Professional Documents
Culture Documents
CHAPTER 2
History and Development of Conventional and Islamic
Banking in Pakistan
2.1
Pakistan came into existence as the first Islamic republic created in the name of Islam on
August 14, 1947. The government of Pakistan is bound to follow the instructions of Allah
Almighty according to Objective Resolution, passed in 1949. Islam is declared the
official religion of Pakistan according to the first constitution of Pakistan in 1956 and all
rules/ regulations should be according to the instructions of the Holy Quran and Sunnah.
The Council of Islamic Ideology was established under the Constitution of 1962, to
eliminate the interest from the economy especially from banking sector. The Constitution
of Pakistan (1973) requires the elimination of interest (riba) from the economy as soon as
possible. The council consulted a large number of bankers and economists to recommend
some alternatives to replace interest-based financial structure in the economy during
1980s. In 1991, Full Bench of Supreme Court of Pakistan ordered the elimination of riba
from the economy until June 30, 1992.
Pakistani banking sector has witnessed drastic changes over a period of 61 years since its
independence. Initially it suffered from acute shortage of resources and uncertainty due to
prevailing political and socioeconomic conditions. Lack of trained human resource and
professionals resulted into poor quality of products and services. Financial liberalization
SBP plays an active role to establish a sound Islamic banking system in Pakistan
according to principles of Shariah as mentioned in its mission statement that read To
promote and develop Islamic Banking industry in line with best international practices,
ensuring Sharia'h Compliance and transparency. SBP issued detailed criteria in
December 2001 for the establishment of full-fledged Islamic bank in the private sector.
Al Meezan Investment Bank received the license from SBP in January 2002 and started
its operations with the name of Meezan Islamic bank as the first Islamic bank from
March 20, 2002 (SBP, 2002).
In 2002, Islamic banks have started their operations in Pakistan and experienced stiff
competition from its peers as well as from conventional banks. Now there are 6 fullfledged Islamic banks and 13 Conventional banks offering products and services
according to principles of Shariah in different parts of the country. They are competing
in a highly competitive environment for the provision of quality services according to
customers' expectations. Now bank customers are much concerned regarding the quality
of services due to increased awareness. They continue to deal with their current bank
only if they feel satisfied; otherwise they feel no hesitation to switch to other banks.
Galbraith (1975) reported, The best economic system is one that supplies the most of
what that most people want. It means that an ideal economic system has the ability to
meet expectations of people what they want in a transparent manner. Islamic economic
system is superior because it is based on the principles of justice, transparency and
accountability that ensure substantial economic growth. Islamic bank is beneficial due to
its capability to spread risk in the economy among the concerned parities (depositor,
banker, borrower etc.) according to their contribution (Siddiqui, 1973).
Islam is a complete code of life that consists upon the instructions given by the Allah
Almighty and practices of the holy prophet Muhammad (peace be upon him). The holy
Quran is the written instructions of Allah Almighty for the human beings. It covers all
aspects of human life and all types of activities (i.e. religious, social and economic) that
are performed for the success in this life and in the life hereafter. There are clear
instructions about halal and haraam. Islam is a universal faith that promotes brotherhood,
Uzair (1976) has presented the working structure of Islamic bank and developed a
mechanism to cope with the challenges of risk and interest. Risk of loss is a potential
threat that creates obstacles for productive activities in the economy. The study suggested
that Islamic banks could help to reduce risk to enhance productive activities in the
economy. It is reported that different stakeholders dealing with Islamic bank are risk
neutral and actively engaged in productive activities according to profit and loss based
contracts (Siddiqui, 1973).
Wilson (1990) remarked the success of Islamic banking that compelled the many
commercial banks to provide Islamic banking products to their clients. It is reported that
profit and loss sharing system generates more profits. On the other hand, interest based
system focus on credit-worthiness. Profitability is more efficient measure for allocation
of funds as compared to credit worthiness. Similarly profit sharing system would be more
stable as compared to interest-based system (Al-Jarhi and Iqbal, 2001).
The existence of two bank streams i.e. conventional banks and Islamic banks poses some
questions about service quality and customers' satisfaction in Pakistan. It is also
important to assess the effect of customer satisfaction on bank performance. Islamic
banks have opened new avenues for acceptance of deposits on interest free-basis and
extend credit facilities excluding interest e.g. Qarz-e-Hasana etc. (Najajmabadi, 1991). It
was found that relationships with bank personnel are important criteria for selection of
bank (Abratt and Russell, 1999).
2.2
Interest based activities are strictly prohibited in Islam as it is ordered by the Allah
Almighty in the Holy Quran. In Islam, religious, social and economic activities have
strong ties with each other, so economic activities (i.e. earning and spending pattern of
any individual) should be in line with the Islamic principles. Banks are actively engaged
in different economic activities by developing a liaison among various stakeholders for
financial and productive ventures. Banking activities must be interest-free and purely
according to principles of Shariah for the welfare of the all segments of the society.
Riba is prohibited step by step by Allah Almighty by conveying its pros and cons in the
Sura-e-Rome (30:39) and finally declared haraam in the Sura-e-Al-Bakara (2:275).
Following verses of the Holy Quran clearly reflects the instructions regarding riba.
That which ye given in riba in order that it may increase on (other) people's property
hath no increase with Allah; but that which ye give in charity; seeking Allah's
countenance, hath increase manifold (30:39).
This is the first stage, to convey the pros and cons of riba. In this verse, Allah Almighty
disclosed the pros and cons of riba and ordered to spread charity. People only consider
extrinsic characteristics of riba to increase their capital manifold and ignores the intrinsic
fatal outcome of riba. You must frequently distribute charity, Zakat and Sadaqaat among
deserving people for sake of increase in your income and success in this life and in the
life hereafter.
That they took riba, though they were forbidden; and that they devoured men's
substance wrongfully. We have prepared for those among them who reject faith, a
grievous punishment (4:161)
This holy Verse shows the historical perspectives of riba. There are always a segment of
people even in the previous nations of the world, they are used to practice riba-based
O ye who believe! Devour not riba, doubled and multiplied; but fear Allah; that ye may
(really) prosper. Fear the fire, which is prepared for those who reject faith. And obey
Allah and the Messenger; that ye may obtain mercy (3:130-2).
This holy Verse makes a strong foundation for the prohibition of Riba by declaring it as
unwanted activity. The People are ordered to stop eating the earnings from Riba and
follow the instructions of Allah Almighty. It rejects manifold increase in the Riba and
warns the people. It also inspires the human being to be obedient to Allah Almighty for
ultimate success.
Those who devour Riba will not stand except as stands one whom the evil one by his
touch hath driven to madness. That is because they say: Trade is like Riba'. But Allah
hath permitted trade and forbidden Riba. Those who after receiving direction from their
Lord, desist, shall be pardoned for the past; their case is for Allah (to judge). But those
who repeat (the offence) are companions of the fire; they will abide therein (forever)
(2:275).
These verses show the final prohibition of riba by the Creator of this universe. The
persons who eat riba are like those that are touched by satan and became unsound of
mind. They foolishly argue that trade is like riba. But trade is declared halaal and riba is
Allah will deprive riba of all blessing, but will give increase for deeds of charity; for He
loved not creatures ungrateful and wicked (2:276).
Allah Almighty does not bestow blessings upon riba-based activities and orders to stop
them, as He dislikes the violent. But there are uncountable blessings attached with the
deeds of charity and sadaqaat.
O ye who believe! Fear Allah and give up what remains of your demand for riba, if ye
are indeed believers (2:278). If you do it not, take notice of war from Allah and His
Messenger. But if ye turn back, ye shall have your capital sums. Deal not unjustly, and ye
shall not be dealt with unjustly (2:279).
These verses are related to desired post prohibition behavior of believers. Believers of
Allah Almighty are required to waive of their interest from borrowers and recover only
principal amount. And if you do not ready to accept then ready for war with Allah and
His Messenger, who can fight with Allah?
If the debtor is in a difficulty, grant him time till it is easy for him to repay. But if ye
remit it by way of charity, that is best for you, if ye only knew (2:280). And fear the
Day when ye shall be brought back to Allah. Then shall every soul be paid what it
earned, and none shall be dealt with unjustly (2:281).
2.2.2
The Holy Prophet (Peace be upon him) gave us a complete code of life in the shape of
Islam that covers all aspect of human life (i.e. religious, social, and economic activities).
Islam is the religion of peace, brotherhood and cooperation having prime concern of
welfare being totally submissive to Allah. Islam ensures complete success in this life and
the life hereafter by following the instructions of the Holy Quran and Sunnah (practices
of the holy Prophet Muhammad-Peace be upon him). The holy Quran has clearly
declared an interest as haraam and people are prohibited to practice it. Similarly, the Holy
Prophet Muhammad (Peace be upon him) discouraged interest based activities and
strictly prohibited to practice it. Prohibition of riba is depicted from following Ahadith.
Abu Saad al Khudri (R.A) narrated that the Holy Prophet (Peace be upon him) said:
Gold for gold, silver for silver, wheat for wheat, barely for barely, dates for dates and
salt for salt, like for like, payment being made hand by hand. If anyone gives more or
asks for more, he has dealt in riba. The receiver and giver are equally guilty (Muslim).
Jabir (R.A) narrated that the Holy Prophet (Peace be upon him), cursed the receiver and
the payer of riba, the one who records it and who witnesses to the transaction and said:
They are all alike (in guilt) (Trimizi).
Ans Ibn Malik (R.A) narrated that the Holy Prophet (Peace be upon him), said: When
one of you grants a loan and the borrower offers him a dish, he should not accept it; and
if the borrower offers a ride on an animal, he should not ride, unless the two of them have
been previously accustomed to exchanging such favors mutually (Kitab al Buyua).
Abu Hurayrah (R.A) narrated that the Holy Prophet (Peace be upon him), said: On the
night of Ascension I came upon people whose stomachs were like houses with snakes
visible from the outside. I asked Gabriel (A.S.) who they were. He replied that they were
people who had received riba (Musnad Ahmed).
Abu Hurayrah (R.A) narrated that the Holy Prophet (Peace be upon him), said: Allah
would be justified in not allowing four persons to enter paradise or to taste its blessings;
he who drinks habitually, he who takes riba, he who usurps an orphan's property without
right, and he who is undutiful to his parents (Kitab al Buyua).
Business organization is primarily originated for the sake of profit by performing lawful
activities. Banks are also one of the business organizations that provide a set of products
and services to generate profits. Inception of Islamic banking practices in Pakistan
created multiple threats and opportunities to meet customers' expectations by the
provision of quality services. It initiated a healthy competition for Islamic banks to
compete with their peers and conventional banks for greater profits. It was observed that
the banking industry experienced stiff competition with banks and with other financial
institutions to attract potential customers (Hull, 2002).
Islamic bank works as a trading concern and financial intermediary to perform interestfree activities purely according to principles of Shariah. It is a welfare organization that
promotes business and trade activities by pooling the financial resources for the sake of
profit and loss for mutual benefit. It is found that Islamic bank performs activities in the
right direction towards human development. It plays a positive role towards economic
development having main focus on human development while performing its functions
(Al-Harran, 1993). It is documented that banks have witnessed more profits on Murabaha
facilities as compared to conventional loans due to profit and loss base of Islamic
products (Ebraim, 1999).
Islamic banks perform a variety of fund-based and non-fund based functions to facilitate
their customers. Some important functions are displayed in figure 2.1.
Specific
Investment Fund
Primary Functions
Islamic Bank
Advance Loans
(Financing Products)
Long Term
Musharika,
Mudaribah and
Diminishing
Musharika etc.
Source: Generated
Medium Term
Ijarah,
Ijarah-Wa-Iqtina
etc.
Short Term
Murabaha, Salam,
Muajjal, Istisna
etc.
Accepts Deposits
Bank may receive deposits from people under current account and do not pay any interest
but may charge a fee for its services. Islamic banks lend money to borrowers for shortterm, medium-term and long-term investment (Musharika, Mudariba, Ijara, Salam,
Murabaha etc.) on the basis of profit and loss. In this way depositor, bank and borrower
share risk of loss according to a valid sales contract. It creates a strong economy on the
principles of transparency and accountability.
Uzair (1976) suggested the working structure of Islamic bank and explained its functions.
Banking transactions are undertaken among three parties i.e. actual users of the capital or
entrepreneurs; the bank as an intermediary and partial user of funds; the suppliers of
funds or depositors. The study recommended that all the transactions should be based on
profit and loss contracts among the concerned parties and exclusively interest-free. It is
also reported that Islamic banks could promote savings and investment activities by
determination of an equilibrium profit sharing ratio between depositors and borrowers
(Siddiqui, 1979).
Table-2.1
Financial Performance of Islamic Banks
Indicators
FY03
FY04
FY05
FY06
FY07
FY08
(March)
12,915
44,143
71,493
119,294
205,212
200,415
8,397
30,185
49,932
83,840
146,945
141,933
0.50%
1.40%
2.10%
2.90%
4.20%
4.10%
Islamic banks have shown tremendous growth during the recent years. Islamic banks are
offering a variety of products and services to its customers. They strive to expand their
operations and perform multiple functions to attract the prospective customers for greater
profit. It requires the quality initiatives to retain valued customers by meeting their
expectations for better performance. Islamic bank proved a successful experience in
Pakistan and gained popularity among general public.
Islamic banks are trade oriented financial institutions that provide interest free deposits
and investment opportunities for the people. It accepts deposits from general public under
general investment fund and specific investment fund that is clearly mentioned in the
agreement between the bank and the customer while opening their bank accounts. Islamic
bank actively performs several operations to provide a variety of products according to
customers' requirements. It deals with different types of customers i.e. depositors,
borrowers and service users. It provides credit facilities, financing products, funds
transfer facilities and other services according to customers' needs.
Table-2.2
Financing Products offered by Islamic Banks (in %)
Financing Products
FY03
FY04
FY05
FY06
FY07
FY08*
Murabaha
79.4
57.4
44.4
48.4
38.9
38.7
Ijarah
16.5
24.8
29.7
29.7
25.4
24.2
0.8
0.8
0.9
1.3
Diminishing Musharka
1.2
5.9
14.8
14.8
25.1
24.8
Salam
1.6
0.7
1.9
1.9
1.4
1.6
Istisna
0.4
1.4
1.4
0.9
2.4
Qarz/Qarz-e-hasna
1.3
9.8
7.1
6.7
Musharka
Others
Specific
Investment Fund
Long Term
Musharika,
Mudaribah and
Diminishing
Musharika etc.
Primary Functions
Customers
Islamic Bank
Advance Loans
(Financing Products)
Medium Term
Ijarah,
Ijarah-Wa-Iqtina
etc.
Short Term
Murabaha, Salam,
Muajjal, Istisna
etc.
Service Quality
Bank Services
Bank Customers
Customer Satisfaction
Customers
Customers
Agency & Gen.
Utility Functions
Customers
Accept Deposits
Islamic banks are striving to capture the maximum number of customers to compete with
conventional banks by providing a large number of products as an alternative for interest
based products. Islamic banks supervise deposits (as Mudarib or investment manager).
Profit or loss is shared between banker and the customers according to an agreed ratio. It
is found that customers are rapidly moving from conventional banks to Islamic banks due
to growing trust in the Islamic banking products and practices. There are different types
of customers (i.e. individuals, households, corporate bodies, financial institutions as well
as government and private organizations) that eager to engage in long term relationships
with the Islamic banks (SBP, 2007). The comparison of various contributors to deposits
of Islamic banks is given in figure 2.3
Figure-2.3
Contributors towards Deposits of Islamic Bank
2.4.2
Khan (1985) reported that Islamic bank could participate in productive activities by the
provision of funds on profit and loss basis to different industries e.g. manufacturing and
agriculture etc. In the agriculture sector, Islamic banks could participate: by the provision
of inputs to farmers; financing the purchase of inputs; provision of funds at a crucial
stage of harvesting; provision of funds for supportive activities like effective marketing
of farm output. The expansion of the banking industry requires a study to assess service
quality in relation to customers' satisfaction and its influence on bank performance.
Service is defined as a set of benefits delivered from the service provider to the service
consumer. It is reported that services have four key features that differentiate it from
goods i.e. intangibility, perishability, inseparability and heterogeneity (Parasuraman et
al., 1985). It is observed that service quality is a major factor in reference to customer
acquisition and retention (Galloway and Ho, 1996). It shows the organizations ability to
meet customers desires and needs (Hanson, 2000). Service quality is an important input
of customer satisfaction in the banking sector (Spreng and Machoy, 1996; Gefan, 2002;
Ibez et al. 2006; Saravanan and Rao, 2007). Dimensions of service quality differ due to
many factors i.e. prevailing environment, political conditions, socio-cultural differences,
technological advancements and demographic characteristics. Service quality is a
multilevel and multidimensional concept that varies in meanings among researchers
(Cronin et al., 2000). Banks operating in Pakistan have realized the importance of service
quality to expand their operations and portfolio. It is reported that service quality leads to
customer satisfaction in the Pakistani banking environment (Jamal and Naseer, 2003).
2.6
Islamic banks are competing for more customers with each other besides stiff competition
with conventional banks. Customer satisfaction is getting importance due to expansion of
banking industry and innovative products according to customers needs across the globe
especially in Pakistan. It is an action of fulfilling a need, desire, demand or expectation.
2.7
Khalid (2006) reported that the performance of Pakistani banking sector had improved
after privatization. Similarly, banking industry in Pakistan has shown an unprecedented
growth as the best performing sector having banking assets of more than $ 60 billions.
Almost 81% of banking assets are owned by the private sector while foreign investors
contributed 47% of total paid up capital (Akhtar, 2007).
2006-07
2007-08
No. of Braches
7852
8233
1690
1715
Private Banks
5597
5935
Specialized Banks
534
534
Foreign Banks
31
49
4351.9
5155.1
836.2
1017.2
Private Banks
3173
3845.2
Specialized Banks
119
1199
Foreign Banks
223.8
172.9
2427.7
2694
429.7
488.7
Private Banks
1807.2
2044.4
Specialized Banks
70.6
72.2
Foreign Banks
120.2
88.7
3255
3852
665.6
813.1
Private Banks
2425.8
2907.8
Specialized Banks
13.5
13.5
Foreign Banks
150.1
117.6
836.7
1275.5
179.9
298.7
Private Banks
601.7
934.5
Specialized Banks
16.6
15.8
Foreign Banks
38.5
26.5
Dec-07
Dec-06
206
4.3
147
4.1
138
3.6
6
12
118
2.9
83
2.8
72
2.4
4
12
72
2.1
50
1.9
48
1.8
2
9
44
1.4
30
1.2
30
1.3
2
7
13
0.5
8
0.4
10
0.5
1
3
150
70
48
17
Dec-05
Dec-04
Dec-03