February Issue 2007

There is an Islamic financing boom going on these days in Pakistan. Either entirely new Islamic banks are being opened or existing commercial banks are starting subsidiaries or branches specialising in Islamic banking. These financial institutions now offer Shariah-based alternative products like Murabaha, Musharakah, Ijarah, Ijarah-Wal-Iqtina and Modaraba to those in the conventional western banking system.

But how much of their claim about Islamic banking is true? Are they really working according to Islamic principles?

These are some crucial questions, which, according to economists and senior bankers, are difficult to answer. Some dispute the difference between the existing interest-based banks and the so-called Islamic banks. Critics argue that the latter actually work on the principle of interest, or Riba, which is, of course, prohibited under Islam — they just dress their products in Islamic clothes.

Even the State Bank of Pakistan (SBP), which is the regulator of all the banking and financial institutions of the country, has not come up with a true solution for Islamic banking, and it has allowed Islamic banking and the conventional banking system, which is based on interest, to live side by side.

“This is not Islamic banking in the real sense because the spirit of Shariah is not observed,” says Dr Shahid Hasan Siddiqui, a senior economist and the chairman of the Research Institute of Islamic Banking and Finance. “In practice, nowhere in the world is there a model Islamic banking system. If you see the international literature on Islamic banking, it has become a mockery.”

At the international level, Islamic banking caught the attention of the leading financial institutions after the global oil boom in 2003. Big banks the world over saw the oil-rich Arabs as a lucrative untapped market. And given that they predominantly prefer to earn profits on their money through Islamic modes of financing, foreign banks had to develop new Muslim-friendly products.

Although many Muslim countries adopted the Islamic banking system decades ago, the system really flourished after 9/11. It is believed that many wealthy Muslims withdrew their deposits from western banks and transferred their holdings to banks in Muslim countries. In an attempt to halt that outflow, banks in the UK, USA and European countries turned towards Islamic banking.

From Standard Chartered Bank to Citibank and ABN AMRO, every major international bank is offering products based on Islamic banking principles.

“The problem is that most clients under Islamic banking are non-Muslims, who say, “We are not concerned with Shariah, as long as we are getting handsome profits.” says Dr Siddiqui.

Internationally, Islamic banking is the fastest growing sector in banking, and it is believed that its growth is between 15 — 20% annually. According to an official of the SBP, assets of Islamic banks worldwide are estimated to be between US$350 to almost 700 billion. Recently, two licenses have been issued in the UK, one to the European Islamic Investment Bank and the other to the Islamic Bank of Britain. Singapore has also opened an offshore centre of Islamic Banking. Bahrain, Malaysia, Indonesia are the oldest players in Islamic banking, and in total about 50 to 60 countries across the world are using the Islamic mode of banking.

In Pakistan, Islamic banking has witnessed a setback because of the unwillingness of successive governments to introduce an interest-free system. Although the government had committed that the banking system would gradually be converted to one based on Islamic principles, no serious effort has been made, and both interest-based and Islamic modes of banking are in operation on a parallel basis. So despite being an Islamic country, Pakistan has lagged behind others in adopting the Islamic banking system.

The efforts for Islamisation of the banking system started way back in the 1960s but, it only gained momentum during the period of General Zia-ul-Haq who, in fact, tried to Islamise every sphere of life. General Zia amended the legal framework of Pakistan’s financial and corporate system on June 26, 1980, to permit the issuance of a new interest-free instrument of corporate financing named the Participation Term Certificate (PTC). An Ordinance was promulgated to allow the establishment of Modaraba companies and the floatation of Modaraba certificates for raising risk-based capital. Subsequently amendments were also made in the Banking Companies Ordinance, 1962, and related laws to include the provision of bank financing through profit and loss sharing, mark-up in prices, leasing and hire purchase.

As a result of that amendment, all the nationalised commercial banks started separate counters from January 1, 1981, to mobilise deposits on a profit-and-loss sharing basis. And from July 1, 1982, banks were allowed to provide financing to meet the working capital needs of trade and industry on a selective basis under the technique of Musharakah, an agreement under which the Islamic bank provides funds, that are mixed with the funds of the business enterprise and others, and profit is distributed among the partners in predetermined ratios, while any loss is borne by each partner strictly in proportion to respective capital contributions.

From July 1, 1985, no bank in Pakistan was allowed to accept any interest-bearing deposits and all existing deposits in a bank were treated on the basis of profit and loss sharing. However, deposits in current accounts continued to be accepted under which neither interest nor a share in profit or loss were allowed. But foreign currency deposits in Pakistan and lending of foreign loans continued on interest as before.

However, these procedures adopted by banks in July 1985, based largely on a ‘mark-up’ technique with or without ‘buy-back arrangement,’ were eventually declared un-Islamic by the Federal Shariat Court (FSC) in a judgment in November 1991.

The government appealed the ruling with the Shariat Appellate Bench (SAB) of the Supreme Court of Pakistan. The SAB, in its historic judgment on December 23, 1999, rejected the government appeals and asked it to remove all laws involving interest before June 30, 2001. The court said that the present financial system had to be subjected to radical changes to bring it into conformity with the Shariah. It also asked the government to set up, within a specified time frame, a Commission for Transformation of Financial System (CTFS) and two task forces to plan and implement the process of the transformation.

Thus, the CTFS was constituted in January 2000 by the SBP under the Chairmanship of Mr I.A. Hanfi, a former governor of the SBP. A task force was set up in the Ministry of Finance to suggest ways in which interest could be eliminated from government financial transactions. Another task force was set up in the Ministry of Law to suggest amendments to the legal framework to implement the court’s judgment.

But the government, through a public sector bank, went to court asking for an extension of the date by 2006. The court gave only a year’s extension to its earlier June 30, 2001, deadline.

The Islamic banking efforts received a serious blow when on June 21, 2002, on a review petition by UBL, the Supreme Court’s SAB set aside all the previous judgments in this regard, including its own historic December 1999 decision, and the November 1991 decision of the FSC. The SAB of the Supreme Court asked the FSC to re-hear the original case. Since then, the case has been lying in a long queue of cases.

Meanwhile, the government decided in September 2001 that the shift to an interest-free economy would be made in a gradual and phased manner and without causing any disruptions. The State Bank issued detailed criteria in December 2001 for the establishment of full-fledged Islamic commercial banks in the private sector. Al-Meezan Investment Bank received the first Islamic commercial banking license from SBP in January 2002, and it commenced its Islamic banking operations on March 20, 2002.

According to Pervez Said, director, Islamic Banking Department at the SBP, the central bank has adopted a system under which it has allowed three types of Islamic banks to operate. “We have allowed full-fledged Islamic banks, subsidiaries of conventional banks, or stand-alone windows. We have introduced a comprehensive Shariah Compliance Mechanism, which is flexible.”

As of December 2006, there were four fully operational Islamic banks and two more were in pipeline. About 12 conventional banks have opened stand-alone windows for Islamic banking. These banks include multinational banks like Standard Chartered. Currently there are about three more banks who are planning to do the same; they include another multinational bank and a pair of local banks.

All the major banks, like Habib Bank Ltd., MCB, Askari Commercial Bank, Bank Alfalah and United Bank, have their separate Islamic banking branches. Presently the assets of Islamic banks in Pakistan are estimated to be about Rs.109 billion. “We have 150 branches of Islamic banks in 25 cities across Pakistan. Market share of total industry assets of Islamic banks is about 2.8%,” says the SBP director of IBD, Mr Said. He further says this share of assets is quite encouraging, when we make comparisons to other countries. For example, over the same period, Indonesia has built up a market share of assets of 1.7%, while Malaysia, which started Islamic banking about 23 years ago, has gained 12% of the market with islamic banking operations. Bahrain started about 30 years ago, and Islamic banking concerns there have a market share of about 20%.

“Currently, no new licenses for conventional banking have been given for the last two or three years, and now licenses are being given only for Islamic banks. Presently, we have not stopped issuing Islamic banking licenses, and if a player can demonstrate that it is offering a value-adding product, we consider them,” says Mr Said.

The SBP has established a Shariah Board comprising two Shariah scholars and three experts in the areas of banking, accounting and law to advise it on modes, procedures and regulations for Islamic banking to ensure both Shariah compliance and the smooth operation of Islamic banks. Similarly a Musharakah-based Export Refinance Scheme has been designed by the State Bank to provide export financing to eligible exporters on the basis of Islamic modes of financing.

Still, the fact there is no proper ruling from the higher courts against interest-based banking means that the two systems continue to run simultaneously — and many observers believe that there is no immediate hope for a fully operational Islamic banking system in the country. So, in the meantime, while it looks as if progress is being made behind the scenes, all the stakeholders, including the government, the SBP and the private banks, are waiting for a decision from the FSC on the status of interest-based banking in Pakistan.