The Evolution Of Islamic Banking Industry In Pakistan

Pakistan is one of only three countries to have expressly committed themselves to the Islamisation of the economy. This has not been a resounding success, primarily because the objective was overly ambitious and the infrastructure was unable to support it. However, since 2001, Pakistan has adopted a more measured approach to developing a vibrant Islamic financial industry in the country. Usman Ahmad looks at the evolution of Islamic banking in a little more detail.

 

The global Islamic finance industry has witnessed considerable growth over the last four decades. At present, the Islamic financial industry operates in more than 75 countries across the world and boasts an asset base of over US$ 1.3 trillion. It is pertinent to note that demand for Islamic finance is not just confined to Muslim states but also exists in non-Muslim countries.

Pakistan is one of the few countries to have undertaken the ambitious aim of Islamising the banking system. The process began in the 1960s but made considerable headway in the 1980s (for details of key historical developments of the Islamic finance industry in Pakistan see Table 1). It is important to note that this attempt achieved only limited success. The abrupt conversion of the whole banking system from riba based to Shari’a based without developing an adequate infrastructural framework and improving the human resources capacity weakened long-term efficacy and sustainability.

The Role of the State Bank of Pakistan

In 2001, policymakers adopted a more phased approach in converting the banking system to interest-free. This time the process of conversion was adequately planned providing a comprehensive legal, regulatory and Shari’a compliance framework. The new paradigm was based on a model that allowed four types of Islamic banking institutions:

1. Fully fledged Islamic banks;
2. Islamic banking subsidiaries of conventional banks;
3. Islamic banking branches (IBBs) of conventional banks;
4. Conventional banks having Islamic banking branches were also allowed to have Islamic banking windows in their conventional branches.

It is important to note that in this second phase of transformation, SBP has been spearheading initiatives for the development of the industry. SBP has been playing the

dual role of both regulators

as well as a facilitator. Some of the initiatives taken by SBP are as follows:

1. SBP issued policies for the formalisation of Islamic banking practices in 2003. These included stipulating eligibility criteria, licensing requirements, and producing guidelines on the physical set-up along of the bank, Shari’a compliance procedures and other operational matters of the banks.
2. a comprehensive Shari’a compliance framework was introduced by SBP for Islamic banking institutions that required:
3. Shari’a board at the SBP;
4. a designated Shari’a advisor at

individual banks;

 

It is important to note that SBP is one of the very few central banks that initiated Shari’a inspections. Before the official endorsement of Shari’a inspections, a comprehensive Shari’a inspection manual was developed and training was imparted to the Shari’a inspectors.

1. For encouraging Islamic microfinance in the country, SBP has allowed the establishment of full-fledged Islamic microfinance banks, Islamic microfinance services by full-fledged Islamic banks and Islamic microfinance divisions in conventional microfinance banks.
2. SBP communicated essentials of major Islamic finance products and instruments along with their model agreements to Islamic Banking Institutions

(IBIs). However, SBP has allowed IBIs to develop their own products with the approval of their Shari’a advisor while ensuring adherence to the essentials. SBP has also adopted five Shari’a standards of the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) after customisation in accordance with the local conditions in order to bring harmony and to make local industry at par with the global Islamic finance industry.

• Risk management guidelines for IBIs based on Islamic Financial Services Board (IFSB) standards were issued. These guidelines cover all major risk categories while providing best practices for establishing and implementing risk management in IBIs.
• SBP is actively engaged in capacity building through various promotion and training programs. These initiatives are undertaken in collaboration with reputed multilateral institutions such as IFSB, AAOIFI and International Islamic Financial Market (IIFM). These initiatives are helping in enhancing awareness and im- proving the depth of the talent pool in Pakistan.

• SBP is currently working on the development of a liquidity management framework for the Islamic banking industry. In collaboration with the local industry, efforts are being made to develop a framework aimed at encouraging Islamic banks to offer participatory mode-based financing. It will help to create more musharaka-based models.

Industry Progress and market share Since 2001, the Islamic banking industry has shown strong momentum registering a high annual growth rate. In the last few years, the growth rate has been 30 percent. Currently, Islamic banking assets constitute around a 7.8 percent market share of the overall banking industry reaching Rs. 641 billion in December 2011 compared to Rs. 477 billion a year earlier. Growth in assets is mainly made up by financing and investment that together grew by 40.4 percent on Year on Year (YoY) basis (Rs. 475 billion in December 2011 compared to Rs. 338 billion in December 2010). Similarly, total deposits in the Islamic banking industry in Pakistan have registered substantial growth over the years and reached Rs. 521 billion in December 2011 thereby constituting a market share of 8.4 percent of the overall industry.

As of December 2011, 5 full-fledged Islamic banks and 12 conventional banks with Islamic banking branches are operational in the country. There are 886 Islamic branches in more than 70 districts across the country. Growth is likely to gather further momentum with increasing awareness and expansion of Islamic banking networks in second and third-tier cities.

In terms of profitability, the profit of the Islamic banking industry crossed Rs. 10 billion mark for the first time in December 2011. Despite the successes, there are still some areas in the Islamic banking industry that need to be addressed. For example, the

the concentration of financing in only a few sectors, and the rising non-performing finances (NPFs) to financing ratio, though less than the the

overall banking industry, are some of the key issues faced by the industry.

The domestic Sukuk market has shown substantial growth over the years. As of March 2011, sukuk worth more than Rs. 436 billion have been issued in the domestic market. A large portion of this issuance (nearly 76 percent) has come from the Government of Pakistan (GoP) ijara sukuk programme. Since the

auction of the first GoP ijara sukuk in 2008, a total of 10 ijara sukuk have been issued, amounting to Rs. 333 billion. The issuance of sovereign sukuk has witnessed an upsurge since November 2010 as 6 GoP ijara sukuk have been issued since then amounting to above Rs. 290 billion. The issuance of sovereign sukuk has helped

not only by providing a much-needed benchmark but also enhanced liquidity management and improved asset quality for IFIs. These high-yielding sukuk have provided a good and stable source of funds to governments and have also encouraged Islamic banks to change their asset structure by shifting their investment from interbank placements (low-return investment avenues) to these Islamic bonds, particularly since November 2010. There are now regular auctions of GoP sukuk.

Despite showing strong growth momentum, the Islamic banking industry is still confronted with several key challenges that need to be overcome in order to sustain the high growth trajectory. Some of these issues are:

1. Despite making a significant contribution to GDP, small and medium enterprises (SME) and agriculture are still underserved sectors in terms of access to finance. By targeting these underserved sectors, Islamic banks can not only increase their depth and breadth but also foster higher financial inclusion levels in the country. SBP has already issued a salam-based product for an agricultural firm and is working with the industry to develop more products. Moreover, Islamic micro-finance is another potential area that can be explored for serving the underserved and deprived population of the country.
2. IBIs in Pakistan, like their international counterparts, need to address the limited availability of instruments to manage their liquidity requirements.
3. A large number of unbanked citizens prevails in the country, either due

to low penetration of the banking system or due to voluntary exclusion. Such potential clientele of the banking system can be tapped by the Islamic banking industry specifically in rural areas. In this context, SBP has recently provided a revised definition of rural areas to help the Islamic banking industry increase its outreach.

Since its re-launch in 2001, the Islamic banking industry in Pakistan has made significant strides forward with both assets and deposits recording a significant increase. A large part of this success has been due to the facilitative role played by the SBP in terms of providing a comprehensive legal, regulatory and Shari’a compliance framework. By adopting a dynamic expansion policy that is inclusive in nature, the Islamic banking and finance industry in the country can significantly increase its outreach while fulfilling the social ethical and moral values embedded in the Islamic economic system. Against this backdrop, it is likely that the Islamic banking industry in Pakistan is going to sustain its growth momentum in the near future. However, a lot will depend upon political will and prudence to fully effectuate a beneficial outcome for Islamic finance.