Source: MY Khan. Banking Regulations and Islamic Banks in India: Status and Issues. International Journal of Islamic Financial Services Vol. 2 No.4
Banking Regulations in India
Indian banks are governed under the Banking Regulation Act 1949, Reserve Bank of India Act 1934, Negotiating Instruments Act and Co-Operative Society Act. Banking regulations provide working framework for banking companies, which accept deposits from public for lending or investment. The deposits are withdrawable on demand or after a fixed maturity period. Banks’ provide cheque facility, drafts etc. and generates deposits through deposit multiplier. Thus they create money supply and add to monetary liabilities in the system. Indian banks have been subjected to a number of banking regulations and guidelines as prescribed by the RBI .Banks in India have to maintain cash reserves ratio (8.5 per cent at present) of which 3 per cent does not get interest and remaining 5.5 per cent get interest at the rate of 4 per cent per annum. Statutory Liquidity Ratio (SLR) is another important condition to be met by the banks. Liquidity assets comprise investment by the banks in central government securities and other approved securities, which earn market determined interest. The Central Bank uses CRR and SLR as instruments of monetary control. The RBI has used CRR frequently to control the monetary liquidity in the economy. The Central Bank has used Bank Rate to encourage or discourage bank credit International Journal of Islamic Financial Services Vol. 2 No.4 demand in the economy. The above instruments cannot be used for Islamic banks as they do not function on the basis of interest. Other sets of conditions which banks have to meet are capital adequacy, assets classification, provisioning for bad debts and income recognition norms. Minimum capital base for a bank is Rs.200 which will get raised to Rs.300 crore and further to Rs.500 crore.
The issue No.1 which is a permanent eye sore for Islamic banks operating in the countries with interest based banking is that they cannot function as banks unless powers of issuing cheques are given to them. They cannot be members of settlement / clearing house unless they accept two conditions regarding their liabilities and assets like conventional banks who have to keep fractional cash reserve with the Central Bank and statutory liquid assets in their assets. Thus banks in India have to maintain deposit account with the Central Bank over which they get interest. The SLR includes Government and approved securities. A bank licensed by the RBI becomes the part of monetary system, which means it can create money by deposit generation through deposit acceptance.
Since these assets are interest based, Islamic bank cannot hold them. Consequently, the Central Bank cannot act as the lender of last resort because such accommodation by the monetary authority is also interest based. Islamic banks cannot inter-act with conventional banks based on principles of interest. A silver lining which is emerging today is that banks are being subjected to prudential norms, cash reserve ratio and statutory liquidity ratio. However, statutory liquidity ratio and cash reserve ratio have been reduced. Interest rate have been decontrolled. Interest on cash reserves have been substantially reduced.
Islamic Banks (Non-Banking Financing Companies) in India and RBI Regulations
Islamic Banks (Non-Banking Financing Companies) in India and RBI Regulations Islamic banks in India do not function under banking regulations. They are licenced under Non Banking Finance Companies Reserve Bank Directives 1997 RBI (Amendment) Act 1997, and operates on profit and loss based on Islamic principles. RBI has introduced compulsory registration system. Only those NBFCs which have net owned funds equivalent to Rs.50 lakhs and above can be registered with the RBI with the minimum capital of Rs.25 lakhs. Subsequently, in the Monetary and Credit Policy for the year 1999-2000, it was proposed that in respect of new NBFCs, which seek registration with the Reserve Bank and commence the business on or after April 21, 1999, the requirement of minimum level of net owned funds(NOF) will be Rs.2 crore. The RBI (Amendment) Act, 1997 has been the most recent effort to address the issue of laying down a comprehensive framework for regulating the NBFCs. Exercising the powers derived under the amended Act, a set of regulatory and supervisory measures was announced by the Reserve Bank in January 1998. The broad thrust of the new Act has been to provide a greater degree of comfort and safety to depositors, while, at the same time, fostering the development of a healthy and diversified financial sector. Accordingly, entry-level norms for new and existing NBFCs have been laid down.
Among the various measures introduced are compulsory registration of NBFCs engaged in financial intermediation, prescription of minimum level of (NOF), maintenance of certain percentage of liquid assets as percent of public deposits in government bonds, creation of reserve fund and transfer thereto every year a certain percentage of profits to reserve fund. The regulations also provide for measures like credit rating for deposits, capital adequacy, income recognition, asset classification, compulsory credit rating provision for bad and doubtful debts, exposure norms and other measures to keep a check on their financial solvency and financial reporting. While the regulatory framework has been dovetailed primarily towards NBFCs accepting / holding public deposits, the supervisory mechanism for NBFCs is based on three criteria viz. (a) the size of the NBFC, (b) the type of activity performed, and (c) the acceptance or otherwise of public deposits. Towards this end, a four-pronged supervisory setup consisting of on-site inspection, off-site surveillance, exception reporting by NBFCs’ statutory auditors and market intelligence system has been instituted. The NBFCs have also been directed to constitute audit committee, consisting of not less than their members of their Board of Directors, if the deposits exceeds Rs.50 crore. They have been required to follow a uniform accounting.
In so far as accepting public deposits is concerned, NBFCs are akin to banks, except that NBFCs cannot accept deposits payable on demand. But it needs to be recognised that as public deposits are unsecured, the accepted global practice is that only banks which are regulated and supervised should be the main institutions that could be permitted to seek public deposits. It is against this background, public deposit taking activities of NBFCs are regulated in the same manner as banks. This is the underlying element of the regulatory regime presently being put in place in respect of NBFCs in India.
There are several Baitul Mals working in cities as well as in villages.Only 10 to 15 Islamic banks with deposits of about Rs. 75 crore operating all over the country in various states. They are actually Non-Banking Finance Companies which work on profits/ loss basis. Islamic banks by and large cater to the needs of local area except a few of them operating across districts or states. Their sources of funds are limited and as a result these banks have to operate on small scale missing the economies of scale. Islamic banks in India provide housing loan, on the basis of co-ownership, venture finance on Mudarabha basis as well as on Musharaka basis and consumers loans. Some banks finance transports also on the mark up basis via hire purchase. Education finance and skill development finance is also provided by them. Investments are made in government securities, small savings schemes or units of mutual funds. Investment in shares of companies is also made by some Islamic banks. Hire purchase and lease finance are other source of investment.
Islamic banks as referred to in the preceding paragraph face resource constraints and have narrow financing avenues. Their capital base is small and weak. In order to overcome these problems they can diversify into equity based financing and resource raising can be done through issue of equity shares. Islamic banks in India can offer their assets portfolios of primary securities in the form of open ended mutual funds units / shares for sale to investors. Islamic banks can be identical to open ended mutual funds that hold only traded non-interest bearing assets. The shares / units of these banks can be used as a transaction medium because investors can withdraw / transfer / sell such units / shares. The units can be listed on the stock exchange also and their value can be ascertained in the market. It is perhaps worth emphasizing that for Islamic banks, resource mobilisation and investment through units or equity, need well functioning equity exchanges market without any tax or penalty on frequent trading. An important development in Indian financial market is the emerging and widening strong capital market with a broad based regulatory system in favour of investors. Now Islamic banks can use two way route they can mobilise capital resources by issuing equity shares and can invest in equities of corporates and financial institutions. The setting up of mutual funds is another important route. Islamic banks can float mutual funds schemes offering dividend on units and these funds can be invested in corporate shares.
However, Islamic banks functioning on profit-loss basis have developed knowingly or unknowingly a number of deficiencies. First, they have not developed adequate internal control system, as a result their accounting system is not very transparent. You may be aware that transparency is the directive of Islam. A number of times they are not able to follow the directives of regulatory authorities pertaining to deposit acceptance from public. For instance, they hardly go for credit rating. They are not submitting required information and data to Reserve Bank of India. Their monitoring system warrants appointment of technical people familiar with reporting system. It is also observed that accounting practices needs to be learned by the officials of these banks.
Lack of skilled staff, professionals and infrastructure frustrate their effort to expand and enlarge their operations. There has been very little effort to provide training facilities. However, there is good news that government would be permitting NBFCs to accept foreign share holdings even on foreign partnership basis upto 100 per cent. This relaxation will enable Islamic banks to augment their resources through foreign holding by foreign investors, consolidate and formalise their operations. Foreign partners bring with them improved standard of disclosures and better management practices.
Banking Regulations in India
Indian banks are governed under the Banking Regulation Act 1949, Reserve Bank of India Act 1934, Negotiating Instruments Act and Co-Operative Society Act. Banking regulations provide working framework for banking companies, which accept deposits from public for lending or investment. The deposits are withdrawable on demand or after a fixed maturity period. Banks’ provide cheque facility, drafts etc. and generates deposits through deposit multiplier. Thus they create money supply and add to monetary liabilities in the system. Indian banks have been subjected to a number of banking regulations and guidelines as prescribed by the RBI .Banks in India have to maintain cash reserves ratio (8.5 per cent at present) of which 3 per cent does not get interest and remaining 5.5 per cent get interest at the rate of 4 per cent per annum. Statutory Liquidity Ratio (SLR) is another important condition to be met by the banks. Liquidity assets comprise investment by the banks in central government securities and other approved securities, which earn market determined interest. The Central Bank uses CRR and SLR as instruments of monetary control. The RBI has used CRR frequently to control the monetary liquidity in the economy. The Central Bank has used Bank Rate to encourage or discourage bank credit International Journal of Islamic Financial Services Vol. 2 No.4 demand in the economy. The above instruments cannot be used for Islamic banks as they do not function on the basis of interest. Other sets of conditions which banks have to meet are capital adequacy, assets classification, provisioning for bad debts and income recognition norms. Minimum capital base for a bank is Rs.200 which will get raised to Rs.300 crore and further to Rs.500 crore.
The issue No.1 which is a permanent eye sore for Islamic banks operating in the countries with interest based banking is that they cannot function as banks unless powers of issuing cheques are given to them. They cannot be members of settlement / clearing house unless they accept two conditions regarding their liabilities and assets like conventional banks who have to keep fractional cash reserve with the Central Bank and statutory liquid assets in their assets. Thus banks in India have to maintain deposit account with the Central Bank over which they get interest. The SLR includes Government and approved securities. A bank licensed by the RBI becomes the part of monetary system, which means it can create money by deposit generation through deposit acceptance.
Since these assets are interest based, Islamic bank cannot hold them. Consequently, the Central Bank cannot act as the lender of last resort because such accommodation by the monetary authority is also interest based. Islamic banks cannot inter-act with conventional banks based on principles of interest. A silver lining which is emerging today is that banks are being subjected to prudential norms, cash reserve ratio and statutory liquidity ratio. However, statutory liquidity ratio and cash reserve ratio have been reduced. Interest rate have been decontrolled. Interest on cash reserves have been substantially reduced.
Islamic Banks (Non-Banking Financing Companies) in India and RBI Regulations
Islamic Banks (Non-Banking Financing Companies) in India and RBI Regulations Islamic banks in India do not function under banking regulations. They are licenced under Non Banking Finance Companies Reserve Bank Directives 1997 RBI (Amendment) Act 1997, and operates on profit and loss based on Islamic principles. RBI has introduced compulsory registration system. Only those NBFCs which have net owned funds equivalent to Rs.50 lakhs and above can be registered with the RBI with the minimum capital of Rs.25 lakhs. Subsequently, in the Monetary and Credit Policy for the year 1999-2000, it was proposed that in respect of new NBFCs, which seek registration with the Reserve Bank and commence the business on or after April 21, 1999, the requirement of minimum level of net owned funds(NOF) will be Rs.2 crore. The RBI (Amendment) Act, 1997 has been the most recent effort to address the issue of laying down a comprehensive framework for regulating the NBFCs. Exercising the powers derived under the amended Act, a set of regulatory and supervisory measures was announced by the Reserve Bank in January 1998. The broad thrust of the new Act has been to provide a greater degree of comfort and safety to depositors, while, at the same time, fostering the development of a healthy and diversified financial sector. Accordingly, entry-level norms for new and existing NBFCs have been laid down.
Among the various measures introduced are compulsory registration of NBFCs engaged in financial intermediation, prescription of minimum level of (NOF), maintenance of certain percentage of liquid assets as percent of public deposits in government bonds, creation of reserve fund and transfer thereto every year a certain percentage of profits to reserve fund. The regulations also provide for measures like credit rating for deposits, capital adequacy, income recognition, asset classification, compulsory credit rating provision for bad and doubtful debts, exposure norms and other measures to keep a check on their financial solvency and financial reporting. While the regulatory framework has been dovetailed primarily towards NBFCs accepting / holding public deposits, the supervisory mechanism for NBFCs is based on three criteria viz. (a) the size of the NBFC, (b) the type of activity performed, and (c) the acceptance or otherwise of public deposits. Towards this end, a four-pronged supervisory setup consisting of on-site inspection, off-site surveillance, exception reporting by NBFCs’ statutory auditors and market intelligence system has been instituted. The NBFCs have also been directed to constitute audit committee, consisting of not less than their members of their Board of Directors, if the deposits exceeds Rs.50 crore. They have been required to follow a uniform accounting.
In so far as accepting public deposits is concerned, NBFCs are akin to banks, except that NBFCs cannot accept deposits payable on demand. But it needs to be recognised that as public deposits are unsecured, the accepted global practice is that only banks which are regulated and supervised should be the main institutions that could be permitted to seek public deposits. It is against this background, public deposit taking activities of NBFCs are regulated in the same manner as banks. This is the underlying element of the regulatory regime presently being put in place in respect of NBFCs in India.
There are several Baitul Mals working in cities as well as in villages.Only 10 to 15 Islamic banks with deposits of about Rs. 75 crore operating all over the country in various states. They are actually Non-Banking Finance Companies which work on profits/ loss basis. Islamic banks by and large cater to the needs of local area except a few of them operating across districts or states. Their sources of funds are limited and as a result these banks have to operate on small scale missing the economies of scale. Islamic banks in India provide housing loan, on the basis of co-ownership, venture finance on Mudarabha basis as well as on Musharaka basis and consumers loans. Some banks finance transports also on the mark up basis via hire purchase. Education finance and skill development finance is also provided by them. Investments are made in government securities, small savings schemes or units of mutual funds. Investment in shares of companies is also made by some Islamic banks. Hire purchase and lease finance are other source of investment.
Islamic banks as referred to in the preceding paragraph face resource constraints and have narrow financing avenues. Their capital base is small and weak. In order to overcome these problems they can diversify into equity based financing and resource raising can be done through issue of equity shares. Islamic banks in India can offer their assets portfolios of primary securities in the form of open ended mutual funds units / shares for sale to investors. Islamic banks can be identical to open ended mutual funds that hold only traded non-interest bearing assets. The shares / units of these banks can be used as a transaction medium because investors can withdraw / transfer / sell such units / shares. The units can be listed on the stock exchange also and their value can be ascertained in the market. It is perhaps worth emphasizing that for Islamic banks, resource mobilisation and investment through units or equity, need well functioning equity exchanges market without any tax or penalty on frequent trading. An important development in Indian financial market is the emerging and widening strong capital market with a broad based regulatory system in favour of investors. Now Islamic banks can use two way route they can mobilise capital resources by issuing equity shares and can invest in equities of corporates and financial institutions. The setting up of mutual funds is another important route. Islamic banks can float mutual funds schemes offering dividend on units and these funds can be invested in corporate shares.
However, Islamic banks functioning on profit-loss basis have developed knowingly or unknowingly a number of deficiencies. First, they have not developed adequate internal control system, as a result their accounting system is not very transparent. You may be aware that transparency is the directive of Islam. A number of times they are not able to follow the directives of regulatory authorities pertaining to deposit acceptance from public. For instance, they hardly go for credit rating. They are not submitting required information and data to Reserve Bank of India. Their monitoring system warrants appointment of technical people familiar with reporting system. It is also observed that accounting practices needs to be learned by the officials of these banks.
Lack of skilled staff, professionals and infrastructure frustrate their effort to expand and enlarge their operations. There has been very little effort to provide training facilities. However, there is good news that government would be permitting NBFCs to accept foreign share holdings even on foreign partnership basis upto 100 per cent. This relaxation will enable Islamic banks to augment their resources through foreign holding by foreign investors, consolidate and formalise their operations. Foreign partners bring with them improved standard of disclosures and better management practices.
