The country can benefit largely from the experience of other Muslim countries making attempt to eliminate Riba from the economy.


Dec 23 - 29, 2002



MANSUR-UR-REHMAN KHAN is currently working as Executive Director (Banking) with State Bank of Pakistan. He is responsible for supervising the work of three departments namely, Banking Supervision, Banking Policy and Banking Inspection departments. He has served as Chairman/Member on various committees/forums constituted to deal with complex banking sector related issues. He has also served as Chairman of the Committee responsible for developing documentation for Islamic modes of financing for introducing Islamic Banking in the country. He also presented a paper on "Experience of Central Banks in Supervising Islamic Banks - Pakistan's Experience" at a seminar on "Islamic Financial Industry" jointly organized by Islamic Research and Training Institute (IRTI) of the Islamic Development Bank, Jeddah and Centre of Managerial Development, Alexandria University, Egypt in year 2000.

Over the last three decades Islamic banking and finance has developed into a full-fledged system and discipline reportedly growing at the rate of 15 per cent per annum. Today, Islamic financial institutions, in one form or the other, are working in about 75 countries of the world.

The experience in Islamic banking operations around the world reveals that transformation of retail banking is not a big problem. The financial sector in Pakistan is already familiar, at least to some extent, with the concept of Islamic banking and finance. However, there are problems in development of instruments for liquidity management by banks and monetary management by the State Bank of Pakistan, the main challenge.

The Government of Pakistan has decided that the shift from conventional banking to Riba free economy would be made in a gradual and phased manner and without causing any disruptions. Pakistan is not trying to reinvent the wheel. It can benefit from the experience of other Muslim countries like Bahrain, Malaysia, Sudan and Iran.

In this exclusive interview with Mansur-ur-Reheman Khan, Executive Director (Banking), State Bank of Pakistan, effort has been made to identify the factors impeding the development of Islamic banking in the country, the central bank policy and the facets of proposed regulatory framework.

PAGE: What measures have been taken to eliminate Riba from the prevailing banking system in Pakistan?

KHAN: Islam was the basis of creation of an independent state within the undivided Indo-Pak Sub-Continent. Since its creation, the people of Pakistan have held the demand for elimination of Riba from the financial system of Pakistan on the basis of Islamic precepts. All Constitutions of Pakistan have incorporated, within the principles of policy, the elimination of Riba as an important objective of the State policy. Quaid-e-Azam, the father of the nation, in his speech at the occasion of the inauguration of State Bank of Pakistan (SBP), had expressed the desire for evolving an Islamic system of banking.

Article 38(f) of the Constitution of the Islamic Republic of Pakistan, 1973 provides: "The State shall.. eliminate Riba as early as possible." The Objectives Resolution, now a part of the Constitution, as well as principles of policy enunciated in the Constitution also require to establish an order in Pakistan [w]herein the Muslims shall be enabled to order their lives in the individual and collective spheres in accordance with the teachings and requirements of Islam as set out in the Holy Quran and Sunnah.".

The measures taken to eliminate Riba are: -

The earliest efforts for finding an alternative to the interest-based system could be found in a number of reports submitted by the Council of Islamic Ideology (CII).

Efforts for economy wide elimination of Riba started during 1970s and most of the practical steps were taken in early 1980s, which are considered as pioneering work in the Muslim world. Numerous measures were taken to introduce Riba free banking in Pakistan. Banking and other relevant laws viz. State Bank of Pakistan Act, Banking Companies Ordinance, Recovery Laws, Negotiable instruments Act, Companies Ordinance, etc. were amended to facilitate Riba free banking system. New regulations were prepared prescribing the modes of financing, profit distribution mechanism for deposits, financing facilities by SBP, etc., which constituted ground work for Islamization of financial system. At that time two important areas were kept outside the purview of Riba free banking system mainly due to lack of research in these fields, viz. government borrowings (both local and foreign) and foreign exchange. However, after 1985, mainly due to lack of commitment of successive governments to Islamize the economy, inadequate judicial system and absence of Shariah compliance mechanism in the banks hampered further research and development in this field.

A number of Commissions, Committees, Task Forces, Working groups, etc. have been formed over the years, which have contributed in thrashing out various issues at conceptual and operational level. However, extensive research and development is still needed for complete elimination of Riba.

In December 2001, SBP issued the Detailed Criteria for establishment of Islamic commercial banks in the private sector. Al-Meezan Investment Bank Limited applied under the criteria issued by SBP to convert itself into an Islamic commercial bank. It was issued the licence in the name of Meezan Bank Limited to operate as full-fledged Islamic bank in January 2002. The bank acquired the business of Societe Generale Bank branches operating in Pakistan and has started commercial operations in March 2002 as a model Islamic bank in Pakistan. The regulatory issues like maintenance of Statutory Liquidity Requirement and Cash Reserve against FE-25 and other deposits have been resolved by allowing Meezan Bank to maintain these requirements in the form of Current Account balance with SBP at a reduced level. An Islamic Export Refinance Scheme has been prepared on Musharika basis, which has been extended to Meezan Bank as a pilot project.

In order to allow existing banks to open subsidiaries for Islamic banking, section 23 of Banking Companies Ordinance, 1962 has been amended and now the banks are authorized to open subsidiaries for Islamic banking. The separate criteria for establishment of such subsidiaries by existing banks will be notified shortly.

A scheme for allowing the existing banks to open standalone branches for Islamic banking operations is being prepared keeping in view the underlying issues and the international practices in this regard.

House Building Finance Corporation Act has been amended to make its financing Shariah compliant and they have issued Asaan Ghar Scheme on the basis of diminishing Musharika.

SBP has taken several steps for capacity building in the areas of Islamic banking and its regulations. Various officers attended local as well as international seminars and conferences on Islamic banking held in Iran, Sudan, Bahrain, Lebanon, Egypt etc. The National Institute of Banking and Finance of State Bank (NIBAF) has started training of SBP personnel in Islamic Finance. As regards commercial banks, courses of Institute of Bankers Pakistan were revised to include topics on Islamic economics, banking and finance. Some other institutions like International Islamic University, Islamabad and Centre for Islamic Economics, Karachi have also conducted training courses in Islamic banking.

A Committee for development/review and adoption of accounting standards for Islamic modes of financing was also constituted in the Institute of Chartered Accountants Pakistan (ICAP) in which SBP is also represented. The Committee is reviewing the accounting standards prepared by Accounting and Auditing Organization for Islamic Financial Institutions, Bahrain (AAOIFI) with a view to adapt them to our circumstances and if considered necessary to propose new accounting standards. The Committee has prepared the standards on Murabaha and Ijara and is now working on Musharika standard. SBP has also reviewed its Forms of Financial Statements for banks in the light of AAOIFI standards.

PAGE: What are the factors impeding the development of Islamic banking in the country?

KHAN: If we look at our history in Islamic banking, the following factors can be identified which have impeded the development of Islamic banking in Pakistan so far:

Ineffective enforcement of contracts and inefficient system for early recovery,

Declining ethical standards in the society,

Taxation policies, due to which, many borrowers do not disclose their true income thereby restricting the scope of Musharika and Modaraba modes of financing,

Absence of Shariah Supervisory Boards in banks,

Non-availability of Shariah compliant government securities and money market instruments,

Dearth of experienced persons trained in the field of Islamic finance,

Lack of research and development in the field of Islamic finance and economics especially Shariah compliant product development,

Inadequate training to the staff of SBP and banks.

Lack of development in related segments of financial system like Insurance, debt markets, non bank financial institutions (with the exception of Modarabas)

Disoriented education system, devoid of Islamic principles,

Lack of public awareness about Islamic economic system,

Social and cultural factors,

Lack of commitment on the part of successive governments to Islamize the economy.

The factors under the control of SBP like Shariah Board in Islamic banks, Shariah audit, training to SBP and bankers, recovery laws and mechanism, etc. have been/are being addressed.


Commercial Banking
Insurance and non bank financial institutions
Financial Markets (Equity and Debt Markets)
Public Debt

In order to develop an integrated Islamic financial system, reforms in all these four areas are needed. Currently, only SBP is working on development of Islamic commercial banks. However, for their success, significant development in the other three segments is also needed.

In order to ensure early enforcement of contracts and redressal to grieving parties, an efficient judicial system is needed. An efficient judicial system can prevent willful defaults and promote Musharika by protecting the rights of contracting parties.

The most challenging area is Islamization of public debt for which some alternatives have been developed in countries like Bahrain, Sudan, Malaysia etc.

PAGE: Is Pakistan trying to reinvent the wheel or adopting the systems prevailing in other Muslim countries?

KHAN: We are learning from the experience of other countries. Various officers have participated in seminars and workshops held in Bahrain, Sudan, Iran, Egypt, Lebanon, Malaysia etc. A delegation comprising representatives of Ministry of Finance, SBP and a renowned Islamic scholar/jurist was sent by the Ministry to Malaysia, Egypt and Saudi Arabia in October-November, 2001, which met with experts in Islamic banking and finance, religious scholars, central bankers and relevant government officials.

In order to prepare regulations for Islamic banking, laws and regulations of countries like Malaysia, Bahrain, Indonesia, Iran etc. are being studied. Further, as discussed earlier, AAOIFI standards for accounting and auditing of Islamic banks are also looked into, wherever the guidance is needed.

SBP has also become a founding member of Islamic Financial Services Board, which is based in Kuala Lumpur, Malaysia. This board has been established to set and disseminate standards and core principles for supervision and regulation of Islamic financial services industry as well as to promote good practices in risk management in the industry through research, training and technical assistance.

PAGE: What is the SBP policy and how is it being implemented?

KHAN: In the light of recent Supreme Court judgement the best course of action is to allow Islamic and conventional banking run parallel till such time Islamic banking assumes the dominating role. Keeping in view the enormous challenges in gradual transformation of financial system, the following three pronged strategy is being followed by SBP for gradual promotion of Islamic banking in Pakistan:

Open full fledged Islamic commercial banks in private sector.
Allow existing banks to open subsidiaries for Islamic banking.
Allow existing banks to open stand alone branches for Islamic banking.

In line with first part of this strategy on December 01, 2001, SBP had issued detailed criteria for setting up of Scheduled Islamic Commercial banks based on Shariah principles in the private sector. Now full-fledged Islamic banks can be established like Meezan Bank Limited, which has started commercial operations in March 2002.

As regards second part of this strategy, Banking Companies (Amendment) Ordinance, 2002, notified in the Gazette of Pakistan dated November 4, 2002, inter alia, a new clause (aa) has now been inserted in sub-section (1) of section 23 of the Banking Companies Ordinance as follows:

"(aa) the carrying on of banking business strictly in conformity with the Injunctions of Islam as laid down in the Holy Quran and Sunnah."

Therefore, the scheduled commercial banks are, henceforth allowed to open subsidiaries for Islamic Banking operations. Accordingly a Detailed Criteria is being worked out to facilitate the existing commercial banks to set up subsidiaries for Islamic banking which will be issued separate licence by the SBP.

As regards third part of this strategy, Guidelines for opening of standalone branches for Islamic banking by existing commercial banks, enlisting Eligibility Criteria, Licensing Requirements and other operational guidelines on the subject have been prepared. These Guidelines are being discussed with the concerned parties and will be issued after getting their feedback.

Other initiatives include preparation of Shariah compliant mechanism for Statutory Liquidity Requirement, Cash Reserve Requirement and development of Islamic Export Refinance Scheme.

PAGE: What will be the regulatory framework for commercial banks following the Riba free system?

KHAN: Islamic banks will be provided a level playing field viz-a-viz their conventional counterparts. The regulatory framework will focus on the following:

Prudential Regulations for Islamic banking.
Accounting Standards and Disclosure requirements.
Shariah compliance mechanism within banks.
Shariah audit by external auditors as well as SBP inspection teams.

It would be appropriate to promulgate an Islamic Banking Law in the country to provide legal cover to Islamic banking operations.

PAGE: Are the international donors being consulted by the Muslim countries?

KHAN: The SBP is also trying to benefit from the global Islamic banking experience. As a part of international collaboration, the IMF provided technical assistance to the Ministry of Finance and the Commission for Transformation of Financial System. A Technical Assistance Mission comprising the Fund's experts, on Islamic banking namely Dr. Ghiath Shubsigh and Mr. Michael Taylor provided guidelines on Islamic financial system. The Commission had detailed discussion with them on the practical aspects of transforming the system. Specific issues discussed with them included:

1) Viability of the new system.
2) Effects on Resource Mobilization.
3) Tools for Monetary Management.
Supervisory and Regulatory needs of the new system.

The IMF experts believed that there was no prior reason to believe that the system per se would generate adverse effects on savings and resource mobilization. They also made presentation on how the tools for monetary management could be developed within the Riba free framework. They, however, emphasized the need to review and revamp the supervisory and monetary mechanism to provide adequate supervision and regulation of the new system. The IMF has played a facilitating role in establishment of Islamic Financial Services Board. Therefore, international donor agencies are receptive to Islamic banking.

PAGE: Is the experience of Bahrain, Malaysia, Sudan and Iran encouraging?

KHAN: Significant developments have been made by these countries in the recent past. Bahrain and Malaysia have adopted the parallel approach with separate laws and regulations for development of Islamic banking in their countries. Bahrain has taken a lead in setting up the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), which has prepared accounting, auditing, governance and Shariah standards for Islamic financial institutions. They are establishing International Islamic Financial Market for liquidity management of Islamic banks and have also issued Ijara and Salam Sukuk as successful instruments for government borrowings. Bahrain has also prepared a Prudential Information and Regulatory Framework for Islamic banks, which is being consulted by us as well. An active Islamic funds market has also developed in Bahrain.

In Malaysia, the Islamic banks now account for about 8.8 per cent of total financial sector. They have also developed Islamic securities market, Islamic debt market and Takaful (Islamic Insurance) companies. They have developed various instruments for government borrowings like Government Investment Issues, Bank Negara Negotiable Notes, Ijara bonds, Global Islamic Ijara Sukuk, etc. However, some debt instruments have been issued on the concept of Debt trading, which is not permitted by the Shariah scholars of other Muslim countries.

Sudan and Iran have made efforts for transformation of economy to Islamic principles. Sudan, although with shallow financial markets, has developed Shariah compliant monetary policy instruments like Government Musharika Certificates (GMC) and Central bank Musharika Certificates (CMC).

GMCs are medium-term paper with one year maturity, traded by Bank of Sudan (BoS) on behalf of the government. The underlying GMC Fund includes state-owned enterprises. GMCs are issued in tranches and sold at auctions.

CMCs are short-term highly liquid paper with no maturity for smoothing short-term fluctuations of liquidity and traded at a very short notice by BoS and commercial banks. The underlying fund consists of BoS shares in commercial banks and their fair value is calculated quarterly on the basis of profits of the underlying shares.

They have also developed some good alternatives as lender of last resort facility to commercial banks like Liquidity Deficit Financing Window. BoS provides temporary liquidity support to banks, which cannot exceed 10 per cent of bank's current local currency deposits in the previous week for a period of one week. The financing is free if paid within one week, after which BoS charges banks 90 per cent of their profits received from using its financing during the whole period. Number of applications for this kind of financing is limited to two in a month and not more than four in a quarter.

PAGE: What is the role of Islamic Financial Services Board?

KHAN: The Islamic Financial Services Board (IFSB) was established with the signing of the Articles of Agreement of the IFSB on November 03, 2002 by the founding members. These included Bahrain Monetary Agency, Bank Indonesia, Bank Markazi Jomhouri Islami Iran, Central Bank of Kuwait, Bank Negara Malaysia, State Bank of Pakistan, Saudi Arabian Monetary Agency, Bank of Sudan and Islamic Development Bank.

A proposal was made two years ago to establish an organization to spearhead the development of a uniform set of prudential, supervisory and disclosure standards for the Islamic financial services industry internationally. This proposal was crystallized and endorsed during a consultative meeting of a group of Central Bank Governors, and officials from the Islamic Development Bank (IDB), the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) and the International Monetary Fund (IMF) in Prague in September 2000 during the occasion of the lMF-World Bank Annual Meetings. The endorsement set in motion the formation of a preparatory committee, with officials from Bahrain, Iran, Malaysia and Sudan, and representatives from the IMF, IDB and AAOIFI, to develop the terms of reference and operational structure for the Islamic Financial Services Board. In a meeting of Governors in April this year, Malaysia was mandated to lead a Steering Committee for the establishment and inauguration of the Islamic Financial Services Board in Kuala Lumpur. The historic event on 3-11-2002 is the culmination of this extensive two-year consultative process.

The IFSB will serve as an association of central banks; monetary authorities and other institutions, entrusted to develop and promulgate internationally accepted prudential regulatory standards and best practices. In advancing this mission, the Board will examine the extent to which existing international best practices need to be adapted and complemented to be consistent with Shariah principles. The IFSB will liaise and collaborate with other international standard setting bodies to achieve the common goal of international financial stability. In addition, the Board will also focus on the development of risk management instruments, cultivate sound risk management practices and facilitate the implementation of robust risk control mechanisms in Islamic financial institutions through research, training and technical assistance. This would encompass the adoption of international best practices on risk management standards as well as the development of new risk management techniques in conformity with Shariah injunctions.