The Role of Islamic Banking Industry in the Economic Growth of Pakistan

Sanaullah Ansari
Shaheed Zulfikar Ali Bhutto Institute of Science and Technology (SZABIST), Pakistan

ABSTRACT

Islamic banking industry is flourishing in Pakistan with a rapid pace. Currently, it is holding
more than 8% share of the total banking industry in the country. As Pakistan is a developing
economy, every sector has to contribute into its economic growth. Banking industry is also
playing its role in the economic growth of Pakistan which includes conventional banks and
Islamic banks. At present, there are 5 full-fledged Islamic banks along with other conventional
banks offering Islamic banking services, are operating in Pakistan.

This study is to examine the role of Islamic banking industry in the economic growth of
Pakistan. For this purpose, the financial data of all 5 Islamic banks has been obtained from
their financial statements from 3rd quarter of 2006 to 4th quarter of 2011 and the data of real
GDP of the country has been taken from the source of State Bank of Pakistan. Different
statistical tools were used to check the impact and role of Islamic banking industry on the
economic growth of the country. It has been found that the financial performance of Islamic
banking industry has a very positive impact on the economic growth because Islamic banking
is attracting majority of the banking consumers on the basis of religion. Whereas, profitability
of Islamic banking industry has very low impact as because Islamic banks are new in the
country and they are struggling to earn profits for their consumers as per the teachings of
Sharia’h. Similarly, asset quality of Islamic banking industry has no impact on the economic
growth of the country. The reason is that the asset quality of Islamic banks is equivalent to the
asset quality of conventional banks and it has no independent impact on the economic growth
of Pakistan. Overall results show that with minor changes in the financial structure of Islamic
banking industry and by increasing this industry’s financial efficiency, it can play a major role
in the economic development of Pakistan.

 
 

Keywords: Islamic banking industry, financial performance, profitability, asset quality,

Pakistan

INTRODUCTION

Financial sector plays a very important role to grow the economics of the nation. When
financial sector is strong and well developed then there are greater chances to use the
economic resources to produce more which contribute to generate the physical capital hence
positive economic growth.

With the passage of time and crises in conventional banking system, Islamic financial system
comes forward with great and valuables outputs, which participate in economic growth
efficiently. Now a day’s, Islamic banking is fast growing industry in Pakistan. Islamic
banking is asset based and works on the concept of risk sharing. First Islamic bank in Pakistan
was registered by State Bank of Pakistan in 2002. There are five full fledged Islamic banks in
Pakistan and 14 other banks offering Islamic banking services in Pakistan. According to the
State bank of Pakistan, total assets of Islamic Banks in Pakistan grown up to Rs. 641 billion
representing 13 percent quarterly growth, FY-11 growth in assets was 34 percent and their
deposits reached Rs. 521 billion showing quarterly growth of 12.5 percent and growth of 34
percent. Growth in assets is mainly due to financing and investment growth in Islamic
banking. Non-performing financing decreased while Return on Assets (ROA) and Return on
Equity (ROE) both remained higher than that of overall banking industry. Growth in assets of
Islamic banking industry is due to the positive growth of financing and investment both
represented significant growth of 13 percent and 16 percent respectively. Financing of Islamic
banking industry would be Rs. 212 billion, depicting growth rate of 13 percent by the end of
December 2011. Investment portfolio of Islamic banking industry increased to Rs. 236 billion
in September 2011 to Rs. 274 billion in December 2011 in Pakistan.

The objective of the study is to examine the interaction between Islamic banking growth and
economic growth of Pakistan. How Islamic banking is contributing in the economy of
Pakistan and what is the impact of Islamic banking growth on the economic growth of

 
 

Pakistan. The study has focused that how performance, profitability and efficiency of Islamic
banks in Pakistan affects the economic growth of Pakistan. Financial services are closely
linked with financial development of the country, the progress of Islamic banking services can
play important role in the economy of country (Hafas Furqani and Ratna Mulyany, 2009). A
well progressed Islamic financial system and a change in economic growth pull our attention
to evaluate the Islamic banking system that is implemented in Pakistan.

Table 1
Industry Progress and Market Share (Rupees in Billion)
Description Dec-08 Dec-09 Dec-10 Dec-11
Total Assets 276 366 477 641
%age of Banking Industry 4.9% 5.6% 6.7% 7.8%
Growth 34% 33% 30% 34%
Deposits 202 283 390 521
%age of Banking Industry 4.8% 5.9% 7.2% 8.4%
Growth 37% 40% 38% 34%
Financing & Investment 186 226 338 475
%age of Banking Industry 4.4% 4.5% 6.2% 7.4%
Growth 35% 21% 50% 40%
Full fledge Islamic banks 6 6 5 5
CBs having IBs branches 12 13 13 14
No. of Branches 515 651 751 886

LITERATURE REVIEW

Islamic banking is positively co-related with economic growth and progress. Improvement of
Islamic banking industry in the country can play important role in economic growth and
economic welfare (Hafas furqani and Ratna Mulyany 2009). They also suggest that in long
run, there is no co-integration between Islamic banking and international trade. Islamic
Banking Bulletin of State Bank of Pakistan (2009) also show that growth rate of Islamic
banking sector is greater than conventional banking sector which means the trend of Islamic

 
 

banking is increasing very quickly. Islamic banking sector represented a growth rate of 12.4
percent in June 2009. The networks of full fledge Islamic banks and conventional banks
offering Islamic banking services increased to 528 branches in 2009. The development of
Islamic banking depicted three types of improvement relationships between bank and
depositors (Monzar Kahf 2007), combination of financial and real market in financing,
progress of ethics and moral values in financial decisions. But, Islamic banking is also facing
problems due to liberalization and globalization barriers in the way of Islamic banking
growth. FDI investment from different European countries in Islamic banks minimize these
impacts as study of Encik Mohamed Ridza Abdullah (2011) said that Islamic banking will
progress due to the entrance of foreign banks in the economy of Malaysia. Development of
Islamic capital market in Malaysia is the step towards economic development and growth of
Islamic banking in Malaysia and it has a long way to go. Also Dr. Shamshad Akhter (2007)
discussed the past, present and future of Islamic banking sector in Pakistan. This study
revealed that total assets of Islamic banks are nearly Rs. 135 billion and Islamic banking
deposits and financing has 2.9% and 2.4% market share showing the growth trend because
many multinational private institutes started investing in Islamic banking. The study further
said that in coming future, Islamic banking industry and State Bank of Pakistan will work
together to achieve numerous goals. In future, Islamic banking will need to grow by 40 to 50
percent to increase its share from 3.5% to 15% of total banking industry.

In different variables, conventional and Islamic banks can perform better than each other due
to their difference in modes of financing. In provisions of profitability and liquidity,
conventional banks are performing better than Islamic banks but in provisions of credit risk
management and solvency efficiency, Islamic banks are better than conventional banking
system. Muhammad Hanif e.tal (2012) proved that customers of Islamic banking system are
motivated due to Sharia’h but in Conventional banking system, customers are satisfied due to
wide range of services and products. Sayyid Tahir (2003) predicted that Islamic banks should
be ready for not only intra-industry competition but also for inter-industry competition in the
Islamic banking industry. Government finances will be problem in the way if Islamic banks
will not introduce new products in the market. Highly ethical and well developed Islamic
banking system can contribute in the welfare of community. Abdel-Hameed and M. Bashir

 
 

(1999) concludes that macroeconomic environment, financial market structure and taxation
affect the profitability of Islamic banks. They also indicate that high leverage and large loan to
asset ratios lead to greater profitability. Their study also shows that foreign banks are more
profitable than domestic banks, also revealed that implicit and explicit taxes affect negatively
the performance of bank. Favorable macroeconomic conditions impact positively the
performance of Islamic banks. M. K Hassan (2006) identified that on average, Islamic
banking industry is less efficient than conventional banking industry and efficiency measures
are highly dependent on Return on Asset ratio (ROA) and Return on Equity ratio (ROE).
Source of inefficiency is allocative inefficiency rather than technical inefficiency. The only
way to attract more customers, Islamic banks should try to improve their products and
services. F. Sufian (2007) investigated the performance of Malaysian Islamic banks and also
studied the performance of foreign and domestic Islamic banks in Malaysia that how Islamic
banks convert deposits into investments and gain profit. He indicates that foreign banks are
more efficient than conventional banks. Prof. Wilson. R (2009) found that profit sharing
policy of Islamic banking is beneficial for Islamic banks and reduces the risk of insolvency.
Islamic banks are more secure in financial crisis because instead of paying interest they have
Mudarabah accounts. He also found that Islamic banking is based on moral values so they
have brighter future and this is help for them to enhance their position in global economy.

Hassan. M. K (2002) predicted that financial environment impacts positively the efficiency of
Islamic banks. He used different ratios to check the profitability and performance of Islamic
banking sector. According to his findings, implicit and explicit taxes negatively affect the
performance of Islamic banks and favorable macroeconomic conditions impacts positively the
performance and efficiency of banks. Sheikh. M. A (2007) examined the customer satisfaction
level of conventional banking system and Islamic banking system by using different variables
including economic benefits, financial position, latest facilities, interest on deposits in
conventional banking system and in Islamic banking system, variables used were interest free
loans, financial position, Islamic Sharia’h and religious environment of Islamic banking
system. He concludes that customers of conventional banking system are more satisfied than
customers of Islamic banking system. Dahduli M. S (2009) identified that Islamic banking is
not only against the Interest-based banking and Gambling, Islamic banking is a complete

 
 

financial framework that supports the concept of social welfare in the society. He said that
developed economies used the concept of PLS procedure to make the entrepreneur role of
their banking system successful. PLS in Islamic banking is performing better than the interest-
based system of conventional banks. Kasri. R. A (2011) proved that the determinants of
Islamic banking growth in Indonesia are the increase in rate of return which can increase the
Islamic banking growth in the country. He also indicated that present bank policies have not
better impact on the growth of Islamic banks. He also proved that positive and increasingly
significant trend of policies can positively enhance the growth of Islamic banks in Indonesia.
Imam. P and Kpodar. K (2010) predicted that majority of Muslims in population and oil
production capacity of the country is closely link to the Islamic banking growth. He said that
Islamic banking is not alternate for conventional banking but a complement to conventional
banking system.

Izhar. H and Asutay. M (2007) said that the performance of bank Muaamalat of Indonesia
depends on ROA and profit is produced through financing activities in the bank. Services do
not contribute in the profit maximization of Bank Muaamalat. They also proved that there is a
positive relation between inflation and profitability measure. Performance and efficiency of
bank is dependent on internal and external determinants of bank Muaalamat. Faculty of
Economics and Business, University of Indonesia (2011) proved that the performance
improvement of Islamic banks is due to the cost and revenue efficiency. It also said that cost
efficiency of Islamic banks is greater than the conventional banks of Indonesia and Islamic
banks are more profit generators than the conventional banks. Big Islamic banks have greater
value of cost and revenue efficiency than the conventional banks. Hanif. M (2011) predicted
that Islamic banking is much more progressed like conventional banking with limitations
imposed by Islamic law hence thinking that Islamic banking as totally foreign in business
world is not right. Islamic banks are successful in creating a trust in front of their customers
and receive deposits on the origin of profit and loss sharing but investing and financing
opportunities are limited for Islamic banks in comparison with conventional banks. Hoq. M. Z
e.tal (2011) proved that there is no much difference between Muslim and non-Muslim
customer on customer image, trust, customer satisfaction and customer loyalty in Islamic
banking sector as both type of customers trust on Islamic banks. They said that image is

 
 

positively related with trust and trust leads to customer loyalty with Islamic banks but
probability of distrust is also present.

THEORETICAL FRAMEWORK

The model of the study is showing the impact of independent variable on dependent variable.
The independent variable of this study is Islamic banking growth in Pakistan and dependent
variable is economic growth. The independent variable is measured by calculating
performance, profitability and asset quality ratios. The dependent variable, economic growth
represented by real GDP as shown in figure 1 which represents the model of the study.

Model of the Study

Independent Variables Dependent Variable

Economic growth of
Islamic banking
Pakistan

Performance of
Islamic banks

Profitability

Asset Quality

Research Methodology

Data Collection and Sampling

The data is collected quarterly from 3rd quarter of 2006 to 4th quarter of 2011. The nature of
the data is secondary and is collected through highly reliable source, State Bank of Pakistan.

 
 

The data for variables related to Islamic banking sector is abstracted from the Islamic
Banking Bulletin and annual reports.

Data Analysis Techniques

Descriptive statistics are used to study the patterns of the relationship. Correlation test is used
to find the relationship between the variables. Linear Regression is used to determine the
impact of independent variables on dependent variable. All these analysis are conducted by
using SPSS and E-views software.
Dependent Variable: Real GDP (Economic growth of Pakistan)
Independent Variables: Performance (Per), Profitability (Prof) and Asset Quality (AQ) of
Islamic banking sector of Pakistan.

RESULTS AND DISCUSSIONS

Table 2
Descriptive Statistics
Mean Median Minimum Maximum Std. Deviation
RGDP 1359.92 1361.69 1215.12 1468.38 71.44
Per 3.88 3.89 2.10 6.06 1.10
Prof 56.71 57.33 52.87 64.77 2.07
AQ 16.39 16.18 12.96 21.86 2.43

According to descriptive statistics, mean of dependent variable RGDP is 1359.92, median is

1361.69 and SD is 71.44 and mean of independent variables (performance of Islamic banking
sector) is 3.88, Median is 3.89 and SD is 1.10. Mean of profitability of Islamic banking is
56.71, median is 57.33 and SD is 2.07. Mean of Asset quality of Islamic banking is 16.39,
median is 16.18 and SD is 2.43. These results show very clear relationship in between
independent and dependent variables.

 
 

Table 3
Correlation
RGDP PER PROF AQ
RGDP 1
PER 0.8695 1
PROF 0.5637 0.4853 1
AQ 0.0194 0.0381 0.1073 1

The correlation analysis is used to describe the relationship between the variables. The
variable which is being used to forecast the other variable's value is known as the independent
variable or at times the interpreter variable. The variable researcher is wanted to forecast is
called the dependent variable or outcome variable. The relationship shows the impact of
change in dependent variable caused by independent variable. Results in Table 3 indicate that
all variables have positively significant relationship with each other.

Table 4
Regression Model Fitness
Model R R2 Adjusted R2 Std. Error
1 .871a .759 .718 37.911
a. Predictors: (Constant), AQ, Per, Prof
b. Dependent Variable: RGDP

The R2 value shows that the .759 of the variation in the dependent variable can be explained
by change in independent variable. The value of beta shows the degree of influence the
corresponding independent variable has on dependent variable. The positive sign in the beta
of variables show the positive relation between the dependent and independent variable. The
results indicate that the model is statistically significant (F = 18.857 , Sig = 0.000).

 
 

Table 5
ANOVA Analysis
Model Sum of Squares Df Mean Square F Sig.
1 Regression 10.083 3 03.361 18.857 .000a
Residual 71.056 18 37.281
Total 81.139 21
a. Predictors: (Constant), AQ, Per, Prof
b. Dependent Variable: RGDP

The results in Table 5 indicate that values of ANOVA are significant at .000 and the model is
fir for analysis. In order to find out that if the model is fit for prediction, it is mandatory that
the R values of the model must be more than .5 which is considered as benchmark and the
significance of the ANOVA must be less than .05. Statistical data shows that the R value of
the model is .718 which can be interpreted as one unit change of independent variables will
bring nearly seventy one percent change is the dependent variable, and the significance value
is also less than .05 . Hence it is proved that model is fit for prediction.

Table 6
Linear Regression Analysis
Model Un-standardized Standardized t-stat Sig.
Coefficients Coefficients
B Std. Error Beta
1 (Constant) 0.689 2.135 3.518 0.002
Per 0.409 1.060 0.503 2.447 0.000
Prof 0.037 0.837 0.059 2.126 0.009
AQ -0.424 0.439 -0.381 -0.181 0.158
*. Dependent Variable: RGDP

RGDP= 0.689 + 0.409(Per) + 0.037(Prof) + -0.424(AQ) (1)

 
 

Regression equation (1) illustrates that the real GDP positively and significantly depends on
the profitability and performance. It shows that if performance and profitability would
increase by 1, then real GDP would increase by 0.409 and 0.037 respectively. Performance
and profitability show the significant impact on real GDP because P-value (sig) is less than
.05 which means that performance and profitability of Islamic banking sector of Pakistan have
the significant and positive impact on the economic growth (RGDP) of Pakistan.

The Table 6 also reflects the non-significant impact of Asset Quality (AQ) with the economic
growth (RGDP). The value of coefficient is negative (-0.424) which means that is if one unit
of asset quality of Islamic banking sector grow then it will decrease the 0.0424 of economic
growth of Pakistan.

CONCLUSION

Financial sector in every country plays a very significant role to grow the economy of the
nation. When financial sector is strong and well progressed then there are greater
opportunities to use the economic resources to produce more which contribute to generate the
physical capital hence positive economic growth. With passage of time and crises in
conventional banking system, Islamic financial system comes frontward with great and
valuables outputs, which participate in economic growth efficiently.

This study is an attempt to find out the relationship between Islamic banking and economic
growth of Pakistan. The objective of the study is to find the impact of Islamic banking on
economic growth of Pakistan. Descriptive statistics is used to study the patterns of the
relationship. Correlation test was used to find out the relationship between Islamic banking
and economic growth of Pakistan. Linear Regression is used to determine the impact of
independent variables on dependent variable. Correlation indicates that all variables have
positively significant relationship with each other. ANOVA results are significant at .000 and
the model is accurate for analysis. Regression equation (1) illustrates that the real GDP
positively and significantly depends on profitability and performance of Islamic banking.

 
 

It has been found that the financial performance of Islamic banking industry has a very
positive impact on the economic growth because Islamic banking is attracting majority of the
banking consumers on the basis of religion. Whereas, profitability of Islamic banking industry
has very low impact as because Islamic banks are new in the country and they are struggling
to earn profits for their consumers as per the teachings of Sharia’h. Similarly, asset quality of
Islamic banking industry has no impact on the economic growth of the country. The reason is
that the asset quality of Islamic banks is equivalent to the asset quality of conventional banks
and it has no independent impact on the economic growth of Pakistan. Overall results show
that with minor changes in the financial structure of Islamic banking industry and by
increasing this industry’s financial efficiency, it can play a major role in the economic
development of Pakistan.

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