The situation calls for reforms
in attitude and approach on both sides
By Muhammad Bashir
July 01 - 07, 2002
The State Bank of Pakistan on 1st December 2001
announced the criteria for the setting up of scheduled Islamic
Commercial Banks in the private sector in Pakistan and has also invited
applications from the interested sponsors. Overall the criteria are
highly demanding on the prospective sponsors. Some suggestions in this
context are offered towards end of this paper. The issuance of the
criteria is a positive development in the sense that now the private
sponsors will join the SBP / GOP efforts to finalize the truly Islamic
products, prepare related draft agreements on Islamic finance and above
all prepare the draft Islamic Banking Ordinance. A Commission and a
number of committees are understood to be working on these and other
RELEVANCE OF THE CRITERIA TO
EXISTING BANKS AND DFIS
The points raised in this paper equally apply to the
new Islamic commercial banks as well as the existing financial
institutions. It is expected that soon the SBP might be issuing
instructions to the existing banks and DFIs in Pakistan for taking steps
more or less on lines prescribed for the new Islamic commercial banks.
Particular attention might be given to the following areas:
The modes of finance proposed
to be used for raising resources and extending financial assistance.
Expertise and other facilities
available for ensuring compliance of their financing operations with
structure, business plans, risk management guidelines, internal
controls, working systems and procedures for business operations.
DIFFERENT PLAYERS UNDER ISLAMIC FINANCE
Banks and other financial institutions mobilize
deposits and extend loans, and make money in the intermediation process.
The Depositor and the User of Funds may be an individual, partnership or
corporate entity. The GOP provides legal framework and the SBP is
responsible for regulatory supervision and oversight of operations of
the banks and other financial institution. SECP supervises the working
of corporate sector, capital markets, leasing and insurance business.
The external auditors audit the statutory accounts and provide other
services. The transactions also involve inter-action with a large number
of government functionaries. Under the Islamic system the
responsibilities of all these players will change. Now in every thing
quicker and justifies actions will have to be taken. It is perceived
that under the Islamic system, operational procedures will also undergo
big changes. Some thoughts on the new role of different players and
other allied issues are discussed here with a view to clarify all the
matters considered essential for the introduction of the Islamic
financing in Pakistan.
Largely part of the savings is turned into deposits.
He or she will be expected to demonstrate to the bank that the money has
been earned or acquired through legal means. He or she will decide with
which bank or DFI the money is to be deposited, and in what particular
scheme. Different people have different motives for keeping deposits.
Under the new system, the depositors may fall in categories such as:
Some depositors will want safety of their
capital. They would want that Rs.100 deposited by them today might
remain nominally Rs.100 until they decide to withdraw part or whole of
Other depositors may want safety of their
capital and in addition they may want to share in a minimum profit
(equal to GOP's consumer price index). They might not share in losses.
Some other depositors may place their deposits
on full profit and loss sharing basis. They may pose confidence in the
deposit taker to invest funds as it wishes. However, in case there are
big losses, the deposit taker banks may be blamed and sued for
negligence, pilferage, and other such things.
Some other people may place their deposits on
full profit and loss sharing basis, and would wish to actually
participate in the business undertaking where the funds will be
invested. Such depositors will be few in number but large deposit
amounts will be involved.
The banks or DFIs are required to know their customer
and to satisfy about the genuineness of the deposit. The banks have to
try to meet the maximum but legal expectation through design of their
products and the quality of the service to them. The SBP is to assure
that the banks / DFIs comply with its instructions in this regard. On
the other hand, the GOP / SBP are expected to ensure that adequate
information about the deposit taking institutions is made available to
the depositors for making an educated deposit decision. Proper legal
framework for protection of depositors from unscrupulous practices will
also be required.
THE BANKS AND DFIS (DEPOSIT
These institutions mainly have two roles, namely
deposit taker and provider of finance. Both roles are important. As
deposit taker, it has to establish the identity of the depositor, that
the money is legitimate (to avoid money laundering), to provide
sufficient information to the depositor and to take steps to protect the
interest of the depositor. In this case the bank is in trustee
relationship with the depositor. As provider of finance, it has to
establish the eligibility of the User of funds, establish viability of
the project, obtain required security and see that all conditions are
complied with and the necessary documentation is complete before money
is released to the User. Proper use of funds has to be ensured. It will
provide for proper audit of business and valuation of assets for
determining the profit or loss situation. There has to be no pilferage
of business assets for the illegitimate benefits of the User, the Bank
or any other person. This is the difficult but an essential element for
success of the new system.
The banks shall be organized to properly handle each
type of deposit. A pool of deposits comprising small deposits will be
established and funds out of this will be advanced for trade or
industrial purposes. Separate account will be maintained of the income,
expenses and profits from the pool funds. Deposit amounts exceeding the
specified limit will be handled separately and separate account shall be
maintained of each deposit for determining profit or loss situation.
Bank personnel shall be trained and guidelines including internal
controls will be put in place by the bank's board of directors who shall
be responsible for full compliance for the guidelines and controls.
Banks shall be scrutinized by SBP to see that they are equipped to
handle the deposit taking function as per Islamic principles and that
proper mechanism for profit determination is there. SBP and GOP shall
provide the structure of the Islamic schemes and the standardized
documentation to be used. SBP shall also be issuing Prudential
Guidelines to them.
The tasks listed above will need to be handled by
experienced and conscientious personnel who are properly motivated by
the institutions concerned. Proper and up-dated manuals, guidelines,
internal controls, procedures and formats are to be in place. In the
present day conditions when employees are under fear of losing job as a
result of rightsizing exercises, it will not be easy to keep the good
personnel, keep them adequately motivated, and to also have updated
guidelines and procedures.
Credibility Checks- the eligibility of the party
desirous of Islamic finance for the purpose of trading or manufacturing
activity is the most critical. They must be known to be honest, people
honouring their legitimate commitments, no defaults to their name in the
past, etc. The question is how this will be established and who will
maintain such data for public benefit.
The bank as per prescribed guidelines will decide the
exact mode in each case. It is presumed that in the meantime SBP
Commission / Committees will have finalized their recommendations and in
the light of such findings necessary changes will be made in the
attributes and mechanism of these products to make them truly Islamic
and permitted as per Sharia. For the sake of this paper names of the old
mode of fiance have been used though these will now carry truly Islamic
characteristics. The following modes of finance will be introduced in
the initial stages:
Qarze Hasna- there is urgent need to start such
financing. Otherwise poverty will not be removed so easily.
Micro-finance from Khush-hal Bank fall in this category. All banks may
be required to advance minimum 10 % of finance in this particular
activity. Criteria for eligibility, standardized documentation, security
and dispute resolution mechanism might be provided by SBP, which may
also supervise the banks.
Musharakah- banks may provide finance out of the
small-deposits pool or individual large deposits to the eligible
business and industrial entities for specified purposes and time.
Minimum 10% advance for the purpose will come from bank's own sources.
Banks will see to it that the money is used for the specified purpose
ensuring value-for-money and that proper accounts are prepared to
determine the profit or loss situation. Bank may hire independent expert
for this job. For participation at the Board level, the bank may appoint
its senior officers as directors or appoint Independent Directors who
are known for their experience or expertise. In case of profit, the bank
will retain 10% of the profit as its intermediation fee and pass the
rest to the respective depositors. The bank will also be eligible for
the profit proportionate to finance provided from its own resources. In
case of losses, bank will proportionately share loss with the respective
depositors. The depositors shall have the right to check the accounts of
the business or industrial entity as well as to see that loss is not due
to negligence of the bank or the illegitimate activities of the
entities. SBP to see that proper guidelines and controls exist for
properly undertaking the activity. In this case it is a Mudarabah
between the depositors and the bank and a Musharakah between the User of
funds and the bank.
Mudarabah- it will be similar to the case described
above, except that the bank will not take part in the management of the
entity by appointing directors on the Board. In this case it is a
Mudarabah between the depositors and the bank as well as a Mudarabah
between the User of funds and the bank.
Equity Participation Mode- the bank will initially
hold majority shares in the business or entity. The private sponsors
will initially be minority owners but shall manage the entity as Agents
to the bank. As long as the bank is satisfied, the private management
will continue the business and share profits in the agreed proportions.
As reward for good performance the bank will, in phases, sell its equity
holding to the private sponsors. In case the private sponsors do not
perform well, the bank will easily replace the management on the
strength of its majority holding.
Open-end and Close-end Mutual Funds Type Shares
Activity- the banks may use pool resources in activities such as
purchase of shares for trading or long-term investment purposes. Care
shall have to be taken to preclude chances of bank personnel shifting
personal losses of share trade to the bank account. Insider trading
shall also require to be controlled. Proper guidelines and internal
controls are must for these operations.
Commodity Trade- the bank may on its account purchase
commodities traded internationally and sell on profit to the customers
The above are the most likely modes to be put into
practice initially by the banks. There may be many other modes to be
adopted after clearance by the Sharia Board. The GOP and the SBP are
expected to pass relevant laws and institute proper guidelines for the
smooth operation of different modes ultimately for use by the
individuals and the banks involved. The above may be easily done for the
new businesses or industries. Existing industries and other enterprises
also need to be brought under the new system. This may involve more
tricky questions. However, patience and hard work, most of all the
sincerity of purpose can overcome this as well.
Getting Ready- it appears foreign banks are better
prepared to handle Islamic finance as compared to the Pakistani banks.
They are taking more interest to know the new system. They have better
qualified and motivated personnel who will readily switch to the new
system. They are expected to maintain their service quality and better
decision-making edge over their Pakistani counterparts. The local banks
need to gird up their lions. They have to train and motivate their
employees, to be able to survive. For excelling in the field and
profitability they shall have to do much more. It is time they realize
it now and start working.
THE USER OF FUNDS
He or she may be expected to demonstrate that he or
she is credit-worthy, has the capability to gainfully utilize the
invested funds and has the financial means to contribute, if required,
his or her share in the undertaking. For screening of users of funds as
to their eligibility, the SBP will issue instructions to the banks and
financial institutions as well as to the general public. For better
control and safety of depositors' interest, the SBP may place certain
restrictions including monetary limits on the financiers as well as the
user of funds. The Users will maintain proper accounts, to be subjected
to proper audit. The Users will account for all transactions done with
the invested money.
High Intermediation Cost- these days depositors on
annual basis gets only 5 to 6% which is subject to Zakat and
with-holding tax. So the net return is very small. As against this, the
borrowers at present pay 15% to 18% to the lender banks. The difference
is the intermediation cost, which is very high and not sustainable, if
the depositors have any say. Under Islamic finance if the intermediation
cost is reduced to say 2% to 4%, both the depositors and the borrowers
can get relief. The return to the depositor will be increased and the
rate payable by the borrower will be brought down. This in turn will
give a real boost to the economy. The SBP has already started asking the
banks to reduce the intermediation cost. The banks will have to adjust
to the new reality and control its expenses while increasing efficiency
of its personnel.
THE REGULATORS (SBP AND SECP)
They shall have to be more vigilant in the
supervision of the banks / corporate entities and in the protection of
depositors' interest. Board of directors of the banks and the corporate
entities will be required to demonstrate that proper guidelines and
internal controls are in place and actually are complied with in letter
and spirit. Pakistan cannot afford the sort of bad loaning as in the
past. Qarze Hasna will also be institutionalized in the new era. The
deposits will be insured. The SBP / SECP will provide regulatory and
operational guidelines and controls for the smooth operations of all the
The SBP and SECP will supervise activities of the
deposit takers. Proper guidelines, restrictions and controls shall be
put in place. SBP shall also put in place mechanism to see that each
scheme introduced by the deposit takers meets the tenets of Islam.
Documentation between the depositors and the deposit takers will be
standardized. It shall be made clear to all that the violators will be
Bank Branch Network- Islamic finance, it appears,
will need larger inter-action between banks and the users of funds. In
that scenario, more wide spread banking networks are needed. However,
under the restructuring exercise the number of bank branches is being
reduced. The two activities do not appear compatible. Are we not
creating a problem situation?
Foreign Investors for Banks- Pakistan is moving fast
to privatize banks. Many foreign investors are interested in acquiring
these banks and DFIs. The Islamic banking is to take full effect from
1st July 2002. It appears we want the foreign investors to own and
operate these banks on Islamic finance principals. Is there some sort of
Licensing of Banks and Continued Supervision- the GOP
and SBP will certify soundness of the banks collecting deposits and
relevant details may be published in the newspapers every quarter.
Boards of Directors of the banks will be reminded of their
responsibility for providing proper guidelines and internal controls and
to see that all of them are fully complied by the banks' personnel. The
GOP and SBP will hold them responsible for the sloppy performance, if
Pivotal Role-The roles of the government are pivotal
in many respects. To provide enabling environment and structure for the
Islamic finance in the true sense, GOP shall identify and amend relevant
laws, rules, and procedures. Possibly many new laws and rules shall have
to be promulgated in order to provide for smooth operation of the new
system and also for taking actions against persons acting in violation
of the spirit of the new system. Incidence of Zakat, Income Tax, Sales
Tax, Excise Duty and other Levies shall have to be rationalized. The
depositors will be provided full protection. The GOP will also ensure
that the Regulators are properly protecting the depositors and that
there is level playing between the depositors, the banks and the Users
of funds. For implementation of its various projects through finance
from the banks, the GOP will demonstrate its eligibility to avail
finance on commercial terms.
Training and Motivation of Public Functionaries-
present day business conditions are such that some mis-guided public
functionaries will not allow the things, which they know, are right and
for which required documents are submitted and applicable fees are paid,
unless some private personal benefit is offered to them. Per force, such
expenditure is shown in the final accounts, but under different heads.
For Islamic finance and the strict audit, the GOP is urged to resolve
this difficulty by educating the public functionaries and by suitably
motivating them by increasing their salary so that they also become a
party for the success of the new system.
Deposit Insurance- the GOP and SBP to consider
instituting deposit insurance up to minimum Rs. one million, per account
as soon as possible.
Corporate Law- the new system will not work smoothly
with the existing Company and other laws. Changes need to be made at the
earliest. The Commission / Committees' reports might provide guidance in
Fear of the Unknown- in its true application in a
society with all Islamic norms, Islamic finance is expected to result
substantial profits for all parties involved. But how long it will take
to reach that stage and what happens before that is not known. So the
foreign investors will heavily discount the potential earnings of
Pakistani banks being offered for privatisation. We will not get a fair
price. It will not be a bad idea if the Islamic system in banking is
introduced before the privatization.
They have been auditing corporate and other accounts
since long and generally have had smooth sailing. Under the new system,
their responsibilities will increase manifold. They shall have to do
complete audit including valuation of assets, as otherwise it will not
be possible to arrive at the true profit or loss amount to be shared by
the parties involved. They may be required to do cost audit and other
appropriate audits in order to discover over or under invoicing
practices. They will naturally be rewarded for their services, but they
may also be questioned for their poor performance. Also due to conflict
of interest they may not be allowed to provide to these very entities
the tax consultancy and financial advisory services.
Audit- Islamic finance is based on sharing of profit
and loss. The profit and loss under the Islamic modes of finance is not
the same to which we are accustomed. It is different. Accounting
conventions will need to be adapted to yield profit and loss in the
Islamic sense. Most realistic decisions shall have to be made in the
cost allocation on time basis or valuation of assets at the end of more
frequent intervals. This will require more work by the accounting and
other experts. Unless the role and duties of the auditors are debated,
clarified and agreed to be fair in the present day conditions, Islamic
finance may not take root here in its true sense.
Valuation of Assets- at the end of agreed time
period, valuation of all assets (and liabilities) will be done, in order
to determine the total value now as compared to the time when the
business was initiated. In case the valuation now is more than the
original valuation, the difference will be termed as profit. The
valuation has to be reliable. It has to be agreed if the valuation will
be on going-concern basis or some other basis will be used. In each case
results will be different and to that extent valuation will be higher or
lower. It is understood that for reliability of accounts, the auditor
will do more extensive work and is expected to certify the cost/price
fairness, not only based on invoices but also on market judgment. The
audit shall have to be planned appropriately with a view to give the
final audited figures soon after the end of the period.
Time Interval for Audit- we are accustomed to the
annual audit based on the calendar or fiscal year or the year, which
suits the tax authorities or the main raw material cropping pattern.
Under the new system, the time interval for determining profit in the
business will be flexible in relation to the nature of the business and
the transactions financed by the depositors / banks. It may differ from
case to case basis. The auditors have to be ready for that. An allied
question is what will be the time basis for levying income tax.
THE SHARIA BOARDS
The products designed for taking deposits, for making
advances or for the parking of spare funds, all need to be scrutinized
by the Sharia Board. Transactions approved by the Board will be cleared
for execution. For this purpose the Sharia Boards may have to work hard
and also keep abreast with the developments in other banks and DFIs
locally and abroad.
Financing the Skill Development- ordinarily the cost
is charged to the bank now and so it will be for the future. However,
there is one difference. The banks will be offering expert services to
the depositors and charging fee for it. The cost of skill development
may be met from bank's own capital or the fee earned and not directly
charged to the account maintained for ultimately determining profit or
loss for the depositors. There will be many other such costs, which need
to be charged to the appropriate accounts. Fair basis for this will have
to be developed.
Their workload is expected to increase substantially.
New cases shall have to be heard and decided rather quickly. Existing
defaulters may also ask forgiveness of old interests on the loans
availed in the past. May be additional such courts are needed. The
honourable judges shall have to be familiar with the new documentation
and the actual transactions under Islamic finance.
SBP CRITERIA, PROSPECTS AND SUGGESTIONS
The criteria issued by the SBP are appropriate in
conditions that are attractive for investment and the capital market is
buoyant. The country is presently in some sort of recession and existing
profitable companies are finding it not easy to offer to general public
large share issues or the TFCs. Major portion of the recent TFC issues
were privately placed with the financial institutions and a small
portion was actually offered to general public. The new Islamic
commercial banks are required to offer minimum Rs 500 million to general
public. They may face major problems in raising such large capital by
public floatation. The SBP / GOP has yet to decide on the Islamic modes
of finance, the standardized agreements for the financing and the
issuance of the Islamic Banking Ordinance as the Commission / Committees
are still working on that. This had added further uncertainty for the
prospective sponsors. Therefore, it is felt that the response to the SBP
call will not be very encouraging unless the situation takes a dramatic
turn for the better. In order to make progress towards the introduction
of Islamic finance in the country, the SBP may as well consider options
Let some of the criterion be relaxed for the time
being. There might be better response if the sponsors are allowed to
incorporate a private limited company having paid up capital of Rs 250
million and to start Islamic banking operations. Initially they may not
be allowed to accept deposits more than four times of the paid up
capital. All other criteria to be maintained as originally prescribed
except that the processing fee may be reduced to Rs0.25 million.
The existing commercial banks and DFIs are to switch
over to Islamic financing from July 1, 2002. Let them sponsor a new
Islamic commercial bank in collaboration with Pakistani businessmen. The
work done for setting up this new bank will also help them in the actual
The success of Islamic banking is predicated to a
number of factors including a clear understanding of the environment in
which various transactions will take place. The bankers, the depositors,
the users of bank finance and services and the facilitators all have to
be ready and committed to work for the success of the new system. In
this context, an attempt has been made to flag the related issues for
timely attention of all the concerned authorities. The Islamic
Commercial Banking in Pakistan will flourish most when the norms in the
society are fully in conformity with the Islamic teachings.