INTEREST-FREE BANKING - ECONOMY
News: What is interest-free banking, recently given the green-light in Pakistan
What's in the news?
● Pakistan’s Finance Minister Ishaq Dar announced that the government would introduce interest-free banking in the country, marking a significant departure from its earlier opposition to the policy.
Interest free banking:
● Islamic banking refers to
banking activity that conforms to laws and values laid down by Islamic law or
Sharia.
● The
basis of Islamic finance is the rejection of usury (the levying of unreasonable
high interest rates) while lending money, along with the requirement that there
must not be any engagement with immoral businesses.
● Interest
free banking is a narrow concept within this system, that denotes a number of
banking operations which avoid interest.
● Riba
is the Islamic term for interest charges on loans, and according to the current
interpretation, covers all interest - not just excessive interest.
○ Under Islamic law, a Muslim is prohibited from paying and accepting interest on a predetermined rate.
Instruments under Interest-free Banks:
● Various
instruments are available for those who want to take credit from a Sharia compliant
bank.
● Ijarah contract:
○ In
an Ijarah contract, a bank purchases the asset on behalf of the client and
allows its usage for a fixed rental rate. After a mutually agreed time, the
ownership of the asset is transferred to the client.
● Murabaha:
○ It
means a sale on mutually agreed profits. In this financing technique, an asset
is purchased by the bank at a market price and sold to the customer at a
mutually-decided marked-up cost. The client is allowed to repay in instalments.
○ Musharaka
refers to a joint investment by the bank and the client. Under the agreement,
an Islamic bank provides funds, which are mixed with the funds of the business
enterprise and others.
○ The bank and the client both contribute to the funding of an investment of purchase and agree to share the profit or loss in agreed-upon proportions.
Interest-free banking in India:
Raghuram Rajan Committee Report:
● In
a report submitted to the government in 2008, a committee headed by Raghuram
Rajan had, without naming Sharia banking, suggested the need to have
interest-free banking in India.
● “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.
RBI Suggestions:
● The
Reserve Bank of India (RBI) in 2016 had suggested that given the complexities
of Islamic finance and various regulatory challenges involved, Islamic banking
could be gradually introduced through the opening of an “Islamic window” in
conventional banks.
● While
replying to a RTI query in 2017, the RBI however said that it had decided to
not pursue the proposal for introducing Islamic banking in the country.