An overview of Islamic financial industry in Pakistan

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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.

Pakistan has a fairly developed IF industry that is bank dominated. At present, the IF Industry of Pakistan consists of IBs, Islamic microfinance institutions, Sukuk, Modarabah companies, and Islamic funds, 22 Takaful companies, and Islamic Real Estate Investment Trusts (iREITs).

The IB sector which dominates the financial industry assumes a variety of forms, including full-fledged IBs and conventional banks offering IB products through subsidiaries, branches and/or windows.

The Sukuk market, which is the second largest segment, is driven mostly by sovereign issuances and is followed by Islamic funds, which include pension and other mutual funds. The Takaful (insurance and reinsurance) and Islamic micro-finance sector are still very small.

IB in Pakistan has been growing very fast since its relaunch in 2001. Though still in an evolutionary phase, Pakistan’s IB industry expanded at a CAGR of nearly 50 percent between 2002 and 2015, and reached a market share of 11.4 percent by end 2015 and 14.5 percent by Dec 2017 in deposits of overall banking system .

Facilitative regulatory support has been propelling the growth of Pakistan’s IB sector. The large Muslim population and low market penetration also suggest that there is substantial upside potential for further growth. About 97 percent of Pakistan’s population of 199 million is reported to be Muslim and the World Bank Findex data show that only 13 percent of the adult population has a bank account. The central bank has also devised a strategic plan for the IB Industry to reach 15 percent of banking system assets by end 2018.

IBs in Pakistan derive their business mainly from the domestic market, thus domestic economic developments drive their performance. At end December 2017, 5 full-fledged IBs and 16 conventional banks having Islamic windows comprised of 2581 branches exsit. Selected IBs have subsidiaries of investment banks and associate mutual funds, thereby making consolidated supervision materially important. The industry offers a wide array of products, and risk-sharing financing has increased to a sizeable share.

The asset base largely comprises of financing, investment and, to some degree, interbank placements. Financing instruments are almost equally divided between trade based products such as Muraba?ah, Ijarah, Salam Istisna and equity products based on Musharakah and diminishing Musharakah whereas Mudarabah has been miniscule. The major share of financing is utilized for manufacturing activities whereas exposure to the real estate sector 22 Modarabah companies are a two-tier fund structure, for undertaking Sharia compliant businesses. This structure of assets suggests that credit, investment, liquidity and operational risks are material risks for the IB sector and for supervision.

The IBs have a healthy domestic funding base. Close to 85.3 percent of the assets are funded by customer deposits, and about 63 percent are PLS deposits accounts based on Mudarabah contracts while current accounts are mostly based on Qard. Funds due to OFIs account for a very small share. The funding is mostly in local currency, thus exchange rate risk is low. Sukuk issuance by banks and other long term funding appear limited, thereby potentially creating maturity mismatches with financing structure.

IBs in Pakistan exhibit strong financial fundamentals. For five -fledged IBs, the CAR was 12-13 percent at end 2018, significantly above the prescribed minimum of 10 percent but below conventional banks. The NPF ratio (gross) of 3 percent is significantly below the average for conventional banks of 8.4 percent.

IBs are also profitable and liquid but the profit margins and liquidity levels are, however, lower than their conventional counterparts.

Regulation of both Islamic and conventional banks is governed by the Banking Companies Ordinance (BCO) 1962 as amended.

The BCO was amended in 2002 to authorize the “carrying on of banking business in conformity with the injunctions of Islam”. The amendments were supplemented with detailed guidelines for establishing full-fledged IBs, subsidiaries and branches. Conventional banks are also allowed to offer IB services through stand-alone branches/window operations, with nominal capital allocation from their existing capital based on RWA of these branches. IBIs are allowed to offer PLS deposit accounts similar to URIAs.

The State Bank of Pakistan (SBP) has a single integrated regulatory framework that applies to all banks with provisions specific to IB. Full-fledged IBs are subject to the same prudential requirements as conventional banks, including the Minimum Capital Requirement (MCR) regime, the minimum CAR, large exposure, loan classification, provisioning and related party lending. The SBP has issued detailed licensing criteria, instructions for Profit & Loss Distribution and Pool Management to improve transparency and safeguard interests of IAHs. It has also adopted the IFSB-1 on risk management, partially adopted the IFSB-4 on transparency and 6 of AAOIFI Sharia standards while banks are required to use the remaining AAOIFI Sharia standards as guidelines with approval of their Sharia Boards. The SBP has tailored some of the macro prudential policies for IBs.

Reforms of the capital and liquidity frameworks are on-going. The SBP is developing instructions for adoption of implementation of Liquidity Coverage Ratio (LCR) under Basel III Liquidity guidelines, HQLAs and run-off rates in line with the BCBS. The SBP is reviewing the IFSB-15 on capital standards for IBs and plans to roll it out after conducting a Quantitative Impact Study (QIS) and soliciting feedback from stakeholders.

Considerable progress has also been made to strengthen corporate and Sharia governance. The SBP has adopted the IFSB 3 on corporate governance, and the IFSB 10 relating to Sharia Governance. The Sharia compliance system is well-structured with a central Sharia board established at the SBP level, and Sharia boards established at bank level, in line with the IFSB and AAIOFI standards, and customized according to the market environment in Pakistan. The SBP has developed detailed fit-and-proper criteria for the appointment of Sharia board members of IBs, which include Sharia-related academic qualification and experience, banking knowledge, and personal and professional track record. Sharia issues can be (and in practice have been) taken before the federal Sharia court.

The consumer protection framework has focused more on addressing potential information asymmetries, limiting scope for exploitation of consumers and providing a resolution framework. IBs are required to disclose details of Charity Account, pool management practices, and remuneration to the Sharia Board. A regulatory limit for Mudarib (the bank) share has been set at a maximum of 50 percent.

The profit sharing ratio can be fixed by IBs in advance and the Mudarib share is calculated on the basis of profit distributable to depositors. IBs can and do give indications of anticipated rates of returns, though the indicative rate is not obligatory and actual rates may vary. Conventional banks that offer IB products and services are required to disclose details of their IB operations as an annexure to their annual accounts. Consumers have, available to them, arbitral forums and ADR frameworks for resolving disputes. However, there are no independent board members to represent IAHs.

The supervisory framework has also been adapted and there are procedures for standardization and Sharia harmonization and auditing. The SBP has developed an on-site inspection manual for IBs and a dedicated supervision department that provide regulatory oversight of IBs. The Banking Inspection Department of the SBP reviews compliance with Sharia related matters during the inspection of IBs. It has specified broader parameters for permissible Islamic modes of finance and banks have been allowed to develop products and services after getting approval of their Sharia Board for each product and service they offer. The scope of the external auditor’s engagement has been broadened to include Sharia compliance and conduct of External Sharia Audit of IBs. Further, the Financial Stability Department (FSD) also performs the overall stability assessment of the IB industry.

SBP performs stress testing of individual banks on a quarterly basis, including for IBs. It has also designed a separate stress testing framework for assessing the resilience of IBs against credit, market and liquidity shocks. The SBP, however, does not yet supervise IBs on a consolidated basis, but is in the process of amending the law. The presentation of audited accounts differs considerably across banks and the different classifications make consolidation and comparative analysis challenging.

The Sharia Governance Framework to strengthen the overall Sharia compliance framework was published in April 2014 and has been updated/revised in following years.

Liquidity Management, Resolution, and Deposit Insurance-The financial markets critical for liquidity management are being gradually developed. The domestic Sukuk market has been growing since the first issuance in 2005. The SBP has also played a major role in the issuance of government of Pakistan Ijarah Sukuk which has paved the way for effective liquidity management of IBs. In addition, despite witnessing growth over the years, the domestic Sukuk market is still confronted with issues such as lack of short term and long term Sukuk of high quality, absence of a secondary market for trading, and identification of assets for sovereign Sukuk.

The liquidity management framework is still to be operationalized. A number of instruments have been developed for liquidity management by the SBP and banks, including Bai Muajjal of Sukuk, interbank Mudarabah, Islamic placements, Wakala and others. A liquidity management framework has also been developed that includes development of a Shari’ah portfolio at SBP, Mudarabah-based facility for IBs at the SBP, development of an Islamic inter-bank money market, and availability of Shari’ah compliant discount window for IBs. However, this framework has not yet been operationalized.

An institutional framework for resolving banks is in place. The Banking Ordinance 1962 provides a general framework for the resolution of banks and the legal framework relating to liquidation equally applies to both conventional and IBs. In case of liquidation, IAHs have priority over creditors and therefore bailing in options are limited. IAHs are legally liable to bear proportionate losses. Thus far, none of the IBs have been liquidated. To facilitate coordination, the SBP has put in place an institutional framework in the form of the Islamic Banking Department (IBD), Sharia Board of the Central Bank and the Sharia Boards of Banks. The IBD can escalate unresolved issues to the Sharia Board of the central bank to resolve conflicts between banks, the Sharia board and the regulator.

Pakistan is in the process of developing a deposit insurance framework. The Deposit Insurance Corporation Act, presently with the Parliament for enactment provides coverage for IB depositors.

The experience of Pakistan offers important lessons for the sound development of the IB industry. The experience shows that rather than forcing a transition toward a fully-fledged IB industry, policy makers should focus on putting in place an enabling environment that levels the playing field with the conventional industry, and let market forces play their role. Since opting for the latter, the IB industry has experienced rapid growth and the IBs in Pakistan have also increased the share of risk-sharing financing (Musharakah and Mudarabah).

Pakistan has made considerable progress in adapting the institutional, legal and regulatory framework to the specifics of IB, but scope remains for further strengthening. Additional reforms are needed to address gaps with respect to consolidated supervision, consumer protection, the resolution framework, and the absence of liquid secondary markets. Ongoing reforms with respect to CAR, liquidity framework and DIS need to be expedited. Concentrations in bank financing, maturity mismatches and development of interbank markets warrant attention and further efforts are needed to develop deep Sukuk markets.

The SBP has an extensive database on IBs operations, but inconsistencies in the data methodologies in IBs audited accounts could affect data quality for policy formulation.

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