Future of Islamic Banking

Posted on May 28, 2021

Muhammad Arif : Chairman Centre of Advisory Services for Islamic Banking and Finance (CAIF), Former Head of FSCD SBP, Former Head of Research ArifHabib Investments and Member IFSB Task Force for development of Islamic Money Market, Former Member of Access to Justice Fund Supreme Court of Pakistan

Currently, though size of Islamic Banking is small as compared to conventional banking but its growth is imminent. Right now it is acceptable to customers because!

(1)Islamic banking is just another way of banking. (2) Islamic banking offers a better financial architecture, on economic grounds.

It is also well-known in traditional finance that interest-based debt finance is an important source of economic instability, as compared with equity finance.  Last but not the least, direct linkage between financing and application of funds under Islamic banking will mean an end to credit or untied cash, as found in the existing interest-based economies. Thus, an important cause of mismatch between aggregate demand and aggregate supply in the economy will be removed. This will mean less demand-pull inflation.

On the other hand, linkage of financing to economic activity will help in easing supply constraints in the economy. This will result in, among other things, employment generation. These considerations lead us to conclude that frequency, intensity and duration of business cycles will be less with Islamic banking.

Islamic banks will become pure financial institutions that fill financial gaps standing in the way of real economic transactions at the grassroots level. The following economic factors will lead to this development. Practitioners of Islamic banking will recognize that efficiency and gains lie in specialization. They will, therefore, delegate to third parties responsibility for field operations in lieu of a financing transaction, of course, in return for a charge. In some cases, such as taking physical possession of a thing in trade- or lease-based financing, this third party may be the bank’s client himself. This is likely to happen because economies of scales enjoyed by third-party specialized institutions will reduce operational costs for the banks. In the end, one expects Islamic banks institutions to touch the economic landscape only on the financial plane, i.e., become pure financial institutions—while acting as economic agents. Notwithstanding the above, regulators also need to recognize the inherent danger.

 Islamic banks, as already seen, provide financing by coming in the picture as traders, lessors or partners. This factor along with their ability to muster sizeable funds can have potentially damaging implications. For example, if there are no checks on the scope of trading operations of Islamic banks, mega traders will emerge as the expense of small traders and businesses.  This monopoly problem can be addressed through limiting the role of Islamic banks to financing matters only.

Islamic banking is ethical banking for, among others, the following reasons: (1) Islamic banks will stay away from financing Shari’ah-proscribed activities—producing alcohol or financing speculative activities, for example. (2) There will be transparency in their transactions with the clients— depositors as well as fund-seekers—due to compliance with the Shari’ahAhkam on gharar. Islamic banks will also contribute to social welfare of the economy to the extent Ahkam on zakah would apply to them. But beyond this, generally they shall be pure economic institutions established by their owners for profit earning. Of course, individually some Islamic banks may specialize in participatory modes of financing modes due to some religious convictions of their owners. But there is no Shari’ah compulsion for this. Islam allows banks to exploit all halal ways to their advantage, of course, subject to willing consent of the all concerned in a given transaction.  As for Islamic banks doing charity, the thinking needs to be set straight. A bank’s money (deposits plus bank capital) belongs to its depositors and shareholders. Prior permission of the ultimate owners is a must for any charity. The same principle applies to profits earned through financing operations in which capital stakes of depositors, and may be the bank’s shareholders, are involved. Technically speaking, bank management may exercise some discretion for charity with prior permission of the shareholders and the depositors. But getting such a mandate is practically not possible because both the group of bank shareholders and that of bank depositors continuously keep on changing.

In Pakistan Islamic banking has 5 full-fledged Islamic banks (IBs) and 17 conventional banks having standalone Islamic banking branches (IBBs), the branch network of IBIs is 3,456 branches. Their assets are Rs 4,269billion with 17.0 % Share in Overall Banking Industry. Their deposits are Rs 3,389 billion with 18.3%Share in Overall Banking Industry. Their net financing and investments are 3,142 billion.

However still Islamic banks after having spent a decade of Islamic banking operations in Pakistanhave to reflect on answers to the following points:

  1. How justified are high Islamic  banking  spreads  (difference  between  averagefinancing  and  average  deposit  rates higher thanconventional banks in Pakistan?

  1. How justified is  the  argument  to  seek  special  privileges  from  the  regulatorswhen Islamic banks use the same benchmark rate, but the difference is that theirspreads (margins) are even higher than conventional banks?

  1. How do they justify their position and analyze their performance on social andegalitarian grounds when  most  of  their  products  are  priced using  the  samebenchmark of the conventional banking industry, which is KIBOR?

  1. Trust and documentation problems do not hinder more than 700 companies  to  get registered  on  Pakistan Stock  Exchange  while  thousands  of  public  limitedcompanies are operating in Pakistan as well. Why Islamic financial institutionscould not help support more IPOs either through investment banking operationsor alternate institutional structure.

Further piecemeal solutions to eliminate interest from the financial sector of Pakistan cannot succeed. It concludes that all intellectual, practical, political, constitutional and legal efforts undertaken in Pakistan to enforce an interest‐free system were not meant in earnest and therefore they inflicted serious damage to the cause of Islam as well as Islamic banking. Interest is prohibited in Islam for its exploitative nature. In case of Pakistan, interest institution is not only deep‐rooted, but also strongly interlinked with other exploitative tools that are prevalent in the hands of some selected people to keep their control over political, economic and social spheres of Pakistan. There is an indispensable need to eradicate interest along with its allied forces from the polity of Pakistan. The practical success of interest‐free banking and finance movement in Pakistan could not be materialized unless the state and polity of Pakistan are not convinced seriously to discover the paradigm of their personal and state institutions based on Islamic guidance and principles.

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