Inaccessibility to faith based Banking- Denial of a Constitutional Privilege??

"There have been from time to time demands for experimenting (with) Islamic banking. I would certainly recommend to RBI, which is looking into the question, to look at what is happening in Malaysia in this regard", - the then Indian Prime Minster Mr.Manmohan Singh was quoted as saying in the year 2010. Dr.Raghuram Rajan Committee, a high level Committee on the Financial Sector Reforms appointed by the Planning Commission, Government of India recommended that measures be taken to permit the delivery of interest-free finance on a larger scale, including through the banking system. That it would be possible, through appropriate measures, to create a framework for such products without any adverse systemic risk impact. Though these indicate that a shift, from the common perception that Islamic banking is not feasible under the Indian statutory and regulatory regime, seems to be gripping the political mind-set and regulatory outlook, nothing plausible ensued. The political leadership and consequently regulatory machinery continue to shelter behind the legal unviability argument which remains largely unchallenged.

It appears that there cannot be more apposite a time to offer a legal challenge to the views on Islamic banking in the milieu of India.The Hon’ble Supreme Court of India in a decision rendered on 30 September 2010 observed –“The BR Act, 1949 is an Act enacted to consolidate and amend the law relating to banking. Thus, while interpreting the Act one needs to keep in mind not only the framework of the banking law as it stood in 1949 but also the growth and the new concepts that have emerged in the course of time”. The Hon’ble High Court of State of Kerala held in a decision dated 3 February 2011 that it is constitutional for an instrumentality of a state to partake in a Sharia’a Compliant business and that compliance with Sharia’a principles in addition with the laws of the country is not inconsistent with the secular principles as embodied in the Constitution of India. The ratio emerging from the submission of the question of sustainability of Islamic banking vis-à-vis the secular constitutional fabric of India to judicial scrutiny for the first time, for the enthusiasts of Islamic banking, is in affirmative.

Basic traits of Islamic banking relevant to Indian legal regime

So, what is Islamic banking/finance?? ‘Islamic law’ (Sharia’a) covers all aspects of human behaviour. It is much wider than the Western understanding of ‘law’, and governs ‘the Muslim’s way of life in literally every detail, from political government to the sale of real property, from hunting to the etiquette of dining, from sexual relations to worship and prayer[1]. In general, Islamic law (or Sharia’a) extends to the understanding of a believer’s rights and obligations vis-à-vis God, humankind, and the universe at large[2].As such it extends to the financial and commercial transactions engaged into by an Islam including banking. “While Islamic banks respond to the needs of Muslim customers, they are not acting as religious institutions. Like other banks they are profit-maximizing entities. They act as intermediaries between savers and investors and offer custodial and other services found in traditional banking systems”. However, what makes Islamic Banking distinct from conventional banking is that Islamic banking works in accordance with the prescriptions of Sharia’a. The foundations of Islamic finance are (broadly) based on 5 principles such as prohibition of riba (interest), prohibition of gharar (uncertainty) and maysir (speculation and random), prohibition of investment in haram (illicit) activities, tangibility of assets and Sharing of profits and losses[3]. The Organization of Islamic Conference (OIC) defined Islamic banking as “a financial institution whose statutes, rules and procedures expressly state its commitment to the Principles of Islamic Shariah and to the banning of the receipt and payment of interest on any of its operations[4]”.   The transactions are so structured so as to ensure compliance with Sharia’a. “In Islamic finance, interest-bearing contracts are replaced by a return bearing contract, which often takes the form of partnerships. Islamic banks provide savers with financial instruments that are akin to equity called Mudaraba or Musharaka. In these lending arrangements, profits are shared between the investors and the bank on a pre-determined basis”[5]. The banking system compatible to Sharia’a principles based on two-tier Mudarabah comprise of a contract in between depositor and banker whereby the parties agree to share the profits accruing to the bank’s business[6].

It can be seen that the ban on interest and the structuring based on profit and loss sharing accounts for the fundamental difference in between conventional and Islamic banking[7]. Islamic banking though serves the purpose as that of a financial intermediary akin to conventional banking; it is the said structure of Sharia’a compliant transactions that invite statutory and regulatory road block especially in non- Sharia’a compliant and secular countries. The position is same with India too, being a secular[8] country with a robust statutory and regulatory regime especially in financial sector.  Banking sector in India is governed by a series of legislations such as Banking Regulations Act, 1949, Reserve Bank of India Act, 1934, Negotiable Instruments Act 1881, and Co-operative Societies Act 1961. In addition it is regulated by RBI and SEBI Regulations. The basic characteristics of Sharia’a compliant banking are unknown to Indian banking practices and to the regulatory machinery. As far as India is concerned, due to the constitutional mandate of being a secular country any search into the compatibility of Sharia’a compliant banking shall be commenced from a Constitutional view point.

Is Islamic banking constitutional in India?

This question would have generated a mixed response from the legal luminaries if asked prior to the pronouncement of a landmark decision by Hon’ble High Court of Kerala[9]. This judgement has alleviated various concerns regarding the conflict of Islamic finance principles with the doctrine of secularism as enshrined in the Constitution of India. The judgement’s importance lies in the fact that it not only holds that Islamic finance is constitutional in India but also that the association of State or its instrumentality with a Sharia’a compliant business is not contrary to the Constitutional requirement that the State should be a secular State. The main challenge, as far as relevant to the topic covered in this paper, raised in the writ petition challenging the decision of Govt. of Kerala and its instrumentality, KSIDC to contribute for share capital of a sharia compliant institution is that it is directly contrary to the mandate contained under Article 27[10] of the Constitution of India[11]. The business proposed to be carried on was one of Non-Banking Financial Service as defined under Section 45-I (a) of The Reserve Bank of India Act [12](RBI Act). It was also contended that the proposed business is one that is not permissible under Chapter III B[13] of the RBI Act.

A brief narration of facts is essential before commenting on the aspects of the judgement and its possible effect on Islamic finance in India. ‘The Government of Kerala based on the realisation that The Islamic Financial Services (IFS) Industry has grown substantially over the years forming a significant segment within global financial services and is generating lot of interest as an alternative model of financial intermediation entrusted KSIDC[14] with conducting studies and looking into various aspects of formation of an Islamic investment company in Kerala for attracting investments in a right manner as per the Sharia’a of the Muslim community for the development of the common public at large. The professional studies conducted on this project have concluded that there is a genuine commercial potential for an Islamic Financial Institution based in Kerala that has the potential to become a global player. The Board of KSIDC had approved a share contribution amounting to 11% of the initial paid up Share Capita of the proposed company and decided to proceed with further steps for registration of the company for promoting the Islamic Financial Institution’[15]. It is at this juncture the instant petition was filed challenging, inter alia, the constitutionality of the decision of Government of Kerala.

‘The case of Government of Kerala and KSIDC was that the impugned decision was taken in order to garner huge amounts of unutilised funds from the Gulf countries available with the non-resident Indians working in those countries with a view to utilise such funds for the investment in the State of Kerala for the development of its people by promoting and providing financial assistance to the industries in the State of Kerala. That the business of the proposed company would be conducted strictly in accordance with the law of the country and as such intention to additionally comply with Shariah principles will not render the activity of the company inconsistent with secular Constitutional principles’[16]. The High Court while indulging in a detailed investigation aimed at gathering a clear understanding of the expressions "secularism", "religion", "secular activity associated with religious practice", explored the landmark decisions of the Hon’ble Supreme Court of India and other High Courts in this sphere. The Court observed that the Constitution of India recognizes the distinction between practices which are essentially religious and activities which are secular such as economic, financial and political which are amenable to regulation by law, but associated with religious practice[17].   Further that Under Article 298, it is declared that the executive power of the Union and of each State extends to carrying on of any trade or business and also to acquire, hold and dispose of property and making of contracts for any purpose and as such it would be illogical to restrict the commercial interaction of the State even with a religious denomination, on the ground that it is inconsistent with the declaration that the State should be a 'Secular Republic'[18]. The Court held that there is no constitutional infirmity in the impugned action of Government of Kerala observing that the Constitution of India does not adopt the doctrine of “Wall of separation”. It was also held that the act of the Government of Kerala is not violative of Article 27 as the intention of the Government is to employ the returns from the business activities for the general welfare of the State of Kerala and not for any religious purposes. It was further contended on the strength of the affidavit filed by Union of India stating that the current statutory and regulatory frame work (of the Country) is not feasible for Islamic Banking Activities including NBFC’s[19]. The Court rejected this contention, accepting the contention of Government of Kerala held that while considering the constitutionality of the impugned action it need not concern itself with the question of violation of any relevant statute and that as such the said question is to be considered by RBI before whom the approval application is pending[20]. The Court also did not decide or express any view on the question if principles of Shariah which the Respondents propose to comply with while carrying on the business are inconsistent with the mandate of secular State contemplated by the Constitution of India or the laws of India on the grounds of lack of specific pleadings & on relying on the submission of the Respondents’ that the business would be conducted strictly in accordance with the law of the land. However, it could be inferred from the observation made in Para 42 of the judgement that a Court of Law is unlikely to interfere merely on the grounds of compliance with Shariah principles if such compliance is in addition to the compliance with the law of the land. It makes it abundantly clear that Islamic banking especially Sharia’a compliant banking through Islamic windows can be prevented in India only if the regulators can point out a legal provision expressly barring a specific Sharia’a compliant product offered through Islamic windows.

Is Islamic banking permissible under the existing statutory & regulatory framework?

The position that Islamic banking per se is not violative of Constitution of India drives us to the question as to the conflict Islamic banking can possibly have with the Indian statutory regime. It would be a misnomer to use the term Islamic banking while undertaking an investigation of a conflict with Indian laws. Indian statutes do not have anything that prevents “Islamic banking” per se provided such banking complies with statutory and regulatory framework governing the sphere. As such it is not the concept of faith oriented (Islamic) banking that is facing statutory and regulatory road blocks in India but the practices , based on profit loss sharing and prohibition of cash to cash transactions, followed while perpetuating Islamic banking that is prima facie seen as unfeasible. This section would analyse the impact of the primary legislation governing banking in India, the Banking Regulation Act, 1949 on the practices followed in Sharia’a compliant banking practices.

The principal statute that governs banking is Banking Regulation Act, 1949 (BR 1949). The purpose of BR 1949 is to consolidate and amend the law relating to banking in India[21]. It is essential to understand certain provisions of BR 1949 that is widely perceived as fundamentally preventing Islamic banking in India. BR 1949 defines “banking” in a comprehensive manner in order to bring within its purview all such institutions that receive deposits for lending or investing.  BR 1949 also provides Reserve Bank of India (RBI) with power to regulate banking companies. Banking is defined to mean accepting deposits to lend[22]. BR 1949 further provides that a banking company may engage, in addition to the business of banking, in any one or more forms of business as enumerated in sub-clauses (a) to (o) of Section 6(1)[23]. The said clauses cover, inter alia, borrowing, lending, advancing of money, acquiring, holding and dealing with property (security) or right, title and interest therein; selling, improving, leasing or turning into account to otherwise dealing with such security; doing all such other things as are incidental or conducive to the promotion or advancement of the business of the company and any other form of business which the central government may notify. Section 8[24] of BR 1949 contains a prohibitory provision whereby it is provided that no banking company shall deal in the buying or selling of goods except in connection with the realization of security. Section 9[25] of BR 1949 further deals with disposal of assets which prescribes for mandatory disposal of certain non-banking assets. It is pertinent to note that both Ss.8 and 9 are notwithstanding the provisions of s.6 (1).

The provisions of BR 1949 conscripted herein above, appears prima-facie as conflicting with the principles of Sharia’a upon which Islamic banking is founded. The definition of banking as per s.5(b) of BR 1949 has three limbs to it, such as (i) acceptance of deposits of money from public (ii) acceptance of deposits is for the purpose of lending or investment (iii) repayment of such deposits on demand or otherwise. Thus, “banking”, contemplates inter alia, lending of deposits of money from public, but in Islamic Banking, as it may prima-facie appear and resorted to as an argument by anti-enthusiasts of Islamic Banking , the bank accepting deposits of money from public is not engaged in lending or the pure financial activity in a conventional manner, but is engaged in equity financing and trade financing (Musharaka[26] and Mudaraba[27]), i.e. taking risk of sharing profits or losses as against lending (where there is no risk of loss and only profit in the form of interest at a specified rate). Islamic banks resort to purchase and resale of properties, which might appear contrary to the provisions of Ss.8&9 of BR1949. The stipulation that banks shall not deal in immoveable property other than for own use in s.9 might appear contrary to structures like Ijarah.

The sustainability argument

I would contend that, in spite of such prima facie conflict, operation of an Islamic window by conventional banks is permissible within the frame work of BR 1949 as it exists now. The definition of banking is an enabling provision rather than a prohibitory one and in light of s.6, it can be contended that the intention of the s.5 (b) is not to provide an exhaustive definition of activities that could be undertaken under the aegis of ‘banking’ activity. The observations made by Hon’ble Supreme Court of India in ICICI Bank Limited v APS Star Industries & Ors[28] (ICICI case) are squarely applicable in this regard. The Court held - “While laying down such policies under the said Act, RBI can lay down parameters enabling banking companies to expand its business. For example, RBI’s permission is required to be obtained if a banking company seeks to deal in "derivatives". It is a business which will not fall in Clauses (a) to (o) of Section 6(1) (a) and yet RBI can lay down guidelines and directions enabling banking companies to deal in derivatives like futures and options. The point we are trying to make is that apart from the principal business of accepting deposits and lending the said 1949 Act leaves ample scope for the banking companies to venture into new businesses subject to such businesses being subject to the control of the Regulator, viz. RBI. In other words, the 1949 Act allows banking companies to undertake activities and businesses as long as they do not attract prohibitions and restrictions like those contained in Sections 8 and 9. In this connection we need to emphasize that Section 6(1) (n) enables a banking company to do all things as are incidental or conducive to promotion or advancement of the business of the company[29].”

Thus the test laid down by the Hon’ble Supreme Court to determine if a business undertaken by banking company is permissible under BR Act 1949 is two pronged;

(i)     that the proposed transaction/business need not be strictly falling within the definition of banking as contained in s.5(b) of BR 1949

(ii)   that the proposed transaction/business would be permissible if not falling within the purview of restrictions imposed by Ss.8 & 9 of BR 1949

It is straightforward that a Sharia’a compliant product offered by a conventional bank satisfies the first test. In other words, the first test is an enabling one for an unconventional transaction (unconventional to Indian banking regulatory regime) such as Sharia’a compliant transactions. The second test on a prima facie analysis might appear to be a stumbling block as s.8[30] prohibits a banking company from buying or selling or bartering of goods. The ingredients of the section are as follows;

(iii)    shall not engage in buying or selling or bartering of goods except in connection with the realisation of security given to or held

(iv)    shall not engage in any trade or buy or sell or barter goods for others otherwise than in connection with the bills of exchange received for collection or negotiation or with its business within the purview  of clause (i) of sub-section (1) of section 6

(v)        the restrictions are not withstanding anything to the contrary in section 6

(vi)      the restrictions are not withstanding anything to the contrary in any contract

It is pertinent to note here that issue involved in the ICICI case was permissibility of banks engaging in trading of NPA.  The said activity is not expressly provided for in the BR 1949 and it was contended that trading is not possible as it violates the prohibition contained in s.8 of BR 1949 and that the guidelines issued by RBI governing such trading is ultravires BR 1949. The Hon’ble Supreme Court, rejecting the said contentions, held that trading in NPA[31]’s has the characteristics of bonafide banking business and as such not violative of BR 1949. Such argument of violation of s.8 of BR 1949 can at least prima facie be extended to the Sharia’a compliant structures such as Musharaka, Murabaha, Twarruq. However, as there is no universally applicable structure and as structure can be reengineered to suit relevant regulatory environment for any Sharia’a compliant transaction, RBI as a regulator cannot resort to a generalist assumption as to the permissibility of such structures. s.8 might not be applicable for certain Sharia’a compliant structures or by engaging in  careful product-designing or reengineering process by jurists, lawyers and bankers collectively can remove elements not complying with s.8 requirements or replace it with complying elements[32]. Moreover, in the light of RBI allowing and regulating transactions such as derivatives and trading of NPA’s without any amendment in BR 1949 authorising such business and the apex Court validating such powers of RBI, RBI without seeking an amendment of BR 1949 can initiate appropriate measures so as to regulate a Sharia’a compliant transaction of a conventional bank. RBI has the power to formulate guidelines, if at all so felt, with respect to such transactions and shall allow such transactions. The following observation of the Hon’ble Supreme Court in the ICICI case is relevant;

‘The "banking policy" is enunciated by RBI. Such policy cannot be said to be ultra vires the Act. The idea behind empowering RBI to determine the Policy in relation to Advances is to enable banking companies to expand their business of banking and in that sense such guidelines also define - as to what constitutes banking business[33] ’

Another element to be analysed in this regard is the intention of s.8 of BR 1949. The BR 1949 was drafted and enacted at a time when the concept of Islamic banking was unheard off. The Islamic banking Industry as such is a young one compared to the conventional banking industry. The true launching of Islamic finance with the creation of Islamic bank such as Islamic Development Bank (Jedda), Dubai Islamic Bank and Albaraka Banking Group (Bahrain) happened in seventies[34]. The buying and selling involved in a Sharia’a compliant transaction such as Musharaka or Twarruq is essentially banking tailored to meet the requirements of Sharia’a. The concept of a banker buying a product solely for the purpose of enabling its customer to own/possess that product is perhaps attributable only to Islamic banking and not foreseeable at the time when BR 1949 was enacted. The BR 1949 being an Act enacted to consolidate the law relating to banking, the intention behind s.8 would have been to prevent a banker from engaging in the activity of buying and selling as a business separate and distinct from ‘banking’ business. I would contend that such a prohibition is not intended to be applied to a transaction which in which buying and selling is only incidental to facilitating banking activity in a manner compliant with Sharia’a principles.  The following observation made the Hon’ble Supreme Court in ICICI case supports this contention;

‘The BR Act, 1949 is an Act enacted to consolidate and amend the law relating to banking. Thus, while interpreting the Act one needs to keep in mind not only the framework of the banking law as it stood in 1949 but also the growth and the new concepts that have emerged in the course of time Thus, the BR Act, 1949 mandates a statutory comprehensive and formal structure of banking regulation and supervision in India[35] ’

“By definition, an Islamic bank abides by Islamic law, the Sharia’a. The literal meaning of the Arabic term Sharia’a is ‘the way to source of life’ and in a technical sense, it is now used to refer to a legal system in keeping with the code of behaviour called for by holy Qur’an and the hadith (the authentic tradition). Muslims cannot in good faith compartmentalise their behaviour into religious and secular dimensions, and their actions are always bound by the Sharia’a. Islamic law thus embodies an encompassing set of duties and practices including worship, prayer, manners and morals, marriage, inheritance, crime and commercial transactions”[36]. As such in light of the decision rendered in Subramanian Swamy v State of Kerala, the above argument can further be stretched to content that reluctance on the part of RBI to allow Islamic windows will amount to denial of Constitutional privilege to some and hence such act of RBI is unconstitutional. Sharia’a compliant banking ipso facto is not violating the Constitution and as such a narrow import of s.8 BR1949 would in fact amount to denial of certain constitutional rights to a citizen/person who is bound to follow the principles of Sharia’a in all walks of one life. The ratio of Subramanian Swamy case r/w ICICI Bank case abundantly proves that Islamic banking is constitutional in India and that RBI has a positive mandate on it to facilitate banking business so as to expand the same. Of course it is with the proviso that the intended transaction shall be bonafide. Any argument that a Sharia’a compliant transaction would not be a bonafide banking transaction would sound unreasonable and illogical to any man of prudence.

However, it may be noted that even if RBI as a regulator allows Islamic Banking windows, there are other statutory obstacles. The most fundamental one would be the application of double stamp duty and taxation.  The issue of stamp duty is more complex as the Constitution of India divides the power to levy stamp duty between Union and the State. Under the Constitution of India, the power to levy stamp duty is divided between the Union and the State. The Central Government has the power to levy stamp duty on the instruments specified in Article 246 read with Schedule VII, List I, Entry 91 and the State Government has the power to levy stamp duty on instruments falling under Article 246 read with Schedule VII, List II, Entry 63[37]. As such amendment of the applicable provisions in each state would amount to a herculean task considering the divergent political and economic conditions prevailing in India. It could be possible to structure an Islamic banking transaction so as to avoid double stamp duty as opined by legal experts[38]. Such views predominantly may be based on the fact that multiple transactions involved in an Islamic Banking transaction is in fact multiple legs of same transaction and multiplicity is not for undertaking a sham transaction so as to avoid stamp duty. The provisions permitting in transit sales can also be explored for getting over the issue of double taxation on sales of moveable goods.

Conclusion

I would conclude by stating that the flexibility Sharia’a compliant banking possess with respect to product designing and reengineering shall be utilized by the stakeholders to commence Sharia’a compliant banking through Islamic windows which appears in principally permissible, as aforesaid. We being anextremely complex country, politically and legally, a formal regulatory approval might take eras especially in the back ground of absence of any Islamic banking activities through Islamic windows. As such the Islamic finance experts, bankers and regulators shall strive for striking a consensus. The regulators shall lead, especially when we have sorts like Mr.Raghuram Rajan, who is in favour of ‘interest free banking”, heading RBI. The regulators and political leadership shall introspect why a financial committee headed by an economist was forced to use the term “interest-free banking” substituting “Islamic finance”. Mr. Narendra Modi, the Prime Minster who enjoys the mandate of a majority, purportedly aims for an inclusive and sustainable growth trajectory. Probably, a single point remedy lies in promoting Islamic finance. It might help in winning the confidence of a minority and in driving an inclusive and sustainable financial growth beneficial for the majority.