State Bank of Pakistan's Shariah Board has reviewed and approved the essentials of Islamic modes of financing


Aug 09 - 15, 2004















The Islamic financial services industry, despite its remarkable growth during the last few years, is still in its infancy and needs careful nurturing and development to make a perceptible impact in the global financial markets. The creation of institutions such as IFSB, AAOFI, IIFM, etc. has given rise to expectations that the constraints and impediments facing this industry will be tackled in a systematic and informed manner.

Dr. Ishrat Husain, Governor, State Bank of Pakistan has highlighted six major challenges facing the industry those need priority attention of all the stakeholders, particularly the regulators, market participants, judiciary and religious scholars. He also believes that the thrust of the future deliberations should shift from generalized discussions to focused discourse so that some headway can be made and progress monitored and measured in the achievement of the objectives.

The six challenges identified by Dr. Husain are:

1) Islamic financial service industry (IFSI) has to safeguard and maximize the interests of major stakeholders for enhancing its market share from the existing insignificant level. There are four major stakeholders in this industry three are common to both conventional and Islamic but the additional stakeholder in case of Islamic finance is the Shariah scholar, who have to be satisfied that the products are compatible with Shariah precepts and principles. Not only that there is an additional stakeholder, the nature of relationship between Islamic finance service provider and other stakeholders is also quite different.

Customer relationship is varied, complex and multiple. The relationship ranges from that of a buyer and seller (Murabaha); transferor and transferee; lessor and lessee (Ijara); guarantor and guarantee; depositor and custodian; partner and partner (Musharika); investor and working manager (Modaraba). In conventional banking there are only two forms of relationships i.e. borrower or depositor.

Risk premium in IFSI is relatively high while risk mitigation, risk allocation and risk transfer techniques are not that well developed; unless risk adjusted returns are equalized across the two market segments, the IFSI growth will remain stunted. Absence of hedging products places the Islamic products at a relative disadvantage as far as risk mitigation is concerned.

Standards and codes, Principles of Corporate Governance, internal controls, disclosure and transparency have to be separated and made distinct from conventional banking to reflect the peculiar characteristics of IFSI. Some progress has been made but still there are a lot of knotty issues to be settled.

There are conflicting pronouncements and continuing debate as to what is and what is not permissible under Shariah. These controversies in the interpretation of Shariah precepts among scholars from different Fiqahs and create a lot of uncertainties among the potential investors who then shy away from taking a plunge in the Islamic products keeping the overall size of the small market.

2) The legal framework provides confidence to stakeholders that the courts can enforce their rights and obligations, if and when a situation arises. But in case of IFSI there is both ambiguity and lack of predictability about the enforceability of contracts under the Islamic Banking. For example, there is a dual judiciary system in Pakistan. Jurisdiction of Courts is unclear whether Civil or Shariah Courts will take cognizance and decide. Dispute resolution mechanisms such as mediation, conciliation and arbitration are not binding under the existing legal system and practices, although litigation is not the preferred mode of dispute resolution in Islam. Judges lack training in banking and Shariah. Lawyers are not trained in Islamic banking and finance. Case law and precedents from one system such as English law are not binding. Enforcement mechanisms are found wanting.



3) Accounting, Auditing, Taxation and Information Support Systems have to evolve over time. Infrastructure for Islamic Financial Institutions (IFIs) is still underdeveloped and will take time and efforts. To that extent conventional banks will have an edge over the IFIs, AAOFI and IFSB are the right vehicles and must accelerate and disseminate their work. Tax differentials do erode the competitive edge of IFIs and will amplify the divergence. These differentials will have to be removed to provide equal tax treatment to both segments of the market, i.e. IFIs and conventional.

4) Product Innovation and Development should move ahead to keep pace and provide alternative options that are at least as attractive as conventional products with the additional stipulation that these products should be Shariah compliant. Standardization, harmonization and application of Shariah compliant products based on some general principles should be promoted. A menu approach whereby the markets can develop and documents new Shariah compliant products rather than await for ex-ante approvals of Shariah Boards in each single case will enhance the response capacity of Islamic financial markets and enable them to compete with conventional products. At present, the transaction costs of Shariah compliant products are higher relative to the traditional products and have to be reduced by adopting this menu approach.

5) Human Skill Development that includes selection, training retention and continuous capacity up-gradation of the managers and staff of IFIs are essential for the success of the Islamic financial system. Islamic financial industry has to make strategic investment in all these areas as hiring and merely re-labeling conventional bankers as Islamic bankers is not going to work in the long term. Managers and leaders in this industry are badly missing and unless we can identify, find and empower them the rest of chain in human skills development will have important missing links. Dogmas, strongly held opinions and narrow-minded beliefs in some rigid doctrines of the religion should not be allowed to dominate the field. Open minded, pragmatic and innovative men and women committed to the growth of Islamic financial industry should be encouraged and drawn into this profession.

6) Inculcation of Islamic values of integrity, ethics, truthfulness, justice, compassion and absence of exploitation among the Ummah will provide the glue and adhesive that will make this stick in the long run. If the practice of values move in one direction and the financial system evolves in the other, the foundation of the system will get weakened over time and it will not be able to withstand the tremors and vibrations created by exogenous shocks.

The Commission for Transformation of Financial System set up in the State Bank of Pakistan in pursuant to the Supreme Court Judgment on Riba dated December 23, 1999 approved essentials of Islamic modes of financing including Musharaka, Mudaraba, Murabaha, Musawama, Leasing, Salam and Istisna. The recently established State Bank of Pakistan's Shariah Board has reviewed and approved the essentials of Islamic modes of financing and recommended that the same may be circulated to the banks conducting Islamic banking business in Pakistan as guidelines that would form the basis for Prudential Regulations on Islamic banking in due course. It does not preclude the possibility of developing new modes or instruments of financing, modifications or variants of the modes provided these are Shariah compliant.


These Guidelines/Essentials are proposed to be enforced as Prudential Regulations for Islamic banks in due course. The State Bank invites suggestions and views for enforcing them as part of Prudential Regulations from all concerned, particularly the Shariah Scholars, Academics, Bankers and the Business community. With dual objectives of facilitating the existing Islamic banking sector and the potential market players to develop Islamic banking products in particular and to create awareness about Islamic banking products in general, Model Agreements for following modes, vetted by the Shariah Board, have also been placed on SBP website.

It may be pointed out that these are model agreements, which can be modified, according to the products designed by the banks conducting Islamic banking business, with the approval of Shariah Board of Islamic Commercial Banks or Shariah Adviser of banks having Islamic banking branches, ensuring that such changes are consistent with the principles of Shariah.

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 with the concepts of Islamic banking and finance and some of the financial institutions are already practicing it. However, there are problems in development of instruments for liquidity management by banks and monetary management by the State Bank of Pakistan. Government's financial transactions constitute a large part of the financial system of the country. Banks and financial institutions have sizable investment in government securities. The monetary management is also primarily linked to transactions of government securities. Therefore, the process of Islamization of financial system crucially depends on development of instruments for Shariah compliant government financial transactions. The development of instruments and restructuring the national/public debt on the Shariah compliant poses a serious challenge.

The introduction of Islamic Banking System is a long process requiring development of legal and regulatory framework, institutions, markets, and efficient and appropriate practices. This process requires constant monitoring and fine-tuning. Since a lot of work has already been done, Pakistan can benefit from the experience of other countries. It seems that Pakistan is following the example of Malaysia, Egypt and Saudi Arabia by adopting a dual/parallel banking system. However, Pakistan should be mindful of the factors, which have so far impeded the development of Islamic banking in Pakistan.

There is a desire among many to see the whole of Pakistan's economic system Islamised as soon as possible. However, it a mammoth job needing research, for setting up of controls and designing of new operational procedures and documentation. Undue haste may lead to serious problems, which would surely be exploited by the critics to discredit the whole Islamic system.