Constraints & obstacles in Islamic banking

University of Baluchistan

Submitted by Mr. Umar Javaid Enrolment no 2008-A32 MBA (banking & finance)

Submitted to Sir Zia Ul Hassan


I dedicate this report to my parents Whom unwavering faith in me Has been the driving force in my life Their unconditional love and prayers Remain my unremitting source Of strength

(Umar Javaid)


Chapter 1


1 2

Introduction & Objectives History and Present Status of Islamic Banking around the World

4 5-6

Chapter 2
3 4 5 6 7 8 9 10

Problems Faced By Islamic Banking In The World An Overview on the Review of Problems The problem of forward contact/booking of foreign currency Portfolio Management The Regulatory environment Use of Advanced Technology and Media & Absence of Liquidity Instruments Need for Professional Bankers
Blending of Approach of Islamic Scholars with the Approach of the Conventional Banker

7 8 9 10 11 12 13 14

Chapter 3
Problems of Islamic Bank Operating under Conventional Banking System
11 12 13

Failure of Islamic banks to finance high-return projects Sacrifice of allocative efficiency Sacrifice of allocative efficiency

15 15 16

Chapter 4 Problem Specific to Islamic Banking in Pakistan
14 15

Absence of Islamic Money Market Absence of Suitable Long-term Assets

17 17

16 17 18 19 20

Shortage of Supportive and Link Institutions Organizing Relationship with Foreign Banks Long-term Financing Conclusion

18 18 18 19 2021

Executive summary

As per the requirement for the degree of MBA course of institute of management sciences university of Baluchistan I am submitting a report on Islamic banking (topic =constraints & obstacles in Islamic banking)

This report is based on the experience and knowledge which I got from the course of Islamic banking

In the first chapter I have discussed about the introduction of Islamic banking The story begins with the history of Islamic banking and incorporation of Islamic development bank

In second chapter I have discussed the major problems faced by Islamic banks globally the goal of this chapter is to cover and explain different sort of problems faced by Islamic banks globally.

In third chapter I have discussed comparative analysis of conventional and Islamic banks , the goal of this chapter is to analysis different advantages and disadvantage of conventional and Islamic banks

In fourth chapter I focused the main problems of Islamic banks operating in Pakistan. In last I have given some concussions and personal recommendations as how Islamic banks bank industry can improve its performance .


An Islamic Bank is a financial institution that operates with the objective to implement and materialize the economic and financial principles of Islam in the banking arena. The Organization of Islamic conference (OIC) defined an Islamic Bank as a financial institution whose statutes, rules and procedures expressly state its commitment to the principles of Islamic Shariah and to the banning of the receipt and payment of interest on any of its operations. According to Islamic Banking Act 1983 of Malaysia, an Islamic Bank is a company which carries on Islamic Banking business....... Islamic Banking business means banking business whose aims and operations do not involve any element which is not approved by the religion Islam.

The objective of Islamic Banking is not only to earn profit, but to do good and bring welfare to the people, Islam upholds the concept that money, income and property belong to Allah and this wealth is to be used for the good of the society. Islamic Banks operate on Islamic principles of profit and loss sharing and other approved modes of Investment. It strictly avoids interest which is the root of all exploitation and is responsible for large scale inflation and unemployment. An Islamic Bank is committed to do away with disparity and establish justice in the economy, trade, commerce and industry; build socio-economic infrastructure and create employment opportunities.

History and Present Status of Islamic Banking around the World

The History of Islamic Banking
The History of Islamic Banking can be divided in to two parts. First When it still remained an Idea, Second-When it became a reality-by private initiative in some counties and by law in others.

Islamic Banking as an Idea
The scholar of the recent past in early fifties started writing for Islamic Banking in place of Interest Free Banking. In the next two decades Islamic Banking attracted more attention. Early seventies saw the institutional involvement. Conference of the Finance Ministers of the Islamic Countries was held. The involvement of institutions and Government led to the application of theory to practice and resulted in the establishment of the Islamic Banks. In this process the Islamic Development Bank (IDB) was established in 1975.

The coming into being of Islamic Banks
The first private Islamic Bank, the Dubai Islamic Bank was also set up in 1975 by a group of Muslim businessmen from several countries. Two more private banks were founded in 1977 under the name of Faisal Islamic Bank in Egypt and Sudan. In the same year the Kuwaiti Government set up the Kuwait Finance House . In the ten years since the establishment of the first private commercial bank in Dubai, more than 50 Islamic Banks have come into being. Though nearly all of them are in Muslim countries, there are some in Western Europe as well: in Denmak, Luxembourg, Switzerland and the UK. In most countries the establishment of Islamic banking had been by private initiative and was confined to that bank.. In Iran and Pakistan, however, it was by

government initiative and covered all banks in the country. The Governments in both these counties took steps in 1981 to introduce Islamic Banking.


Twenty-five years ago Islamic banking was considered a wishful thinking. However, serious research work of the past two and half decades has shown that Islamic banking is a feasible and viable way of financial intermediation. A number of Islamic banks have also been established during this period under heterogeneous social and economic milieu. The successful operation of these institutions and the countrywide experiences in Pakistan, Iran, Sudan and partly in Malaysia are sufficient to show that Islamic banking offers an alternative method of commercial banking. The commendable achievements during the last twenty years should not lead us to ignore the problems that Islamic banking is facing, and there is no dearth of those. While many problems are a result of the inappropriate environment in which Islamic banks are working, there are others which have arisen from the practices of Islamic banks themselves. Most of the Islamic Banks operate on Bai- Murabaha, Bai Muazzal, Bai- Salam, Istisna, Hire Purchase/ Leasing mode of Investment i.e. Islamic Banks always prefer to run on markup/ guaranteed profit basis having Shariah coverage. For this reason some times the conventional Economists and General people fail to understand the real difference between Islamic Banking and conventional Banking.

An Overview on the Review of Problems

The Islamic banks face a number of problems. y First, they have not yet been successful in devising an interest-free mechanism to place their funds on a short-term basis. They face the same problem in financing consumer loans and government deficits. y Second, the risk involved in profit-sharing seems to be so high that most of the banks have resorted to those techniques of financing which bring them a fixed assured return. As a result, there is a lot of genuine criticism that these banks have not abolished interest but have in fact only changed the nomenclature of their transactions. (Example while financing use of conventional KIBOR, and fixed profits + variable in monthly mudarbah certificates issued by Meezan bank LTD.

y Third, the Islamic banks do not have the legal support of central banks of their respective countries (except in Pakistan and Iran), which exposes them to great risks. y Fourth, the Islamic banks do not have the necessary expertise and trained manpower to appraise, monitor, evaluate and audit the projects they are required to finance.(comparatively to conventional banks like MCB) As a result, they cannot expand despite having excess liquidity. The future of Islamic banks hinges, by and large, on their ability to find a viable alternative to interest for financing all types of loans. They should recognize that their success in abolishing interest has been at least partial and they have yet to go a long way in their search for a satisfactory alternative to interest. Simultaneously, Islamic banks need to improve their managerial capabilities by training their personnel in project appraisal, monitoring, evaluation and performance auditing. Moreover, the future of Islamic banks also depends on developing and putting into practice such accounting standards which provide timely and reliable information of the type that the Islamic banks would require for profit-sharing, rent-sharing or

for cost-plus financing. These standards are yet to be developed. The Islamic banks would have to work hard to pursue their clients to accept these standards so that a reliable information base is established. They should introduce their own bench mark for deciding profit sharing other then the conventional KIBOR.

The problem of forward contact/booking of foreign currency
The value of US Dollars ($), Pound Sterling, Euro and others are not fixed in Pakistan; they are fluctuating from time to time. Most of our imports and exports are made in USD and USD being a strong currency always moves upward and the exporters are in better position than the importer in our country. In Pakistan Forward Booking is required to check the exchange fluctuation for import of heavy/project Machineries where it take long time say one year or six months to produce the same. But due to the restrictions of Shariah we can not cover the risk of Exchange fluctuation by forward contract as Forward Booking is not permitted by Shariah. As per Shariah, currency, transaction is to be made under certain terms and conditions laid down for sarf by Shariah, such as spot possession of both the currencies by both the parties which is not available in forward Booking. It is also prohibited to deal in the forward money market even if the purpose is hedging to avoid loss of profit on a particular transaction effected in a currency whose value is expected to be declined. This problem requires a solution by Shariah experts

Unfamiliarity with the Islamic Banking System
The first problem is that despite the growth of Islamic banks over the last 30 years, many people in the Muslim and non-Muslim world do not understand what Islamic banking actually is. The basic principle is clear, that it is contrary to Islamic law to make money out of money and that wealth should accumulate from trade and ownership of real assets. However, there does not appear to be a single definition of what is or not an Islamic-banking product; or there is not a single definition of Islamic banking. A major issue here is that it is the Shariah Councils

or Boards at individual Islamic banks that actually define what is and what is not Islamic banking, and what is and what is not the acceptable way to do business, which in turn can complicate assessment of risk for both the bank and its customer. More generally, the uncertainty over what is, or is not, an Islamic product has so far prevented standardization. This is difficult for regulators as they like to know exactly what it is, they are authorizing. It is also an added burden on the banks that have to educate customers in new markets.

Portfolio Management
The behavior of economic agents in any country is determined partly by past experience and present constraints. The Islamic banks are still growing in experience in many countries. Regarding constraints, Islamic banks in different countries do not freely choose arrangements, which best suit, their need. As a result, their activities are not demand-oriented and do not react flexibly to structural shifts in the economic setting as well as to changes in preferences It is known to the bank management that a certain portion of the short-term fund is normally not withdrawn at maturity; these funds are used for medium or longterm financing. However, a precondition for this maturity transformation is that the bank be able to obtain liquidity from external sources in case or unexpected withdrawals. Islamic banks, without having an interest-free Islamic money and capital market, have no adequate instruments to meet this pre-condition for effective maturity transformation. On the other hand, Islamic banks can enhance term transformation if there is an interest-free bond market or a secondary market for Islamic financial papers. Adequate financial mechanism still has to be developed, without which financial intermediation, especially the risk and maturity transformation, is not performed properly.

The Regulatory environment

The relationship between Islamic banks and monetary authorities is a delicate one. The central bank exercises authority over Islamic banks under laws and regulations engineered to control and supervise both traditional banks. Whatever the goals and functions are, Islamic banks came into existence in an environment where the laws, institutions training and attitude are set to serve an economy based on the principles of interest. The operations of Islamic banks are on a profit and loss share basis (PLS), which actually does not come fully under the jurisdiction of the existing civil laws. If there are disputes to be handled, civil courts are not sufficiently acquainted with the rationale of the operations of Islamic Banking. Regarding the protection of depositors, Islamic Banks are required to let the authorities know the difference between money paid into current accounts and money paid into investment accounts. Islamic banks operate in two broad types of deposits: a) Deposits which cover transaction balance. These have a 100 percent reserve requirement and completely safe, thus satisfying the needs of risk averters. b) The PLS or equity account, in which depositors are treated exactly as if they were shareholders in the bank. There is no guaranteed rate of return or nominal value of the share. In non-Muslim counties (i.e., the countries with less than 50% Muslim population) the central banks are very stringent in granting licenses for Islamic banks to operate. In order to be established in those countries Islamic banks must also meet the additional requirements of other government and non-government authorities.

Absence of Liquidity Instruments

Many Islamic banks lack liquidity instruments such as treasury bills and other marketable securities, which could be utilized either to cover liquidity shortages or to manage excess liquidity. This problem is aggravated since many Islamic banks work under operational procedures different from those of the central banks; the resulting non-compatibility prevents the central banks from controlling or giving support to Islamic banks if a liquidity gap should occur. So the issue of liquidity management must come under active discussion and scrutiny by the authorities involved is Islamic banking

Use of Advanced Technology and Media
Many Islamic banks do not have the diversity of products essential to satisfy the growing need of their clients. The importance of using proper advanced technology in upgrading the acceptability of a product and diversifying its application cannot be over emphasized. Given the potentiality of advanced technology, Islamic banks must have to come to terms with rapid changes in technology, and redesign the management and decision-making structures and, above, all introduce modern technology in its operations. Many Islamic banks also lack the necessary expertise and institutional capacity for Research and Development (R & D) that is not only necessary for the realization of their full potential, but also for its very survival in this age of fierce competition, sophisticated markets and an informed public. Islamic banking cannot but stagnate and wither without dynamic and ongoing programmes. In addition, Islamic banks have so far not used the media appropriately. Even the Muslims are not very much aware that the Islamic banking is being practiced in the world. Islamic banks have not ever used an effective media to publicize their activities. The authorities concerned in Islamic banks should address these issues on a priority basis.

Need for Professional Bankers

The need for professional bankers or managers for Islamic banks cannot be over emphasized. Some banks are currently run by direct involvement of the owner himself, or by managers who have not had much exposure to Islamic banking activities, nor are conversant with conventional banking methods. Consequently, many Islamic banks are not able to face challenges and stiff competition. There is a need to institute professionalism in banking practice to enhance management capacity by competent bankers committed to their profession. Because, the professionals working in Islamic banking system have to face bigger challenge, as they must have a better understanding of industry, technology and the management of the business venture they entrust to their clients. They also have to understand the moral and religious implications of their investments with the business ventures. There is also a need for banking professionals to be properly trained in Islamic banking and finance. Most banks professionals have been trained in conventional economics. They lack the requisite vision and conviction about the efficiency of the Islamic banking.

Blending of Approach of Islamic Scholars with the Approach of the Conventional Bankers

Bankers, due to the nature of their jobs have to be pragmatic or applicationoriented. There is and will be tendency in the bankers practicing in Islamic banks to mould or modify the Islamic principles to suit the requirement for transactions at hand. Additionally, being immersed in the travails of day to day banking, they find little time or inclination to do any research, which can make any substantial contribution to the Islamic banking. Islamic Scholars active in researching Islamic Banking and finance, on the other hand, typically have a normative approach, i.e. they are more concerned with what ought to be. A very few of them are knowledgeable about banking or the needs of the customers.

Problems of Islamic Bank Operating under Conventional Banking System

Failure of Islamic banks to finance high-return projects

Islamic bank fails to appropriate high profit from high-return projects since the owners of these projects prefer borrowing from conventional banks where cost of borrowing turns out to be lower. That means, only the projects with rates of return equal to or below the market rate of interest are left with the Islamic banks. At this situation, Islamic banks are not able to invest on the projects having rates of return below the prevailing rate of interest thereby limiting their capacity to utilize investment opportunity to the level of their conventional counterpart. This leads to limiting the application of profit-loss-sharing modes such as Mudaraba and Musharaka. In other words, Islamic banks, at that situation, switch over to other modes of financing such as Murabahah, hire purchase, leasing, etc.

Sacrifice of allocative efficiency

Allocative efficiency of Islamic bank, if it is truly a profit-loss-sharing bank, is builtin to its financing mechanism. It is not possible to achieve the desired level of allocative efficiency when entrepreneurs switch over from Islamic banks to conventional banks to avoid high cost borrowing. Profitability of projects being the ideal device of efficient resource allocation, at this situation, does not apply to Islamic banking system as it, considering the rational behavior of the borrower, takes recourse to modes other than profit-loss-sharing. This situation continues as long as Islamic banks operate side by side with the conventional banks. Experts are very much worried about this situation of Islamic banking. Up till now no

effective policy prescription is available to the Islamic banks to ameliorate the situation.

Loss of distributive efficiency

It has also been found that distributive efficiency of Islamic banking is lost when an Islamic bank starts operation under conventional banking framework. Any shift from profit-loss-sharing modes leads the system break the direct relationship between the incomes of the entrepreneurs, the bank and the depositors. The inefficiency of conventional banking about distribution is neither influenced nor modified by the introduction of Islamic banking in the economy.

Problem Specific to Islamic Banking in Pakistan

Absence of Islamic Money Market
In the absence of Islamic money market in Pakistan, the Islamic banks cannot invest their surplus fund i.e., temporary excess liquidity to earn any income rather than keeping it idle.(how ever in Pakistan SBP issue SUKOOK bonds) Because all the Government Treasury Bills, approved securities and Pakistan Bank Bills in Pakistan are interest bearing. Naturally, the Islamic banks cannot invest the permissible part of their Security Liquidity Reserve and liquid surplus in those securities. As a result, they deposit their whole reserve in cash with state Bank.where SBP invest these funds islamicaly under supervision of Shariah board and gives the profits to these banks. Similarly, the liquid surplus also remains uninvested. On the contrary, the conventional banks of the country do not suffer from this sort of limitations. As such, the profitability of the Islamic banks in Pakistan is adversely affected.

Absence of Suitable Long-term Assets
The absence of suitable long term assets available to Islamic banks is mirrored by lack of short term tradable financial instruments. At present there is no equivalent of an inter-bank market in Pakistan where banks could place, say, over night funds, or where they could borrow to satisfy temporary liquidity needs. Trading of financial instruments is also difficult to arrange when rates of return are not known until maturity.Obviously, these factors place Islamic banking in Pakistan at a distinct disadvantage compared to its conventional banking counterpart.

Shortage of Supportive and Link Institutions
Any system, however well integrated it may be, cannot thrive exclusively on its built-in elements. It has to depend on a number of link institutions and so is the case with Islamic banking. For identifying suitable projects, Islamic banking can profitably draw the services of economists, lawyers, insurance companies, management consultants, auditors and so on. They also need research and training forums in order to prompting entrepreneurship amongst their clients. Such support services properly oriented towards Islamic banking are yet to be developed in Pakistan.

Organizing Relationship with Foreign Banks
Another important issue facing Islamic banks in Pakistan is how to organise their relationships with foreign banks, and more generally, how to conduct international operations. This is, of course, an issue closely related to the creation of financial instruments, which would be simultaneously consistent with Islamic principles and acceptable to interest-based banks, including foreign banks

Long-term Financing
Islamic Banks stick very closely to the pricing policies of the government. They can not benefit from hidden costs and inputs, which elevate the level of prices by certain entrepreneurs without any justification. On the other hand, Islamic banks as financial institutions are even more directly affected by the failure of the projects they finance. This is because the built in security for getting back their funds, together with their profits, is in the success of the project. Islamically, it is not lawful to obtain security from the partner against dishonesty or negligence, both of which are very difficult if not impossible to prove.


Islamic banks can satisfy most of the efficiency conditions if they can operate as a sole system in an economy. Conventional banking, on the other hand, does not satisfy any of the efficiency conditions analyzed above. However, when Islamic banks start operation within the conventional banking framework, their efficiency goes on decreasing in a number of dimensions. The deterioration is not because of Islamic bank's own mechanical deficiencies; rather it is the efficiency-blunt operation of the conventional banking system that puts a negative impact on the efficient operation of Islamic banks. This does not mean that the survival of Islamic banks operating within the conventional banking framework is altogether threatened. Evidence from Bangladesh indicates that Islamic banks can survive within the conventional banking framework by switching over from PLS to trade-related modes of financing. Even under the conventional banking framework Islamic banks can operate with certain level of efficiency by applying in a reasonable percentage the PLS modes the distinguishing features of Islamic banking. This has been possible in some countries of the Muslim world where the management of Islamic banks was cautious about possible impacts of every policy measure. Particularly, the management of these banks was judicious in selecting major sectors or areas of their operations.

In order to operate in global markets effectively, it is desirable that the size of operations of Islamic banks be substantially increased. In this regard, serious consideration should be given to mergers. Islamic banks have to increase their size as well as form strategic alliances with other banks. It will also be useful to build bridges between existing Islamic banks and those conventional banks that are interested to do banking on Islamic principles.

To promote teaching, training and research in Islamic banking and finance and to produce and disseminate authentic information on their activities with a view to develop new Islamic financial products, it is proposed that Islamic banks strengthen their cooperation with the assistance of the Islamic Research and Training Institute.

With a view to broaden the equity base of the economies of Muslim countries, it is desirable to establish institutions dealing more in equities. These include mutual funds, unit trusts, pension plans etc. It would also be desirable to encourage businesses through macro-economic policies to increase the use of equity finance and decrease their reliance on debt. Until Islamic countries do not opt for a complete Islamic banking system, it is necessary to enact some laws to facilitate the operation of a mixed system. In this context, one of the most serious problems being faced by Islamic banks is the lack of proper legal framework to deal with cases of delayed payments and bad loans expeditiously. Since Islamic banks cannot charge interest on the delayed debts, they face a bigger risk of default as well as loss in income. These considerations, among others, necessitate that special laws for the introduction and practice of Islamic banking be put in place. Another important policy issue relates to tax treatment. Under the conventional system, interest paid by corporations is treated as a tax-deductible expense. Similar

treatment must be given to the dividends paid out by financial institutions. It is proposed that an autonomous Board for shari¶ah supervision of Islamic banks, may be constituted. In addition, there is also a need for Central banks in Muslim countries to consider the special nature of Islamic banking and devise suitable international standards for major control variables similar to the Basle Committee for Banking Supervision. There is an urgent need to increase the supply of scholars with dual specialisation in shari'ah and finance. In order to meet this need, it is recommended that courses may be introduced for shari'ah scholars in economics and finance. Similarly, courses in shari'ah especially designed for economists and financial experts may be initiated


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