hspace=6On February 11, when Dubai Islamic Bank, the UAE's largest Islamic bank, posted a profit of $327 million for 2009, it was a shot in the arm for those who have been preaching against the greed of the Western financial world and the advantages of Islamic banking. Profits were lower than the previous year's $471 million, but that was almost entirely because of provisions for doubtful debts. At a time when many institutions in Dubai seem to be drowning in debt, the bank's balance sheet has shown surprising resilience.

The bank has been spreading its wings. In early February, its subsidiary - the Jordan Dubai Islamic Bank - opened its first branch in Amman, the first of 10 branches planned this year. In December last year, it had opened 10 new branches in Pakistan. Its rapid pace of expansion has not been slowed by the global financial crisis.

Dubai Islamic Bank has not yet entered India, though Islamic banking is already making waves across the sub-continent. Last month an India-Arab conference in Delhi, organized by the Indo-Arab Economic Cooperation Forum and the Institute of Objective Studies, spent a day discussing Islamic finance. The subject was Beyond the Meltdown: Search for Options. A delegation later called on Union corporate and minority affairs minister Salman Khurshid to urge the introduction of instruments that are compliant with the Shariah (Islamic law).

Support for Islamic banking is still minuscule in India. In 2006, a Reserve Bank of India (RBI) committee came to the conclusion that Islamic banking did not fit into the country's banking laws. In 2008, a Planning Commission panel on financial sector reforms headed by Raghuram Rajan, a finance professor at the University of Chicago and former chief economist at the International Monetary Fund, recommended the introduction of interest-free banking. The final report included this paragraph: Another area that falls broadly in the ambit of financial infrastructure for inclusion is the provision of interest-free banking. Certain faiths prohibit the use of financial instruments that pay interest. The non-availability of interest-free banking products (where the return to the investor is tied to the bearing of risk, in accordance with the principles of that faith) results in some Indians, including those in the economically disadvantaged strata of society, not being able to access banking products and services due to reasons of faith. This non-availability also denies India access to substantial sources of savings from other countries in the region.

Interest-free Banking

Islamic finance has been around in India since at least 1961, with the setting up of a Muslim fund in Deoband in Uttar Pradesh. The closest it came to becoming mainstream was through the Bait-un-Nasr Urban Co-operative Credit Society, set up in Mumbai in 1980. This firm ran on the Islamic principle of interest-free banking for 25 years through 19 branches in the city. But in March 2005, amid mounting losses, Bait-un-Nasr had to close down.

More recently, in October 2009, in the southern state of Kerala, a state development corporation received commitments of up to $214 million from non-resident Indians working in the Gulf region to set up an Islamic finance company, Al Baraka Financial Services, which would run on the principles of Shariah. Advised by Ernst & Young and Taqwaa Advisory and Shariah Investment Solutions (TASIS, which has a tie-up with Dubai Islamic Bank), this firm plans to invest in India's infrastructure -- in ports, airports and expressways. Through a product called Ijara, or leasing, Al Baraka will buy capital equipment and receive rent in return for leasing them out.

The success of Al Baraka could lead to the setting up of India's first Islamic bank, says T. Balakrishnan, principal secretary of industry and commerce in the Kerala government. Bait-un-Nasr was a cooperative, and an exception to the rule. But to introduce a full-fledged Islamic bank, amendments are required in the Banking Regulation Act, which states that Indian banks can accept deposits from the public only for further lending. Also, no bank in India can directly or indirectly deal in buying or selling or bartering of goods. While India's private-sector players like ICICI Bank and Kotak Mahindra Bank have Islamic products, these are sold exclusively to clients overseas.

Al Baraka was ready for launch in January this year when it got caught up in a snag. Subramanian Swamy, a pro-Hindu politician and Harvard-educated economist, filed a petition against the Kerala State Development Corporation in the state's High Court arguing that the firm would report to a Shariah body, and not to a constitutional authority. Investing public money in the firm - where the state government will own 11% - would be unconstitutional, he says.

The next High Court hearing is in April when presentations will be made by the Central government and the RBI. We are confident of the removal of the stay order by then, says Balakrishnan. India is in need of funds for development, and there is a lot of investor interest from the Gulf region, he adds. There is no point in holding this money back.

Success with Sukuk

Islamic finance has gained in popularity since the 1970s, and even more in recent times. (See Islamic Banking Comes of Age -- But What's Next?) According to a Standard & Poor's report, assets of the top 500 Islamic banks expanded 28.6% to a total $822 billion at the end of 2009, compared with $639 billion at the end of 2008. Only recently, the Indonesian government sold more than $850 million worth of sukuk bonds to domestic retail investors, says Samir Nair, partner (business advisory services), at Ernst & Young. (Sukuk is an Islamic bond that represents proportionate beneficial ownership in the underlying asset. The issuer provides collateral security over the assets to sukuk holders to secure payment of the sukuk. In Malaysia, sukuk bonds account for nearly a third of the corporate bond market.)

But Islamic banking is really a variant of everyday banking. On the balance sheet, short-term trade finance, medium-term investments, long-term partnerships and fee-based services are listed as assets. Instead of charging interest, Islamic banks have a practice called Murabahah where the bank buys the item and sells it to the customer. The sale price includes a profit margin agreed upon by both parties and is repaid on a deferred basis. There is also Takaful, or Islamic insurance, which offers joint risk-sharing in the event of a loss by one of the participants.

Another product, named Mudarabah, is an investment partnership, where the investor provides capital to the entrepreneur to undertake a business or investment activity. Profits are shared on a pre-agreed ratio, while losses are borne by the investor alone. The banker is a passive partner with no right to interfere in management, but specifies conditions that ensure better management of money. Loans are permitted in Islamic finance, too, as long as the fee relates to service-related expenses.

As the market continues to develop, Islamic banking products have started to get more sophisticated. In a book titled, Islamic Finance: The Regulatory Challenge, by Simon Archer and Rifaat Karim, the authors argue that already the Malaysian procedure for securitization of the al bai bithaman ajil contract, which results in bai al dayn securities (sometimes referred to as debt securities) has proven contentious in the Arab world. Outside of Malaysia, a majority of Shariah scholars argue that any further trading in the income stream will be trading in debt, because the receivables are not directly attributable to the asset on which the investor has a beneficial title.

Emerging Hubs

Today the largest markets for Islamic products are Indonesia and Malaysia, but centers like London, New York and Hong Kong have emerged as hubs for Islamic finance. There are (only) about three million Muslims in the UK, says Parsoli Corporation's managing director Zafar Sareshwala, and yet London is a hub for Islamic finance. We have 160 million Muslims in India. Given our growth rate, this has potential to be the biggest market for Islamic finance.

Muslims account for about 13% of India's population, according to the Forum on Religion and Public Life. This is smaller than the Muslim population of Pakistan and Indonesia, but still accounts for 10% of the world's Muslims. Yet Islamic finance in India has been marginal, provided by charitable trusts and loan societies. Among the few established Islamic finance companies is Al Idafa, with 750 clients and offices in Mumbai and Surat. More exist, but are under constant RBI scrutiny.

Take Parsoli Corporation, for instance, which has an office in Mumbai along a row of shops in the bustling Crawford market area. This is the only listed non-banking financial entity in India that sells Shariah-compliant Islamic investment products. Sareshwala has on his team a group of English-speaking, laptop-carrying Maulanas and Maulvis - educated at the Markazul Maarif Education and Research Center in Mumbai, which picks its students from 30 Islamic seminaries across India. They have devised the Parsoli Islamic Equity (PIE) Index, he says, where companies selected are compliant with the Shariah, the Muslim way of life.

Parsoli has interests in stock broking and offers depository services. It has an institutional equity sales and trading team, and offers portfolio management services. The firm has today about 15,000 clients spread across 70 locations in India, and it advises its clients to invest in companies that belong to the PIE Index.

The basis of selection of these companies, he says, are plenty. Our scholars disqualify companies directly engaged in gambling, alcohol and sale of cigarettes. What about taking loans and earning or paying interest; doesn't every company take recourse to credit? There is a concept of debt to market capitalization - where the former cannot exceed 33% of market capitalization, he says. But what if a hotel company sells alcohol, and an aviation company serves pork? In such areas we have introduced the term impure income, which cannot exceed 10% of the net worth or 8% of profit. So an equivalent of that impure income is passed on to charity, he adds. Parsoli's calculations allow nearly 58% of the Bombay Stock Exchange as eligible for Islamic investment.

Next on Sareshwala's list is a unit-linked insurance product, developed by insurance company Tata-AIG that will be distributed through Parsoli's outlets. There is such a large segment of the Muslim community out of the financial net, and even fewer have access to insurance, he says. No matter how aggressive we are there is still a large market to capture.

Unlike neighboring countries Muslims in India remain a minority community, and there are large sections in need of social upliftment. Rajesh Chakrabarti, assistant professor of finance at the Hyderabad-based Indian School of Business (ISB), notes: These are devout people who do not go to the banking sector. Islamic products will help bring this community into the financial mainstream.

A similar view is echoed in the Raghuram Rajan Committee report. Interestingly, the report does not name any faith in its analysis, simply referring to Islamic banking as interest-free banking. This product doesn't have to be attached to a faith, says Sareshwala. It can easily be sold as just another form of finance. If it has a captive customer base, that's only the icing on the cake.