PROGRESS AND

Development OF
ISLAMIC BANKING
IN PAKISTAN

Submitted by: Muhammad Rehan Saeed

Submitted to: Dr. Abuzar Wajidi
Seat No. :085724 MHRM (FINAL)
 CONTENTS

Page No.
CHAPTER 01: INTRODUCTION AND BACKGROUND

1.1 Introduction…………………………………………………. 04

1.2 Purpose of Study……………………………………………. 09

1.3 Research Objectives………………………………………… 10

1.4 Limitation of the Study………………………………………. 11

1.5 Research Methodology……………………………………… 12

CHAPTER 02: LITERATURE REVIEW

2.1 What are Islamic Banks…………………………………… 13

2.2 Knowledge about Islamic Banks …………………………….. 14

2.3 History of Islamic Banking ………………………………….. 16

2.4 Islamic Banking System …………………………………… 18

2.5 Principles of Islamic Bank…………………………………… 18

CHAPTER 03: ISLAMIC BANKING IN PAKISTAN

3.1 Growth……………………………………………………… 23

3.2 Investment………………………………………………….. 33

3.3 Market Share……………………………………………….. 38

3.4 Prospects…………………………………………………… 41

CHAPTER 04: PROBLEMS AND ISSUES

4.1 Taxation Issues…………………………………………….. 47

2
4.2 Financial Reporting and Accounting Standards…………….. 48

4.3 Islamic Export Refinance Scheme………………………….. 49

4.4 Lack of Expertise…………………………………………… 50

4.5 Network Issues…………………………………………….. 53

4.6 Lack of Awareness…………………………………………. 54

CHAPTER 05: RESEARCH FINDINGS

5.1 Customer’s Preferences………………………………… 56

5.2 Customer’s Understanding……………………………… 62

CHAPTER 06: CONCLUSION

AND
RECOMMENDATIONS

6.1 Conclusion………………………………………………. 65

6.2 Recommendations........................................................ 69

BIBLOIGRAPHY……………………………………………. 74

ANNEXURE-A………………………………………………… 77
RESEARCH PROPOSAL …………………………………….. 78

3
 1. INTRODUCTION

1.1 Introduction
In any economy banks play very important role. A bank is a reliable

financial institution, which has core business of mobilizing the savings of people for

investment purposes. It receives the money from one group and lends to other group

of people. So bank performs the duty of financial intermediary.

Usually there are two types of banks, conventional banks and Islamic banks.

In simple words Islamic banks operate in interest free system. Prohibition of interest

is ordained in Islam in all forms and intent. This Prohibition is strict, absolute

and unambiguous.

The Holy Qur'an in verse 278 of Surah Al-Baqarah states:

"O ye who believe! Fear Allah and give up what remains of your demand for

riba, if ye are indeed believers."

Verse 2: 279 says:

"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 you shall not

be dealt with unjustly."

It therefore, follows that interest is prohibited as it leads to injustices and Islam

is against all forms of injustices and exploitations and pleads an economic system,

which aims at securing extensive socio-economic justice. The Islamic law of

prohibition of riba, which includes interest, was originally not based on economic

4
theory but on Divine Authority which considers the charging of interest as an act of

injustice (Dr. Siddiqui).

Islamic banks appeared on the world scene as active players two decades ago.

But many of the principles on which Islamic banking is based have been

commonly acceptable all over the world for centuries rather than decades, as it is

evident that Islamic finance was practiced predominantly in the Muslim world

throughout the middle Ages, promoting trade and business activities. In Spain and the

Mediterranean and Baltic States, Islamic merchants became indispensable middlemen

for trading activities. It is claimed that many concepts, techniques, and instruments of

Islamic finance were later adopted by European financiers and

businesspersons."Although the western media frequently suggest that Islamic

banking in its present form is a recent phenomenon, in fact, the basic practices and

principles date back to the early part of the seventh century" (Islamic Finance: A Euro

money Publication, 1997).

The main issue here is to know about the differences between operations of

a conventional bank and an Islamic bank by focusing on the principles and

instruments of Islamic banking.

It is difficult to say with accuracy which was the first such company or bank

that pioneered this concept of Islamic banking in practice. Some analysts and experts

in the field are of the opinion that, Islamic banking and finance, in the modern

context, first emerged in 1963, when Mit Ghamr Saving Bank began an experimental

project offering interest free banking in Egypt. The project was a success and lead to

the bank opening four new branches by 1967. In the same year, eight new banks

mushroomed offering interest free banking. Due to the political climate prevailing in
5
Egypt during that period, the success of these Islamic banks was seen as a threat,

and they were forced to close down in 1971.

Some observers are of the opinion that the concept of an "Islamic bank" was

born at the Islamic Summit of Lahore, Pakistan in 1974 which recommended the

creation of an Islamic Development Bank. Since then Islamic banking and financial

institutions have grown rapidly. A 1993 report from the International Association

of Islamic Banks estimated the then industry to be valued at $80 billion. A more

recent article appearing in the Wall Street Journal estimates the potential market for

Islamic investments to be up to

$150 billion.

Within a time span of a few decades, Islamic banking and financial

institutions have been swift to establish themselves in all parts of the world in the

form of Islamic

Commercial Banks, Investment and Holding Companies, Takaful Insurance)

Companies, and Development Banks. The over 150 such institutions that invest

money according to Islamic economic principles, are poised to increase in number

over the next few years. Several Muslim countries, Indonesia, Iran, Malaysia,

Pakistan, Sudan and Turkey, in recent years have been taking systematic steps to

establish an Islamic banking and financial sector. The speed with which Islamic banks

have sprung up and the rate at which they have progressed make it worth while to

study them systematically.

Malaysia in 1983 passed an Islamic Banking Act to facilitate the growth

of indigenous Islamic banks and finance companies thus became the first Muslim

economy to issue bonds on an Islamic basis. Since then, some 50-60 institutions

6
have been established, and are now in the process of forming an Islamic inter-bank

market (i.e. in which banks borrow or lend to each other). Within 10 years of

introducing the Islamic Banking Act, the Malaysian government has taken further

steps to popularize Islamic banking and finance, by allowing conventional banks

to offer Shariah-compliant instruments. The most distinctive feature of Islamic

banking in Malaysia is that it is being embraced by its Chinese and non-Muslim

population who are opting to deposit their savings or borrow money on an Islamic

basis.

The momentous decision of the Pakistani Supreme Court, in Ramadan 1420,

to strike down all laws that condone interest and their orders to the Federal

government to bring all existing financial organizations in line with Islamic

principles is truly path-

breaking. The world is watching with bated breath to see how the whole economy

faces this challenge (www.alrajhibank.com.sa/islamicebanks.htm).

These trends in Malaysia and elsewhere are having a profound effect on

the banking and financial world as a whole. For example, America's Citibank was

the first major conventional bank to establish an Islamic bank in Bahrain, with an

operating capital of $20 million (The Economist, 1996). It may be a puny sum, but, it

does suggest to some degree that conventional banks have begun to embrace

Islamic banking on a moderate scale. Here again the point arises, that, there is some

difference between the operations of two banking systems and also there is

something which is attracting conventional banks towards Islamic banking system.

A significant proportion of the banking system has been Islamized in

7
Pakistan. Recently the state bank of Pakistan has allowed commercial banks to set

up Islamic banking subsidiaries or provide full Islamic banking facilities through

dedicated branches (Dawn economic & business review, 2003).

Meezan Bank of Pakistan had conducted a research last year to ascertain,

is Islamic banking really a need of the people? The main findings of the research

were that there is a strong need for a riba-free banking system. People perceive a

number of emotional benefits from a product that is based on the tenets of Islam. The

objective is to alleviate the feeling of guilt by following the tenets of Islam. There is

also a belief that Islamic banking will help fight the ills of the economy of the country.

A number of other Western financial institutions have followed suit by

offering Islamic mutual funds and other investment products. For example, ANZ

Grindlays is now offering financial products that meet Islamic criteria. Germany's

fourth largest bank, Commerz bank, started offering Islamic mutual funds from

December 1999. In February

1999, Dow Jones introduced the Dow Jones Islamic Market index (DJIM) of

600 companies worldwide that comply with the Shariah laws.

Many Western Academic Institutions are introducing Islamic Economy

and Banking as Subjects, like Harvard University Center for Middle Eastern Studies

(CMES), Durham University, UK, Dow Jones University….etc.

These indicators reflect the rising trend of Islamic banking and finance

throughout the world. This encourages one to know in detail what Islamic banking is

all about, what are its principles and how it is different from conventional banking

system.

8
 The Amana Fund, the LARIBA bank, in USA and the Halal investment

company in London is another indicator of the growing salience of Islamic banking

institutions not just in Muslim countries, but in the West as well. These efforts in

different countries for Islamic banking present not only an excellent working

examples for those who did not believe in the practicality of the interest free banking

but also provide a spade work over which the infrastructure of interest free banking for

a country could be built up.

1.2 Purpose of Study

It is true that external financing is utmost important almost for every kind

of business in an economy and banking industry is the main facilitator in this regard.

Islamic banking system plays its role in the banking industry as its minor part. Even

though it’s a minor part it can’t be left behind because banks are the citadels of the

economic growth. So, studying Islamic banking system in detail will not only benefit

the researcher but also will be a source of effective information for many classes of

bank customers. It will help better understanding Islamic banking system and its

salient features.

Our main purpose of the study of this topic to focus on the growth of Islamic
Banking sector in Pakistan, as we came to known to know being slow
economic activities Islamic banking sector grow more than the conventional
banking sector in Pakistan, we will highlight the growth in all aspects, growth in
Market Share, Investment, Branch network, Depositors and many more factors
will be include in the study.

9
1.3 Research Objectives

This research report or thesis is the basic requirement of University of

Karachi, for any student to obtain the degree. This is a way to help students enhance

their knowledge by making them learn from the practical environment and also to

apply the learned theoretical concepts in the practical field. Thus, the main objective

of this research is to fulfill the partial requirement of the University for obtaining the

degree.

As such, the purpose of this study is to review the various aspects of Islamic
Banking and to identify the factor of growth of Islamic banking in Pakitan and also
assess their viability and applicability with respect to individual and corporate
consumers. More specifically the objectives will be:

To review the History and Development of Islamic Baking in the

Pakistan. This will enable the readers in understanding the evolution of
Islamic Banking and will consequently enable them in evaluating its need
in present times.
To focus on the growth of Islamic banking system in Pakistan, as stated
in the report of the state bank of Pakistan that Islamic banks have more
growth than the conventional banks in Pakistan.
To gauge the differences between ‘interest based banking’ and ‘Islamic
banking’. This will assist us in inferring as to whether ‘Islamic Banking’
does indeed protect the interests of the debtor and will highlight
significant advantages and disadvantages of the two systems.
To understand the role of government of Pakistan in the
implementation of the proposed system.

To gauge the attractiveness of Islamic Banking System for local and foreign
banks. As these banks are expected to incorporate Islamic Banking in
their current structure, it is essential that this option be made feasible for
them.
To ascertain corporate and individual consumer attitude towards Islamic
10
 Banking in order to evaluate its success in Pakistan. It is essential to
gauge the interest of potential clients for a new product. If the potential
market for Islamic Banking is insufficient to justify investment, the
banks might want to develop the product further in order to make it more
attractive for their clients, such as Islamic Car Financing Schemes.

1.4 Limitation of the Study

The research is conducted within the following limitations:

 To keep the study manageable research is conducted on limited grounds.

 The study is conducted on small level and only the important aspects are

considered.

 There was a shortage of time that’s why limited data is collected. Still the

researcher has tried to collect sufficient data to make an effective analysis.

 Limited period of time and small sample size in survey questionnaire.

Results may not be indicative for the target respondents at large.

 Some respondents, who have limited knowledge of Islamic banking or no

knowledge about the financial modes of conventional and Islamic banking,

also answered the questions; hence the replies of some questions may be

based on their own imagination or thoughts.

 Although majority of our respondents of Islamic banking questionnaire were

account holders of Meezan Islamic Bank,however some of our respondents

had accounts in other Islamic banks too or accounts in Islamic branches of

11
 conventional banks, so the results of this study are not fully applicable to

Meezan Islamic Bank of Pakistan.

Therefore, in this study the results about Islamic banking should be taken only as

indicative and perceptive rather than conclusive.

1.5 Research Methodology

This study is basically descriptive in nature, and this would explore & review the

research done on Islamic banking by different researchers and scholars.

This research work used data collection direct from the financial Statements of the

banks, both Islamic and conventional and also from the reports of State Bank of

Pakistan, another source is direct from the customer of the both kinds of banks,

documents researches and interviews of the relevant authorities. Fieldwork was

conducted during the months of September and October of year 2009. Although

all

replies were collected in personnel at the allocated areas, some replies were

collected after the period prescribed above. The primary data collection applied

obtaining the information from peoples through filling of questionnaires, observation,

and interview methods in Karachi. Local university students and friends have also

helped for this work. 300 persons at Meezan Islamic bank and 300 at conventional

banks in karachi were asked to express their views during this study.

12
 CHAPTER 2

LITERATURE
REVIEW

2.1 What are Islamic Banks (RIIC by Prof. Khursheed)

Unlike their counterparts elsewhere, Islamic bankers do not expect to

advance money and receive a predetermined sum on a fixed date in the future. Under

the Shariah, the bedrock of the Islamic faith, they are instead responsible for

ensuring that money is invested in viable projects, with reliable borrowers. If the

project succeeds the banker shares in the profit. If it fails he suffers the losses.

The Shariah, which dictates the activities of the banks as well as forming the

basis of the daily lives of all Muslims, requires that reward comes from risk

sharing. Profit must be justified through the creation of value that the banker brings

to complement the value of the borrower’s efforts and skill as mentioned in report

on Islamic ideology council.

Against a background of rapid growth in Middle Eastern economies over the

last 20 years and a desire to increasingly compete internationally, Islamic

banks have begun to change and develop to provide a range of alternative

financial products - still firmly based on Islamic principles.

13
 Islamic financial techniques have been employed successfully in a

growing number of major projects in the West. Al Rajhi Bank has completed

deals for the financing of ships and aircraft (using the Ijara - lease financing

technique), and many industrial projects including the building of power stations, a

refinery and schools, and the expansion of an aluminium smelter in Bahrain (using

the Istisna - deferred financing technique).

Given the huge potential for development in the Islamic world and the

increasing amount of funds being invested according to the Shariah, it seems perfectly

reasonable to suppose that the recent growth in Islamic banking will continue at an

accelerated pace (Colin Willis).

2.2 Knowledge about Islamic Bank

A research on “Bank Patronage Factors of Muslim and Non-Muslim

Customers”conducted in Malaysia in 1994 shows that almost 100 per cent of

the Muslim population was aware of the existence of the Islamic bank; the

sources of knowledge are mainly newspapers and magazines, television and

radio, and family members. Many of the Muslim respondents visit the

bank’s branch and seek information about the bank services and operations on

their own initiative. For non-Muslims, about 75 per cent of the

respondents know of the existence of the Islamic bank from information

derived mainly from newspapers and magazines. Other sources of information

are not so effective for the non-Muslims.

14
 Even though it has been nearly a decade since the Islamic bank was

first established in the country, only about 63 per cent of the Muslims have

understood either partly, or completely, the differences between the Islamic bank and

conventional banks. Non-Muslims showed much less understanding. Only 12 per cent

of the Muslims and 32 per cent of the non-Muslims believe that the Islamic bank is for

Muslims customers only. In terms of why people patronized the Islamic bank, about

39 per cent of the Muslim respondents believe that religion is the only reason why

people patronize the Islamic bank, and, surprisingly, the percentage is much lower for

non-Muslims. More than half of both respondent groups have indicated the possibility

of establishing a relationship with the Islamic bank if they have a complete

understanding about the operations of an Islamic bank (International journal of bank

marketing, 1994).

The changes in the banking system have created a new dimension in the

banking industry within which the institutions in the banking system have to

compete, not only with financial institutions outside the banking system, but

also with themselves to remain in business. Indeed, the fiercer level of

competition is not only faced by the banking industry in Pakistan, but also it

is becoming the most influential factor in the structure and activities of the

banking system around the globe.

In the UK, for example, increasing competition has pushed British banks

into much greater customer-oriented and competitive behavior. In other countries, the

industry has been transformed from its traditional staid image to that of a vibrant

and dynamic environment (Turnbull and Gibbs, 1989).

15
2.3 History of Islamic Banking

Haqiqi & Pomeranz in their article “Accounting Needs of Islamic Banking”

gave the history of Islamic banking. They explained that, In Muslim communities,

limited banking activity, such as acceptance of deposits, goes back to the time when

the Prophet Muhammad was still alive. At that time, people deposited money with

the Prophet or with Abu Bakr Sedique, the First Khalif of Islam. The first

modern Islamic bank, established in Egypt in 197, was called Nasser's Social

Bank. Islamic accounting, an essential tool for the success of Islamic banks, is

said to have been developed contemporaneously at the University of Cairo (Crane).

The desirability of abolishing fixed interest rates and the Islamization of

financial systems were discussed at the first meeting of the Islamic Organization

Conference (IOC) in Jeddah in 1973. Subsequently, many Islamic banks were

founded under the profit-and- loss sharing system (PLS), which will be

discussed below.

Modern Islamic banking has undergone three phases of

development:

Emergence-1972 through 1975: This period was marked by a surge in

oil revenues and great liquidity.Parallel event sincluded resurgence of

fundamentalist Muslim movements, reemphasis on the Wahabi School

of Brotherhood and Pan-Islamism, and establishment of IOC.

16
 Expansion-1976 to the early 1980s: Islamic banking spread from the:

Arabian Gulf eastward to Malaysia, and westward to England. More than

Accounting Needs of Islamic Banking 155 20 Islamic banks were

established, including international and intercontinental institutions.

Maturity--1983 to the present: The Arab world was confronted by

`economic setbacks, including slowdowns in oil revenues, the collapse of Ku-

wait's Souk al- Manakh, the relative strength of the U.S. dollar, higher interest

rates in the United States, and capital outflows from OPEC nations. At the

same time, Arab banks opened branches in the United States and Islamic

banking practices were implemented in both Pakistan and Iran.

Islamic banking operations are not limited to Arab soil, or Islamic countries,

but are spreading throughout the world. One reason is the "growing trend

toward transcending national boundaries, and unifying Muslims into a political and

economic entity that could have a significant impact on the pattern of world trade.

...Since Muslims are inclined to follow Islamic traditions, there is a tendency to

establish an Islamic economic system in every Islamic nation, And to restore Shariah

Law as the basic source for legislation" (Abdel-Magid).

Further expansion is planned for example; DMI has announced a five-

year program to create a network of branches and subsidiaries in more than twenty

countries (The Economist, 1982). An American businessman of Iraqi origin plans to

establish a U.S. based financial institution to be administered in accordance with

Islamic banking practice. When approved by U. S. authorities, the institution will

serve several million American Muslims (Barron's 1985).

17
2.4 Islamic Banking System (Fredric Mishkin)

“Islamic banking system deal with money and not deal in money”

It is argued by Muslim scholars that whereas traditional banking is

concerned with financial intermediation on the basis of lender-borrower

relationship between depositors and banks, on one hand, and banks and the fund-

seekers, on the other hand, Islamic banking is about addressing genuine concerns of

the owners of funds and needs of the resource-strapped through Shari’ah permitted

forms of transactions.

The argument is built on the following premise.

“What is permitted for an individual is also permissible for the banks (that

are groups of individuals – shareholders) unless there are reasons to conclude

otherwise”.

2.5 Principle of Islamic Banking

For millions of Muslims, banks are institutions to be avoided. Islam is a

religion which keeps Believers from the teller's window. Their Islamic beliefs prevent

them from dealings that involve usury or interest (Riba) Yet Muslims need banking

services as much as anyone and for many purposes: to finance new business

ventures, to buy a house, to buy a car, to facilitate capital investment, to undertake

trading activities, and to offer a safe place for savings. For Muslims are not

18
averse to legitimate profit as Islam encourages people to use money in Islamically

legitimate ventures, not just to keep their funds idle (Nida'ul Islam 1995).

However, in this fast moving world, more than 1400 years after the

Prophet (s.a.w.), can Muslims find room for the principles of their religion? The

answer comes with the fact that a global network of Islamic banks, investment

houses and other financial institutions has started to take shape based on the

principles of Islamic finance laid down in the Quran and the Prophet's traditions 14

centuries ago. Islamic banking, based on the Quranic prohibition of charging

interest, has moved from a theoretical concept to embrace more than 100 banks

operating in 40 countries with multi-billion dollar deposits world-wide. Islamic

banking is widely regarded as the fastest growing sector in the Middle Eastern

financial services market. Exploding onto the financial scene

barely thirty years ago, an estimated $US 70 billion worth of funds are now

managed according to Shari'ah. Deposit assets held by Islamic banks were

approximately $US5 billion in 1985 but grew over $60 billion in 1994.

The best known feature of Islamic banking is the prohibition on interest.

The Quran forbids the charging of Riba on money lent. It is important to understand

certain principles of Islam that underpin Islamic finance. The Shari'ah consists of the

Quranic commands as laid down in the Holy Quran and the words and deeds of

the Prophet Muhammad (s.a.w.). The Shari'ah disallows Riba and there is now a

general consensus among Muslim economists that Riba is not restricted to usury but

encompasses interest as well. The Quran is clear about the prohibition of Riba, which

is sometimes defined as excessive interest. "O you who believe! Fear Allah and

give up that remains of your demand for usury, if you are indeed believers."

19
Muslim scholars have accepted the word Riba to mean any fixed or guaranteed

interest payment on cash advances or on deposits. Several Quranic passages expressly

admonish the faithful to shun interest.

The rules regarding Islamic finance are quite simple and can be summed up

as follows:

a) Any predetermined payment over and above the actual amount

of principal is prohibited.

Islam allows only one kind of loan and that is qard-el-hassan (literally good

loan) whereby the lender does not charge any interest or additional amount

over the money lent. Traditional Muslim jurists have construed this principle

so strictly that, according to one commentator "this prohibition applies to any

advantage or benefits that the lender might secure out of the qard (loan) such

as riding the borrower's mule, eating at his table, or even taking advantage of

the shade of his wall." The principle derived from the quotation emphasizes

that associated or indirect benefits are prohibited.

b) The lender must share in the profits or losses arising out of

the enterprise for which the money was lent.

Islam encourages Muslims to invest their money and to become partners in

order to share profits and risks in the business instead of becoming creditors. As

defined in the Shari'ah, or Islamic law, Islamic finance is based on the

belief that the provider of capital and the user of capital should equally share

the risk of business ventures, whether those are industries, farms, service

companies or simple trade deals. Translated into banking terms, the

20
 depositor, the bank and the borrower should all share the risks and the

rewards of financing business ventures. This is unlike the interest-based

commercial banking system, where all the pressure is on

the borrower: he must pay back his loan, with the agreed interest, regardless of

the success or failure of his venture.

The principle which thereby emerges is that Islam encourages investments

in order that the community may benefit. However, it is not willing to

allow a loophole to exist for those who do not wish to invest and take risks

but rather content with hoarding money or depositing money in a bank

in return for receiving an increase on these funds for no risk (other than the

bank becoming insolvent). Accordingly, under Islam, either people invest with

risk or suffer loss through devaluation by inflation by keeping their money

idle. Islam encourages the notion of higher risks and higher returns and

promotes it by leaving no other avenue available to investors. The objective is

that high risk investments provide a stimulus to the economy and encourage

entrepreneurs to maximize their efforts.

c) Making money from money is not islamically acceptable.

Money is only a medium of exchange, a way of defining the value of a thing;

it has no value in itself, and therefore should not be allowed to give rise to

more money, via fixed interest payments, simply by being put in a bank or

lent to someone else. The human effort, initiative, and risk involved in a

productive venture are more important than the money used to finance it.

Muslim jurists consider money as potential capital rather than capital,

meaning that money becomes capital only when it is invested in

21
 business. Accordingly, money

advanced to a business as a loan is regarded as a debt of the business and

not capital and, as such, it is not entitled to any return (i.e. interest).

Muslims are encouraged to purchase and are discouraged from keeping money

idle so that, for instance, hoarding money is regarded as being unacceptable.

In Islam, money represents purchasing power which is considered to be the

only proper use of money. This purchasing power (money) cannot be used to

make more purchasing power (money) without undergoing the intermediate

step of it being used for the purchase of goods and services.

d) Gharar (Uncertainty, Risk or Speculation) is also prohibited.

Under this prohibition any transaction entered into should be free

from uncertainty, risk and speculation. Contracting parties should have

perfect knowledge of the counter values intended to be exchanged as a

result of their transactions. Also, parties cannot predetermine a guaranteed

profit. This is based on the principle of 'uncertain gains' which, on a strict

interpretation, does not even allow an undertaking from the customer to repay

the borrowed principal plus an amount to take into account inflation. The

rationale behind the prohibition is the wish to protect the weak from

exploitation. Therefore, options and futures are considered as un-Islamic

and so are forward foreign exchange transactions because rates are

determined by interest differentials.

A number of Islamic scholars disapprove the indexation of indebtedness

to inflation and explain this prohibition within the framework of qard-el-

22
 hassan. According to those scholars, the creditor advances the loan to win the

blessings of Allah and expects to obtain the reward from Allah alone.

A number of transactions are treated as exceptions to the principle of

gharar: sales with advanced payment (bai' bithaman ajil); contract to

manufacture (Istisna); and hire contract (Ijara). However, there are legal

requirements for the conclusion of these contracts to be organized in a way

which minimizes risk.

e) Investments should only support practices or products that are not

forbidden in Islam.

Trade in alcohol, for example would not be financed by an Islamic bank; a

real- estate loan could not be made for the construction of a casino; and the

bank could not lend money to other banks at interest.

3. ISLAMIC BANKING IN PAKISTAN

3.1 Growth

Islam was the basis of creation of an independent state within the undivided Indo-
Pak Sub- Continent. All Constitutions of Pakistan have incorporated, within the
principles of policy, the elimination of Riba as an important objective of the State
policy. Quaid-e-Azam, the father of the nation, in his speech at the occasion of the
inauguration of State Bank of Pakistan, had expressed the desire for evolving an
Islamic system of banking. In Pakistan Islamic banking emerged as a response to
both religious and economic needs.
23
Efforts for economy wide elimination of Riba started during 1970s and most of the
significant and practical steps were taken in early 1980s. It was a very bold and
comprehensive exercise. Pakistan was among the three countries in the world that
had been trying to implement interest free banking at comprehensive /
national level.

Numerous measures were taken to introduce interest free banking in

Pakistan. Banking and other relevant laws viz. SBP Act, Companies
Ordinance, recovery laws, negotiable instruments act, etc. were amended to
facilitate interest free banking system and the industry was given a specific
timeline to convert to the Islamic banking system.

State Bank Pakistan also gave the industry the products which it was allowed to use
without any change or exception. Islamic banking was rolled out country-wide.
New regulations were prepared prescribing the modes of financing, profit
distribution mechanism for deposits, financing facilities by SBP, etc. which
constituted ground work for Islamization of financial system. The mid-80s attempt
was a significant step in the evolution of Islamic banking system in the country. In a
technical sense it was the most advanced model compared to any other model being
practiced anywhere in the world at that time. The efforts and practical steps
undertaken in the 1980’s to Islamize the economy at national level are considered
as pioneering work in the Muslim world as this became important reference
material for other countries which undertook the path towards introduction and
establishment of an Islamic banking system. In early 90s the whole exercise
was challenged in the Federal Shariat Court and the procedure adopted by banks in
Pakistan since July 1, 1985 was declared un-Islamic by the Federal Shariat Court
(FSC) in November 1991. The system was based largely on ‘mark-up’ technique
with or without ‘buy-back arrangement’. The FSC declared that various provisions
of the laws held repugnant to the injunctions of Islam in its Judgment dated
November 14, 1991 would cease to have effect as from July 1, 1992.

In a meeting held on September 4, 2001 under the Chairmanship of the

President of Pakistan, attended by officials of the Ministries of Finance and Law,
24
Governor State Bank of Pakistan, Chairman and some members of the Council of
Islamic Ideology and the Chairmen, and the two Task Forces it was decided that the
shift to interest free economy would be made in a gradual and phased manner and
without causing any disruptions. It was also agreed that State Bank of Pakistan
would offer three institutional options:

1) Setting up subsidiaries by the commercial banks for the purpose of

conducting Shariah compliant transactions;

2) Specifying branches by the commercial banks exclusively dealing in Islamic

products with all safeguards to ensure integrity and purity of Islamic banking
operations,

3) Setting up a new full-fledged commercial bank to carry out exclusively

banking business based on proposed Islamic products.

As a result of these efforts, in 2001, an Islamic Banking Division was

established in the Banking Policy Department at SBP. This time around,
concerted efforts were made by SBP to undertake Islamic Banking in its true spirit
and also keeping in view the lessons learnt from the experience of Bahrain,
Malaysia and Saudi Arabia etc. in this area. Accordingly, steps have been taken to
set up a parallel banking system, so that an enabling environment is ensured
for the sector, avoiding any serious repercussions of entire transformation of
financial sector.

Shariah Compliance Developments

The present re-launch of Islamic Banking in Pakistan by the State Bank of

Pakistan has been based not only on the lessons learnt from the history of Islamic
Banking efforts in Pakistan but also on the experiences of other countries in the
world that are currently known for their leadership role in this banking sector. The
basic difference, in SBP’s current policies regarding Islamic banking and the
previous efforts, is the approach adopted by SBP wherein the introduction of
Islamic Banking is being viewed more as a change management issue rather than as a
25
religious or a legal issue.

This basic difference in approach defines the policies on Islamic Banking and is
primarily responsible for the success achieved so far. It was decided to promote
Islamic banking in a gradual manner and as a parallel and compatible
system that is in line with best international practices. Following the
pronouncement of the government to shift to interest free economy in a phased
manner without causing any disruptions the effort was envisaged to be based on a
market driven and flexible approach.

Furthermore this approach is also helping build a broad based financial system
in the country to enable all segments of the population to access financial
services.

Shariah compliance is the most important aspect of Islamic finance. The

credibility of Islamic Banking Institutions (IBIs) not only depends on the
financial health of the institution but also on its adherence to the Shariah.

Under the current strategy for promotion and development of Islamic Banking as a
parallel, viable and compatible system, State Bank of Pakistan has put in place a
comprehensive Shariah Compliance Structure.

The Shariah Compliance Framework established by State Bank of Pakistan consists

of:

1. Shariah Board at SBP

2. Shariah Advisor
3. Essentials & Model Agreements of Islamic Modes of Financing
Instructions and Guidelines for Shariah Compliance in Islamic
Banking Institutions
4. Shariah Advisors Forum
5. Shariah Compliance Inspection
6. Standardization of Shariah Practices- Adoption of AAOIFI
(Accounting and Auditing Organization for Islamic Financial Institutions)
26
 Shariah Standards

Each Islamic Banking Institution (IBI) is required to work under the guidance of a
Shariah advisor. To keep this process more objective, broad based and responsive
to the market conditions SBP Shariah Board has approved Fit & Proper Criteria
for Shariah advisors of IBIs. According to this Criteria, minimum required
Shariah and contemporary educational qualification as well as experience and
exposure for becoming a Shariah Advisor has been defined. Moreover, to
minimize conflict of interest, it has been specified that a person cannot work as
Shariah Advisor for more than one IBI in Pakistan. Further, it has been specified
that a Shariah Advisor shall not hold any executive/non-executive position in
any other financial institution, except working as Shariah Advisor of Islamic
mutual funds of the same IBI. In addition to that, Shariah Advisors of IBIs have
been barred from having any substantial interest in or becoming employee of some
types of organizations like exchange Companies, corporate brokerage houses or stock
exchange.
These provisions in Fit and Proper Criteria for Shariah Advisors has ensured
objectivity in evaluation criteria, minimization in conflict of interest and
induction of new lot of Shariah advisors in the market.

Current Industry Review

This time there has been a shift in the approach from the legal & regulatory
perspective to that of dealing with the whole affair of introducing Islamic
banking in Pakistan as a change management issue. As compared to our past
experience our new approach provides flexibility to the IBIs as regard to
products, instruments and Shariah compliance methodology. This new
initiative has witnessed a very encouraging response. As at end of the year
2003 only one bank operated as a full-fledged Islamic bank and three
conventional banks were operating Islamic banking branches. Currently there are 6
full fledged licensed Islamic banks (IBs) and 12 conventional banks have licenses
to operate dedicated Islamic banking branches (IBBs). All of the five big banks in
Pakistan are providing Islamic banking services. The total assets of the Islamic
banking industry are over Rs. 313 billion as of June,2009 which accounts for a
27
market share of 5.1% of total banking industry assets. The market share of deposits
stands at 5.2%. Total branch network of the industry comprises of more than 528
branches(1) with presence in over 50 cities & towns covering all the four provinces of
the country.

The industry over the years has managed to offer a wide array of products
encompassing almost the\ entire range of Islamic modes of financing that are able to
cater to the needs of majority of the sectors of the economy. Also it has been
noticed that the industry has a good financial performance. Foreign investment in
Pakistani Islamic banking industry is giving the industry a unique look through which
success transfer is taking place as experiences are being shared leading to the
development of the local industry.

SBP has over the years attempted to develop a supportive Regulatory and
Supervisory Framework having special emphasis on Shariah Compliance that is in
line with the best international practices. The aim is to align our industry with the
international best practices so as to enhance the credibility and international
stakeholders’ confidence in Islamic banking efforts of SBP. This will in turn not
only boost the image of our country but will also be instrumental in attracting
foreign investment. Pakistan has adopted a three tiered, somewhat unique,
Shariah Compliance Mechanism and process to ensure a deeper and extensive
Shariah compliance supervision on an on-going basis.

The data for quarter ended June 2009, shows that asset financing activities of Islamic
banks have revived besides substantially higher assets and deposits growth. The
profitability indicators have also shown marked improvement as compared to the
preceding quarter. The financing and investment portfolio of Islamic banks reached
Rs 195.0 billion in June 2009 compared with Rs 185 billion in March 2009,
depicting an increase of 5.1 percent during the last quarter. In terms of market
share, total assets, financing & investment and deposits reached 5.1 percent and 4.2
percent and 5.2 percent, respectively, at end June 2009. The branch network of 6
full-fledged Islamic banks and 12 conventional banks (with dedicated Islamic
banking branches-IBBs) increased to 528 branches in June 2009.

(1) Detail of Year wise Entry of Islamic Bank in given in ANNEXURE-A

28
The State Bank of Pakistan issuing "Islamic Banking Bulletin" for the second
quarter ended on June 30, 3009 said that current growth rate of Islamic banking
industry has envisioned to achieve a share of 12 percent by 2012 as per Islamic
banking strategy plan.

The growing depositors’ confidence is well reflected in last quarter, which shows
an increase of 15.5 percent in the deposits. The deposit base of Islamic banks
stood at Rs 238 billion at end-June 2009 compared to Rs 206 billion in the previous
quarter-end.

Total liabilities of Islamic banks have increased by 13.3 percent to Rs 274 billion
from Rs 242 billion during the quarter. While the net assets and equity increased by
around 7 percent each. There is an increase of 6 percent in the reserves to one
billion rupees and then appropriated profits increased by 79 percent to Rs 900
million in last quarter.

The most of the indicators of the Islamic banking in Pakistan showed

reversion towards the usual high growth trend. It may be recalled that the Islamic
banks also witnessed some slowdown as a result of the financial stress of recent
times.

The financing portfolio has increased by 3 percent quarter on quarter basis. This is
encouraging, as during the last quarter (January-March 2009) the financing had
actually declined by Rs 10 billion. The resurgence in financing is accompanied by 9.3
percent increase in investment. The increased financing may be reflecting the
improving economic outlook of the country.

While the investment has largely increased due to 3rd issuance of Ijara Sukuk.
Nonetheless, there is a welcome increase of Rs 2.4 billion in Musharika
financing, though Modaraba financing declined by almost 50 percent.
Nonetheless, the net mark-up income increased from Rs 7.8 billion to Rs 15.4 billion-
a healthy 94.0 percent growth. Non-mark up income increased by a hefty 213.2
percent from Rs 0.5 billion in March 2009 to Rs 1.6 billion in June 2009

29
Islamic Finance has made commendable progress in the last few years. The growth
rate remained consistently higher than the conventional finance industry,
culminating in continuously rising share of Islamic finance in the local and global
financial markets. The SBP is leading the way in Pakistan and has envisioned to
achieve a share of 12 percent by 2012 in its Islamic banking strategy plan. A
relatively restricted branch network coupled with the preferred policy of some
conventional banks having IBBs (Islamic Banking Branches) to borrowing funds from
their head offices has partly contributed to this skewed distribution.

Figure 2.1 Deposits of Islamic Banking Industry (In Billions)

30
 Deposits
212
210

208

206
204

202

200

198
196

194
2007 2008 2009

31
*Source: SBP Quarterly Report Jun-09
*July 2009

The rapid growth experienced during the year 2004 was primarily due to the entry
of Albaraka Islamic bank and an aggressive strategy adopted by Bank Alfalah.
Similarly the entry of four new full fledged Islamic banks i.e. Dubai Islamic,
Emirates Global, Dawood Islamic & BankIslami during 2006 and 2007 contributed
towards the healthy growth in overall deposits position during these years.

Figure 2.2 Bank Wise Share of Deposits

*Source: SBP Quarterly Report Jun-09

The bank wise share of deposits as on Jun-09 is presented in the Figure. Over all
the share of Meezan Bank’s deposits is dominant while among IBDs (Islamic Banking
Divisions of Conventional Banks having IBBs) of conventional banks Bank Alfalah is
leading the group.
However the new entrants like Dubai Islamic and BankIslami have also
managed to capture good share in relatively shorter period of time. Going forward
the remaining two full fledged players i.e. Dawood Islamic and Emirates
Global are also expected to catch up with other competitors.

Deposits structure consists of Fixed Deposits, Saving Deposits, Current

32
Accounts non remunerative and other deposits. Savings, Fixed and Current account
(non remunerative) of customers deposits are 32%, 36% and 20% respectively of
Overall Deposits and Other accounts.

Breakup of Deposits -June2009

33
 Current
Others Accounts
9% 22%

Fixed
Deposits
37% Saving
Deposits
32%

34
*Source: SBP Quarterly Report Jun-09

Growth (Branch Network)

The share of full fledged Islamic banks in overall branch network of the
industry has increased over period of time. Furthermore, it shows that during the
year 2006 highest growth rates in overall branch expansion were experienced
wherein two new full fledged Islamic banks (Dubai Islamic Bank
& BankIslami) and four conventional banks having IBBs commenced
operations. As the full fledged banks consolidate themselves it is expected that the
rate of growth in network expansion will increase at a much higher pace.
Currently Islamic Banking is available through 6 full-fledge Islamic banks and
12 conventional banks having Islamic banking branches. The experience as
reported by some of these banks is that around 10% to 15% customers walking
into their branches are new to banking. These are the people that have remained
away from the conventional banking system because of their beliefs. Additionally
those who have been using conventional banking but minimizing the depth of
their relationship again based on their beliefs tend to deepen their relationship with
an Islamic bank thus again contributing to the size of the banking sector from
within its existing coverage and base. From the above figure we can identify the
growth of Islamic Banking by Branch network, as this is the statistics from 2002
where there was only 6 Branches of Islamic Banks as up to June - 2009 there are 528
branches.

3.2 Investment

June-2009 the Investments has been 4.5% (194Bn) with respective to

Industry’ growth Initially due to non availability of Shariah compliant
instruments the Islamic banking institutions suffered from a relative
disadvantageous position. Specifically, until the issuance of WAPDA Sukuk in
November 2005, there was no approved security for meeting the Statutory

35
Liquidity Requirement. Subsequently KSEW Sukuk has also been categorized as
SLR eligible instrument. Meanwhile SBP has provided the industry with a level
playing field through a separate SLR regime and limit on investment in shares.
Currently for meeting the SLR requirements Islamic Banking Institutions have
been allowed to maintain SLR at 9% of their TDL on an overall basis, with
investment in SLR eligible Sukuk not exceeding 7% of their TDL (however, individual
holding in Sukuk of one issuer shall be limited to 5 percent of total TDL) and remaining in the
shape of cash in hand, balance with NBP in current account, and balance with State
Bank of Pakistan in Special Deposit Account. The direct investment by the Islamic
banks are not the same ratio as the conventional banks are doing, the main
reason of that is the conventional banks are operating from more than decades
where as the Islamic banking just had start recently by getting the full fledge
licenses from the State Bank of Pakistan during 2002, from that starting point
Islamic banks are now growing at the very high pace, as we have already known
from the above discussion that Islamic Banking has high growth rate than the
conventional banking.

Figure 2.3 Islamic Banking Industry Investment

*Source: SBP Quarterly Report Jun-

09
*June
2009

36
Figure 2.4 Bank Wise Share of Investment - june2009

*Source: SBP Quarterly Report Jun-

09

Up June-2009 Meezan Bank continued to enjoy the highest share in overall

investments made by the industry and Bank Alfalah in line with the size of its
balance sheet leads the category of conventional banks having IBBs.

June 2009 compared with Rs.185 billion in March 2009. In terms of market share,
total assets, financing & investment and deposits reached to 5.1% and
4.2% and 5.2%, respectively at end June 2009. The branch network of 6 full
fledged Islamic banks and 12 conventional banks (with dedicated Islamic
banking branches—IBBs) increased to 528 branches in June 2009.

The financing portfolio has increased by 3 percent QoQ. This is encouraging as

during the last quarter (Jan-Mar 2009) the financing had actually declined by Rs 10
billion. The resurgence in financing is accompanied by a QoQ 9.3 percent

Figure 2.5 Assets of Islamic Banking Industry

37
*Source: SBP Quarterly Report Jun-09

Sources of Fund June-2009

7%

14%

7%

72%

Borrowings Capital & Other Funds Other Liabities Deposits

38
*Source: SBP Quarterly Report Jun-09

As from the above graph we have see that the main source of Funding in Islamic
Baking is Customer Deposits, which contributes 72% of its total funding and
remaining 7% is from Borrowing, and 14% and 7% Capital and other liabilities.
From this figure it can be easily identified that the people are diversifying from
conventional to the Islamic Banking.

Uses of Funds june-2009

39
 Cash, Bank
Balance,
placement
14% Other Asstes

52%
67%
Financing
19% 15%

40
 Investment

*Source: SBP Quarterly Report Jun-09

This figure shows the fine combination of financing and investing of the funds used
by Islamic banks in june-2009, as we can easily identified that 67% of spending is
done in the financing and investing section and separately financing contributes
52% and Investing 15% where as the placement portion is about 14%.

3.3 Market Share

As mentioned earlier SBP worked on a three pronged strategy for promotion of

Islamic Banking i.e.

1. Allow new full fledged Islamic banks in the private sector,

2. Allow the conventional banks to set up Islamic banking subsidiaries
3. Allow the existing conventional banks to open Stand-alone Islamic banking
branches.

The first and third options have been exercised so far and none of the
commercial banks have so far set up a subsidiary for Islamic banking.

Figure 2.6 Market Share

41
*Source: SBP Quarterly Report Jun-09

The change in policy approach from the legal & regulatory perspective to that of
dealing with the whole affair of introducing Islamic banking in Pakistan as a change
management issue has received a very encouraging response.
Under the current policy first Islamic banking license was granted on 31st
January, 2002. Since then the industry has been continuously showing
impressive growth. In 2003 only one bank operated as the full fledged Islamic bank
and two conventional banks were operating Islamic banking branches.

The total assets of the Islamic banking industry accounted for a market share of
about 0.5% and the total branch network comprised of 17 branches. Today we have 6
full fledged Islamic banks and 12 conventional banks are operating dedicated Islamic
banking branches.

As on 30th June 2009, the total assets of the Islamic banking industry were around
Rs. 313 billion which accounts for a market share of about 5.1%. The total branch
network of the industry comprises of over 528 branches with presence in over 50
cities & towns and covering all the four provinces of the country.

It is also important to compare progress of Islamic Banking in Pakistan with the

42
progress in other countries15. Malaysia’s first Islamic Bank commenced operations
in 1983 and the market share of the Malaysian Islamic banking system today
stands at approximately 13%. Bahrain’s Islamic banking system is said to have
gained a share of around 8% in over 30 years. Similarly in Indonesia Islamic
banking was introduced somewhere in mid 90’s. According to Bank Indonesia,
Islamic banking assets reached in March, 2009 to 1.67 percent of total assets as
compared with 0.7 percent in 2003 and currently the deposits stand at 1.69% and
financing at 2.60% of the total banking sector.

On the other hand, Pakistan has shown much better performance than other global
players. At certain point of time, 6 full-fledged Islamic banks and 14 conventional
banks with Islamic banking branches were operating. Due to merger of Habib
Bank AG Zurich Pakistan Operations with Metropolitan Bank Limited and Prime
Commercial Bank Limited with ABN Amro Bank N.V. Pakistan (now RBS
Bank), the total number of conventional banks having Islamic banking branches
today stands at 12.

Islamic banks are currently able to offer at least 75% of the product range
available in contemporary conventional banking. On the consumer banking side,
clean lending products like Personal Loans and Credit Cards still pose a challenge.
On the corporate side working capital loans are a challenge.

None of the banks have any Microfinance or Agriculture business although a few
have started offering financing to SME sector.

This offers a huge opportunity to extend the reach of the banking sector and
multiply the size of Islamic banking geometrically. It also clearly points out the
direction that has to be taken. In the existing coverage area, both
geographical and customer type, there is need to enrich the offerings through product
development and extension of distribution channel and network Additionally there is
need to extend the coverage to those sectors that are not being covered by Islamic
banking i.e. Microfinance and Agrifinance and also to deepen the offerings in the
sector with significant potential but limited presence i.e. the SME, infrastructure

43
and housing sectors.

it can be seen that although Islamic banks have an amount-wise 4.2% market share in
financing, however, their share in number of borrowers is just 0.9%. It is because of
following factors:

1. Products: 93% customers of banking industry are availing Consumer and

Agriculture finance facilities. In consumer finance, a large number of
customers are from the credit card or personal loan sectors. However, Islamic banks
have no such products and their financing to Agriculture sector is also negligible.

2. Geographical outreach: Conventional banks have a network of more than

7800 branches in all parts of the country, through which they can extend
financing. However, IBIs being new institutions have just over 582 branches
(around 5.1% of total) as of end June, 2009.

3. Technical Assistance: State Bank has arranged technical assistance in the areas of
SME, Agriculture, Microfinance, etc. which is being availed by conventional
banks through which they are developing products for these sectors.
However, no such assistance has been provided to/availed by IBIs as yet. Despite
these issues, it is believed that Islamic banking can grow at a much faster pace than
conventional banking. This paper outlines and discusses in detail the specific steps
to be taken.

3.4 Prospects

While the number and operations of Islamic banks are fast expanding, this segment
of the market is still small relative to the appetite for Islamic finance. Pakistan, in
light of its past experience, is launching a gradual and steady approach to Islamic
banking. Despite rapid expansion in industry, the share of Islamic banking in the
total banking system is a modest 4.0%. Moreover, it only caters for around
32,000 borrowers through around 300 branches relative to the country-wide 5
million borrowers (or 4.8 million excluding microfinance borrowers) tapped
44
through 7,700 branches by conventional banks. Financing and investment levels
of Islamic banks barely range around Rs77 billion, which is below 3% of the total
banking system’s advances.
On the product side, Islamic banks so far offer about 75% of products
currently available in conventional banking while clean lending for consumer
financing products, like personal loans and credit cards, still pose a challenge. Islamic
banks operate exclusively in large cities with some now venturing into secondary
cities but they are absent from rural areas where there is great potential for
business growth. Global interest in Islamic finance industry and Pakistan’s success
in laying basic foundation and core infrastructure of Islamic financial system
lends confidence that the country has good potential and prospects to further
exploit this industry. Going forward, however, it is important that Pakistan adopts
a more calibrated and coordinated approach and strategy for the development of
Islamic finance industry.

The goal and objectives of the forward looking strategy should be to offer an
alternative avenue of financial intermediation, which is competitive and
promotes efficient allocation of resources in an equitable manner. Strategy should
aim to supplement conventional banking industry’s efforts to broaden and deepen
the process of financial intermediation and financial penetration.

Islamic banking can serve as a key vehicle to improve and strength the access
to development finance by bringing in financial innovation that can cater
adequately to diverse demands of the population as well as corporate sector’s and
country’s infrastructure financing requirements, while ensuring that it nurtures
faith based system of financing consistent with the Shariah principles. Major
elements of this strategy would require both industry and SBP to closely work
together on multiple fronts. Some of the key areas of focus include: ‘Aggressive
deposit mobilization to augment domestic financial savings of the country’. Although
late starter, Islamic banks have phenomenal potential to exploit resource
mobilization. Substantial savings have still not been channeled into the financial
system because of reservations relating to interest based system or return
deficiencies of the conventional system. Islamic banks, besides catering to the

45
needs of small depositors through profit and loss sharing basic accounts with no
charges, need to tap high net worth investors and companies which are increasingly
being driven to the attractive options and returns being offered by more innovative
players worldwide. Fast adaptation of these practices by the Islamic finance industry
will be helpful in competing more effectively with conventional banks in
raising deposits. Resource mobilization is critical for Islamic finance industry to
grow effectively and meet the alternative requirements of economy and society

Despite these issues, it is believed that Islamic banking can grow at a much faster
pace than conventional banking. This paper outlines and discusses in detail the
specific steps to be taken. SBP’s policies towards Islamic Banking will be:
1. Liberal for branch licensing of IBIs
2. Encouraging and supportive of IBIs in using alternate delivery channels in order
to extend their outreach
3. Encouraging foreign Islamic banks to establish Islamic Banks in Pakistan
4. Encouraging the establishment of Islamic microfinance banks
5. Providing enabling environment for IBBs of conventional banks to convert into
Islamic banking subsidiaries.

To achieve the target market share of 12%, an increase in coverage of the

existing banking segments and entry into new segments of microfinance,
agriculture, infrastructure and SME finance will be targeted
.
Based on the above direction of SBP’s policy and feedback from the industry,
following forecast for the industry has been developed:

Figure 2.6 Annual Growth (In Million)

46
*Source: Islamic Banking Review 03-07 SBP

It is forecasted that by 2012 Islamic banking deposits will reach in the range of Rs.
900-1000 billion and financing in the range of Rs. 700-800 billion. The growth
rates of these deposits are expected to be in the range of 45-60% in next three
years. Thereafter the growth is expected to be around 25% as the market would
mature having a larger base and greater competition with the conventional
counterparts. The IBIs are expected to achieve this target on the basis of channelizing
funds from huge untapped markets and supportive role of SBP in regulations and
allowing opening of branches in new business places. SBP will follow relatively
liberal branch expansion policies for Islamic banking or at least at par with
conventional banking. Based on SBP’s projections and the feedback from the
industry, following are projections for expansion in the branch network:

Figure 2.7 Branches Growth Rate

*Source: Islamic Banking Review 03-07 SBP

The IBIs in the next three years will expand their branch network at a faster pace.
However, after the year 2011, the growth in branch network is expected to settle
down. Although this is an ambitious plan however the industry is comfortable
with it and it is also in line with the aspirational market share.
To increase the outreach of Islamic banking offerings, the industry will be
encouraged to enter the Microfinance and Agriculture sectors, in addition to the
SME sector. Some Islamic banks are already focusing on the SME sector and getting
a good response from customers. The basic approach to entering these segments
would be to maximise the leveraging of the existing conventional banking
infrastructure and introducing Islamic banking products through these. SBP will
introduce the Shariah compliance mechanism and segregation of Islamic banking
business on the balance sheet and income statements. The specific steps planned
47
for each of these sectors will be as follows:

Microfinance:

The central bank will use the conventional Microfinance strategy and focus more
on adding the aspects peculiar to Islamic banking. As a first step, SBP has already
issued guidelines for offering Islamic Microfinance Services. According to these
guidelines various types of institutional arrangements have been suggested for
provision of Islamic microfinance services which include

1. Establishing full-fledged Islamic Microfinance Bank (MFB)

2. Islamic microfinance services by full-fledged Islamic Banks
3. Islamic microfinance services by Conventional banks
4. Islamic microfinance services by Conventional Microfinance Banks

For each type of arrangement, a detailed framework has been provided

outlining the systems and controls to be adopted and application procedure as well
as different options available to banks/MFBs by which Islamic
microfinance services can be offered. Going forward help will be provided to the
banks offering Islamic microfinance for developing products through joint forums
of experts from SBP as well as the participating banks. Incremental volumes for
Microfinance will therefore be ensured. At the same time some conversion is also
expected to take place.

Recently announced Microfinance strategy envisions 3 million borrowers by year

2010. It is expected that around 4-5 percent of the borrowers will be using
Islamic microfinance facilities. SBP expects that growth in Islamic
microfinance will pick up gradually as Islamic banks will expand to new areas after
consolidating their position in core sectors like corporate and consumer finance.
Moreover, establishment of dedicated Islamic microfinance bank(s) and
introduction of Islamic microfinance services by conventional MFBs will give a
boost to the sector. The estimated market size has been forecasted as follows:

48
Figure 2.8 Microfinance
Microfinance 2008 2009 2010 2011 2012
Expected Volume 10 100 500 1000 2000
% of Islamic Banking 0.01% 0.04% 0.1% 0.2% 0.3%
Financing
Annual Growth Rate - 900% 400% 100% 100%
*Source: Islamic Banking Review 03-07
SBP

Agriculture

SBP’s approach would remain the same as that for other development finance sectors.
A task force has been constituted that consists of experts from participating
banks and SBP. This committee is in the process of developing products that can
be offered by banks undertaking Agriculture credit. These products are expected
to be operationally ready by the end of the year. Meanwhile SBP will be issuing
guidelines and then regulations for this sector. Keeping in view the inclination of
end users for getting finance through Shariah-compliant products, scope of this
market is huge; SBP expects the following volumes from this sector:

Figure 2.9 Expected Agricultural

Growth

Microfinance 2008 2009 2010 2011 2012

Expected Volume 370 1400 4100 12000 21000
% of Islamic Banking 0.2% 0.5% 1% 2% 3%
Financing
Annual Growth Rate - 278.4% 193% 193% 75%

*Source: Islamic Banking Review 03-07 SBP

49
4. PROBLEMS AND ISSUES

4.1 Taxation Issues

SBP has put in place a process that is comprehensive and provides the necessary
groundwork to all the government departments concerned to enable them
executing their part of the change in rules. This process consists of forming a
committee at ICAP that determines the accounting treatment of Islamic transaction
modes.

Based on the accounting treatment, changes needed in the tax rules to provide
same effective taxation treatment to Islamic transactions as that provided to
conventional transactions are made. SBP initially took up the issue of double
taxation on Murabaha transactions with the Central Board of Revenue (CBR)
and proposed amendments in the taxation laws in
consultation with market players so as to provide a level playing field to the IBIs.
Consequently, in the budget for the year 2004-2005, an amendment was made
(Statutory Regulatory Order 445(1) / 2004) in the Sales Tax Act, in terms of which
goods delivered under a Murabaha financing arrangement to or by a bank or a
financial institution approved by the SBP or the SECP, as the case may be, were not
to be treated as Supply.

Also amendments in Income Tax Ordinance in areas like minimum turnover tax
etc. have been introduced. However lately in the Finance Bill 2007 it has now been
ensured that taxation of Shariah compliant Islamic banking would be treated as par
with conventional banking.

50
4.2 Financial Reporting and Accounting Standards

In Pakistan, the regulatory financial reporting framework for the Islamic Banks
(IBs) and the Islamic Banking Divisions of Conventional Banks consist of:

• The International Financial Reporting Standards (IFRS);

• The Banking Companies Ordinance (BCO), 1962;
• The Companies Ordinance (CO), 1984; and
• Various rules and regulations devised by the State Bank of Pakistan (SBP) and the
Securities and Exchange Commission of Pakistan (SECP) particularly including
the SBP Prudential Regulations and Banking Supervision
Department-Circular-4 of 2006.

According to the SBP’s recently issued Guidelines for Shariah Compliance in

Islamic Banking Institutions following are the Financial Reporting and General
Disclosure requirements:. IBIs shall follow financial reporting standards for
Islamic modes of financing issued by the Securities and Exchange
Commission of Pakistan (SECP) under the Companies Ordinance, 1984. For
modes/areas not covered by these standards, IBIs are encouraged to use AAOIFI
Accounting Standards Moreover in the annual report, IBIs are encouraged to
disclose a) overall basis of working of profit distributed to depositors; b) break
up of their financing by Islamic modes of finance; and c) remuneration of Shariah
advisor. In addition, the annual report of conventional banks having Islamic Banking
Branches shall include separate balance sheet and profit and loss statement of their
Islamic banking operations. Additional disclosure in the form of cash flow statement
of Islamic banking operations is also encouraged. It is to mention here that Institute
of Chartered Accountants of Pakistan has appointed a Committee on
Accounting and Auditing Standards for Interest Free Modes of Financing and
Investments.

51
The Committee comprises experienced Chartered Accountants and experts from all
relevant fields including Bankers, Lawyers, Shariah Scholars and the representatives
from the regulators. The Committee is reviewing the
accounting standards prepared by Accounting and Auditing Organization for
Islamic Financial Institutions, Bahrain (AAOIFI) with a view to adapt them to
Pakistani circumstances and if considered necessary to propose new
accounting standards. So far, the Committee has issued two Islamic Financial
Accounting Standards (IFASs). Murabaha has been notified by the SECP through
SRO 865 (I) / 2005 in August 2005 under section 234 of the Companies
Ordinance, 1984 and accordingly it has now become a part of law for the purpose of
preparation of financial statements of Banks and similar financial institutions. It
was made applicable on financial statements beginning on or after January 01, 2006.

Ijarah has been notified through SRO 431 (I) / 2007 dated May 22, 2007 by the
Securities and Exchange Commission of Pakistan (SECP). It was made applicable
on the financial statements for the periods beginning on or after July 01, 2007.It is
applicable on companies, i.e. the lessees, also. In addition, work is in progress on
standards for Profit Distribution to PLS depositors, Diminishing Musharaka
followed by Musharaka.

4.3 Islamic Export Refinancing Scheme

Similar to the export refinance facility available to conventional banks, in 2002

SBP started a Musharaka based Islamic export refinance scheme (IERS) for Islamic
banks and stand-alone Islamic branches operating in the country. Islamic Banking
Institutions (IBIs) are availing this facility under both parts of SBP’s Export Finance
Scheme (EFS). The framework of the IERS is based on the concept of Profit & Loss
Sharing. The State Bank shares the actual profit of the Musharakah pool of the
Islamic Bank. However, in case the actual profit of the pool is more than ongoing
rates under conventional EFS, the excess profit so received by SBP is credited to the
Takaful fund, (a reserve fund to be maintained by SBP under Islamic modes) for

52
risk mitigation that would be used to meet future losses arising during
implementation of IERS. It is interesting to observe that up till 2005 only Meezan
Bank Limited was availing this facility for their clients, whereas in the FY 2007-08
four full fledged Islamic banks and two conventional banks having IBBs have availed
the said facility.

4.4 Lack of Expertise

Capacity Building is another major challenge being faced by Islamic financial

Industry. Proper understanding of Islamic banking services and their equal
treatment vis-à-vis conventional products is vital for the practitioners in Islamic
Finance Industry for product innovation and differentiation. It is, therefore,
extremely important to have the people with the right kind of skills and
commitment to run Islamic financial institutions. • In the wake of high growth rate
experienced by IBI SBP is putting special emphasis on ensuring that adequately
trained human resource is employed by the Islamic Banking Institutions. Banks
are asked to provide appropriate training to the staff before getting a license from
SBP.

In order to give the relevant local and international exposure to employees of

Islamic Banking Department and also other departments of SBP (that are dealing
with Islamic banking industry) it is ensured that appropriate training opportunities
are utilized. Moreover occasionally the Islamic Banking
Department of SBP conducts an internal Awareness/Training Program on Islamic
Banking which helps in educating the SBP staff on Islamic Banking and Finance
concepts and issues.

Also a Memorandum of Understanding has been signed between State Bank and
International Centre for Education in Islamic Finance (INCEIF), Malaysia which
envisages creating a strategic alliance between the two for promoting educational
excellence in this field in the respective countries. Under this Memorandum of
Understanding 10 scholarships for “Certified Islamic Finance Professional (CIFP)”, a
distance learning program developed by INCEIF were offered to Pakistan. The
candidates for the said Program were nominated by SBP from its own staff, NIBAF
53
and Islamic banks.

Workshops like those on IFSB “Capital AdequacyStandard" and "

Transparency and Market Discipline" have been organized in which participants
from the local industry participate as they provide the much needed facilitation
on the implementation of the said Standards in our local market. Avenues like
arranging / sponsoring International Conferences, Video-Conferencing etc. have
been utilized so as to contribute towards achieving the task of capacity building
of the
industry. Taking advantage of visits of dignitaries, and experts in Islamic
finance, special sessions are organized for the stakeholders. National Institute of
Banking and Finance

Initially the National Institute of Banking and Finance (NIBAF) (training wing of the
State Bank) included a Module on Islamic banking and finance in its training
courses designed for State Bank Officers Training Scheme and other fresh inductees.

In view of the increasing demand for trainings in Islamic banking and finance,
NIBAF designed a 3-week Intermediate to Advance level Certification Course
keeping in view the practical requirements of stakeholders. The course,
comprising 16 modules, was designed in consultation with Islamic banking experts
and Shariah scholars from within the country and also outside. The target group
comprises staff from Islamic banks, commercial banks and the Islamic Banking
Branches of commercial banks operating in Pakistan. The training sessions also
include group work on product development, deposit management, process of
Murabaha & Ijarah pricing beside case studies regarding Securitization, Sukuk,
Diminishing Musharaka (Housing finance), Murabaha and Ijarah etc. 11 courses
have been conducted at NIBAF Karachi
& Islamabad in which 421 out of 446 officers were awarded certificates for
successful completion. The Course has registered success in terms of
coverage, training delivery, coordination and administration. This course, in the
short run is proving to be very beneficial for the rapidly growing Islamic Banking
Industry requirements. The participants are evaluated for each module and at
the end there is a comprehensive test. Only participants scoring above the
54
threshold level i.e. 60percent in each of the modules and the comprehensive test
with 65percent overall weighted score are awarded certificates.

Also an international course on Monetary and Fiscal Policies with a focus on

Islamic Economics has been conducted in collaboration with Islamic Research and
Training Institute (IRTI) of Islamic Development Bank (IDB). The course
participants were invited from the member countries of the IDB. In the same
context, to share knowledge and expertise seminars on Awqaf and Retakaful have
also been held at NIBAF in collaboration with the International Islamic University
Islamabad and IRTI.

Other Initiatives

Institute of Bankers Pakistan conducts seminars, training courses etc. for creating
wider awareness among bankers about the conceptual and
operational framework of Islamic banking. The subject of Islamic Banking and
Finance has also been included in its Banking Diploma courses. The
curriculum of IBP’s Banking Diploma Examination has been revised and
updated. They have also revised the syllabus on the subject of Islamic
Banking and Finance.

A number of other educational institutions like International Institute of Islamic

Economics, International Islamic University Islamabad, and Centre for Islamic
Economics, Karachi, etc are also offering academic and training courses on Islamic
banking and finance. SBP has developed a standardized curriculum for
certification, post-graduate and master level programs in Islamic Banking. The
curriculum has been sent to the Higher Education Commission (HEC). HEC’s
Curriculum Review/Revision Committee would in due course consider the
curriculum for possible adoption in Pakistani educational institutions. This attempt
will hopefully ensure up to a certain extent the quality of the offerings by education,
training and research institutions offering Islamic Banking courses

55
4.5 Network Issues

Distribution Network: As at end of June 200 there were only around 582
licensed branches in the Islamic Banking sector in comparison with around
7800 branches on conventional side. The availability of financing through
Islamic Banking is still very much limited. In this scenario SBP apart from
considering liberal branch licensing policy is also encouraging the Islamic
banking institutions to utilize alternate delivery channels for improving the
accessibility of the Islamic banking services across the length and breadth of the
country. These include the options of Islamic Banking Windows and Branchless
Banking.

Islamic Banking due to its appeal among the masses because of its ethical and
religious dimensions has a strong growth potential in fields like micro- financing,
agriculture financing, infrastructure finance, Small & Medium Enetrprises etc.
Moreover as the demand for launching of diversified and integrated Islamic
financial System in the country is on the rise there is a great potential for Islamic
Banking products in these areas. Till now only one or two Islamic banking branches
are engaged in Islamic Microfinance services and there is a strong need for
development of. this segment. However the major issue in this regard at this
point of time is awareness about Islamic microfinance. Islamic banks were till
recently in developmental phase and high infrastructure cost deterred them from
moving into new sectors & rural areas. However now that they have passed the
break even stage they can afford to explore such avenues. In this regard SBP has
already issued the Guidelines for provision of Islamic microfinance services and
products by financial institutions,Product Development: On the consumer banking
side clean lending products like Personal Loans and Credit Cards still pose a
challenge.

On the Corporate side working capital loans are a test. Similarly the industry has
not yet offered duly approved product under the new SBP scheme for Long Term
Financing Facility (LTFF). Lately some products in these areas have been

56
launched by a few banks which is a good sign for development of the industry as it
penetrates more sectors that are currently served only by the conventional banking
sector. SBP continues to strive for charting a regulatory framework for Islamic
banking that ensures adherence to Shariah principles and at the same time allows
the banks to adjust their offerings in accordance with their customer needs.

4.6 Lack of Awareness

Like any other “new” concept, Islamic banking and finance is also going to take
some time to be fully comprehended by the people at large. Any new product
when introduced in a market will go through the natural dynamics of initially being
understood by a few and with the passage of time as its need and practicability is
felt and appreciated by more and more people greater efforts are employed to
make it recognizable for everyone. In Pakistan the failure of implementing the
Islamic banking system in its true spirit in the
1980’s is another major factor that contributes to the high level of skepticism
expressed by many commentators. These two factors along with many others make
task of creating awareness about Islamic banking among the masses a daunting one.
To address this issue, State Bank had initially conducted a successful awareness
program for providers and users of Islamic banking services.

• A series of interactive seminars were held with some of the key stakeholders
including the SBP staff itself. Similarly seminars were held for prospective banks,
chambers of commerce, business houses, etc.

Lectures in various training and educational institutions have been also been made
such as IBP and International Islamic University Islamabad, Bahria and Karachi
University etc. Moreover, SBP staff participates in various talk shows and interviews
on a number of TV channels. We have also tried to ensure press coverage of
significant events and conferences being held in Pakistan. One part of our strategy
has been to target decision makers i.e. the military and civil bureaucracy and
have made regular presentations in the civil services academy and national
defense and staff colleges.

57
Taking advantage of visits of dignitaries, world renowned scholars and
experts in Islamic finance, special sessions have also been organized for all the
stakeholders. Video conferences on various aspects of Islamic banking have been
arranged in collaboration with Islamic Development Bank and other international
institutions which are attended by the bankers, chartered accountants, academicians
and the students of Islamic finance.

Islamic Banking Department’s page on SBP’s website gives ample

information about the policies, regulatory framework and other important areas.
A quarterly Islamic Banking Bulletin providing update on local as well
international developments in the field of Islamic banking and finance is being
published by Islamic Banking Department. Seminars on Islamic Financial
Accounting Standards on Murabaha and Ijarah and the Risk Management
Guidelines for IBIs have been conducted which were attended by senior
executives/representatives from SECP, Islamic banking industry and SBP.
Professional bankers and accountants delivered lectures on the subjects from various
perspectives and these events provided an excellent opportunity to the participants
to discuss the practical problems faced by them in the implementation of these
standards/ guidelines.

58
 5. RESEARCH FINDINGS

The data collected is summarized according to the numerical order of the

questionnaire and analyzed according to the importance and need of the study.
Some of the questions are analyzed in details and some of are not due to the
requirement of the study.

5.1 Customer Preferences

Demographic Profile of the Respondents

Age distribution of the respondents. (300 responses from each bank)

59
Age Group I. B. % C. B . %
responses responses
18-30 28 9.3 18 6
31-40 yr 72 24 52 17.33
41-50 yrs 126 42 66 22
51-60 yrs 59 19.7 60 20
61 above 15 5 104 34.67

60
Age Distribution of IB Account Holders
 18-30
5 9.3
31-40
19.7 41-50
24 51-60
61 and above

42

Age Distribution of CB Account Holders

18-30
6
31-40
17.33
34.67 41-50
51-60
61 and above
22
20

The table above contains the different age group in both Islamic Bank (I. B) and
Conventional Bank (C. B). The table shows this clearly that Islamic Baking is
more popular in young and middle age peoples of the society, while the conventional
banks are popular in old or senior citizens of the country
Genders. (300 responses from each bank).
IB % CB %
Responses Responses
Male 300 100 288 100
Female 0 0 0 0

This set of distribution shows that respondents in both kind of banks were Male.
During our whole stay, at different place of the projected sites, we could not meet any
female respondent or account holder at Islamic Bank.

While there were some female coming in conventional Banks. This analysis shows
that Islamic banks have to make the females as their target customer, so that the
Islamic banking services can disburse in a balanced way.

Educational Qualifications. (300 responses from each

bank)

IB Responses CB Responses
% %

A. High School 16 5.3 116 38.7

B. Intermediate 91 30.34 82 27.33
C. Graduate 193 64.3 102 34.0
D. Ph.d 0 0 0 0
The analysis of the table 4.3 shows that Islamic banking is more popular in highly
educated class of the society as compared to conventional banks. University
graduates respondents of Islamic banks represent 64.3 percent as compare to the 34
percent of conventional banks respondents. While, high school graduate
respondents at conventional banks are 38.67% as compare to 5.33% in Islamic Bank.

Private employees and businessmen are more in numbers in Islamic banks as compare
to conventional banks. While the numbers of students and government
employees are more in the conventional banks.
5.5 Monthly Incomes. (300 responses from both banks)
IB Responses CB Responses
% %

A.5000-8000 10 3.0 190 63.33

B.8001-10000 17 5.67 67 22.33
C.10001-12000 29 9.67 24 8.0
D.12001-15000 93 31.0 11 3.67
E. More than15000 151 50.3 8 2.67
The result of table 4.5 is negative to one of the dedication of the Islamic banks i. e., to
participate more in human prosperity and elimination of poverty. This result shows
that Islamic banks are more popular in high-level income groups of the society, while
conventional banks are more popular in low-level income groups.

5.6 For what purposes do you use this Bank?

IB Responses CB Responses
% %

Investment/Saving 191 63.67 178 59.33

Borrowings 38 12.66 43 14.34

Others 71 23.67 79 26.33

(300 responses from each bank)

Table 4.6 shows that the distribution of account holders in both types of banks is
symmetric. Although the purposes distribution is not very clear, yet
conventional bank have more numbers of respondents at their services section

5.2 Customer’s Understanding

Do you understand the key concepts of Islamic

banking?
(300 responses each bank)
IB CB
Responses % Responses %

Yes 289 965.33 263 87.67

No 11 3.67 37 12.33

Tabulation of above question illustrates a very interesting result. There was

unexpectedly high percentage of the conventional bank account holders or visitors
who were well aware of the Islamic banking concepts. On the other hand, as
oppose to our expectations 11 of the Islamic bank respondents were not aware of the
concepts of the Islamic banking.

This result shows that Islamic banks did not explained well the concepts of Islamic
banking to their customers. And this result was of opposite to expectations,
that Islamic banks enhance the awareness and education both in economic as well as
religious matters and support the religious resurgence for the community
.
If you have an opportunity to open an account with Islamic bank,
would you transfer your account to Islamic bank?
(300 responses from conventional bank)

IB CB
Responses Responses %

Yes 211 70.33

N/A
No 10 3.33
N/A
No reply 79 265.33
N/A

The table 4.8 indicates very supportive response for transfer of their financial
activities from conventional bank Islamic bank.

Would you please tell us the reason for the transfer of your account ?

I.B Responses CB
Responses %

RIBA 126 59.72

N/A
Higher Profit 52 26.64
N/A
Other 33 15.64
N/A

Peoples want to transfer their bank dealings from conventional banks to Islamic
banks because of religious background as well as higher profits as shown by the
annual financial reports of both kinds of banks.

68
Would you continue to deal with Islamic bank even if its
services charges are higher than the conventional banks?
(300 responses from each bank)

IB CB
Responses % Responses %

Yes 231 77.0 194 64.7

No 13 4.3 17 5.7
No Reply 56 18.7 89 29.6

This question also shows an affectionate attachment of the people for Islamic baking.
Even in the case of higher bank charges peoples are willing to continue their
dealings with Islamic bank.

Do you agree ? Islamic Banks can contribute more to the societal

balance, human prosperity and welfare.
(300 responses from each bank)

IB CB
Responses % Responses %

Agree 226 75.3 234 89

Disagree 13 34.33 6 2.3
Don’t Know 61 20.33 23 8.7

The replies of above question show that peoples in Pakistan expect that
Islamic banks are more helpful for economic development, societal balance
and human prosperity. It is also verdict from the injunction of Shariah rules
that Islamic financial institutions are obliged to participate in the equal
distribution of wealth, human prosperity and equal economic development
This research study is result of a pioneer fieldwork conducted so far on
Islamic Banking in Pakistan. Therefore, the results should be taken only as
indicative and perceptive rather than conclusive. It is hoped that further
empirical or theoretical studies will be done to draw more definitive realities.
69
 6. CONCLUSION AND RECOMMENDATIONS

6.1 Conclusion

Theoretically speaking, there is no concept of loans and credits in Islam

for financing trade, industry and agriculture except Qard Hasan and where profit

and loss sharing is not feasible like interest-free loans by the federal government to

provincial governments for their developmental needs. Islamic banks, therefore,

involve themselves in financing (short, medium and long term) for the working capital

requirements, and also contribute to the capital of an enterprise by participating in its

equity. These financings are on profit and loss sharing basis. Islamic banks also

mobilize resources on profit and loss sharing basis as distinct from interest payments

to depositors on predetermined rates.

Islamic banking is a part of over-all value system of Islam. It is,

therefore, imperative that simultaneously genuine efforts are made to ensure that the

people are imbued with honesty of purpose and their actions conform to Islamic

values. The basic values that Islam seeks to establish are: (a) Freedom (b)

Brotherhood (c) Equality (d) Justice (e) Trust i.e. treating the God – given

capabilities and resources as trust. (f) Honest Consciousness i.e. sense of

responsibility and care for one’s obligations.

In a system based on profit and loss sharing, it is to the advantage of banks

and financial institutions to invest in those projects where higher rates of

70
profits are anticipated. The financing by Islamic banks under this system is

done within the framework and keeping in view the social considerations, the

requirements of priority sector and the safety of funds. The Islamic banking system,

therefore, induces savings and capital formation and lead to optimum allocation of

resources.

Islamic banks operating on profit and loss sharing basis are definitely in

a stronger position to absorb the shocks to their assets position (bank’s financing), as

the losses are simultaneously absorbed by the changes in the value of deposits

placed with the banks. The nominal value of deposits of Islamic banks is not

guaranteed like investment in shares of a bank or for that matter of a joint stock

company. The real value of “Assets and Liabilities” (Uses of Funds and Sources of

Funds) of Islamic banks is, therefore, equal at any point of time. It is, however, to

be ensured through prudent and professional banking practices, procedures and

systems that the losses in the financing portfolio are as low as possible and that

highest possible returns are paid to the depositors and investors.

It emerges from all this that Islamic banking has following

distinguishing features: (a) Islamic banks deal with money and do not deal in money,

(b) it is interest- free, (c) Lending and investing are treated differently; loans are

interest-free but carry a service charge, while investing is on a profit-and-loss-sharing

(mudaraba) basis, (d) it is multi-purpose and not purely commercial, (e) it is strongly

equity-oriented, and (f) Value erosion of capital due to inflation is compensated.

Theoretically and empirically, it is not difficult for specialists in economics

and finance to find Islamic banking in not only viable and acceptable, but also

efficient and significantly effective. It is not therefore surprising to see large

71
 multinational banks and institutions are providing Islamic financial services

to their customers in significant amounts. As an innovation, Islamic banking

has been practiced for more than a quarter of a century.

Theories reviewed in chapter 2 show that interest is the basic cause of

business cycles and financial instability, these theories also prove the bad effects of

the interest on resources, production, distribution, and on the economy as whole.

On the other hand theories presented by Fisher, Minsky…etc show the bad effects

of debt, Similarly the research and work of many researchers and scholars like

Lloyd Metzler, Mohsin Khan, Nejatullah Siddiqi……etc have also proved that

Islamic banking system is more stable than conventional banking systems. The

problem statement of this research was “why some of conventional banks moving

towards Islamic banking system”, findings of all these theories and answers of all

research questions discussed previously clearly show that Islamic banking system is

more stable, secure, sustainable, less cyclical in nature and better for economy, that’s

why Islamic banking system is becoming more popular and many of conventional

banks are moving towards Islamic banking system.

Islamic banks share with their conventional counterparts similar

specialization and business interests. Differences that exist between their modes of

operations afford them excellent opportunities to cooperate and collaborate. Areas

like joint financing and financial market operations can be the stage of daily

collaboration. As conventional banks have been first in the field, they can be a

valuable source for professional techniques and standards. In other words,

Islamic banks have a lot to learn from conventional banks in this regard.

72
Islamic banks, being aware of their innovative methods, have toiled to develop the

new modes of finance. That included a lot of work to formulate new contractual

arrangements on both their asset and liability sides. In addition, they have been

able to acquire a niche that conventional banks do not have. The latter can participate

and make use of such new and innovative techniques that would help them better

serve their customers.

Although, Islamic banking system is more viable than conventional

banking system it has some challenges also, like: The well-known fiscal prejudice

against profit and in favor of interest is just an example, where interest payments are

partially or fully tax exempt, and profit gets no such advantage. Similarly New

instruments are needed, a uniform regulatory environment and legal framework have

yet to be developed. The total implementation and success of Islamic banking in a

country needs re-shaping the society, re-structuring of the economic system and re-

framing of the laws according to the dictates of Islam. Islamic banks also face a

challenge of developing innovative services and products for mobilizing deposits

and utilizing them effectively and efficiently for financing under profit and loss

sharing system. Islamic banks like all other modern conventional banks under

interest-based system have to remain competitive and tailor their services and

products according to the needs and requirements of their clients, ensuring that the

products designed by them remain within the framework of Shariah. International

operations would have to be continued on interest basis till such time, that a suitable

and mutually acceptable alternate is found. This will, however, depend upon the

success of Islamic banking on the domestic fronts in a large majority of Muslim

countries of the world. While taking steps to enforce Islamic banking, it will have to

73
be seen that interest is eliminated in such a way that it does not abruptly disturb the

basic structure of the economy. It has also to be ensured that initially the

confidence of the people is developed and strengthened in the new system. This

approach would also provide an opportunity to refine the newly formed laws to

support the Islamic system of banking in the light of experiences gained during the

process. The development of an interbank market is another challenge. With the

establishment of the Islamic Fiqh Academy (IFA) in Jeddah and wide spread growth

of specialized training centers dedicated to train people in Islamic Finance and

banking practices, and a series of International conferences, the challenges are being

addressed with vigor. With the forced opening up of the economy and gradual

removal of barriers, Governments and regulatory bodies, too, are co- operating

in making Islamic banking a part of mainstream banking. In the years to come, as

Islamic banking breaks new ground and expands into new areas, there is sure to be an

increased effort in broadening its principles and scope.

6.2 Recommendations

It, however, appears that although tremendous efforts for Islamization of

banking system and for streamlining and enhancing the scope of the activities of

Islamic banks are being made in many Muslim countries, but effective steps for

reformation of the societies in the respective countries are not being taken up with the

same zeal and enthusiasm. This is an essential prerequisite for the success of

Islamic banking and deserves serious considerations by all those who are involved in

the process of Islamic banking.

The following are the suggestions for future growth and success of Islamic
74
banks. Which be successful and produce full dividends, if the society in which it

operates, is geared on Islamic principles. It is, therefore, of utmost importance

that sincere and effective efforts are simultaneously made to transform the

existing societies, in the Muslim countries, into truly Islamic societies.

1. A basic tenet of commercial banking is capital guarantee. The capital entrusted

to the bank by a depositor must be returned to him in full. Conventional

banking system fully complies with this requirement. While Islamic banking

as practised today does not provide capital guarantee in all its deposit

accounts. In many countries, this is one of the two main objections to

permitting the establishment of Islamic banks. There is no objection to paying

zero interest on deposits. Thus, by paying zero interest and guaranteeing

capital, the proposed system satisfies both the riba-prohibition rule of

Islam and the capital guarantee requirement of conventional Banking

Acts. This enables it to obtain permission to set up and operate as a deposit

bank in all countries of the world, while obeying the riba- prohibition rule

and qualifying to be an “Islamic” bank.

2. All relevant laws in Muslim countries who have established or are in the

process of establishing Islamic banks should be reviewed so as to bring

them in conformity with the Shariah. Necessary laws also need to be framed

for providing legal cover to the transactions, services and products developed

under the Islamic banking system.

3. The research and training centers for Islamic banking established in

various Muslim countries should pass on their findings to their Muslim

75
 countries to assist them in establishing new Islamic banks and enhancing their

existing capabilities.

4. Muslim scholars, bankers and economists should explain, to their counterparts

in Western / American countries as also to various international financial

and monetary agencies like The World Bank and International Monetary

Fund, the salient features of Islamic banking. It should also be a good idea

to invite their suggestions for achieving the objective of socio-economic

justice, in the context of Islamic baking.

5. There is an urgent need for more extensive cooperation among Islamic

banks throughout the world. There should, therefore, be more organized and

systematic meetings, seminars, conferences and workshops to exchange

experiences and expertise and to foster closer cooperation in all spheres of

operations.

6. Muslim countries, who have established Islamic banks, should transact

the imports and exports business between them on Islamic principles. This

would lead to handling more and more international transactions under

interest-free system and would provide a model for other conventional banks

to deal with Islamic banks on interest-free basis. This will also help in

developing the much needed International Islamic Financial Markets.

7. The central banks of Muslim countries should prepare themselves

more vigorously for fulfilling their new and enhanced responsibilities under

76
 Islamic banking system. In addition to their normal functions of

supervising the operations of banks and the quality of their financing

portfolio, central banks should also regulate the ratios of profit sharing, by

prescribing a range within which, the banks would be free to deal with their

clients under the Islamic system.

8. Islamic Development Bank has to adopt a very innovative approach to

gear themselves for assuming a global role on the footprints of The World

Bank. It has accordingly to establish a number of affiliates and subsidiaries for

carrying out the multi dimensional functions and responsibilities, under

the Islamic banking system.

9. A Monitoring commission for Islamic banks should be constituted by all

Muslim countries. Prominent Muslim scholars of all school of thought, economists,

jurists and bankers should be the members of this commission. The commission

should have a number of committees to deal with various issues of Islamic

banking and should be entrusted with responsibilities mainly the following:

a) Developing by Ijma (a secondary source of Islamic

jurisprudence through the process of consensus of opinion) a

uniform banking code with in the prescribed regulatory framework

of Shariah. This banking code would provide legal certainty had

would also develop uniform banking practices to be adopted by

Islamic banks.

77
 b) Ensuring that all the existing modes of financing are

appropriately amended, wherever necessary, so that they are

bought within the purview of Shariah.

c) Developing of uniform accounting systems and standards

for providing consistency in accounting treatment of various

operations and products of Islamic banks.

d) Designing new and innovation services and products for financing

on profit and loss sharing basis.

e) Standardization of the systems, procedures, charge forms and

other documents for handling various banking transactions under Islamic

banking system.

f) Providing solution to any problem or guidance on any matter

referred to it, by any bank.

10. Finally, conclusion is that, being a Muslim we should discontinued the

interest based Financial and banking system. So that we may be saved

from the punishment of “Riba" described in Quran and Hadith. E.g.

The Prophet peace be upon him said as follows “on the night of ascendance

to The Heavens, I passed by a group of people who had tummies as big as

houses, filled with snakes that could be seen from outside. I asked The Arch-

Angel Jibrael as to who they were. He said that they were the people who ate

“Riba.” And the earlier it is realized better it would be for all.

78
 BIBLIOGRAPHY

Principle of Islamic Banking, 10th issue of Nida'ul Islam

Magazine, November-December 1995, source: msa-usc.

What is Islamic Banking

(http://www.islamic-banking.com/ibanking/whatib.php).

Mishkin, S. Fredevic (1995) the Economic of Money, Banking

and

Financial Markets.

Siddiqi, Muhammad Najatullah (1983) Banking without

Interest. Leiscester: the Islamic founded on, UK.
Siddiqui, H. Asrar (1975) Practice and Law of Banking in Pakistan.
International Institute of Islamic Economics IIUI (1999) Islamabad.
Siddiqui, Shahid Hasan. Islamic Banking Karachi: Royal Book
Company. Khan, Mohammad Ikram. (1992) Islamic Banking in
Pakistan. Lahore: All

Pakistan Islamic Education Congress.

Khan, Abdul Wadood. (1999) Interest Free Banking. Lahore.

Khawaja, Abdul Haleem (1994) Economic Theory Lahore:

Naveed

Publications.

www.alrajhibank.com.sa/islamicebanks.html

commercial banking in the presence of inflation by Abdul

Gafoor. mudaraba-based investment and finance, Abdul
Gafoor.
http://www.islamicconferences.com

http://www.islamicbanking-
finance.com http://www.islamic-
banking.com
79
Islamic banking, Abdul Gafoor.

http://www.islamic-finance.net

http://www.albaraka.com/islamicinfo/islamicbooks/instruments/table.ht
ml

http://www.worldbank.org/fandd/english/0697/articles/0140697.htm

islamic-economics.com

riba-free-economy.com
interest-free commercial banking, Abdul Gafoor.

islamic-economy.com

riba-free-banking.com

www.rhbbank.com/islamic/index.shtm

www.gdrc.org/icm/islamic-banking.html

www.islamicbankingnetwork.com

www.library.northwestern.edu/govpub/resource/internat/foreign.html

www.fordham.edu/halsall/mod/modsbook35.html

www.lib.upm.edu.my/iisib.html

www.my-muslim.com/dir/business_and_economy
Muhammad Taqi Usmani (1998), “An Introduction to Islamic Finance.”

80
Idaratul Ma'arif, Karachi, Pakistan

Mohammad Uzair (2001) “Interest Free Banking”.Royal Book

Company Karachi.

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State Bank of Pakistan (2007) Islamic Banking Review 2003 – 2007

www.businessweek.com/magazine/cont/05-32/ b3946141-
mz035.htm-

61k-Nov.10.2006

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ANNEXURE-A: YEAR WISE ENTRY OF ISLAMIC BANKS

2003
1. Meezan Bank
2. Bank of Khyber
3. MCB Bank
4. Bank Alfalah

2004
1. Albaraka Islamic Bank
2. Habib Bank AG Zurich
3. Standard Chartered
4. Metropolitan Bank
5. Soneri Bank

2005
1. Habib Bank
2. Bank Al Habib

2006
1. Dubai Islamic Bank
2. Bank Islami Pakistan
3. ABN Amro N.V. (Now RBS Bank)
4. Askari Bank Ltd.
5. National Bank
6. United Bank Ltd.

2007
1. Emirates Global Islamic
2. Dawood Islamic Bank

82
 RESEARCH PROPOSAL

Purpose of Study

It is true that external financing is utmost important almost for every kind

of business in an economy and banking industry is the main facilitator in this regard.

Islamic banking system plays its role in the banking industry as its minor part. Even

though it’s a minor part it can’t be left behind because banks are the citadels of the

economic growth. So, studying Islamic banking system in detail will not only benefit

the researcher but also will be a source of effective information for many classes of

bank customers. It will help better understanding Islamic banking system and its

salient features.

Our main purpose of the study of this topic to focus on the growth of Islamic
Banking sector in Pakistan, as we came to known to know being slow
economic activities Islamic banking sector grow more than the conventional
banking sector in Pakistan, we will highlight the growth in all aspects, growth in
Market Share, Investment, Branch network, Depositors and many more factors
will be include in the study.

Research Objectives

This research report or thesis is the basic requirement of Bahria Institute

of Management And Computer Sciences, Islamabad, for any student to obtain the

degree. This is a way to help students enhance their knowledge by making them

learn from the practical environment and also to apply the learned theoretical

concepts in the practical field. Thus, the main objective of this research is to fulfill
83
the partial requirement of the University for obtaining the degree.

As such, the purpose of this study is to review the various aspects of Islamic
Banking and to identify the factor of growth of Islamic banking in Pakitan and also
assess their viability and applicability with respect to individual and corporate
consumers. More specifically the objectives will be:

To review the History and Development of Islamic Baking in the

Pakistan. This will enable the readers in understanding the evolution of
Islamic Banking and will consequently enable them in evaluating its need
in present times.
To focus on the growth of Islamic banking system in Pakistan, as stated
in the report of the state bank of Pakistan that Islamic banks have more
growth than the conventional banks in Pakistan.
To gauge the differences between ‘interest based banking’ and ‘Islamic
banking’. This will assist us in inferring as to whether ‘Islamic Banking’
does indeed protect the interests of the debtor and will highlight
significant advantages and disadvantages of the two systems.
To understand the role of government of Pakistan in the
implementation of the proposed system.

To gauge the attractiveness of Islamic Banking System for local and foreign
banks. As these banks are expected to incorporate Islamic Banking in
their current structure, it is essential that this option be made feasible for
them.
To ascertain corporate and individual consumer attitude towards Islamic
Banking in order to evaluate its success in Pakistan. It is essential to
gauge the interest of potential clients for a new product. If the potential
market for Islamic Banking is insufficient to justify investment, the
banks might want to develop the product further in order to make it more
attractive for their clients, such as Islamic Car Financing Schemes.

84
Limitation of the Study

The research is conducted within the following limitations:

 To keep the study manageable research is conducted on limited grounds.

 The study is conducted on small level and only the important aspects are

considered.

 There was a shortage of time that’s why limited data is collected. Still the

researcher has tried to collect sufficient data to make an effective analysis.

 Limited period of time and small sample size in survey questionnaire.

Results may not be indicative for the target respondents at large.

 Some respondents, who have limited knowledge of Islamic banking or no

knowledge about the financial modes of conventional and Islamic banking,

also answered the questions; hence the replies of some questions may be

based on their own imagination or thoughts.

 Although majority of our respondents of Islamic banking questionnaire were

account holders of Meezan Islamic Bank,however some of our respondents

had accounts in other Islamic banks too or accounts in Islamic branches of

conventional banks, so the results of this study are not fully applicable to

Meezan Islamic Bank of Pakistan.

Therefore, in this study the results about Islamic banking should be taken only as

indicative and perceptive rather than conclusive.

85
Research Methodology

This study is basically descriptive in nature, and this would explore & review the

research done on Islamic banking by different researchers and scholars.

This research work used data collection direct from the financial Statements of the

banks, both Islamic and conventional and also from the reports of State Bank of

Pakistan, another source is direct from the customer of the both kinds of banks,

documents researches and interviews of the relevant authorities. Fieldwork was

conducted during the months of September and October of year 2009. Although

all

replies were collected in personnel at the allocated areas, some replies were

collected after the period prescribed above. The primary data collection applied

obtaining the information from peoples through filling of questionnaires, observation,

and interview methods in Karachi. Local university students and friends have also

helped for this work. 300 persons at Meezan Islamic bank and 300 at conventional

banks in karachi were asked to express their views during this study.

86