Islamic Banking and Finance in Pakistan At Cross Road

Former Member of IFSB on Islamic Money Market, Former Head of FSCD SBP, Former Head of Research Arif Habib Investments, Member visiting Faculty/ KASBIT/BIZTEK/Sheikh Zayed Institute University of Karachi/PAF KIET/MAJU

There is a popular belief that Islamic finance or banking is for Muslims for their personal satisfaction and for getting “ Janat” in the world and above.Contrary to this itis not so in its complete sense. In Quran it has been repeatedly said that “Allah” means for all living on this planet. So if Islamic Banking and finance is implemented in real sense than it can serve all human beings irrespective of the fact whether they are Muslims or not. But for that we have to lay its foundations on an ethical and fair financial system, which consequently affects the socio-economic conditions of the market  with the objective to come up with socio economic justice for all.

Yet, this stance is not as clear as how it should replace the centuries old financing methods firmly embedded within the economic system and how it is going to tackle issue of inflation or time value of money.

Islamic Banking started in 2000 in Pakistanyet needs direction. Every PM or Finance Minister or Governor of SBP come with a pledge that soon Islamic Banking is going to steer the whole financial system. For instance in his recent speech Governor SBP has indicated that NIBAF as training arm of SBP is going to make breakthroughsby bringing new expertise in Islamic finance. But then we see almost all trainers in universities and training centers either Sharia scholars or bankers come up with their old mindset i.e.living in mercantile era. This is just waste of time. If repeatedlyyou are saying that main hurdle in Islamic Banking is lack of awareness, than it meanssomewhere you are making mistake. It is now a universal truth that we have used Islam for our business needs i.e. to mint money that is why we are going down and down on economic front with poverty on increase and every one standing with a gun toimplementIslamic system. Islam has never spread by force but has been spread with logic and new ideas. If we have to move forward than we have to leave behind Mercantile era ashas been done by the west in the 18^th and 19^th centuries. Just few days back I was seeing some Islamic experts and businessmen sitting on TVs saying that by adopting Islamic Banking “Barkat”has comein their “Karobar”. Than what about Warren Buffet and Bill Gates who have earnedbillions of dollars without touching Islamic Finance. So we should come on ground, allow changes and find new products to make Islamic Finance popular and purposeful.

First of all market is confronted with the issue of lack of awareness about concept of Islamic banking since it has been commercialized fairly instead of adopting right course of action. Banks and asset management companies are still struggling with how better to portray Islamic products for consumers’ understanding in minimal ad spaces. There is also a communication gap between the Sharia councils issuing the fatwas pursuant to Islamic Finance, and the managers devising products and drafting the advertisements.

Above all the  bigger issue is that even financial advisors lack awareness of the concepts behind Islamic finance. If you ask any financial expert to come up with the merits of funds in which one wants to make some investments – the difference between conventional funds and Islamic funds. The answer would be a disappointing “nothing!”

An instant answer to the question would be the often-repeated phrase – ‘Islamic products do not offer interest (Riba)’. The statement is without doubt true, but this is not the sum total of Islamic finance.

Riba is indeed deemed haram in Islam, for the reason that it is ‘unfairly’ exploitive in nature. It is ‘unfair’ because Riba requires the lender to return the borrowed money, plus an extra amount. This requires the borrower to work harder to return not just the principal, but also the interest or mark-up levied on the amount. But in real terms borrowers from a bank has to return the principal with some additional amount which they call profit or markup but not interest.  So what is the difference.

Secondly, interest is set arbitrarily. The concept treats money as a tradable entity which fluctuates volatilely in the markets. There is no set ceiling; meaning that loaning money may become cripplingly expensive for the borrower.

Thirdly according to different Fiqahs, Riba is being defined differently. In Iran it is different,In Malaysia it is different. In Pakistan GCC and Sudan it is different. Even on mode of Wakalah PakistaniSharia scholars have different definition from GCC. Further on defining Ribacase is still pending in Pakistani courts in spite of the fact that Supreme Court has defined the definition as “above to principal”.  What can be the solution. In presence of Sharia Scholars in different Muslim Countries it is bit difficult to arrive on one definition. So how we can make it an international alternative to current conventional system is a question for all.

Islamic financing is asset-backed and believes that only assets with an intrinsic value may be sold for a profit, instead of exchanging money – which is considered to have no intrinsic value – for interest. Each unit of money has the same value as the other of the same denomination, which is simply why there cannot be a profit on its exchange. Hence, Islamic finance lays its foundation on real, non-liquid assets; the exchange and sales of which result in ‘fair’ profits. However mostly they follow conventional benchmarks so one cannot say with its certainty about their actualfairness

Moreover the problem starts from onward when we categorize Islamic financing products in to two categories i.e. Non debt based as Musharakah, Mudarbah and Ijarah and Debt based  as Salam, Diminishing Musharakah, Murhabah, Istisna and others. The products as debt based are difficult to trade as theyrequire different documents to be agreed and signed. This makes them basically non tradable. Now realistically every country and in Pakistan we see almost 80% financing based on debt based products i.e. Murhabah or Diminishing Musharakh. With this how you can perceive an Islamic Money or long term debt market. For this no formidable solution has been arrived as yet.

On equity side differentpractices exist in different countries that how much debt can be accepted for a company to consider it as Islamic. In Pakistan this ratio is 30 to 70 i.e. 30% debt but in Bahrain and other countries the ratio is different.

By taking in to account these facts Stakeholders in the industry must now step forth and present a clear picture of Islamic finance: one which presents it as a way of rethinking economics and finance, instead of just as a cosmetic solution tailor-made for religious investors finicky about where their money is going.

An important characteristic of Islamic banks is that they arein general prohibited from trading in financial risk products, such as derivative products but they can go for hedging as per some scholars but still knowledge is very limited on this. Inorder for banks and their clients to comply with Sharia, though over the past decades, specific productshave been developed that avoid the concept of interest and imply a certain degree of risk-sharing but still the tilt is towards debt based products that are almost similar to conventional products and hard to trade.

One important feature is the pass-through of risk between depositor and borrower.Among the most common Islamic banking products are partnership loans between bank andborrowers. Under the Mudaraba contract, the bank provides the resources, i.e. the “loan”, whilethe client – the entrepreneur – provides effort and expertise. Profits are shared at apredetermined ratio, while the losses are borne exclusively by the bank, i.e. the entrepreneur iscovered by limited liability provisions. While the entrepreneur has the ultimate control over hisbusiness, major investment decisions, including the participation of other investors, have to beapproved by the bank. This is the flaw that in case of loss it has be borne by the Rabul Maal i.e. depositor or bank and not by theentrepreneurthus shifting overall risk towards depositor or bank.  The Musharaka contract, on the other hand, has the bank as one ofseveral investors, with profits and losses being shared among all investors. This partnershiparrangement is mirrored on the deposit side, with investment accounts or deposits that do notimply a fixed, preset return but profit-loss sharing. Such investment deposits can be either linkedto a bank’s profit level or to a specific investment account on the asset side of a bank’s balancesheet.However the banking based on Musharkah is almost nonexistent.

An alternative is the Murabaha contract, which resembles a leasing contract inconventional banking. By involving the purchase of goods, it gets around the prohibition tomake a return on money lending. As in leasing contracts, the bank buys an investment good onbehalf of the client and then on-sells it to the client, with staggered payments and a profit marginin the form of a fee. Similarly, operating leases (Ijara) where the bank keeps ownership of theinvestment good and rents it to the client for a fee are feasible financial transactions underSharia is the legal framework within which the public and private aspects of life are regulated for those living in alegal system based on fiqh (Islamic principles of jurisprudence) and for Muslims living outside the domain. But mostly these transactions are paper based and do not bring any impact on country’s economy.

The discounting of IOUs and promissory notes is not allowed under Sharia-lawas it would involve indirect interest rate payments, a similar structure can be achieved bysplitting such an operation into two contracts, with full payment of the amount of the IOU on theone hand, and a fee or commission for this pre-payment, on the other hand.On the deposit side, one can distinguish between non-remunerated demand deposits(amanah), seen as depositors’ loans to the bank– thus similar to demand deposits in manyconventional banks around the world – and savings deposits that do not carry an interest rate, butparticipate in the profits of the bank. However, according to some Islamic scholars, banks areallowed to pay regular bonuses on such accounts. Investment accounts, finally, and as discussedabove, mirror the partnership loans on the asset side, by being fully involved in the profit-loss risk. As can be seen two contract concept make the transaction bit difficult and both sides taxable making it a costly proposition.

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Mostly or ironically the products offered by Islamic banks are the same as inconventional banks (demand deposits) and other are structured in similar ways as conventionalproducts (leasing products), there is a strong element of equity participation in Islamic banking.How do these products fit with the traditional picture of a bank as financial intermediary?Transaction costs and agency problems between savers and entrepreneurs have given rise tobanks in the first place, as they can economize on the transaction costs and mitigate agencyconflicts. Banks face agency problems on both sides of their balance sheet, with respect to theirdepositors whose money they invest in loans and other assets and where the bank acts effectivelyas agent of depositors, and on the asset side where borrowers (as agent) use depositors’ resourcesfor investment purposes. The debt contract require deterministic monitoring (in case of default).In addition, however, banks face the maturity mismatch between deposits, demandable on sight and long-term loans, which can result in bank runs and insolvency.

How does the equity component of Islamic banking affect these agency problems is another question? Onthe one hand, the equity-like nature of savings and investment deposits might increasedepositors’ incentives to monitor and discipline the bank. At the same token, the equity-likenature of deposits might distort the bank’s incentives to monitor and discipline borrowers as theydo not face the threat by depositors of immediate withdrawal. Similarly, the equity-like character of partnership loans can reduce the necessary discipline imposed on entrepreneurs by debt contracts. The equity character of banks’ asset-side of the balance sheet, however, might alsoincrease the uncertainty on depositors’ return and increase the likelihood of both uninformed andinformed bank runs. This is exacerbated by the restrictions that banks face on terminatingpartnership loans or restricting them in their maturity.Given the agency problems that the equity character of some Islamic banking productsmight entail, Islamic banks have designed alternative contracts, where clients are allowed toretain profits completely until a certain level is reached, while at the same time the bank is notallowed to receive more than a fixed fee and the share of profits until another threshold level ofprofits is reached. This effectively can turn a profit-loss arrangement into a debt-like instrument.

In reality therefore, many Islamic banks offer financial products that, while being Sharia compliant,resemble conventional banking products. It is unclear, however, whether theyeffectively are structured as such, thus providing the same incentive structure to depositors,banks and borrowers as conventional banks, or whether the equity-like character is still present,thus impacting the incentive structures of all parties involved.

What do the different characteristics of Islamic and conventional banks imply for theirrelative business orientation, efficiency, asset quality, and stability is another question ? Take first businessorientation; the Sharia-compliant nature of Islamic bank products implies a different businessmodel for Islamic banks that should become obvious from banks’ balance sheets and incomestatements. We consider three aspects: the relative shares of interest and non-interest revenue,the relative importance of retail and wholesale funding and the loan-deposit ratio. On the onehand, there might be a higher share of non-interest revenue in Islamic banks as these banks mightcharge higher fees and commissions to compensate for the lack of interest revenue. On the otherhand, the share of revenue related to non-lending and including investment bank activities shouldbe significantly lower for Islamic bank. The overall implications for the relative share of interestand non-interest revenues in total earnings are therefore a-priori ambiguous. Similarly, in termsof retail vs. wholesale funding, there is a-priori no clear difference, as Islamic banks can rely onmarket funding as much as conventional banks, as long as it is Sharia-compliant. Similarly, thedifference in loan-deposit ratios across bank types is not clear a-priori.

In terms of efficiency, it is a-priori ambiguous whether conventional or Islamic banksshould be more efficient. On the one hand, monitoring and screening costs might be lower forIslamic banks given the lower agency problems. On the other hand, the higher complexities ofIslamic banking might result in higher costs and thus lower efficiency of Islamic banks.On theone hand, the pass-through role and risk-sharing arrangements of Islamic banks might be a risk reducingfactor. Specifically, interest rate risk – well known feature of any risk management tooland stress test of a conventional bank – should be absent from an Islamic bank. In addition,adverse selection and moral hazard concerns might be reduced in Islamic banks if, depositors have stronger incentives to monitor and discipline. Further, Islamic banks canbe assumed to be more stable than conventional banks, as they are not allowed to participate inrisk trading activities. This however, also points to the importance ofcontrolling for the importance of non-lending activities in conventional banks. On the otherhand, the profit-loss financing increases the overall risk on banks’ balance sheet as they takeequity in addition to debt risk. In addition, the equity-like nature of financing contract mightactually undermine a bank’s stability as it reduces market discipline.

Further, operational risk aspects might be higher in Islamic banks stemming from thecomplexities of Sharia law and including legal and compliance risks. In nutshell, it is a-priorinot clear whether Islamic or conventional banks are more or less stable than conventional banks.

Summarizing, currently we do not have clear answers whether and how the businessorientation, cost efficiency, asset quality and stability differ between conventional and Islamicbanks. This ambiguity is exacerbated by lack of clarity whether the products of Islamic banksfollow Sharia in form or in content. Mostly they exist in shape of form.

In nut shell than why we may go for Islamic Banking. Away from issue of belief, in reality it can bridge monetized part of economy to real sector,the clash of which havebrought the 2007 global recession. Secondly it can put a ceiling on government borrowings since they always stand with short of assets required for the borrowing and thirdly under this no one is allowed to go for gambling or haram business thus bringing social discipline in societies. As regards its featuresmost of it would be entrenched on current economic models whether one likes it not. Only they require to be refined for the betterment of the society and in accordance with provisions of Quran and Sunnah with Ijtiahd and not taqleed. It is the same as bodily, every mankind whether Muslim or non-Muslim have the same biological features. The difference lies in their tackling the matters differently.Thus for getting there Islamic Banking requires new direction based on research to find out new ways and products to deal with every part of economy.

Comparison as of Feb 2015 Pakistani Banks
Rs in billions	Conventional Banks	Islamic Banks	Islamic Banks share in % (total Market)
Assets	10446	1259	10.75
Deposits	6707	1070	13,75
Investment in Govt Securities	4474	267	5.63
Loan to Non-Government sector	4106	125	2.95
Loan to private sector	3485	422	10.80

Financing Mix of Islamic Banks in Pakistan Feb 2015
	Amount Rs in billion	Share in %
Murabaha	127.2	30.1
Ijarah	32.3	7.7
Musharaka*	46.5	11.0
Mudaraba	0.2	0.1
Diminishing Musharaka (DM)	137.7	32.6
Salam	19.2	4.5
Istisna	35.2	8.3
Qarz/Qarz-e-Hasna	0.0	0.0
Others	23.8	5.6
Total	422.1	100.0