bank financial companies to operate under a participatory model.

Under this model, NBFCs would not charge interest but instead pay depositors with the proceeds of investment funds.

However, RBI officials told Reuters they did not think this would be feasible. Rules for NBFCs are the same as for banks with regard to interest rates, they said.

Abdur Raqeeb, general secretary of the Indian Centre for Islamic Finance in New Delhi, said laws other than the banking act could be amended to facilitate Islamic finance. This has been done in Singapore, Japan and Britain, he said.

"Changes have been introduced through the finance act as in the UK and other jurisdictions in the tax laws, to create a level playing field," Raqeeb told Reuters via email.

Tax rules are important for Islamic finance because many popular asset-based transactions are vulnerable to double taxation under conventional accounting methods.

"It primarily will be a political decision that has to be made by the government through legislation in the parliament," similar to steps taken by Sri Lanka in 2005, Ahmed at Infinity Consultants said.

This will test how serious the government is about creating an inclusive financial system, he added.

Even if top government officials decide in principle to change rules, though, progress is likely to be very slow because of a complicated consultation process, the large number of stakeholders involved, and opposition in some political parties.

Contacted by Reuters, the Reserve Bank of India declined to elaborate on Subbarao's comments. A person with direct knowledge of India's regulatory environment, declining to be named because of the issue's sensitivity, said the RBI had written to the government requesting clarification of its stance on Islamic finance.

Court case

A court case now underway is testing the legal climate; in May, the RBI revoked the licence of Kochi-based Alternative Investments and Credits Ltd, which had operated under a participatory model since 2002.

"The RBI took a stance that compliance to the code requires declaring a fixed rate of interest rather than profit-sharing ratio," AICL chairman Mohammed Ali A said in September.

AICL has challenged the RBI's decision, with the matter still being heard in Indian courts.

"In our opinion sharia-compliant NBFCs can operate within the existing legal framework," said Jayesh at Juris Corp.

He noted that in a separate case, the High Court in Kerala had upheld the constitutionality of the state government's investment in a company set up to carry out sharia-compliant financing activities.

(Editing by Andrew Torchia)