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By: Omar Mustafa Ansari – ACA

Nowadays Islamic finance is a more common term not only in the country, but throughout the
world and the Islamic financial institutions are now handling an asset base of around US$ 300 billion.
These institutions are spread all over the world including European countries and the United States. In
particular these have their significant presence in the Saudi Arabia, Bahrain, United Arab Emirates, other
GCC countries, Malaysia, Sudan and Iran.

With the grace of Allah Almighty, we are now fortunate enough to have a number of Islamic
financial institutions operating in the country. These Institutions include Islamic commercial banks,
Islamic banking branches of various commercial banks, certain Islamic investment finance companies,
Islamic mutual funds, Modarabas, Takaful companies (incorporated but not yet commenced operations)
and certain other financial institutions that are offering financial products under Islamic modes of
finance e.g. House Building Finance Corporation and certain leasing companies.

With such a fortune, the next target which the Islamic banking and finance industry is facing is to
build the public reliance on the Islamic finance and banking.

Can Banking and Finance Ever Be Really Islamic?

At the outset, we feel it pertinent to discuss a very common question that is in the mind of every
Muslim, particularly in Pakistan because here we have already faced a complete disaster in the name of
interest-free banking and so-called Islamic financial institutions particularly including Modarabas.

The question, as to whether Islamic banking is really Islamic, has two different facets. The first
one is that whatever is being performed in the name of Islamic banking is apparently quite similar to the
operations of a conventional financial institution hence creates doubts in people’s mind. The second
facet of this question is more important and deals with the socio-economic factors associated with the
overall Islamic financial system.

May we remind you that that the Islamic economic system is not something that can work in
isolation of the geo-political and legislative system, as well as, and more importantly the society’s
behavior towards the injunctions of Islamic Shariah in personal and collective matters. Accordingly, one
can easily imagine that in an economy whereby most of the businessmen are not honest in fairly
presenting the financial statements of their businesses, how difficult it is to introduce a profit and loss
sharing based financial solution. Similarly, in most of the cases payment of Zakat and Sadqat depends on
the individual and particularly, in view of the gigantic volume of the black economy in the country, which
according to certain estimates is larger than the white economy in Pakistan, what can be expected even if
a good system for Zakat and Ushr is introduced? Accordingly, it should be kept in mind that the
complete transition of economy to an Islamic economic system can be performed when and only when
the overall consensus of the society is developed towards practical application of Shariah in all the facets
of human life, particularly including the governmental, political and legislative structures.

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Despite such an unsatisfactory and rather discouraging attitude of the society towards application
of Islamic Shariah, it should be noted that such a situation do not relieve a Muslim from the applicability
of Shariah principles, but rather increases his responsibilities in the way that it becomes his duty not only
to try to abide by all applicable Shariah requirements in his personal capacity but also to put his
endeavors towards improvement in such system.

Interest-free Banking Introduced in 80s

As far as the first question is concerned, we may conclude that Islamic banking in Pakistan may
be divided in two different regimes. The first one that is generally called interest-free banking was
introduced in the regime of General Mohammad Zia-ul-Haq, and which is still in operation in Pakistan
with the conventional commercial banks and other financial institutions. Without any doubt on the
intentions of the people who initiated the same and who endeavored to convert the whole system on an
Islamic basis, it may be concluded that in the softest terms we may call such experiment a disaster for
Islamic banking which was not only a failed experiment of its own but also resulted in practical
impediments in the operation of real Islamic banking in Pakistan.

The overall scheme implemented by General Zia’s team was consisting of following steps:

 Replacement of complete interest-based banking system with non-interest based system;

 Amendments in company law and certain other laws to introduce certain Shariah
compliant financial solutions including interest-free redeemable capital and certain
restrictions on purely interest based instruments including debentures and preference
shares; and
 Introduction of Modarabas as interest-free limited financial service providers and special
purpose vehicles for raising interest-free finances.

Although we feel that the intentions of the initiators were quite positive, but the system could not
survive because of a few basic factors, as follows:

 The implementers (bankers and public at large) were generally not believing in the
prohibition of Riba in Islam or were not aware of applicability of practical alternatives of
interest based financial solutions and were of the opinion that this system cannot survive,
or more appropriately we can say, that they were not willing to change it due to reasons
of their own;
 People amongst the general public who were well aware of prohibition of interest in
Islam were practically away from the banking and financial markets and no sincere efforts
were made to bring them in, and accordingly they are still away from that system. In other
words we may say that banking system, Islamic or conventional, has no impact on them
as they are already away from the same leaving majority of such people in effective
position (both from the bankers and public including industrialists and traders) who are
practically unaware of their responsibilities as a Muslim in this respect;
 No adequate training of Islamic banking was carried out for the bankers nor for the
public at large; and
 Although the scheme of interest-free banking introduced through the State Bank’s
circulars, by itself contained a few question marks from Shariah perspective. Moreover,
there was no monitoring structure for the same from Shariah perspective by the
regulators, resulting in a situation that every banker got a few Shariah compliant

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agreements prepared and then started interpreting Islam of his own resulting in a purely
interest based financing system with the title of mark-up and profit instead of interest.

The above mentioned factors should not be considered as all inclusive, however, these may cause
us to believe that the interest-free banking system as in vogue in Pakistan is absolutely not Islamic.

Islamic Banking and Finance – What’s-up Now

After the historical judgments on Riba, first by the honourable Federal Shariat Court and then by
the honourable Shariat Appellate Bench, Supreme Court of Pakistan on an appeal there against, it has
been established that the banking system in vogue in the country is not Shariah-compliant at all and
according to the Constitution of the country any law repugnant to the principles of Islamic Shariah shall
be considered invalid and accordingly, both the honourable courts allowed the federal government with
some time to ensure transition of conventional banking and economic system into a Shariah compliant
economic system duly including the financial system in practice.

Although with a more recent judgment of the honourable Supreme Court of Pakistan, the said
judgment has been set aside and apparently the government quarters, as in the past, are not appearing to
do the needful. However, in order to lower the day by day raising voice in demand of Islamic banking in
the country, and to some extent by the endeavors of certain sincere officials, the State Bank has now
decided to implement a parallel Islamic Banking system in the country and is now allowing opening of
Islamic commercial banks and Islamic banking subsidiaries and branches of conventional banks who will
operate under strict Shariah compliance under monitoring by their respective Shariah Boards / Shariah
Advisors and to some extent by the regulators also. Similarly, the Securities and Exchange Commission
of Pakistan (SECP) has principally agreed to allow Takaful (Islamic Insurance) companies to operate in
Pakistan, although the relevant rules are presently in development stage. A few Modarabas have already
been operating in Pakistan under Shariah compliant modes for last two decades whereas as a recent
introduction, two Islamic mutual funds have commenced operation in the country within the past two

In this respect it should be appreciated that the State Bank has offered its maximum support to
these Islamic banks in form of various Shariah compliant schemes for them particularly including and
Islamic Export Refinance Scheme which was a prominent demand of the Islamic banking sector.
Similarly, an important amendment has been introduced in the Sales Tax law to support Murabaha
transactions by Islamic Banks.

Operations of Islamic Banks

Now the Islamic banks in the country having been licensed as Islamic commercial banks are
operating under the requirements of Islamic Shariah. These banks have their own Shariah Supervisory
Boards and Shariah Advisors generally comprising renowned Shariah scholars and it may be concluded
that these banks do not do anything Haram by will except under compulsion (‫ )اار‬for which they
obtain approval from their Shariah Boards and Advisors. If, for any reason, they earn some earning
which is not Halal, the same is contributed to charity under approval of their Shariah Boards and
Advisors. These include full fledged Islamic commercial banks and the Islamic banking branches of
conventional banks.

However, when considering their operations it may be observed that although their liability side
is purely based on Musharaka and Modaraba, their asset side generally comprise of Murabaha and Ijara

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Muntahia Bittamleek which are although permissible but are considered less desired or border-line
transactions. In this respect, their perspective is also important to be heard, according to which, unless an
adequate documentation and fair financial reporting culture is implemented in the country, with due will
of the businessmen fraction, Musharaka and Modaraba based financial services may not be offered at

Socio-economic Effects of Islamic Banking and Finance

The second facet of our question is about the socio-economic factors of Islamic banking. In this
respect a few people, generally practicing Muslims, are of the view that since the Islamic banking is also
based on profit motive and in present form it generally works on fixed return basis although the risks it
take are higher than the traditional banking, hence the same cannot be a positive factor towards the
socio-economic changes Islam desires. This question is very important and the writer personally concurs
with the concerns of those who raise the same, at least to certain extent.

In this respect it can easily be concluded that the fixed return based banking, although being
Shariah compliant, is not what has been desired by Islam as a complete way of living. On the contrary,
besides Islamic banking in the country is in its experimental stages, we should also bear in mind that only
the change in banking system is not a solution to the overall revolution of economic system unless other
facets of Islamic economic system are not implemented simultaneously. Consequently, in case the Islamic
banking, in your opinion, is not contributing enough towards betterment of society, you cannot blame
the same alone.

Why Islamic Finance?

Most importantly, it should be kept in mind that in some areas Haram and Halal have a very
small difference. For an example, only saying the name of Allah Almighty on an animal at the time of
slaughter makes it Halal and permissible while by not saying that name we make it Haram or by just a
few words of acceptance in Nikah, in presence of a few persons, a man and woman become Halal for
each other. Similarly, if a transaction can be engineered in a way that the same becomes Shariah
compliant, then we should not conclude that the same is Haram only due to its resemblance with the
interest based financing.

It is also pertinent to note that since the Islamic financial services sector is in its initial stages, as
compared to the conventional banking, we unfortunately have to follow the conventional system in the
pattern of financial products and are still not in a position to invent absolutely new financial services. For
example, if they have running finance and overdraft as a financing tool, we have invented an alternate to
the same in form of Istijrar with Murabaha or Musharaka based running finance model. Similarly, if they
use finance leases as a financing tool, we have converted the same in a Shariah compliant form in form
of Ijara Muntahia Bittamleek or in form of Diminishing Musharaka. These are only two examples, but
the tally is practically very high and for each interest based financial product except for those explicitly
Haram, more than one alternates have been engineered.

In this respect, it also needs to be considered that during the last few centuries, the conventional
banking system has well read the human needs and psychology and has invented a considerable number
of financial products and accordingly, it is not simple to just invent a new financial tool just for the
purpose of inventing one.

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As a conclusion to this question, we may say that we are required by our religion to implement a
complete Islamic way of living in our individual and collective lives and the society and the government
as well. The Islamic banking and financial system is a part of such system and is not construed to be
applicable in isolation while other laws and customs repugnant to the Shariah requirements are still in
force. However, for the sake of our own benefits, in order to avoid interest by ourselves and providing
interest-free opportunities to our brothers and sisters in Islam, we should promote and support the
Islamic banking and finance in the country with all our possible efforts and endeavors. Such Islamic
banking can provide us with a shelter from interest based transactions for the time being and might
support us in augmenting a truly Islamic financial system, and more appropriately said, will serve as an
experiment for the time when we will really be in a position to the implement the complete Islamic way
of living in our beloved country.

General Arguments against Islamic Finance and Banking

During past some time, when I have been a member of a team working on a few projects on
Islamic finance and banking, I came across a number of questions and arguments from various circles.
These circles include my friends, relatives, my students and staff, general public, State Bank and
commercial Banks’ executives and even students of a professional accounting body by which I was
invited to have a lecture on Islamic Banking. It would be worthwhile to discuss a few most important
arguments amongst those numerous questions, to understand the pressures that Islamic finance and
banking are facing day by day.

The first argument which is generally heard is that there is NO difference between the
conventional banking and Islamic banking and this is merely a change of name. The second argument is
that even in Islamic banking, the most common products being used e.g. Murabaha, Musawwama, Salam,
Istisna and Ijara Muntahia Bittamleek are on fixed return basis. Answers to these observations have
already been discussed in the preceding paragraphs. However, we should just recall the fact that unless
we can distinguish an Islamic bank from a conventional bank, it would be difficult for any of us to rely
on the same. Particularly, it is observed that they try to make sure that their product is similar to the
conventional products in all respects, even if for that purpose they have to incorporate a few provisions
in these products which are not considered to be good or a few of them are considered Makrooh. In
addition, their endeavors are focused towards minimization of their risk through every possible option
and accordingly, the essence of Islamic finance which is based on risk taking is killed.

The third question is generally raised on the honesty and integrity of Islamic financial institutions.
This question, which is asked the most times, is that these Banks are using the name of Islam to earn a
few bucks more as compared to the conventional banks. This question has two sides. The first one is on
the financing side, where these Banks charge higher than the charges of a conventional bank. In other
words, internal rate of return on Islamic financial products is higher than the conventional products. A
justification of this argument is that since the Islamic financial institutions are subject to the commodity
risk and the price risk, in addition to the conventional risks that a bank faces, they are justified in their
demand. In addition, particularly in case of Ijara Muntahia Bittamleek, since the risk and reward of the
asset rests with them for the whole tenure of lease, which inter-alia includes payment of insurance
premiums, they may be justified in charging a higher rental. Nevertheless, financial experts have generally
felt that even if these factors are considered, the pricing by these Banks is on the higher side.

On the contrary, it is observed that on the deposit sides they pay less as compared to the
conventional banks. In addition, it is generally observed that the expected rates, as well as, the actual rates
of return offered by these financial institutions are fairly equivalent to the rates being offered by

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conventional financial institutions. In a profit and loss based model, it is agreeable that they assign
weightage to different types of deposits in a manner that the total return on investment and financing
pools is allocated amongst various depositors and the Bank (working as a partner). Nevertheless, the
question that a participant of a lecture asked me was very distressing for me, as well as, most of the
supporters of the Islamic finance in general. He asked the reason as to why the return to depositors of
these banks averages out to be 2 percent per annum – which is slightly less than or fairly equivalent to
the rates being offered by the conventional banks, whereas their return on capital employed, which is
attributable to the shareholders is around 20 percent per annum.

Fourth question is the acceptability of insurance under conventional mode. A number of

practicing Muslims and jurists are of the view that unless the option of Takaful is available, the Islamic
financial institutions should not opt for conventional insurance which is impermissible. Instead, options
for internal Takaful fund or any other similar option shall be used. However, we all hope that such
question shall stand resolved in near future once the rules for Takaful companies are finalized by the
SECP and these are operational in the country.

Fifth argument is about the marketing approach being used by these financial institutions, which
adversely effects the public reliance on this mode. People raising such question have two grounds for the
same. The first one is the general marketing approach being applied by the a few Islamic financial
institutions which include advertisement and other publicity materials including involvement of women
and employment of women for Islamic banking business without Hijab or even appropriate attire (as
defined by Shariah). Although a few modern and liberal Muslims will not like this objection at all,
nevertheless, it should be kept in mind that a common man cannot understand “Islamic” banking while
he feels that other factors of business are not really Islamic. Another similar objection is the marketing
strategy in which sometimes it is felt that false statements are made for promotional purposes. An
example of the same is the claim by a leading Islamic bank that all its day to day activities are monitored
by its Shariah Advisor. Just imagine, if it is humanly possible, that a part time Shariah Advisor can look
after all day to day activities of a full fledged bank with a number of branches even located at other cities.
Another example is the claim by an Islamic mutual fund that it is the first one of its kind in the country,
whereas another fund was operating in the country for around one year earlier to subscription for such
mutual fund.

Sixth argument is of key significance from the perspective of the overall control environment of
these banks with regard to the applicability of Shariah principles. You would note that most of these
institutions have hired the conventional bankers and generally no or very little consideration is awarded
to ensure that they are well conversant with the Shariah requirements with regard to the modes of
finance being used by these Banks. Consequently, a number of non-compliances of such requirements
have been discussed on various forums. Since the objective of this article is just to highlight the issues,
these are not being discussed in detail. Anyway, I have myself met a few Islamic bankers at various
occasions who were not fully conversant with the basic principles of Shariah compliant products that
they were marketing.

Seventh question with which I can’t personally agree is regarding the appointment of Shariah
Boards and Shariah Advisors. People have largely noted and discussed at various forums that the major
contribution in this field in Pakistan is limited to a very small group of jurists most of whom relate to a
single family and their pupils. Besides this, another question is also being raised that generally the
honorariums, consultancy fee and other benefits being offered to such jurists by the Islamic financial
institutions in Pakistan, as well as, abroad are quite high and this may jeopardize their independence. I
personally along with most of the people conversant with the business and operations of Islamic finance

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do not agree with this observations because the contribution of these people to the industry as a whole is
remarkable and they deserve even more than that based on their contribution and efforts in the
promotion of this industry. The general concept that a Moulvi should be paid the minimum at which he
can live, is not something justifiable. If you are getting benefits from their efforts, their knowledge and
skills, then they should be justifiably rewarded.

However, we all agree that it is the right time that contributions from jurist from other schools of
thought should necessarily be provided opportunities to enter into the field. For this purpose, it would be
a good idea that a jurist should not be allowed to hold more than one remunerative position as a Shariah
Advisor or member of a Shariah Board. However, honorary / advisory members may hold upto three
positions in all. This will ensure that fresh blood gets a route to enter into the field which will eventually
improve the overall Shariah compliance in the field, as well as, will help these institutions to innovate
fresh products.

How to Build Reliance on Islamic Finance and Banking

Islamic banking industry is presently growing at a very high pace. Nevertheless, having discussed
the general concerns raised by various circles hampering the public reliance on Islamic finance, it would
be worthwhile to propose a three fold strategy for building public reliance on the same. This strategy will
also help out the industry to remain compliant with the Shariah requirements for all the time. The
proposed strategy is as follows:

1. Standardization of Shariah Compliance Regulations for Islamic

2. Shariah Compliance Assurance for Islamic Financial Institutions; and
3. Shariah Compliance Rating of Islamic Financial Products.

Standardization of Shariah Compliance Regulations for Islamic Finance

Internationally, there have been a lot of efforts for standardization of practices being followed by
various Islamic financial institutions. These efforts include a lot of research work. Nevertheless, the most
admirable job has been performed by the Islamic Fiqh Academy of the Organization of Islamic
Countries and the Accounting and Auditing Organization of Islamic Financial Institutions (AAOIFI).
This organization has been established by a number of Islamic financial institutions operating throughout
the world and is based at Bahrain. AAOIFI has established an Accounting and Auditing Standards
Board, as well as, a Shariah Board. These Boards have, to date, performed a commendable job by issuing
accounting, governance, auditing and Shariah standards for Islamic financial institutions.

Since these Boards have been established by choosing the experts of the fields from throughout
the Islamic world, their works, are considered to be a consensus of the experts from the field and hence
these work may be used for standardization of practices of Islamic finance and banking throughout the

In Pakistan, the Institute of Chartered Accountants of Pakistan has issued draft Islamic
accounting standards for Ijara and Murabaha which are under finalization phases. However, these drafts
do not contain enough details regarding standardization of transactions. On the other hand, the State
Bank has issued essentials for Islamic banking and financial products and a bunch of model agreements.
A very useful book has also been published by the State Bank on the topic of Islamic finance.
Nevertheless, these are just guidelines and not a mean of standardization of practices. As a part of its

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efforts, the State Bank has established a Islamic Banking Department, duly supported by an independent
Shariah Advisory Board comprising of Shariah jurist, lawyer and account members. Nevertheless,
without going into further details it is pertinent to mention that as evident from its name, it is just an
advisory board and accordingly, advises when and only when such advices are sought.

In contrast, SECP has not yet demonstrated any concrete initiative for promotion of Islamic
finance in country. As an example, the matter of establishment of Takaful companies in Pakistan is
pending finalization of rules on the part of SECP. Similarly, there is no monitoring of Islamic financial
institutions that come under its umbrella, including, Islamic mutual funds, Modarabas, Housing finance
companies etc., as well as, the Islamic financial products issued e.g. Musharaka TFCs issued by Sitara

From the above details, it is established that a great deal is outstanding on the part of our
regulators, as well as, the lawmakers to ensure that a conducive environment for promotion of Islamic
finance is made available in the country, particularly including the standardization in order to build public
reliance on these products and institutions. However, from the old times a Shariah Board for Modarabas
was operating or rather not-operating.

In view of the same, it may be recommended that the State Bank and the SECP shall join forces
to form an independent authoritative Shariah Monitoring Board for Islamic financial institutions and
Islamic financial products. In our humble opinion, such Board shall besides advising on matters, as and
when its advices are sought, also establish an independent and effective monitoring framework for
Islamic financial institutions. Besides this, its functions shall include setting standards of operations for
these institutions based on Islamic Shariah.

For that purpose it is advisable that in addition to the honourable members of the State Bank’s
Shariah Advisory Board and the members of the Supervisory Board for Modarabas, a few executive, full-
time working members of such Board shall be appointed. These members shall also be taken from
bankers, accountants, lawyers and most importantly from Shariah jurists. Islamic banking department of
SBP and SECP shall support such Board in development of rules and regulations for Islamic financial
institutions, particularly ensuring standardization and consistency in the practices of Islamic financial
institutions and their maximum compliance with the requirements of Islamic Shariah.

However, unless such standards are developed, which shall obviously take some time, the State
Bank and the SECP may decide to adopt Shariah Standards issued by AAOIFI as a regulatory framework
for Islamic financial institutions. Even after, these standards will provide a solid base for further
strengthening the standardization process.

Shariah Compliance Assurance for Islamic Financial Institutions

Most importantly, it should be kept in mind that even these rules, regulations and standards
might not work unless and until an effective network of check and balance is established to ensure
compliance of the same in letter and spirit. My personal experiences have proved, which I am sure that a
number of readers will second, that the Shariah compliance cannot be ensured merely on the basis of
approval of products by the Shariah Supervisory Boards and the Shariah Advisors.

Presently the framework of Shariah compliance assurance in Pakistan may be divided in three
different types of assurance as follows:

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1. The first option which is being used by a leading Islamic commercial bank is the Shariah
compliance review report of the Bank’s own Shariah Supervisory Board or the Shariah
Advisor. This option is although considered an effort to ensure Shariah compliance; the
same can not be construed to fulfill the need in this respect because of three basic
weaknesses being discussed as follows:

 The first weakness is that the Shariah jurists who are sitting on the Board or are
appointed as Shariah Advisors generally have no or a very little knowledge about the
principles of finance, accounting and auditing, and more importantly, of the
operations of the financial institutions. Consequently, their compliance review
generally remains limited to the extent of assurance of the legal form of transactions
i.e. vetting of agreements etc. On the contrary, the operational matters which include
the substance of the transaction might remain unattended because it is not the core
competence of these respectable jurists. Besides this, generally the management do
not wish to bring each and every matter in the attention of the Board or the Advisor;
 The second weakness is independence of the person performing the assurance
function. Although we don’t have any doubt on the personal independence and
integrity of these respectable jurists, they would themselves appreciate that the work
performed under one’s guidance should always be counter checked by an
independent person. Particularly, keeping in view the human tendency of errors, it
cannot be advised that the person supervising and monitoring the transactions is also
entrusted to recheck the same; and
 The third issue is of time and skilled staff. Generally those on the Shariah Boards and
on the seat of Shariah Advisors are busy guys. They are generally serving a number of
Boards and educational institutions and are involved in a number of social and
religious activities. In addition, they do not have any skilled staff hired for the
purpose of assisting them in the assurance work. Consequently, you can easily
imagine that it is humanly not possible for a single person to perform a
comprehensive Shariah compliance audit of the operations of a full-fledged Islamic
financial institution which may even have a number of branches.

2. The second option being used by two Islamic mutual funds in the country is Shariah
compliance audit by the external auditors of the Islamic financial institutions. In such
option, the external auditor is also assigned with the task of performing Shariah
compliance audit with a scope defined in advance. This may be considered to be a viable
option for independent assurance of compliance with the Shariah terms. However, such
system has two basic weakness being discussed as follows:

 Since the external auditor is also entrusted with the task of performing the Shariah
compliance audit, his expertise in Islamic finance is not ensured. You would
appreciate that if the auditor is not equipped with the necessary skills and knowledge,
the output of the assignment might not be as good as may be expected from an
experience auditor; and
 Since the scope of the audit is pre-defined and the matter of permissibility of a
transaction is generally subject to the opinions and perspectives of the Shariah
Supervisory Board or the Shariah Advisor, the independence of the exercise, to some
extent, remains in jeopardy.

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3. The third option is being exercised by the State Bank in form of Shariah Compliance
Inspection of Islamic commercial banks. This is a very good option, as it is independent
and authoritative in nature. Nevertheless, since the results of such inspections are
considered to be confined to the management of the Bank and the State Bank, the
benefits of such exercises cannot be forwarded to the general public. Moreover, such
exercise is limited to the Islamic commercial banks and the Islamic banking branches of
conventional commercial banks and consequently other financial institutions that are
governed by the SECP including Islamic mutual funds, Modarabas, Takaful companies,
Housing finance companies, Investment finance companies and leasing companies shall
remain out of ambit of such exercise.

In view of the same, it is proposed that a framework for Shariah compliance audits of Islamic
financial institutions shall be introduced. In this framework, a common panel shall be approved by the
State Bank and the SECP amongst reputable firms of chartered accountants, having experience,
knowledge and skills in Islamic banking and finance. All the Islamic financial institutions operating in the
country shall be required to get a Shariah compliance audit performed. In the absence of relevant
expertise in the country, in the beginning phase, the existing external auditors may also be allowed to
perform such audit, if they are amongst the approved panel of Shariah compliance auditors as approved
by the State Bank and the SECP. However, in the later phases these duties may be allocated to different
auditors in order to improve the independence in performance of their duties.

It is, anyway, pertinent to note that the scope of such audit needs to be assigned by the regulators
i.e. the State Bank and the SECP. Due consideration shall be given to the nature of each financial
institution and accordingly different scope of work may be assigned for Shariah compliance audits of
various Islamic financial institutions. However, in the absence of initiative from the regulators, an
association of Islamic financial institutions may, with the help of respectable jurists, define such scope.

Shariah Compliance Rating of Islamic Financial Products

Anyone having basic understanding of Islamic finance would easily understand that generally all
the products being launched by Islamic financial institutions cannot be termed equivalent for Shariah
compliance purpose. There might be certain provisions in an Ijara contract that may render it less
desirable as compared to a similar Ijara contract. Or in general a Murabaha may be less preferable as
compared to a Modaraba product.

In addition to the products being launched by the Islamic financial institutions that are subject to
the approval of their respective Shariah Advisors and Shariah Supervisory Boards there are certain
Islamic financial products that are launched by the conventional financial institutions or by various
companies and even by the Government. These products, for example, include the housing finance
option offered by the House Building Finance Corporation, Sukuks being issued by the Government of
Pakistan, Musharaka TFCs issued by the Sitara Energy and operating lease options offered by various
leasing companies. Needless to mention, if the option of offering of Shariah compliant products is used
by the conventional financial institutions or other businesses or the government itself, the Shariah
compliance of such products might become questionable from the perspective of a common man who is
not aware of the details of Islamic financing options. Similarly, and more importantly, if such products
are launched using any controversial option of Islamic finance e.g. Tawarruq or Ba’y Inah, the same
might not be considered appropriate by a number of practicing Muslims who would prefer to avoid such
financial products, if they are made aware of the questionable nature of such financial products.

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Similarly, certain Islamic financial products offered by Islamic financial institutions might also be
entailing such questionable options.

You would appreciate that those having regard to the commandments of Shariah shall always
prefer to avoid the questionable options and will prefer to go directly to the options that do not entail
any such questionable issues. In view of the above, it may be construed that a framework for Shariah
compliance rating of Islamic financial products is an essential. The model that works out to be more
feasible is that instead of making it a job of the regulators, the same shall be opened for Islamic finance
professionals. In other words, such a model shall work similar to the concepts of a credit rating agency.

The model rating that we wish to propose would be as follows:


A+ Products which are fully compliant with the Shariah requirements and do not
include any questionable matter at all. These products will generally include
Modaraba and Musharaka products. These will also include Ba’y Salam and
Istisna based products, as well as, the Ijara products. A requisite for being
rated as A+ will include the presumption that no questionable option has
been included in these products. Units of Islamic mutual funds are an
example of such products.
A These products will include the common products being used in Islamic
finance that are although allowable in nature, but include certain questionable
issues and are engineered in a complex way to ensure that these do not cross
the borders. These products include Murabaha, Ijara Muntahia Bittamleek,
Diminishing Musharaka with fixed rentals and certain other products
engineered in a complex way. These will also include the Sukuks issued by the
Government under various options. In addition, the products of agricultural
financing including Muzar’a and Musaq’a will also fall in this category.
Generally Takaful products will also fall in this category.
B These will include products which are although allowed, but are not
considered to be good in nature because the very nature of these transactions
resembles to Interest bearing transactions. As an example, these transactions
might include Diminishing Musharaka products with guarantee of purchase
price and variable rentals linked to KIBOR. Nevertheless, these products
shall be termed as permissible from Shariah perspective. A Takaful product
with a conventional reinsurance option, is another example of products that
may fall in this category.
C The financial products rated as C shall be considered to be impermissible in
nature because of being Makrooh in principle. Nevertheless, these may be
opted in case of extreme exigencies that may be termed as compulsion or
Iztirar. These will, as an example, include products with Ba’y Inah or Ba’y
Wafa i.e. Sales with repurchase options (REPO) and certain options that have
been allowed by the Shariah jurists as an alternate at the time of conversion
of a conventional bank into Islamic bank.
N These will not permissible from Shariah perspective due to non-compliance
of certain very basic principle of Islamic Shariah.

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In case a few questionable options are included in a product included in a particular category, the
rating of the same shall be adequately decreased. As an example, in an Ijara Muntahia Bittamleek product,
if the rentals are set on variable basis linked with a benchmark, generally the KIBOR or SBP rates, such
product shall be ranked as B instead of A. Similarly, if the option of conventional insurance is included in
an A+ category product because of unavailability of Takaful option, the same shall be rated as A instead
of A+. However, these are just examples of a few products and the detailed lines and borders for such
ratings shall need to be drawn by the experts of the field in guidance of Shariah jurists.

While awarding any rating to a particular product, it shall be useful for the general public that any
impermissible or questionable covenants of the financial product shall also be mentioned in detail in
order to enable the prospective investor to understand the Shariah issues with the same.

It would be worthwhile to propose that such rating should be performed by Islamic finance
professionals with the help of Shariah jurists of repute. These professionals might include management
consultants or an association of Islamic financial institutions. State Bank and the SECP and the Shariah
Board established by them shall just help them out in determining the broad categories and guidelines for
these ratings. The organizations and consultants willing to undertake the task shall be required to be
registered with the State Bank and the SECP who shall, at the time of granting such license and from
time to time, review the experience, skills, knowledge and repute of such organizations and consultants.

However, it also needs to be specified that Shariah compliance rating of Islamic financial
products may only be performed on the “paper-work level”. In other words the letter of the same may
be rated by the Islamic finance professionals but the applicability of the same cannot be ensured unless
and until a comprehensive Shariah compliance audit of the same is performed.

Although these proposals and views are the perspective of a beginner in the Islamic finance, I
feel that these words will capture the attention of Islamic finance experts, as well as, the concerned
officials of the State Bank and the SECP. I feel that once the standard for Shariah compliance are set out,
Shariah compliance assurance of Islamic financial institutions is made public, as well as, the Shariah
compliance rating of Islamic financial products is generally available, general public will be in a better
position to rely on the Islamic financial institutions and the Islamic financial products.

As an alternate, it may be proposed that if our regulators, as well as, the law makers are still not
sincere in promotion of Islamic finance in the country, those in the business of Islamic finance shall step
forward to form an association with such an objective. In this respect, Shariah compliance audits may be
voluntarily introduced as already being performed in case of Islamic mutual funds and an Islamic bank.
However, as discussed above, in order to improve the process, these audits shall be carried out by
independent Islamic finance experts, preferably independent firms of chartered accountants having
experience in Islamic finance and banking.

May Allah Almighty bestow us his blessings and enable us to evolve a complete system of life in
accordance with the principles of life provided by the Holy Quran and the Holy Prophet (SAAWS).

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