The emergence and growth of the Islamic finance industry is a phenomenon that has generated considerable interest in the financial world in recent years. Given its ability to offer innovative financial solutions to an under-served market, it is seen as a socially responsible, faith-based banking niche with considerable growth potential.
In the Muslim world and increasingly in the West, significant segments of the institutional and retail markets are increasingly choosing Islamic finance for their financing and investment needs. Today, more than 500 Islamic financial institutions are operating throughout the world. Western banks are also doing Islamic banking, through their Islamic units in the UK, Germany, Switzerland, Luxembourg and other countries. The industry is growing at a rate of roughly 15 percent per year, and could serve 40 to 50 percent of the world's Muslim population within a decade.
State Bank of Pakistan's released figures indicate that branch network of Islamic banks in Pakistan has grown in excess of 649 branches in March 2010. The total asset base of local Islamic banking industry is Rs 366bn and the deposit base is - Rs 283bn. The industry has shown tremendous growth rate of 55% since inception. The ever-increasing share of Islamic banking in the local banking system stands at 5.9%.
Despite the impressive growth, the Islamic banking industry is facing a number of challenges that are preventing it from attaining an even higher pace of growth. Some of the most important issues are identified below. Short-term liquidity management: The lack of investment avenues, especially short-term, has been one of the major problems faced by Islamic financial institutions (IFIs) in Pakistan.
The IFIs cannot invest in conventional interest-based sovereign debt instruments such as T-bills and Pakistan Investment Bonds. Therefore, short-term liquidity management has been a key challenge. Although the government of Pakistan's Ijarah Sukuk in 2008 provided some relief as an alternative to PIBs; however, due to limited supply and increasing demand from Islamic treasuries, these Sukuk are rarely traded in the secondary market. A short-term liquidity solution is still awaited from the government.
Regulatory and tax reforms: The government patronage and regulatory/tax reforms play a pivotal role for any industry to grow with leaps and bounds. On the international front, governments, like the United Kingdom and Malaysia, are offering relaxed rules and taxation for tapping the great demand for Shariah-compliant investment by Muslim investors, especially from the Middle East. Pakistan too can become a regional hub for Islamic finance if proper regulatory reforms are introduced. To achieve this goal, the government needs to revamp the existing structure of taxes and duties to make them conducive to Islamic finance. The most important areas where incentives can be offered are:
i) Stamp duties: Stamp duties, especially the land revenue duties paid at the time of transfer of property increase transaction costs and hampers assets-based financing.
ii) Tax incentives for investors: Islamic banks are new players in the market and they should be given some relaxation in terms of taxation. Theoretically speaking, depositors in Islamic banks are partners with Islamic bank and they share in actual profits and losses, as against interest-based banks where depositors are creditors and their principal is protected. Therefore, to encourage people to invest in Shariah compliant products, the government should introduce incentives in the form of tax credits. When we look at international markets, for example, the Malaysian government has given certain incentives for investors in Islamic finance industry till the year 2016 to make Malaysia a regional hub for investment.
iii) Regulatory reserves and capital requirements: The regulatory capital requirements like minimum capital requirement (MCR), current reserve requirement (CRR) and statutory liquidity reserve (SLR) requirements serve to stabilise the financial sector. However, the nature of depositors in the Islamic banking industry is entirely different from that of conventional banks; therefore, percentages for regulatory reserves for Islamic banks should be relaxed further keeping in view their peculiar risk profile. This will create a level playing field and better reflect risk sharing nature of deposits in Islamic bank.
Human capital: Since the inception of the industry, the supply of trained or experienced human resource has lagged behind the expansion of Islamic banking. There is a dearth of qualified bankers, who are well-versed in Islamic laws as well as contemporary economics and finance. Currently, few universities and training institutes are offering courses in Islamic finance, but they also face lack of competent human resources to conduct these courses.
At the experts' level, there are only a few scholars with the requisite knowledge and expertise in the field of Islamic finance. Therefore, the industry has to rely on a handful of Shariah scholars for the product development needs and these scholars find it difficult to accommodate multiple requests for their time. To cater to the needs of the industry, both business schools and religious schools should offer specialist courses in conjunction with industry experts to prepare the next generation of Shariah scholars and Islamic-financial managers.
Investment avenues: Islamic principles stipulate certain conditions that need to be adhered to while developing Islamic banking products. Having left with no choice due to the absence of attractive investment avenues, Islamic banking products mainly rely on asset-based financing to generate returns for their depositors. The SBP figures indicate a heavy concentration of trade-based product of Murabaha (cost plus sale) in the total financing portfolio of Islamic banking to the tune of 37% as at March 31, 2010. Together, Murabaha, Ijarah and Diminishing Musharakah, which are all essentially asset-based, fixed return products, constitute more than 80% of the financing portfolio of Islamic banks in Pakistan.
Although no less Shariah-compliant, these fixed rate trade based products draw criticism from certain quarters of the economy due to their apparent resemblance with conventional, interest bearing counterparts, usually in terms of returns only. The critics demand a more 'Islamic' way of investment by way of profit and loss sharing arrangements for investments by the banks in the form of equity based financing rather than trade based financing. However, this is easier said than done; due to lack of documentation in the economy, Islamic banks are finding it difficult to enter the profit-and-loss sharing-based real business ventures with their customers instead of fixed return products. Moreover, entrepreneurs and industrialists are also reluctant to share profits with the financiers in low risk ventures.
Standardisation of contracts: The introduction of various Shariah standards by Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFIs) has started to bring some uniformity into the Shariah-based legal framework of the Islamic finance industry, but efforts are needed to bring these agreements in conformity with the local taxation and related laws so as to make them more acceptable among all users.
Perception of users: Due to unsatisfactory experiences in the name of Islamic banking in the past, some Pakistani customers are now skeptical about the authenticity of Islamic banking practices. Part of it could be attributed to psychological tendency to stick to the decades' old banking habits and perception of banking. Most customers have opinions that are based on misinformation and represent lack of understanding of Fiqh issues. Changing these perceptions has been one of the greatest challenges for Islamic banks that can only be addressed through collective efforts by all, especially the media.
Benchmark: Using the conventional interest-based benchmark (KIBOR) as the base of pricing an Islamic financial product puts Islamic banks as well as their customers at the mercy of movements in the interest-based money market. Also, a negative perception is created among the clientele that there is no real difference in Islamic banking products as these are also using the same interest based benchmark. It is argued that Islamic banks should have their separate benchmark for investment pricing. This was not possible initially due to limited market, however, some Pakistani banks have now taken the initiative and work has already started to develop an Islamic benchmark.
Conclusion: To succeed as a viable banking option, Islamic banks not only need passionate supporters, but also a number of supporting institutions/arrangements to perform functions, which are being carried out by various financial institutions in the conventional framework. Attempts should be made to modify the existing structure to provide better products and quality service within the ambit of Islamic laws. While interest-based banking has taken hundreds of years to mature to the level where it is today, expecting the same maturity from Islamic banking in its nascent stage will be expecting too much. To develop an economic system truly reflective of the sacred principles of Islam, all stakeholders should understand the limitations at this stage and work towards its advancement.
Key recommendations
-- Dedicated R & D efforts to develop viable short term liquidity products for the industry
-- Dedicated learning centres at university level to train and develop competent workforce and Shariah scholars
-- Collective mass awareness campaign by Islamic banks
-- State Bank should take measures for uniformity of Islamic banking contracts and products
-- Dedicated research and product development teams should be developed at all Islamic financial institutions.
(The writer is attached with Product Development, Shariah Compliance and Islamic Financial Advisory Department (PDSC) Meezan Bank Limited)
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