Islamic banking and finance in Pakistan: challenges and roadmap

“Allah has permitted trade and forbidden usury”. Al Baqarah. The creation of Pakistan was indeed based on the ideology of Islam. This is reflected in its Constitution, which declares Islam as the state religion and outlines principles of Islamic law to guide legislation.

A core principle of Islamic law is the prohibition of riba (interest).

Islam envisions an economic system free from riba, aiming to protect humanity from its harmful consequences.

However, the global economic system is currently dominated by interest-based practices, leading to wealth concentration in the hands of a few and the creation of powerful monopolies. This has widened the gap between the rich and the poor, with the top 1% of the world’s population possessing more wealth than the remaining 99%. This inequality fuels injustice, crime, and unhealthy competition.

A riba-free economy is the only viable solution to address these issues. By eliminating interest-based transactions, we can create a more equitable and just and fair economic system that benefits all members of society.

The efforts for Islamisation of economy began in the 1950s when Shariah scholars began researching Islamic economic principles, and an Islamic Economic Division was formed within the State Bank of Pakistan.

While initial efforts were made, it was not until the late 1970s that a concerted push to eliminate interest-based transactions and legislative changes aimed at aligning the economy with Islamic principles began.

A significant turning point came in 1991 when the Federal Shariat Court declared bank interest to be incompatible with Islamic law and after extensive deliberations, the Federal Shariat Court issued a landmark judgment in April 2022, setting a five-year deadline for the complete eradication of interest-based transactions from the country’s financial system.

Following this judgement, in a historic move towards promoting Islamic finance, Pakistan’s Parliament has unanimously passed the 26th Constitutional Amendment, mandating the complete elimination of Riba (interest) by January 1, 2028. This significant amendment marks a key milestone in the country’s efforts to align its financial system riba-free and based on Shariah principles.

Over the past 70 years, Islamic banking in Pakistan has lagged considerably behind its conventional counterpart.

Islamic banks currently hold only a 22% of total deposits and 29% of the total financing. These numbers are the indications that still there is a long way to go.

While I applaud the Parliamentarians’ and institutions’ efforts for a Riba-free system, which is a strong indicator of the nation’s commitment to transitioning towards an Islamic economy, a strategic and consistent roadmap is crucial for its successful implementation.

The challenges in Islamic banking cannot solely be addressed by central banks and banking institutions.

Addressing these challenges requires a concerted effort from various stakeholders, including policymakers, business community, regulators, and Shariah scholars.

Rather than reinventing the wheel, it would be wise to see similar experiences across the globe. Islamic finance started 50 years ago in various countries with many Muslims who wanted to ensure that their money sources followed Shariah and other Islamic principles for Islamic Banking, Islamic Insurance (Takaful), Islamic Bonds (Sukuk), and Islamic Funds.

Starting with the establishment of the first Islamic commercial bank, Dubai Islamic Bank in 1975, the Islamic finance industry continues to record remarkable progress. Today, total Islamic banking asset is estimated to have reached more than US$ 5.0 trillion.

Fueled by a growing Muslim population, increasing interest in ethical investing, and innovative Shariah-compliant offerings from Islamic financial institutions, the market exhibits substantial growth potential.

Islamic financing mechanisms are gaining global recognition for aligning financial services with ethical and religious values.

Our brother country Malaysia has developed a comprehensive regulatory framework that supports the growth of Islamic banking and finance.

The central bank of Malaysia has been proactive in promoting Islamic finance. It has introduced policies and initiatives to create an enabling environment for Islamic financial institutions.

Malaysia offers a wide range of Islamic financial products and services, including Islamic banking, takaful (Islamic insurance), sukuk (Islamic bonds), and Islamic investment funds.

The Malaysian Islamic banking industry’s share of total financing in the financial system is 46% while the Takaful industry’s share of total net contribution is 24%. However, it is pertinent to clear that their contribution in corporate and long term financing is not significant to be proud of.

In Europe, the UK has a long history of Islamic finance, where the industry continues to grow and evolve, driven by increasing demand from the Muslim population and institutional investors.

The UK’s supportive regulatory environment and strong financial infrastructure have contributed to its success in Islamic finance. Of course, we can learn from these experiences.

In anticipation of our forthcoming target set in the Constitution, it is imperative to inform our society that the transformation of our economy into a riba-free system is a complex endeavour.

The realization of this goal will necessitate consistent and substantial efforts. As we strive to achieve this target, we need to keep in mind that

(a) Public perception: a lot of people lack a clear understanding of how Islamic finance works and its differences from conventional banking and other economic tractions. A common misconception is that Islamic banking products are not substantially different from conventional ones, raising questions about their adherence to Shariah principles. This perception, coupled with the belief that Islamic banking products are more expensive, often leads to mistrust. This situation aggravates when there is a conflict in various school of thoughts. The organized efforts are in the sector of banking only but not much of the focus is given on other economic activities of the society.

(b) Human resource constraints: a critical challenge is the shortage of qualified Shariah scholars capable of interpreting Islamic law and developing innovative Shariah-compliant products and services. Additionally, there’s a lack of skilled professionals in areas like risk management, finance, and accounting who understand the intricacies of Islamic finance. For 24% Muslim population of the world, a couple of thousand are Islamic Finance Education Providers,

(c) Product innovation and standardization: One significant issue in Islamic economy is the limited range of Shariah-compliant products, particularly in areas like long-term financing, investment banking and insurance. This lack of product diversity restricts the industry’s ability to meet the evolving needs of its customers. Additionally, the absence of standardized products and services leads to inefficiencies and hinders the industry’s overall development.

(d) Regulatory and legal framework: Lack of comprehensive and existence of complex regulatory framework can hinder the efficient operation of Islamic financial entities.

(e) Operational challenges: Islamic financial contracts are often more complex than conventional contracts, requiring specialized expertise to understand and implement them. This is beyond the understanding of a common man.

(f) Integration with the conventional financial system: Challenges in seamlessly integrating Islamic banking with the conventional financial system, particularly in areas like payment systems and interbank transactions, hinder its efficiency. A lack of harmonization between Islamic and conventional banking regulations also poses significant challenges.

(g) Accounting practices:

The accounting practices in many countries are not appropriate and do not show the correct state of the affairs and profitability. Standardized accounting practices and reporting for Islamic Banking and Finance is lacking.

(h) Heavy taxes and levies:

Heavy taxes of 55-60 percent and extra expenditure encourage the companies not to reveal the actual profitability and the financial statements are not reliable for assets backed transactions. The government has to bring the regressive taxes at a level which can be accepted by the taxpayers. In the past, there used to be 29 percent corporate tax and it was agreed that it would be reduced by 2 percent in three years. There was no concept of super tax and windfall profits. These tax policies are a breeding ground for financial misconduct.

The Islamic banking and financial institutions should also be ready to answer the following questions:

1- Competitiveness of Islamic economy:

Why do Islamic banks offer lower deposit rates compared to conventional banks, while maintaining similar or higher lending rates? Given these circumstances, how can Islamic banking institutions effectively compete in the global financial market?

2- Distinctive characteristics:

Why do Islamic financial institutions rely on conventional benchmarks like KIBOR and policy rates for their lending, borrowing, and returns? Why distinct Islamic mechanisms are not employed instead of these conventional tools

Islamic financial institutions often follow conventional practices in setting present and future prices, focusing on profitability. However, the element of potential loss, a core principle of Islamic finance, seems to be overlooked in this approach. This has led to the misconception that Islamic modes are merely rebranded interest-based transactions into mark-up based transactions with additional paperwork.

Islamic banks should not only focus on asset-backed transactions but also assess the cash flow viability of business ventures to compete effectively in the global financial market.

3- Distinctive Islamic ideology of the business:

I had been to the UK couple of years back and I found that Jews’ banks also have their Islamic banking counters. This raises questions about the true underlying principles and motivations behind these ventures.

One may wonder whether the driving force is a genuine commitment to Islamic principles or simply a strategic move to capitalize on the growing Islamic finance market. It is essential to critically examine the extent to which Islamic values are truly integrated into these institutions’ operations.

In a nutshell, improving Islamic finance in Pakistan requires a comprehensive approach involving various stakeholders, including the government, regulatory authorities, Islamic financial institutions, and the public to:

a) Have a robust regulatory framework for the growth and stability of the Islamic finance industry as well as protect consumer interests. Regulatory bodies can play a crucial role in establishing guidelines and standards for Sharia governance practices;

b) Chalk out proper accounting and reporting standards for Islamic finance. This responsibility goes to the accounting bodies of the country;

c) Ensure robust Sharia governance practices within Islamic financial institutions to maintain strict adherence to Islamic principles;

d) Foster research and development to drive innovation in Islamic finance products and services;

e) Simplify regulatory procedures to reduce bureaucratic hurdles and encourage innovation;

f) Align with international accounting and auditing standards to enhance transparency and credibility;

g) Promote Islamic finance education and training programmes to develop a skilled workforce. Conduct awareness campaigns to educate the public about the benefits and principles of Islamic finance;

h) Focus on social finance including Qarz-e-Hasna, short-term support and interest-free loans to individuals and businesses, especially those with limited financial resources, which may overcome poverty.

i) Collaborate with international Islamic finance institutions to share knowledge and best practices; and

j) Use global of rapid development of Islamic finance.

By implementing these strategies, Pakistan can strengthen its position as a global hub for Islamic finance, contributing to economic growth and financial inclusion.

Copyright Business Recorder, 2024