Islamic Banking Industry of Pakistan Gaining Significance

Ever since the establishment of Pakistan in 1947, there was great zeal to introduce Islamic institutions in the socio-economic milieu of the country. Muhammad Ali Jinnah, the First Governor General of the country stated in his address at the inauguration of State Bank of Pakistan:

The adoption of Western economic theory and practice will not help us in achieving our goal of creating a happy and contented people. We must work our destiny in our own way and present to the world an economic system based on true Islamic concept of equality of manhood and social justice. We will thereby be fulfilling our mission as Muslims and giving to humanity the message of peace which alone can save and secure the welfare, happiness and prosperity of mankind.

Nonetheless, political turmoil in the early years did not allow adequate attention to this vision. Afterwards, given the increased focus in 1970s around the Muslim world to develop an Islamic financial system for Muslims, positive effects were also felt in Pakistan. On the regulatory front, the 1973 constitution of Pakistan in Section 38(f) stated that Riba should be eliminated as early as possible. On the theoretical front, the Pakistan Council of Islamic Ideology in its 1980 report on the elimination of interest from the Pakistan economy clearly defined Riba and suggested that steps should be taken to replace Riba based banking with an Islamic alternative. The report stated: “The term Riba encompasses interest in all its manifestations irrespective of whether it relates to loans for consumption purposes or for productive purposes, whether the loans are of a personal nature or of a commercial type, whether the borrower is a government, a private individual or a concern, and whether the rate of interest is low or high.” Later on, the Historic Judgment on Interest in 1991 by the Supreme Court of Pakistan settled the debate both in academics as well as in legal sphere. However, lack of political will by the subsequent governments has still remained as a hurdle in the way of replacing the interest based banking system with an Islamic one. Nonetheless, Islamic banking had begun its journey. The country’s first full-fledged Islamic bank, i.e. Meezan Bank was established in 2002.

The basic structure of Islamic banking in Pakistan can be briefly summarized as follows. Initially, an Islamic bank establishes a pool of assets. The asset pool consists of funds contributed by the shareholders and the depositors. Deposits include two further classifications, i.e. remunerative deposits and non-remunerative deposits. Remunerative deposit funds are mobilized by the Islamic banks through partnership mode of Mudarabah. In Mudarabah, the depositors act as Rabb-ul-Maal (financier or investors) and the bank acts as Mudarib (fund manager). Profit sharing ratio is agreed at the start of this partnership for each period. Non-remunerative deposits are mobilized using Qard (non-compensatory loan). This pool of assets is used to provide asset backed financing. These financing assets are based on different underlying financing contracts, such as lease based contracts (Ijarah) and credit sale based contracts (Murabaha, Salam and Istisna).

In all such financing contracts, the Islamic bank does not lend money. It provides asset backed financing in which the asset is owned by the bank. Income is earned either through profit on credit sale and rental income from the sale and lease of assets respectively. From economic theory, we know that savings is part of income which is not consumed in a period, while investment is expenditure on fixed assets (real estate and capital equipment) in a period. Asset backed Islamic banking tries to ensure that savings convert to investment naturally and necessarily. According to a World Bank study, Muslims are significantly less likely than non-Muslims to own a formal account or save at a formal financial institution. For instance, in countries like Afghanistan, Morocco, Iraq, Niger and Djibouti, the percentage of adult population with no bank accounts based on religious reasons stands at 33.6%, 26.8%, 25.6%, 23.6% and 22.8%, respectively. In a lot of populous Muslim-majority countries, the savings ratio is very low. Part of the reason why savings culture is weak, is that people do not want to invest in interest-based investment options. The sustained increase in deposits growth in Islamic banking, wherever it is being offered, substantiates this. Hence, if Islamic banks increase their outreach, Muslim economies will also benefit by reducing their savings–investment gap.

Currently, Islamic banks in Pakistan use the same interbank benchmark rate, i.e. Karachi Interbank Offered Rate (KIBOR). It is used for pricing assets in credit sale for profit determination and computing necessary amount of rentals to amortize the cost of assets during the lease period. Income from the sale or lease of real assets is distributed among the contributors in asset pool, including bank’s shareholders and depositors. To achieve spreads for financial intermediation function, profit sharing is done between the bank and the depositors as per the pre-agreed profit sharing ratio. Currently, Islamic banking in Pakistan is an established industry with 11.7% and 13.3% market share in total banking assets and deposits respectively as at December 31, 2016. The industry experts are further aiming at a 20 percent market share for Islamic banking in the overall banking industry by 2020. There are 5 full-fledged Islamic banks operating in the country along with 16 conventional banks with Islamic banking branches. The market share of Islamic banking assets has grown from a meagre 0.5% in 2002 to 11.7% in 2016. By year-end 2016, the total Islamic banking assets in Pakistan stood at Rs 1.85 trillion ($17.65 billion) while the total Islamic banking deposits stood at Rs 1.57 trillion ($15 billion). With increased participation of conventional banks in Islamic banking industry, the branch network has swelled to 2,322 branches by year-end 2016. With the launch of innovative products like Running Musharakah, now the Islamic banking is catering to the working capital needs of corporate sector. This has also helped the industry to make effective use of equity based modes of financing and reduce the share of debt based modes of financing.