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Challenges and opportunities in Pakistan Islamic Banking

Islamic banking and finance are emerging as viable alternatives to conventional interest-based banking and financing. Islamic financing is not only expanding its footprint in Muslim countries but also expanding in Western countries. In today’s connected world of business, Islamic finance is a concept that people working in the banking and finance industries are likely to come across in their careers.

Islamic finance is not limited to Muslim countries. It has shown growth globally, including in Europe. Total Islamic finance assets worldwide are projected to grow to USD3.5 trillion by 2021 from USD2.5 trillion currently, according to a report. There are over 600 institutions providing Islamic finance courses worldwide, and over 200 provide Islamic finance degrees, according to a report of KPMG London. Europe is increasingly showing interest in Islamic finance education. There are 109 institutions that provide Islamic finance education in Europe, 63 percent of them in the UK. Britain issued its first Islamic bond (Sukuk) worth British pound 200 million (over USD 250 million) in 2014.

Islamic finance is not a religious product it is, however, a growing series of financial products developed to meet the requirements of a specific group of people. Conventional finance includes elements (interest and risk), which are prohibited under the Shariah law. Developments in Islamic finance have taken place to allow Muslims to invest savings and raise finance in a way, which does not compromise their religious and ethical beliefs. It is estimated that between 1.5 and 1.8 billion people (one quarter of the world’s population) are Muslim. Geographically, most Muslims live in Asia (over 60 percent) or the Middle East and North Africa (about 20 percent). Despite these figures, Islamic finance is still very much a niche market, with the vast majority of Muslims, who have access to finance, using conventional financial products.

Islamic banking, which became established in the 1970s, currently consists of a variety of financial instruments or products. These include Mudarabah (trust financing), Musharakah (equity financing), Ijarah (lease financing), Murabahah (trade financing), Qard al-Hassan (welfare loan), and Istisna` (progressive payments). According to the Shariah, Islamic financial institutions and modes of financing are based strictly on the following principles:

  • Transactions must be free of interest (riba’).
  • Goods and services that are illegal (haram) from the Islamic point of view cannot be produced or consumed.
  • Activities or transactions involving speculation (gharar) must be avoided.
  • Zakat (the compulsory Islamic tax) must be paid.

The Islamic banking industry in Pakistan has grown rapidly over the last few years. However, the sector is facing certain challenges as well. Islamic banks have developed a number of lending instruments but little research has been done in devising the tools to attract the deposits. One of the reasons could be that banks are not facing shortage of deposits so far. But if they do not pay attention to devise a strategy to compete with the interest bearing tools of raising deposits, then there is a possibility that banks will likely to face problem in their growth particularly when they are working side by side with the conventional banks.

It is required to make an effort on a large scale basis to devise some instruments for depositors as well. The existing Islamic banks should do some research which is not only in their own interest but also in the interest of the Islamic banking globally.

 

Another factor that puts the Islamic banks at a disadvantageous position vis-a-vis the interest-based banks is that the Islamic banks have to supervise and in some cases manage the operation of the project that they are financing. This is an issue where businesses, generally, do not maintain proper books of accounts or keep different sets of account for different purposes. This is quite common in Pakistan.

The presence of such malpractices raises the cost of Islamic banking. Unless fool-proof devices are developed that do not entail these extra costs for Islamic bankers, the growth of Islamic banking activities are likely to be constrained considerably. The loan has gained a prominent role in the present day economic activities. Apart from the loans for commercial or productive needs, the loans are required for the personal consumption as well. The Islamic banks with very limited funds for such loans ignore the needs of a large class of population. Institutions have to be developed a financial instrument for this purposes as well.

Despite being asset-backed, Islamic finance is still not immunized from risks associated with deficiencies in due diligence, inadequate buffers, lack of transparency and weak risk management practices. Effective liquidity management is the key challenge and has gained more prominence owing to dearth of Shariah-compliant investment opportunities and absence of Shariah-compliant SBP standing facility. In Pakistan, sovereign Sukuk is being issued since 2008 that provides the key liquidity management avenue to the domestic industry but demand for such instruments far surpasses the supply. SBP, in consultation with the industry, is working to develop alternate solutions for liquidity management within Islamic banking.

Islamic banks are generally inclined towards investing in the projects with quick returns. This is perhaps because the banks have to pay a sizeable profit every year on to their depositors and they cannot afford to have no-profit for some time in case they are competing with the interest-based banks. This doesn’t mean that Islamic banks do not finance infrastructure projects but they keep a limit of investing in infrastructure projects.

Islamic banking can play a key role to address the four major challenges of poverty, income equality, regional disparity and illiteracy facing the country. It is important to note that non-performing loans are one of the biggest challenges to the industry; Islamic banking, being Shariah-compliant, can assess the risk better than conventional institutions. Islamic banking is more suitable to fund startups which are otherwise avoided by conventional banks in Pakistan. Use of Ijara in agricultural financing and to educate poor students from backward areas be an area where Islamic Banks can work in Pakistan. Islamic financing should be used for underserved agriculture and small and medium enterprises while housing finance could be another attractive avenue.

State Bank of Pakistan (SBP) has issued guidelines for Modaraba-based Islamic refinance scheme for the working capital financing of small and low-end medium enterprises. Islamic banks in Pakistan are not required to maintain a minimum deposit rate. Mostly, average bank customers’ move to other banks for better rates is inelastic (barring large corporate clients).

It can be safely say that Islamic Banks need to overcome the challenges and make a proper strategic so as to expand their footprint. Although Islamic Banking is behind the conventional banking system but the current rapid growth of Islamic Banking system is an indication that it wouldn’t take them long to successfully compete with the conventional system.

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