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Islamic Banking A Catalyst To Financial Inclusion In India

Posted in Finance Articles, Total Reads: 3127 , Published on January 18, 2014

“The non-availability of interest-free banking products results in some Indians, including those in economically disadvantaged strata of society, not being able to access banking products and services due to reasons of faith.”

Raghuram Rajan (A Hundred Small Steps)

This was the view expressed by Raghuram Rajan in ‘A Hundred Small Steps’, which was the report of his committee on financial sector reforms, published in 2008. Financial inclusion came into lime light in India, after the recommendations of Khan Commission (2004) were incorporated into the mid-review of RBI’s 2005-06 policy. In simple words, financial inclusion is the delivery of financial services at affordable costs to vast sections of disadvantaged and low income groups. In ‘A Hundred Small Steps’, the committee felt that provision of interest-free banking is the most important area in the ambit of financial infrastructure for financial inclusion. The main purpose of inclusion is to expand the coverage of the financial system in the country, which is the key objective for the emerging economies.

Image Courtesy: freedigitalphotos.net, adamr

Islamic Banking, an alien concept in India’s conventional banking system, is a Sharia Law based banking system which promotes profit sharing, but prohibits the charging and paying of interest. Islamic banks are operating in over 75 countries with assets touching $1.1 trillion and have grown at a Compounded Annual Growth Rate (CAGR) of 15%. These countries include non-Islamic nations like UK, USA, Germany, France, Singapore etc. Similar to Basel norms for conventional banking, Islamic banking follows the standard prescribed by Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI). These developments across the world seem promising for implementing the same in India. Recently, the RBI gave nod to Kerala government to launch financial institution following Islamic finance.

Currently, India has a network of 82,000 branches of commercial banks across the country, but only 5% of villages are catered to, where 70% of the population resides. ‘Mudarabah’, a kind of financing agreement, involves one party supplying the capital and the other supplying the labour, with both the lender and the borrower sharing the risk. This is helpful to the low income group, especially less wealthy farmers who otherwise would not be able to provide collateral. ‘Riba’, which means a ban on interest payments and collections, prevents the accumulation of interest payments, when the farmer or business person becomes bankrupt. This is possible because, the Islamic banks not only share profits but also losses, thereby preventing the pile-up of interest. According to Sachar Committee report, Muslims avail just 4% and 0.48% of the credit from NABARD and SIDBI respectively. And the Muslims credit deposit ratio is only 47% compared to the average of 74%. In places like Lakshadweep with 95% Muslim population, the credit deposit ratio is mere 9.3%. States like Uttar Pradesh, Bihar, Assam and West Bengal etc. (with considerable Muslim population) have credit deposit ratios much less than all India average for credit deposit ratio and people living in these states have much low per capita credits compared to national per capita credits average pushes the people of these states behind the national average in economic growth. This reflects injustice in part of Indian Muslims to utilize their savings for economic growth.

Islamic Banking has the potential to create new financial products which can be safer than the existing products. One probable product could be debentures with modified or no coupon rates. Many orthodox Muslim businessmen are still self-financing their businesses; Islamic banking can help in including all these people in the nation’s growth by expanding their horizon of businesses. The current population of Muslims in India is 177 million, which is 13% of the total population of India; countries like Pakistan and Indonesia have population of 173 million and 246 million as per 2012 census. Though the percentage figure seems low in India, countries which have implemented Islamic Banking serve as a lesson for targeting the correct segment of population to reap the benefits. This would also promote the entry of foreign currency and investments into India from the Islamic countries across world.

On the flip side, devising a regulatory framework satisfying both Islamic and conventional banking systems would be a challenging task for RBI. Educating the people about the new banking system would be tough, given the low awareness levels of conventional banking system. Another challenge is the common perception among the people of other communities in India against Islamic Banking. There is a serious dearth of Islamic banking experts in India who can manage the banks in the current competitive environment. Nevertheless, the interest-free solutions of Islamic Banking could restore equilibrium in Indian society by providing succour to debt ridden farmers, labourers and other marginalized groups. Hence, Islamic Banking is a potential tool for financial inclusion.

This article has been authored by Y. VENKATA ACHYUTH KUMAR and K. SATYA HARISH from IIM Raipur


  1. ‘A Hundered Small Steps’, Report of the Committee on Financial Sector reforms, Planning Commission, Government of India.
  2. ‘Why India need Islamic Banking’ thought paper, Infosys Finacle.
  3. http://www.scief.es/blog/shariah-banks-look-to-farmers-2011-04-04/
  4. http://www.dnaindia.com/analysis/1877270/standpoint-why-islamic-banking-in-india-is-a-good-idea
  5. http://www.businessworld.in/news/finance/banking/rbi-allows-non-bank-islamic-finance-firm/1040826/page-1.html
  6. http://www.ethicainstitute.com/webinar/Achieving_Financial_Inclusion_For_Indian_Muslims.pdf
  7. http://www.economicinitiatives.com/Indian_Economy/Inequality_in_Disbursement_of_Credit_among_various_states.htm

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