APM Mohammed Hanish, IAS, is a very busy man. It is impossible to speak to him without being interrupted by a phone call, an email, or a secretary.
From his office in Kochi, a comfortably laid out room done up with Ravi Varma reproductions, he runs Roads and Bridges Development Corporation of Kerala, part of the State’s Public Works Department.
Building roads is Hanish’s easier job. Most people visiting him these days, whether business owners, investors or journalists, want to discuss his other baby, Cheraman Financial Services Ltd, of which he is the Managing Director. Cheraman is the first Government-promoted sharia-compliant financial institution in the country.
Islamic finance
The sharia, Islam’s body of religious and social laws, also prescribes how a Muslim must run his business. It forbids interest both when lending and borrowing. So, investment must be based on the principle of shared risk, making the lender a partner in the business and not a creditor. Businesses considered immoral, such as trade in tobacco, liquor, explosives and lending money for interest, are automatically excluded.
“The crux of Islamic finance is that one must share both risk and reward. The concept of earning an ‘interest’ without risk is unacceptable,” says Aziz Tayyebi, head of International Development for the professional accounting body, ACCA Global, who has studied the subject.
Contrary to popular perception, sharia-banking isn’t restricted to Muslims. The system can also be used by non-Muslim entrepreneurs to fund their businesses. Indeed, if unlocked, it has the potential to provide abundant funding for businesses across India.
A tamer, under-the-radar version
Full-fledged Islamic banking isn’t allowed in India yet but it is thriving overseas. While its largest centres are Malaysia and West Asia, it is widespread in the West as well, with almost every leading Western bank, including the likes of Standard Chartered, Deutsche Bank, Citibank and BNP Paribas, having Islamic finance windows.
An EY report released this March states that Islamic banking assets worldwide are worth $1.55 trillion and will cross the $2-trillion mark by 2015.
The Reserve Bank of India has frequently said in the past that it cannot allow Islamic banking in India until key financial laws, including the Banking Regulation Act, are altered. So, what exists now is a tamer, often splintered and sometimes under-the-radar version called sharia-compliant finance.
An ambitious venture
Sharia rules are being adapted by individuals to provide credit and investment options to Muslims. Most work independent of each other, through non-banking finance companies (NBFCs), venture capital funds, stock brokerages and mutual fund houses. Cheraman Financial Services, in Kochi, is the most ambitious of them all.
For a State Government whose funds seem to be scraping the bottom of the barrel — Kerala’s revenue-raising plans include building a mall and selling G-secs to pay Onam bonuses – the NBFC is one way of attracting well-heeled private Muslim investors.
Credit for the idea must go to the previous Government. In 2009, the Left Government hit upon the sharia-compliant financing concept to route petrodollars from West Asia to Kerala, based on a feasibility report by EY. Additionally, the consultants pointed out, the Government could also attract some of the Rs 37,000 crore (then) coming into the country annually as remittances from non-resident Indians (NRIs) in the Gulf.
A thorny path
The Kerala Government created Al Barakah Financial Services Ltd in 2010 with authorised capital of Rs 1,000 crore. The Kerala State Industrial Development Corporation got 11 per cent equity.
The NBFC generated considerable interest soon after it was launched. Business Line had reported in June 2010 that Reliance Capital, Doha Bank and members of West Asian royal families were all keen on contributing to Al Barakah.
However, it encountered one hurdle after another. First, getting RBI and Securities and Exchange Board of India (SEBI) approval proved hard. Later, BJP politician and former Union Minister Subramanian Swamy filed writ petitions against the Kerala Government, alleging that its support for sharia finance went against the secular principles that guide a government. The case was dismissed in 2011, and this August, the NBFC received its RBI licence to operate as a non-deposit taking NBFC.
Al Barakah has since been renamed Cheraman Financial Services Ltd after the Cheraman masjid in Kodungallur, Thrissur district, believed to be the first mosque built in India.
Cheraman’s private backers today are among the richest Indians in West Asia, including P. Mohamed Ali, Vice-Chairman of Galfar Engineering and Contracting in Oman, C.K. Menon, Chairman and Managing Director of Qatar-based Behzad Group, and P.N.C. Menon, founder of Bangalore-based Sobha Developers.
Big hopes
Hanish, Cheraman’s MD, expects considerable foreign investment to flow into Kerala now. He says that the Gulf Cooperation Council (GCC) alone will have foreign assets to the tune of $3 trillion by 2017, citing statistics from the International Monetary Fund. (The GCC members are Saudi Arabia, Kuwait, United Arab Emirates, Qatar, Oman and Bahrain.)
“Besides, the Islamic investment market, leaving aside the GCC, is bound to touch $2 billion, according to our estimates,” says Hanish. This, he adds, is precisely why 75 countries, including the US, the UK, and even small entities such as Hong Kong, have subscribed to interest-free financing as an alternative way to mobilise funds. “At least a portion of these sovereign funds can be accessed by India, and Kerala, given our historical and cultural ties with the ruling families and Governments of the Middle East.”
The RBI licence allows the NBFC to make leasing and equity investments. Hanish says the plan is to begin with medical and construction equipment leases and move on to industrial machinery and commercial vehicles.
In such an arrangement, interest is replaced with a lease rental in the sharia system. Rental rates, Hanish says, will be at least one/two percentage points lower than interest rates on comparable loans.
The NBFC’s equity finance arm will invest in State-sponsored special purpose vehicles for infrastructure development. It will also buy the equity of private sector enterprises, especially start-ups.
The infrastructure division hopes to one day fund Kerala’s roads and bridges. For Hanish, who also heads the State’s road development body, that is a “confluence of interest” with his Cheraman duties.
For now, however, the plan is to turn fallow religious endowment lands, usually attached to a waqf board, into commercial properties on a build-operate-transfer basis.
Most sharia-compliant institutions do not operate on the scale Cheraman aspires for. Instead, they focus on middle-class and poor Muslims who are cut off from mainstream banking because of various reasons, including religious diktats.
Local experiments
Muslims constitute over 13 per cent of India’s population. The November 2006 Sachar Committee report on the status of Muslims in India found that despite priority sector lending, Muslims fare worse than other minority communities in access to banking and credit.
In fact, in 2009, a committee headed by Raghuram Rajan, now the RBI Governor, had suggested taking measures “to permit the delivery of interest-free finance on a larger scale, including through the banking system”.
Even among those who do have bank accounts, interest income often goes unclaimed. The 2009 EY report for the Kerala Government estimated that about Rs 5,000 crore, belonging to devout Muslim account-holders, could be lying unclaimed in banks across India.
This vacuum has given rise to localised experiments in sharia-compliant finance. Alternative Investments and Credits Ltd (AICL), based in Kozhikode, Muslim-dominated north Kerala’s business hub, is perhaps the best known among these. Promoted by the Jamaat-e-Islami and other prominent Muslim Malayalees, AICL received an NBFC licence in December 2001 and began operations in 2002. Thus far, it has invested Rs 7.3 crore in a variety of sole proprietorships, on a profit-sharing basis. Thanveer Mohiyudheen, Company Secretary and Chief Operations Officer of AICL, says that the NBFC never takes more than a 50 per cent stake in a client’s business.
However, in 2012, the RBI cancelled AICL’s licence alleging that it was violating the NBFC fair practice code by not explicitly stating what interest rate would be charged. AICL contends that it has been adopting the relevant rules of the code for the interest-free financing model. Meaning, it would not be possible to state the interest rate up front, since the concept of ‘interest’ does not exist in sharia-compliant finance.
In a January 2012 report, the Union Finance Ministry asked the RBI to clear the air on the fair practice code and differentiate between the usurious interest rates charged by some microfinance institutions and the interest-free model adopted by some NBFCs.
AICL has filed a case in the Bombay High Court over the cancellation of its licence by the RBI. If the lawsuit fails, Mohiyudheen says AICL will switch to the venture capital model, which does not require the central bank’s sanction, to stay in business.
Sharia-compliant VC
In 2009, when real estate investments from the mainstream market had dried up, M.A. Mehaboob, Director of HiLite Builders in Kozhikode, started a sharia-compliant real estate venture capital (VC) fund called Secura. VC funds need SEBI approval and Secura says it is the first sharia-compliant real estate VC to get it. The first fund has financed four projects — three commercial one residential — for HiLite.
Mehaboob, who is also MD of Secura Investment Management, finds there are two sets of investors interested in the real estate fund. “Some want investment options that are in line with sharia and their religious beliefs. The other set wants a product that is safe and transparent and not something that’s complicated or highly leveraged. With the sharia-compliant fund, we can satisfy both these groups.”
HiLite Builders was always averse to taking bank loans, instead offering discounts if customers bought apartments early. With Secura, it overcame the financing challenge.
The fund collected Rs 6-7 crore from a number of small investors. By the time the fund closes in September 2014, Mehaboob says Secura would have delivered 18-20 per cent annualised profits to its investors. “With a real estate fund, we can sell the building and make our exit easily. Sharia compliance is absolutely no problem.”
Bouquets & brickbats
P.K. Abdul Latheef, a manufacturer of jute packing material, and Nasar Nalakath, a restaurant owner, who have businesses near Kochi, had both partnered with AICL. Latheef, who started his business in 2000, says that early on, he was frustrated by banks and their tedious loan processes. When AICL started operations in 2002, it invested Rs 3 lakh, an amount he repaid with relative ease. Latheef is hoping to expand to Bangalore now and plans to turn to AICL again for funding. Nalakath sold about 39 per cent of his restaurant business to AICL for Rs 10 lakh in 2011. With every monthly share of profit he pays back, he regains a part of the portion he gave up.
Bhavesh Shah is a Gujarati Jain who calls Kozhikode his home. His sole proprietorship, Kishore Kumar and Co, is the city’s largest three-wheeler financier by turnover. Shah says that with the success of the sharia model in the region, investors are now keen on a similar arrangement in the commercial-vehicle segment, and he is seriously considering switching to such a format. Besides, the autorickshaw drivers who take loans from his firm are mostly Muslims. “The important thing,” Shah says, “is to package the product well and make it attractive to auto drivers.”
But not everyone has had success with sharia-compliant finance. While the fineprint for business loans is clear, it’s a lot harder extending the sharia rules to personal loans and consumer credit. Globally, in Islamic finance, an education loan, for instance, is extended through a transaction called tawarruq, structured like a commodity forward trade, where the borrower’s repayment liability is linked to the price movements of a commodity. The practice has met with both praise and derision, with naysayers alleging that a tawarruq is nothing more than a masquerade for an interest-based loan.
Saif Ahmed, who is the Managing Partner of Infinity Consultants, may have the answer.
Ahmed’s educational and professional background are impressive – he schooled at Bishop Cotton in Bangalore, and later attended the Indian School of Business (Hyderabad), Bates College (Maine, US) and London School of Economics. He worked on Wall Street for Merrill Lynch before becoming an Islamic investment banker at Kuwait Finance House, among the biggest Islamic banks in the world.
When Ahmed decided to launch his own Islamic finance institution in India, he found a working local model that fits Islamic finance to a T: the chit fund. Zayd Chit Funds, which has, for about a year now, been offering credit to Bangalore’s Muslim community.
Zayd does not allow bidding, since that would implicitly amount to collecting interest. Instead, members whose names are picked get the full chit value, while the fund charges a five per cent service fee. Ahmed says his research team is working on a model for sharia-compliant home finance, which will be launched in the next three months.
Islamic vs conventional finance
“Over the next 20 years, you will see a substantial surge in Islamic banking, globally. But if Islamic finance is going to be done, it should be done right. What currently passes as Islamic finance is a veneer,” says Jamal Mecklai, CEO, Mecklai Financial, a foreign exchange risk advisory.
Look close enough, and the lines between Islamic and conventional finance can blur. In global practice, sometimes, a car loan from a conventional bank and a car lease from an Islamic bank (where the bank buys the car and lets you use it while you pay back the principal and a rental charge) can seem similar, but for the nomenclature.
Ahmed, from his experience as an Islamic investment banker, says that most Islamic banks even try to match their rate of return on investments to the industry benchmark, so as not to scare away investors and borrowers. He says that Muslim depositors and borrowers prefer sharia-compliant options as long as their returns and repayments match what everybody else is getting.
Additionally, there is difficulty deciding what exactly is ‘sharia compliant. Interpretations of the sharia vary across the globe and scholars in West Asia often disagree with their counterparts in Malaysia, the other powerhouse in the Islamic finance world. In India, there is a need for training to help people get familiar with the concept and adopt the economic principles of sharia to modern finance. Only then can it hope to take off.
Nevertheless, Ashok Haldia, Director of PTC India Financial Services and former Secretary of the Institute of Chartered Accountants of India, believes participatory banking has strong possibilities here. “These products sometimes seem to be creatively designed to meet Islamic finance perspectives. But if it satisfies religious requirements, what is the problem?
Currently, those active in sharia-compliance differ on what it should be called. Syed Zahid Ahmad, advisor to the NBFC Bhartiya Samruddhi Finance Ltd, wants it introduced as participatory finance and not as Islamic banking, so it doesn’t alienate non-Muslims. “This can be both a change in name and attitude. Besides, it can explain the terms better. For example, ‘equity financing’ instead of mudharabah and a lease instead of ijarah.”
Ahmed of Zayd Chit Funds believes otherwise. “Being interest-free is only the first rule. There are a hundred other conditions and all of those come from the sharia. Calling (Islamic banking) anything else doesn’t give the true picture. There’s no need to be apologetic.”
Both, however, worry that the subject will be politically manipulated. So much so, that Ahmed does not want Islamic banking introduced as yet. He would rather have it grow bottom up and reach a stage where the central bank is forced to regulate it.
Hanish echoes his views. Cheraman, he says, is quite content with the NBFC licence it now has. “If the RBI gives us more, we would be happy. But we need to firm ourselves up before venturing into anything else. We need to prove to everyone, including the RBI, that this is a sustainable form of finance.”
Islamic finance 101
The abolition of interest (riba) is the foremost, and possibly the most well-known principle of Islamic finance. But there are a host of other rules, drawn primarily from the sharia’s legal framework and also from traditional practices and the decisions of scholars. Business deals must be free from ambiguity (gharar) and speculation (maysir), and firms must compulsorily give to charity (zakat and sadaqah).
Revenues, thus, come only when both sides share risk and reward, and investments must be backed by a real good or service. M.H. Khatkhatay, of Mumbai-based Sharia advisory firm TASIS, says that for financial transactions to be sharia-compliant, “there should be an intrinsic theoretical possibility of the investment returning a loss due to business parameters, as opposed to just the counterparty’s default (which can also happen on a loan).”
“The ideal of Islamic finance, actually, is a benevolent loan, where you lend Rs 1,000 and get Rs 1,000 back from the borrower. Therefore, certain forms of assets are more acceptable in sharia. Venture-capital structures, for example, where you invest in a business and share the risks. However, given the need to beat inflation and so on, some bond-like structures have evolved too, where investors accept a mark-up on the principal when the loan is repaid. It is not interest,” says Aziz Tayyebi, head of International Development for the professional accounting body ACCA Global.
But then, do investors have to make a sacrifice on returns? “Yes, they pay a premium for such services, mainly because the Islamic finance industry lacks scale. It shouldn’t be so, but it is,” admits Tayyebi.
A common form of financing is a cost-plus-markup contract. For instance, if you want to buy a car, the bank will buy one from a dealer and resell it to you for a profit. Home financing is usually through a leasing arrangement, where the homeowner repays the principal and a lease rental through instalments.
Businesses are generally funded by buying equity. In a profit and loss sharing agreement, while profit can be shared among parties in any ratio agreed upon in advance, losses must be borne in the same proportion as capital contribution. By relinquishing part of his profits in the early years, the business owner can eventually regain control of his firm.
Trading in stocks is a grey area, however. The sharia insists that business transactions create real assets, which should make the stock market haram and a sharia stock plan an oxymoron. But most scholars now allow stock market investments because it is one of the few institutional alternatives available to ordinary investors, making sharia stock brokers quite common these days.
But there are many rules to comply with. To begin with, a Muslim investor can only take long positions. Anything more exotic — short selling, derivatives, margin trading, F&Os — is prohibited. A company whose core business has to do with lending on interest or a haram commodity (such as tobacco, liquor, entertainment) is excluded.