Interest Free Banking Model: Indian Perspective


Dr. Pavnesh Kumar
Associate Professor
IILM-Academy Of Higher Learning
1, Viraj Khand, Gomti Nagar, Lucknow

1. Introduction

Interest-free banking system works on profit/loss sharing principle and according to this  banking model  the funds that are collected from customers are used in real economy as loan and then, distributed to customers again.

Interest Free Banking is the basic foundation of the  Islamic Banking.  It is a system of banking that is consistent with Islamic law (Sharia'h) principles and guided by Islamic economics. In Islam riba or interest collection and payment is prohibited .Islamic law  prohibits trading in financial risk (which considered as a form of gambling). In addition to this  Islamic law prohibits investing in businesses that are considered unlawful, or haraam. All of the business forms are appreciated in Islam as far as they do not involve interest in any kind. There are lot of tools introduced in Islamic Banking which deal with equity financing rather then reflecting  on debt financing .Interest free banks as a replacement of fixed interest rates on the savings account gives a small percentage of return on deposits on an annual basis. This type of banking activity operates on professional and ethical standards.

When we look at historical background of modern interest-free banking based on profit/loss sharing, we can see that the need for this system arose in the 20th century as a result of industrial revolution  observed in Islamic countries and sudden increase in oil prices in 1970s. The section between 100 and 107 of famous Hammurabis Code demonstrates how loan (borrowing) issues can be arranged, it especially emerges as the first model of interest-free investment in history. With the rise and spread of Islam the basic concepts of current interest-free banking, such as borrowing, partnership and leasing, improve and are practiced in a wide geography.

Islamic Banking and Finance system without usury or interest was started around the later part of the nineteenth century when the Muslims were doing well, both politically as well as economically. Islamic Banks started to establish their centers in the big and famous cities of Islamic countries as well as non-Islamic countries to supply their comprehensive business needs. Generally all interest (Riba) or usury free banks harmonize on the essential values of Islamic banking. Nonetheless, individually all the banks differ from the services and benefits. These differences occur due to the country rules, needs of the inhabitants and the customized bank's experiences and objectives.

Many Islamic Banks have sprung up over the last few years. These changes are occurring both in Muslim and in western countries, and are driven by a global trend amongst Muslims to become more observant of their faith. It might have been the reason why Islamic Banking emerged, however, today interest free banking is sought by Muslims and non-Muslims due to the benefits it offers. Industry size is currently estimated at more than $400 billion, with projected growth of 15% per annum. Financial institutions around the globe are trying to keep pace with the growing demand for Sharia'h compliant products and services to meet the expectations of there clients.Interest free banking can help the economies by assembling savings  needed for financing major investment projects.

2 Functioning  of Interest Free banking

Figure No.1 :-The functioning of Riba free banking system

Loan : It means providing all kinds of raw material, goods and semi-manufactured goods, real estates, machines and equipments required for enterprises from  abroad, payment of their costs in cash to the dealer on behalf of customer and debiting it to the customer for a certain period.
* Profit/Loss Partnership: It enables customer to share both profit and loss acquired via purchase and sale of goods or an activity according to the proportions previously arranged by the bank.
* Leasing: It is a agreement in which a real estate or its right of use (risk and interest) is leased to a tenant in return of a rent for a period of time by lessor.
* Cash against Documents: It is a transaction in which the interest-free bank buys goods for cash against document and resells them for a higher price to the fund user

3 Difference between Interest and profit sharing banking

Interest  is  basically gained from a certain amount of principal on a certain rate for a period of time.  In other words there is an agreement in which lender (a bank or a person) sets period and rate, and borrower accepts. In interest-bearing financial activities both parties know the amount to be gained or lost apart from principal. In interest-free banking system, , an amount of profit derived from principal that is used for a commercial or industrial economic activity in the real economy  until a specific date set by the parties and distributed to the parties on a ratio of 80:20. 80% of the yield, namely profit, acquired at the end of the term is allocated to the saver, and 20% to the Bank.  In this both the profit as well as loss is also possible. On the contrary , in interest-bearing systems this is impossible; the amount guaranteed  to the account owner beforehand must be definitely paid to the owner of the principal at the end of term. The significant difference between profit share and interest is that the earning acquired at the end of term is guaranteed in interest-bearing systems, whereas it is determined as per the efficiency of the supported projects in interest-free system.

4 Advantages of this model to the Banks

Interest-free banks have never lost money for 17 financial years. In trade both profit and loss are natural and inevitable. Thus, this does not mean that they will never lose money. Each year interest-free banks support many different projects. If the yield of loans, that is, the projects supported is analyzed at the end of period, it is observed that whereas some of the projects return more profit than that is expected or bring exactly expected amount, some others return less profit or even cause loss. If most of the projects that are provided fund lead the banks to make profit, naturally these banks never distribute loss to the savings accounts. However, it cannot be overlooked that loss may also be distributed to customer accounts under particular conditions such as mismanagement of these organizations or global crisis in the market. After all, these organizations are working and investing according to profit/loss principle.

There is no question that profit shares distributed by interest-free banks are equal to bank interest rates. Profit rates distributed by these banks are even different among the banks themselves. Even slight differences in profit rates result in great amounts in total. Interest-free banks operated in our country make the funds they collect use for production support. That is, they meet the need of raw material, goods or semi-manufactured goods used in trade for enterprises. On the other hand, the banks specify the interest rate to be given, when cash is deposited. However, interest-free banks use money on valid profit shares and share what is earned. Because it is not possible to estimate profit shares beforehand, it is not possible to track other banks, either. Namely, customer can find the rate offered by interest-free banks high and use loan with a lesser cost from the dealers or the banks that work on interest-bearing system. If loan rates increase above the current rates in market, funds in interest-free banks may remain inoperated or interest-free banks may lose money on the contrary. If this possibility is taken into consideration, why profit shares distributed by interest-free banks to savers are equal to interest rates offered by banks can be understood more clearly.

5 Legal status of Interest free banking in India

Interest free banking would not require any separate banking regulation in India , but just RBI's permission to accept any sort of deposits and lend money with flexible interest rate structure with a possibility to have zero percent interest at any bank. The following are the provisions given in the RBI Act 1934.

A.  Section 17 of the The RBI Act 1934 states that the Bank shall be authorized to carry on and transact the several kinds of business specified, as the accepting of money on deposit without interest from and the collection of money for,  the Central Government, the State Governments ,  local authorities, banks  and any other persons;

B.  Section 21 states that Bank to have the right to transact Government business in India.

(1) The Central Government  shall entrust the Bank, on such conditions as may be agreed upon, with all [its] money, remittance, exchange and banking transactions in India, and, in particular, shall deposit free of interest all its cash balances with the Bank: Provided that nothing in this sub-section shall prevent the Central Government from carrying on money transactions at places where the Bank has no branches or agencies, and the Central Government may hold at such places such balances as it may require.

(2) The Central Government shall entrust the Bank, on such conditions as may be agreed upon, with the management of the public debt and with the issue of any new loans. In the event of any failure to reach agreement on the conditions referred to in this section the Central Government shall decide what the conditions shall be. Any agreement made under this section shall be laid, as soon as may be after it is made, before Parliament.

C. Section 21A. Bank to transact Government business of States on agreement.

The Bank may by agreement with the Government of any State undertake–

(a) all its money, remittance, exchange and banking transactions in India, including in particular, the deposit, free of interest, of all its cash balances with the Bank

(b) the management of the public debt of, and the issue of any new loansby, that State.

(2) Any agreement made under this section shall be laid, as soon as may be after it is made, before Parliament.

D. Section  45 W. Power to regulate transactions in derivatives, money market instruments, etc.

(1) The Bank may, in public interest, or to regulate the financial system of the country to its advantage, determine the policy relating to interest rates or interest rate products and give directions in that behalf to all agencies or anyof them, dealing in securities, money market instruments, foreign exchange, derivatives, or other instruments of like nature as the Bank may specify from time to time: Provided that the directions issued under this sub-section shall not relate to the procedure for execution or settlement of the trades in respect of thetransactions mentioned therein, on the Stock Exchanges recognized under section 4 of the Securities Contracts (Regulation) Act, 1956(42 of 1956).

(2) The Bank may, for the purpose of enabling it to regulate agencies referredto in sub-section

(1), call for any information, statement or other particulars from them, or cause an inspection of such agencies to be made.

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Source: E-mail April 11, 2011


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