Can ESG Popularise Islamic Banking in India (2024)

ESG investors evaluate companies based on environmental and social impact, ethical behaviour and corporate practices. Islamic banking is a financial system prohibiting the payment or acceptance of interest (riba) and promoting risk-sharing and ethical investment. Islamic banking prohibits interest, whereas conventional banking operates mainly on interest-based transactions.

Islamic banking operates on risk-sharing, where the profits and losses are with its customers. Conventional banks do not share their profits with customers. Islamic banking relies on asset-based financing, where the bank purchases an asset and leases it to the customer, who pays rent until the ownership transfers. Conventional banks offer loan-based funding, which provides a loan to the customer and charges interest. Islamic banking emphasises social responsibility, ethical investment, and environmental stewardship and prohibits investments in activities considered harmful to society, such as gambling, tobacco, and alcohol. Conventional banks invest in such activities if they deem them profitable. Although both types of banking focus on maximising profits for their shareholders, the approach paths differ.

ESG (Environmental, Social, and Governance) evaluates a company's sustainability and ethical practices. There is a strong relationship between ESG and Islamic banking as both share a common goal of promoting sustainable and socially responsible practices. Islamic banking requires financial institutions to ensure their investments and transactions are consistent with environmental and social responsibility. There has been a growing interest in incorporating ESG criteria into Islamic banking, as it aligns with the values and principles of Islamic finance. Some Islamic financial institutions have adopted ESG principles and integrated them into their investment decision-making processes.

RBI Guidelines on Islamic Banking

The Reserve Bank of India (RBI) still needs to issue separate guidelines for Islamic banking in India. However, in 2018, the RBI allowed conventional banks to open Islamic banking windows to offer their customers Shariah-compliant financial products and services. The initiative promotes financial inclusion and meets the banking needs of the Muslim population in India.

Under the RBI's guidelines, banks must ensure that their Islamic banking windows comply with Shariah principles and the laws of the land. The guidelines state that banks should ensure that the funds mobilised through Islamic banking operations are kept separate from their conventional banking operations and that the risks associated with Islamic banking activities stand mitigated.

The RBI has stated that Islamic banking products and services should be marketed and transparently offered to customers, with clear disclosures on such products' features, benefits, and risks. Banks must obtain the necessary regulatory approvals and comply with laws and regulations related to Islamic banking operations.

Despite RBI guidelines, Islamic banking is a relatively new concept in India, and many people need to become familiar with its principles and practices. The need for more awareness has limited its adoption and acceptance among the public. Some political groups in India do not favour the introduction of Islamic banking, citing concerns over its compatibility with Indian laws and potential links to terrorism. Despite the large Muslim population in India, the demand for Islamic banking products and services is, therefore, limited. Many Muslims in India already have access to conventional banking services, which serve the last mile Indian with great aplomb and sincerity physically and digitally.

Outside India, Islamic banking is a great success, mainly in the vibrant economies of the Gulf countries, where it identifies with the ethical and moral principles that visibly promote economic justice, social welfare, and financial stability. Most international banks have also opened branches across the Gulf, offering full-stack Islamic banking. The prosperity of Gulf nations is a testimony to the success of Islamic banking.

As the world increasingly focuses on the importance of ESG and sustainability, Islamic banking appears closer to the concept. The relationship between ESG and Islamic banking is evolving into a natural fit, as both promote sustainable and socially responsible practices. With central Islamic banks avoiding fossil fuel financing, the attraction towards Islamic banking will likely strengthen in the coming years. India must open its economy to Islamic banking as a significant economic player, with GDP scaling to $ 5.0 trillion.

RBI's decision, therefore, to allow conventional banks to open Islamic banking windows is a positive step towards promoting financial inclusion and ESG compliance.