Islamic Banking in Pakistan

(Introduction, history, formation, statutory requirements, and accounting standards)

Introduction and History of Islamic Banking:

In the early stages of 20th century, the Islamic banking was only limited
to models and modus operandi. The full-fledged system of Islamic
banking was introduced in 1960s by an Egyptian bank 'Myt Ghamr'. The
earliest Islamic banks faced serious challenges ranging from general suspicions
about their viability to a common mistrust about their intentions. Since then, the
Islamic banks have been steadily growing to a remarkable level at this stage.
During the last decades, financial instruments used by Islamic banks have
developed significantly, both on assets and liability sides. Many instruments have
been developed to mobilize financial surpluses. A number of Islamic banks have
launched investment instruments in the form of certificates with short-term
maturities or have established funds earmarked for certain
investments. Accordingly, at present, there are around 70 countries in
which the Islamic financial institutions are operating in full-fledged or in
part. Recently six countries including Bahrain, Saudi Arabia, Malaysia,
Indonesia, Brunei and Sudan have signed a memorandum of
understanding (MOU) for establishment of the first International Islamic
Financial Market (IIFM) in co-operation of Islamic Development Bank
(IDB). IIFM is designed to provide a co-operative framework among
around 200 Islamic banks and financial institutions all over the world. A
Liquidity Management Centre (LMC) is also working in Bahrain which
addresses the critical need for liquidity management by Islamic banks in
line with the Shariah principles.

The Islamic Financial Institutions (IFIs) can be divided into two broad
categories:

1. Islamic commercial banks; and

2. Islamic investment institutions and international holding
companies

Legendary names of Islamic finance are as follows:

Banks / Financial Institutes Countries

Darul-Mal Al-Islami Switzerland
Dallah Al-Baraka Group Saudi Arabia
Bahrain Islamic Investment Bank Bahrain
 Al-Rahji Banking and Investment
Saudi Arabia
Corporation
Al-Meezan Bank Pakistan
Faisal Islamic Bank Egypt
Jordan Islamic Bank Jordan
Islami Bank Bangladesh
Bank Islam Malaysia Berhad Malaysia
Dubai Islamic Bank UAE
Kuwait Finance House Kuwait
Al-Baraka Islamic Investment Bank Pakistan

Islamic financial institutions are diverse and becoming increasingly innovative.

Value of their assets has reportedly exceeded $200 billion with a steady growth
rate of 10-15 percent per annum. They represent a small but dynamic market, no
longer confined to its original strongholds in the Middle East and South East
Asia. In USA, UK and a number of other European countries, various Islamic
funds have existed for a number of years. Some conventional financial
institutions of international standing have established Islamic banking
subsidiaries and windows. Many banks, both in the Muslim world and outside,
are offering Islamic financial products and take active part in capital market
transactions. Liquid instruments are emerging through Securitization by way of
Islamic finance like equity/mutual funds. There is also Dow Jones Islamic Market
Index.

In Pakistan, the process of Islamic financing and banking started with

the reforms in specialised financial institutions like NIT, ICP and HBFC
in conformity with the Islamic principles. From 1st July, 1985 all the
commercial banking operations were made 'interest free'.

Estabilishment of Islamic Bank as per to the Requirements of State Bank of

Pakistan:

Recently, State Bank of Pakistan has allowed the formation of full-

fledged Islamic banks in the private sector. The existing scheduled
commercial banks were also authorised to open subsidiaries for Islamic
banking operations. Such subsidiaries shall be considered as the
Islamic Banking Subsidiaries and shall have a separate body of
governance. It is a statutory requirement for the bank to appoint a
Shariah Adviser / Shariah Supervisory Committee consisting of Shariah
scholars of repute to advise the Islamic bank on matters pertaining to
Shariah. Shariah Adviser / Committee will be responsible to vet all
agreements, and products offered by the Islamic bank. The detailed
criteria for setting up Islamic Banking Subsidiaries has been issued by
the State Bank, which are highlighted as below:

1. The proposed subsidiary shall be a Public Limited Company and

shall be listed on the Stock Exchange;
2. The banking subsidiary (Islamic) are required to conduct the
banking activities strictly in accordance with the Shariah
principles;
3. To commence the business, the subsidiary shall have a minimum
paid up capital of Rs. 1 billion; and
4. At least 51% of the total paid up capital shall be subscribed by the
(parent) banking company, and a maximum of 49% of shares
shall be offered to public.

Islamic Banking Division: The bank shall be required to set up an Islamic

Banking Division (IBD) at the head office / country office in Pakistan.
The bank is also required to prepare a full detail of the organisational
structure of the IBD and submit to State Bank. The responsibilities of
IBD are as follows:

(a) To manage and be responsible for the operations of Islamic

Banking Branch (IBB) including policy and procedural matters;

(b) To liaise with other departments in the bank and the Shariah
Adviser / Committee to ensure smooth operations of IBB;

(c) To ensure that all funds pooled into the Islamic Banking Fund
(IBF) are channelled into Shariah complaint financing and
investment activities;

(d) To arrange training of staff on Islamic banking;

(e) To arrange for compilation and submission of such returns, as

may be required to be submitted to State Bank from time to
time;

(f) To ensure that all directives and guidelines, particularly those

applicable to Islamic banking, issued by State Bank are strictly
complied with;
 (g) To maintain the Statutory Cash Reserve and Liquidity
Requirement with State Bank as prescribed by State Bank from
time to time; and

(h) Other roles and responsibilities as determined by the bank or

State Bank from time to time.

Islamic Banking Fund (IBF): The bank shall be required to maintain a

minimum fund of Rs. 50 million or 8% of risk weighted assets of IBB,
whichever is higher. The funds of Islamic Banking shall be funded by
the head office or its country office and controlled by the IBD for the
operations of IBB.

Shariah Compliance: Obviously, the sole purpose of the Islamic bank is

to conduct banking strictly in accordance with the Shariah principles, as
outlined in Holy Quran and Sunnah. The bank is required to ensure the
Shariah compliance on all the agreements, and products and services
offered and handled by the IBD and / or IBB. The responsible authority
for the Shariah compliance is the Shariah Adviser / Committee
consisting of Shariah scholars having sufficient related knowledge,
qualifications and experience. The Shariah adviser or Shariah
Supervisory Committee, appointed by the bank, shall advise the IBD on
all of the business matters pertaining to Shariah.

Islamic Financial Accounting Standard:

Recently the Institute of Chartered Accountants of Pakistan (ICAP) has

issued the first Islamic Financial Accounting Standard (IFAS) 1
- Murabaha. The purpose of this Standard is to provide guidance for the
transactions regarding Murabaha. Murabaha is a particular kind of sale
where seller expressly mentions the cost he has incurred on the
commodities to be sold and sells it to another person by adding some
profit or mark up thereon which is known to the buyer.

Thus, Murabaha is a cost plus transaction where the seller expressly

mentions the cost of a commodity sold and sells it to another person by
adding mutually agreed profit thereon which can be either in lump-sum
or through an agreed ratio of profit to be charged over the cost, thus
resulting in an absolute price. According to IFAS 1, Murabaha should
fulfill the following conditions:

(a) The thing or commodity is in existence;

 (b) It is owned by the seller;

(c) The bank must have a good title to the commodity before it
sells it to its clients; and

(d) The commodity must come into the possession of the bank,
whether physically or constructive, in the sense that the
commodity must be its risk, though for a short period.

For a Murabaha transaction, the bank itself may purchase the

commodity and keep it in its possession. But, as soon as the client
purchases the commodity from the bank, the ownership, as well as the
risk, passes to the client. According to this Standard, for a valid
Murabaha transaction, the financing must be in accordance with
Shariah principles.

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