Why Is Raghuram Rajan Toying With A Deceptive Idea Like Islamic Banking?

The Reserve Bank of India (RBI) seems to be close to accepting the idea of interest-free banking, often mislabelled as Islamic banking. A report by the RBI panel on “Medium-Term Path for Financial Inclusion” by Deepak Mohanty suggested some time ago that regular banks should be allowed to open “interest-free windows” with “simple products like demand deposits, agency and participation certificates on the liability side and cost-plus financing and deferred payment, deferred delivery contracts on the asset side.”

This is a big change from the regime of the earlier RBI Governor, Duvvuri Subbarao, when he stated simply that “Islamic banking is not possible…. We have studied the issue. We appreciate the objectives behind the request. But there are some legal problems, It can be got around not through banking, but other vehicles.”

Why is a Raghuram Rajan-led RBI veering towards Islamic banking when his predecessor did not think it made sense?

Prime Minister Narendra Modi’s diplomatic outreach to the Arab nations also seems to have given this bad idea a leg up. According to this Times of India report, the Saudi Arabia-based Islamic Development Bank (IDB) will start its India operations from Modi’s home state, with the stated objective of boosting economic development and social progress “in accordance with the principles of Shariah.”

There are two reasons why this is a bad, bad idea. While India need not object to any bank that wants to set up operations in India, the purpose of such operations should never be based on religious ideas. Even when it comes to interest-free banking, which the RBI seems to be warming up to, it should be allowed only within the contours of current prudential guidelines.

The real truth about Islamic banking is that it is an all-pervasive myth. As one sceptic put it, it is normal banking “sprinkled with holy water.” As a marketing tool, the mere title of Islamic may help attract Muslim customers, but in practice Islamic banking is just normal banking in disguise. All that really happens is the use of Islamic terms to camouflage interest as profit or profit-sharing.

Let’s be conceptually clear: there are only two types of capital in existence. One is equity, and the other is debt. Equity carries risk, and earns dividends and profits; debt (usually) carries lower risk, and earns interest. So if you want to follow the Prophet’s injunction against giving or taking interest, Muslims should invest in equity or equity-oriented products and mutual funds.

So how do so-called Islamic banks get away with it? A book by Mohammad Salim, a former advisor to Islamic banks and author of a 2006 book titled “Islamic Banking: A $300 billion deception”, blows apart the idea that the Prophet wanted a complete ban on interest payments. He also debunks the idea that Islamic banks actually offer interest-free banking. According to Salim, what the Koran prohibits is usury, and not interest itself. And, the Amazon book summary notes, “Islamic banks do not practice what they preach; they all charge interest, but disguised in Islamic garb. Thus they engage in deceptive and dishonest banking practices.” The Financial Times called it “smoke and mirrors” banking.

There you have it from a Muslim who knows the Koran. Islamic banking is a marketing deception used to sell a financial product to Muslims.

A blog by the Middle East Media Research Institute (MEMRI) observes that “the fundamental practice of charging interest (e.g., charging a premium on the principal amount of the loan, for the time value of the loaned money) is not truly eliminated in Islamic banking, but is merely relabelled and disguised using various legal tricks. Arab and Muslim critics have likened them to ‘contractum trinius’, a method devised by European bankers in the Middle Ages to circumvent the church laws against charging interest on borrowed money.”

In short, the modern approach to Islamic banking is only an elaborate repackaging of the ruse discovered by businessmen seeking to stay on the right side of church strictures.

The MEMRI blog goes on to show how murabaha is one of the “common instruments of deception”. Murabaha “refers to a mechanism in which a borrower enters into a mark-up or cost-plus financing contract with a lender….As a financing technique, it involves a request by the client that the bank purchase for him certain merchandise, real estate, or consumer durables such as cars or household appliances. Since the client lacks the cash to make the purchase himself (otherwise he would not have turned to the bank), the bank buys the item and sells it to the client on deferred payment. Repayment, usually made in regular instalments, is specified in the contract. The bank’s profit is calculated either on a percentage of cost basis or as a fixed amount. Critics have questioned the alleged religious foundation of murabaha because the profit margin attached to the total amount of the sale is tantamount to riba - it is interest in disguise.”

It’s like relabelling a HDFC loan and calling the EMIs deferred monthly payments.

But clearly murabaha exists and is called Islamic. One can presume that Islamic clerics can be coaxed to bless the product as Islamic. Ultimately, the mullahs decide what is or is not Islamic, never mind the underlying reality. Or even what the Prophet actually said.

Islamic banking is not the same as interest-free banking, for which you need capital and grants, not new holy water.

Equity and venture capital are truly interest-free. Debt is interest-free only if the interest is waived. This can only be financed by charity or government subventions.

The questions votaries of Islamic banking should ask themselves are these: is it better to fool Muslims by deception or focus on helping the poor with interest subsidies or low-interest loans so that they can afford it? What about depositors? Which savings bank depositor will save with Islamic banks if her savings are going to be the subject of genuine profit- or loss-sharing? Should the poor be asked to take such risks with their money? The alternative they are being offered is regular banking with Islamic terminology.

To repeat: Islamic banking is nothing but an attempt to carve out holy space in normal banking. It will create financial ghettoes in the same way the community is being ghettoised in cities. Financial inclusion does not need financial ghettoisation and subterfuge.

It should be rejected.