The paradigm shift in the commercial banking seems to have started positive results

Oct 11 - 17, 2004

The banking sector in Pakistan is going through a fast-paced transitory process. New groups are buying out Pakistan operations of foreign banks and number of listed banks is also increasing. While the income from core banking activity is increasing due to higher business volume, earnings are also expected to further improve due to venturing into consumer finance, housing finance and enhanced lending to agriculture sector. However, there are growing apprehensions about the profitability from the new businesses because of absence of any track record.

The financial sector in Pakistan comprises of Commercial Banks, Foreign Banks, Development Finance Institutions (DFIs), Micro Finance Banks (MFBs), Non-banking Finance Companies (NBFCs) (Leasing Companies, Investment Banks, Discount Houses, Housings Finance Companies, Venture Capital Companies, Mutual Funds), Modarabas, Stock Exchange and Insurance Companies.

Under the prevalent legislative structure, the supervisory responsibilities in case of Banks, Development Finance Institutions (DFIs), and Microfinance Banks (MFBs) falls within legal ambit of State Bank of Pakistan, while the rest of the financial institutions are monitored by other authorities such as Securities and Exchange Commission and Controller of Insurance. Under the Banking Companies Ordinance 1962, the State Bank of Pakistan is fully authorized to regulate and supervise banks and development finance institutions.

During the year 1997, some major amendments were made in the banking laws, which gave autonomy to the State Bank in the area of banking supervision. The Ordinance made the responsibility of State Bank to systematically monitor the performance of every banking company to ensure its compliance with the statutory criteria, and banking rules & regulations. In every case in which the management of a bank is failing to discharge its responsibility in accordance with the applicable statutory criteria or banking rules & regulations or is failing to protect the interests of the depositors or for advancing loans and finance without due regard for the best interests of the bank or for reasons other than merit, the State Bank is empowered to take necessary remedial steps.

The State Bank is empowered to determine Statutory Liquidity and Cash Reserve Requirements for banks/DFIs. Presently the Cash Reserve Requirement is 5% on weekly average basis subject to daily minimum of 4% of Time & Demand Liabilities. In addition to that banks are required to maintain Statutory Liquidity Requirement (SLR) @ 15% of their Time & Demand Liabilities. Similarly, DFIs are required to maintain SLR of 14% and Cash Reserve of 1% of their specified liabilities. The banks have to maintain a Capital Adequacy Ratio in a way that their capital and unencumbered general reserves are, at the minimum 8% of their risk weighted assets, and effective from 1st January, 2003 banks are required to maintain a minimum paid up capital level of Rs.1 billion.


At present there are 34 scheduled banks, 6 DFIs, and 2 MFBs operating in Pakistan whose activities are regulated and supervised by State Bank of Pakistan. The commercial banks comprise of 3 nationalised banks, 3 privatised banks, 15 private sector banks, 7 foreign banks, 2 provincial scheduled banks, and 4 specialized banks. The number of listed banks has gone up to 17 in year 2004 as a result of mergers and acquisition. Five banks are still not listed, which are Habib Bank, United Bank, Allied Bank of Pakistan, Bank Alfalah, Dawood Bank. The leading foreign banks having the intention to stay in Pakistan in the long-run are Standard Chartered Bank, Citibank, Deutsche Bank and ABN AMRO Bank.

Therefore, it may be said that in nearly one and a half-decade the proportion has virtually reversed. However, it is also a fact that these four banks continue to enjoy a significant share in the market, both in terms of deposits and advances.

The forecast of these banks staying in the country is based on the fact that the management has been not only expressing their intentions to stay in Pakistan but also supporting the words by acts. They have been investing heavily in technology to overcome branch limitation as well as launching new products and services and often emerge as the market leaders. Their strength is evident in credit card business, consumer finance and housing finance.

The transition in banking sector is taking place at faster than expected rate. The growth in advances has started matching growth in deposits. The quality of asset as well as liability products have been improving that is evident from declining non-performing loan portfolio. However, the real impact of enhanced consumer finance, housing finance and lending to agriculture sector is yet to be seen. The only fear is that some of the banks are not following prudent policies, which is evident from increasing provisions against non-performing loans. It may be true that for the time being the provisions may be a small percentage when compared with total advances but it is the responsibility of the central bank to ensure that banks follow the appropriate risk management policies. This can be ensured through strict monitoring and imposing heavy penalties for the lapses. It is the depositors' money and the custodians have no right to misuse it.

The recent wave of liberalization and financial reforms has raised questions about the future prospects of the financial industry in general and the banking industry in particular. In just four years the banking industry has expanded tremendously and now there are more than two dozen commercial and investment banks functioning in the country. Over the last couple of years banks have been suffering from 'surplus liquidity crisis' mainly due to low demand for credit. As a make shift arrangement and taking the advantage of the bullish capital market some of the banks increased their exposure in equities. This became a cause of concern for the central bank and it issued the instructions to follow the Prudential Regulations in letter and spirit.

However, some of the critics were of the view that instead of asking the banks to meet the prevailing benchmark, the central bank should have enhanced the limit. Lately, some of the banks following pro-active strategy started investing in equities to overcome 'surplus liquidity crisis'. However, it raised some concerns and the central bank was quick in advising the banks to bring down their investment in equities within the limits stipulated in Prudential Regulations. Banks have been given the timeframe to meet the requirement.

Still, costs remain extremely high in the public sector banks. Inefficiencies and a carefree and indifferent attitude as service is concerned are matters that have yet to be controlled by the top management of most of Pakistan's public sector banks. Foreign banks do have a small share, but this is more by choice than by chance. The policy in general is to maintain efficiency and keeping costs at a minimum.

The savings rate in the country is at about 15% which remains one of the lowest compared to other emerging economies like India (22%), Thailand (30%) and Indonesia (40%). For a stable deposit base, which is imperative for the smooth functioning of the financial sector to extend affordable credit to different sectors of the economy, the country must have a satisfactory savings rate. At the same time deposits are becoming increasingly expensive and lending rates, with or without a cap on them cannot be raised by banks beyond a certain limit. Blue chip clients, who constitute the major portion of most of the banks' borrowers, do not pay beyond a certain level of interest and hence banks are facing a tight squeeze. The prime lending rates vary from 3 to 5 percent. The rate of returns on government securities is fairly attractive, where all scheduled commercial banks are required by prudential regulations to keep 20 percent of their time and demand liabilities.


The five large scheduled commercial banks are, namely National Bank of Pakistan, Habib Bank Limited and United Bank Limited are owned by the Government of Pakistan. Although two other banks, Muslim Commercial Bank and Allied Bank Limited were privatised in 1992, the GoP still has significant stakes in them. These five large banks are dominant in terms of total number of branches, deposits and advances, collectively accounting for 78% and 77% of total deposits and advances respectively. However, they are relatively less profitable than private sector banks and foreign banks.

Private sector banks are relatively new compared to public sector banks. The Sharif government opened up banking to the private sector in 1991. The new banks formed as a result of this liberalisation policy included Askari Commercial Bank, Bank Al Habib, Soneri Bank, Prime Bank, Bolan Bank, Metropolitan Bank, Union Bank and KASB Bank.

There have been problems along the way though as the corporate banking culture was still new to the country and there were fiascos like Mehran Bank. These banks are still very small in terms of branch network and level of operations. They focus on very selective market segments where they are quite successful. Despite a lower profile in total deposits and advances, these banks account for 22% of the total profitability of the sector.

Owing to the inefficiencies of the public sector scheduled banks which stem from their nationalisation in the 70s, the relatively lower standing of the private sector banks and the dollarisation of the economy, foreign banks have been able to perform extremely well by exploiting gaps in the local banking sector.

In times of slow economic activity and high inflation as is the case with Pakistan, the financial sector as a whole is likely to experience depression with shrinking interest margins and troubled assets because of bad debts.


The paradigm shift in the commercial banking seems to have started positive results. Growing deposits and ever increasing appetite for credit by the private sector have provided the added impetus. Low interest rates are encouraging the existing players to expand their installed capacities as well as to undertake greater value addition. The vibrant equities market also allows the bank to make large capital gains as well as draw substantial dividend income from their investment portfolios. The financial accounts released by commercial banks shows that despite low interest rates and persistently growing operating expenses, all the players have been able to post results better than previous years. One of the factors contributing to improved profits was the reduction in tax rate applicable on banking companies.

Commercial banks operating in Pakistan can be divided into four categories: 1) Nationalized Commercial Banks (NCBs), 2) Privatized Banks, 3) Private Banks and 4) Foreign Banks. The central bank has been following a supervisory framework, CAMEL, which involves the analysis of six indicators, which reflect the financial health of financial institutions. These are 1) Capital Adequacy, 2) Asset Quality, 3) Management Soundness, 4) Earnings and Profitability, 5) Liquidity and 6) Sensitivity to Market Risk.

The commercial banks in the private sector have so far given a satisfactory performance since their inception, registering an overall growth in the deposit base and profits and are maintaining healthy credit portfolios, the question that needs to be answered is about future profitability of the industry in times of intense competition for chasing cheap deposits and risk worthy borrowers.

Commercial Banks faced an increase in operating expenses that can be attributed to the ongoing branch expansion program. Another factor responsible for higher operating expenses is the massive investment being made in upgrading the existing branch network and substantial investment being made in technology. The private banks have been fully cognizant of their limited branch work. To overcome this limitation they are relying heavily on technology. The concept of 'bricks and mortar' branch is being replaced by e-banking.

Another emerging phenomenon is 'dying commercial banks and emerging financial super market'. Historically, commercial banks in Pakistan have been maintaining checking accounts, providing working capital loans and offering international trade related services and financing. However, over the last decade they also ventured into leasing, housing and consumer finance. Though the quantum of income generated through these activities is still low, the growth in business volume has been very significant. Since the market size is very large only the policies of an institution limits its share.

The key to success for commercial banks is their deposit base and this is where the real crunch is expected, particularly for the newer banks. The deposit base is expected to grow but will probably not be able to maintain a rate of 20 percent while the established banks should not have a problem. The new commercial banks like Al Habib, Soneri, Askari, Union and Bank of Punjab are not expected to be any major competitors for the established banks and their share in the national deposit base is expected to stay meagre at around 5% with the share of foreign banks at less than 25%. The nationalised banks have the lions share and along with ABL and MCB account for about 80 per cent of the national deposit base.

Lately, Pakistan witnessed the establishment of a commercial bank offering commercial banking based on Sharia. The response has been overwhelming to the extent that most of the banks have either established separate window for Islamic Banking or are in the process of opening dedicated branches. Most of the banks were not able to identify the size of Islamic Banking market and the potential response from the clients, despite pressure for eliminating Riba from banking. They chose to offer Islamic Banking in parallel with conventional banking and allowed the clients to make their own choice. The response has been beyond expectations.

At present the minimum paid-up capital requirement for listed commercial banks is Rs 1,000 million. This should be enhanced to Rs 1,500 million by December 31, 2004 and to Rs 2,000 million by December 31, 2005. This can be achieved with complete ease as shareholders' equity of most of the banks was around this amount at the end of year 2002. Looking the financial results of the banks for the year ended December 2003 it can be said with complete confidence that meeting the enhanced capital requirement does not pose any problem. However, meeting the requirement may be difficult for couple of banks. These are the banks where there was a management change lately.


The paradigm shift in commercial banking, resulting from freezing of foreign currency accounts (FCAs) in May 1998 has affected the foreign banks operating in Pakistan significantly to a large extent adversely. The recovery process, through changed strategy, has started yielding positive results. Foreign banks are expected to emerge stronger in the near future as Pakistan moves towards Internet-based banking. Still, the competition with domestic banks is expected to remain ferocious.

Over the last many years, foreign banks have continued to command nearly three-quarters of the overall profitability of the banking sector in Pakistan, in spite of the tight manacles on their expansion. Foreign banks chiefly thrived on business from top-tier multinational corporations and blue chip companies. The business of foreign banks operating in Pakistan, in the past, also flourished due to FCAs and swap dollar funds which are no longer there.

The withdrawals from resident FCAs in the shape of rupee, was quite dramatic during the second half of 1998, which continued in 1999 though at a lower pace. The bulk of converted amount eventually showed up in the banking system but the share of foreign banks in total deposits reduced. Domestic banks were able to increase their deposits and advances mainly due to an elaborate branch network. The lottery schemes of Habib Bank, United Bank and Muslim Commercial Bank drained desposit's virtually from both domestic and foreign banks. With the loss of low cost deposits and advances, profitability of a number of key players in the financial sector came under pressure in 1998.

Bank of America was the first to decide to close its operations in Pakistan. As a result of global merger of ANZ Grindlays Bank into Standard Chartered Bank, the amalgamated bank is expected to emerge financially the strongest foreign bank in Pakistan. Many banking sector analysts expect a few more closures and more mergers and acquisitions. They estimate that within next five years the number of foreign banks in Pakistan will come down to less than a dozen. However, these mergers and acquisitions will be aimed at attaining synergy rather than due to declining profit margin.

There are 6 foreign banks presently operating in the Pakistan: ABN Amro, American Express, Standard Chartered, Citi Bank, HSBC and Habib Bank AG. The foreign banks have a strong presence in all the major cities and are targeting high net worth individuals and blue chip companies. Their strategy is quite successful as they account for 34% of total sector profits, despite having only 15% of deposits and 16% of advances. To achieve constant growth in size they have been using innovative approach. Keeping in view the changing demands, the emphasis is more on personalized service, electronic transfer of funds and sophisticated financial products, etc. They offer innovative deposit schemes to remain competitive in resource mobilisation.

Foreign banks have consolidated their edge in phone banking, ATM network and on-line banking. Offer of these services has become a norm at almost all the large-size foreign banks. While some of the banks have installed their own ATMs, others have entered or are entering into strategic alliance with other domestic and foreign banks. Offering such facilities is capital intensive, however, helps in reducing human resource cost, improving quality of services and above all bringing a bank outside the four walls of conventional branch network. As foreign banks largely cater to multinational companies and blue chip corporations they would be able to offer better services and also cater to larger number of clients.

Another important development, over the years, is that small foreign banks have developed their own niche market. The foreign banks of Middle East origin concentrate more on handling remittance and international trade. Even the large-size banks have added other services. Standard Chartered Bank and Citibank provide custodian service to foreign investors in capital markets. They have also started financing of cars and other durable. Earlier, Citibank had established two separate entities, a housing finance company and an investment bank. However, later on, it sold its stake in investment bank to Jahangir Siddiqui and Company. Citibank has also become a little more selective in distributing credit cards.

According to some analysts foreign banks share about a quarter of deposits and total advances within the banking system. Traditionally, the foreign banks have focused on short-term trade finance, targeting mainly low risk blue chip corporations and high networth individuals. A couple of year's back, these banks began making foray into merchant banking, capital market operations and consumer/retail banking. The resources and expertise of their global operations proved a valuable asset in these areas and many of them were able to quickly capture large share in the capital market operations and consumer/retail banking.

Foreign banks have enjoyed years of robust profitability, however, to survive in the changed environment they will have to come up with real innovative financial products. At the same time they will have to identify new clients other than multinational companies and blue chip corporations. In the face of stagnant private sector industrial growth and poor demand for credit, competition with domestic banks is getting tougher with the passage of time. Domestic banks are also fighting for their existence and are determined to intrude into an area considered to be an exclusive domain of foreign banks in the past.


Leasing is an Islamic mode of financing and is being widely practised throughout the world. Companies have been mostly extending short and medium term credit facilities to industries and consumers, but still there is room for improvement, since many sectors of the economy remain unexplored and neglected.

Lease finance by all means is the most suitable financing arrangement for developing countries and especially Pakistan. Despite the fact that most banks of the country are facing surplus liquidity crises and have unutilised funds, they are still not catering to the needs of micro enterprises in an effective and efficient manner. The growth in leasing companies has come in the backdrop of their ability to provide mid-term financing to the industrial sector. The concept of leasing gained acceptance and as a result a number of companies ventured into this field

Leasing has grown at about 20 percent in the last five years and is expected to see a dramatic reduction in this growth rate because of funding constraints faced by this sector. With an interest margin of around 3 percent, the rise in US interest rates and the increase in the local forward cover fee, leasing companies may find it hard to mobilise lower cost funds from abroad in future. Companies having access to local as well as foreign credit lines and backed by reputable groups could outperform the market but these are few and far between.

However, competition is strict and not just from banks but from leasing modarabas and now term finance certificates being introduced by corporate. Less than half of the leasing companies so far have permission to issue certificates of investment and this further hampers their ability to mobilise funds.

Those that have launched Certificates of Investments have had a fair amount of success, which is a ray of hope for the sector. Offshore credit lines were at one time a good source of low cost funds but now the cost of drawing on these lines has increased tremendously.

The major problem faced by leasing companies is that of mismatching maturities. Leasing companies will have to maintain a sustainable growth rate for which they will need a perpetual flow of funds. Mobilisation of funds is the main issue facing leasing companies. In the prevailing circumstances, it will be a testing time for the lessors. Innovative thinking is required to come up with new projects for fund raising. Asset scrutinization as a vehicle to induct funds in leasing companies has not traversed beyond the conceptual stage.

If leasing companies are to survive, they will need a change in the regulatory and taxation framework. They do not have the customer base that can ensure the growth of the industry as a whole. However, we believe that as the concept of lease financing gains wider acceptance, a trend that has seen favourable growth in the past few years, the conditions for the sector should improve.


With the commencement of process of Islamization in mid eighties Pakistan saw the dawn of Modarabas. The first ever Modaraba was listed in 1985 and the decade of nineties witnessed the largest number of listing. Over the years, the total number of listed Modarabas touched as high as 48.

Modarabas are the most regulated financial sector with several restrictions to the source of their funds and controls over payoff timetables as well. Strict regulations implemented by the State Bank of Pakistan (SBP) and the Securities and Exchange Commission of Pakistan (SECP) have contributed substantially to dampening the future prospects for this financial instrument, introduced by the Pakistan government in the early eighties. It does not hold as much promise as it once did now being hastily overshadowed by the rapid emergence of private banks.

Subdued economy during nineties, growing competition and constraints in resource mobilization, which was one of the most serious constraints, brought the balance sheet of a number of Modarabas into red. Not only that the situation was a source of concern for the Modaraba certificate holders, but regulators were also perturbed. Modarbas has proved to be inadequate and the interests of the investors and certificate holders have not been adequately protected.

Modarabas have not been able to diversify their products or differentiate from other market players such as leasing companies. Today 75% of their business is concentrated on leasing which does not provide any market niche or comparative advantage to them. The leasing portfolio mostly covers traditional industries such as textiles, light engineering, cement etc. New activities have by-passed the leasing sector so far.

As an overall slowdown in the economy took place, Modarabas appeared to be the most adversely affected, having to rely mostly on borrowed resources from financial institutions for expansion. Historically, Modarabas possess the best performing financial sector stocks but without the financial backing or access to regular funding lines from Islamic banks they are finding it difficult to sustain earnings growth and operating income momentum. Since 1992, modarabas have been facing a shortage of funds because of the SBP's regulation, which directs the banks. At the same time Modarabas like other investment financial institutions, have suffered a lot on their stock holdings due to the below average performance of the stock markets.

The other constraints faced by the Modarabas pertain to regulatory environment. The Modarba Association of Pakistan is actively pursuing with the regulators, the SECP and State Bank of Pakistan (SBP). The Association has asked the regulators to specifically amend the rules pertaining to borrowing of Modarabas from commercial bank under Musharika arrangements. As per existing rules, Modarabas that enjoy B3 credit rating are eligible for borrowing from the commercial banks only.

In late 1998, when some crucial measures were taken for the restructuring of financial institutions and revival of economy, efforts were also made to revitalize this important mode of Islamic financing. Management of a number of ailing Modarabas was handed over to better managed entities. Around the same time the process of mergers and acquisitions was seriously looked into and since then a number of weaker entities have been merged into financially strong Modarabas.

The single largest contribution of Modarabas is that they are playing a dynamic role in the process of Islamization of financial system in the country. They have the capacity to bring the change as an appropriate infrastructure is in place with more than twenty years of experience. Modrarabas are capable of undertaking any kind of business that is in conformity with the Shariah. A large number of Modarabas are engaged in the leasing business. Others are engaged in trading and portfolio management. One modaraba is in manufacturing.

Modarabas are contributing towards the economic development of the country. The close liaisons of the regulators with the MAP have helped in improving working environment and capacity building of the players. The recent mergers and acquisitions indicate the general shift towards consolidation, much needed to usher in greater financial stability and operational flexibility.

The major sources of funds are Morabaha and Musharika financing. In Morabaha financing the modaraba sells it's assets to a bank or other financial institution with an agreement to repurchase at a higher price at some fixed time in the future. In Musharika financing the modaraba and the concerned party, for example a bank, each contributes capital on a profit and loss sharing understanding on the basis of contributed capital. The Modaraba provides around 20 percent capital up front with the bank generally providing the rest.



* Local banks have a large network of locations, including remote areas of the country, where the consumers can access bank facilities. Foreign banks might have not seen investing in remote areas as profitable, but it gives the local banks a clear-cut edge in larger market share and consumer base.

* The central bank policies are aimed at strengthening commercial banks in general. They helped domestic banks more while supporting foreign banks marginally. Some policies were recovery of non-performing loans, exemption of accrued income at the time of calculating tax liability and rules governing provisions against doubtful loans.


* Due to stringent corporate governance standards, as well as lack of commitment when tackling the problem of non-performing loans, the banking industry has never been able to perform to its utmost potential.

* Inefficiencies and a carefree and indifferent attitude as service is concerned are matters that have yet to be controlled by the top management of most of Pakistan's public sector banks.

* Adjudicating on an appeal filed by the State Bank against the November 1991 decision of the Supreme Court against interest-based banking, the Shariat Appellate bench upheld the original verdict, which had declared the charging of interest as un-Islamic. Even as of now, the government's response is not clear. As Pakistan is an Islamic state, its banking sector has a few hurdles, which it has to cross. This, in turn, has slowed down the progress of this sector.

* Political instability through out the history of Pakistan's existence has always been a major influence on the development of its banking sector. Lack of investments in projects, trade sanctions, freezing of foreign accounts and a feeling of insecurity amongst general population, are a few significant reasons, which highlight the weakness of today's banking sector of Pakistan.

* There are a large number of banks and some of them are undercapitalised, poorly managed with a scanty distribution network.

* Banks have typically focused on trade and corporate financing with a narrow range of products and have not diversified into consumer and mortgage financing for which there is an ample unsatisfied demand.

* Family-owned businesses and small businesses are reluctant to disclose information to banks to obtain loans, which may result in frauds or money laundering.


* The local banks need to diverge more of their time and resources towards electronic banking. There is a surge of demand amongst local population to use online banking, as it is hassle free and saves time. Local banks need to upgrade their technology and utilize this opportunity, because at the moment, no bank has fully exploited this venture.

* Agriculture, small and medium enterprises and housing sectors are underserved and have limited access to credit. It is potentially a huge market which local banks can reach into. With good marketing and careful planning, local banks can make the most of this opportunity, especially in the agricultural sector, as local banks have the infrastructure already in place, to reach remote places within Pakistan.


* The biggest threat to local bank comes from foreign banks and the competition they bring into the banking sector. Automation and greater use of technology by foreign banks has improved the standards and quality of services. If local banking sector does not react to this situation quickly enough, soon the foreign banks will take over their market share.

* Pakistani banks have a majority of the market share, but one needs to look at profit margins of both foreign and local banks to really assess the inefficiencies or the lack thereof. If the local banks do not make themselves more efficient and introduce some drastic cost cutting measures, they will soon loose not only their market share but also their own capacity to operate.






Habib Bank Ltd



United Bank



National Bank



Muslim Commercial



Allied Bank















Habib Bank AG



Standard Chartered



Citi Bank




The essential feature of Islamic Banking is that it is interest-free. Although it is often claimed that there is more to Islamic Banking, such as contributions towards a more equitable distribution of income and wealth, and increased equity participation in the economy, it nevertheless derives its specific rationale from the fact that there is no place for the institution of interest in the Islamic order. The Islamic ban on interest does not mean that capital is costless in an Islamic system. Islam recognises capital as a factor of production but it does not allow the factor to make a prior or predetermined claim on the productive surplus in the form of interest.

At the deposit end of the scale, Islamic banks normally operate three broad categories of account, mainly current, savings, and investment accounts. The current account, as in the case of conventional banks, gives no return to the depositors. It is essentially a safekeeping (alwadiah) arrangement between the depositors and the bank, which allows the depositors to withdraw their money at any time and permits the bank to use the depositors' money.

Modaraba and Musharaka constitute, at least in principle if not in practice, the twin pillars of Islamic Banking. The Musharaka principle is invoked in the equity structure of Islamic banks and is similar to the modern concepts of partnership and joint stock ownership. In so far as the depositors are concerned, an Islamic bank acts as a Mudarib, which manages the funds of the depositors to generate profits subject to the rules of Modaraba as outlined above. The bank may in turn use the depositors' funds on a Modaraba basis in addition to other lawful modes of financing. In other words, the bank operates a two-tier Modaraba system in which it acts both as the Mudarib on the saving side of the equation and as the rabbulmal on the investment portfolio side.

The bank may also enter into Musharaka contracts with the users of the funds, sharing profits and losses. The savings account is also operated on an al-wadiah basis, but the bank may at its absolute discretion pay the depositors a positive return periodically, depending on its own profitability. The investment account is based on the Modaraba principle, and the deposits are term deposits, which cannot be withdrawn before maturity. The profit-sharing ratio varies from bank to bank and from time to time depending on supply and demand conditions.

In Pakistan, it was the government's initiative and covered all banks in the country. The government took steps in 1981 to introduce interest-free banking. In Pakistan, effective January 1, 1981 all domestic commercial banks were permitted to accept deposits on the basis of profit-and-loss sharing (PLS). New steps were introduced on January 1, 1985 to formally transform the banking system over the next six months to one based on no interest. From July 1, 1985 no banks could accept any interest bearing deposits, and all existing deposits became subject to PLS rules. Yet some operations were still allowed to continue on the old basis.

One of the main selling points of Islamic Banking, at least in theory, is that, unlike conventional banking, it is concerned about the viability of the project and the profitability of the operation but not the size of the collateral. Good projects which might be turned down by conventional banks for lack of collateral would be financed by Islamic banks on a profit-sharing basis. It is especially in this sense that Islamic banks can play a catalytic role in stimulating economic development. In many developing countries, of course, development banks are supposed to perform this function. Islamic banks are expected to be more enterprising than their conventional counterparts. In practice, however, Islamic banks have been concentrating on short-term trade finance which is the least risky.

The main problem, both for the banks and for the customers, seems to be in the area of financing. Bank lending is still practised but that is limited to either no-cost loans (mainly consumer loans) including overdrafts, or loans with service charges only. Both these types of loans bring no income to the banks and therefore naturally they are not that keen to engage in this activity much. That leaves us with investment financing and trade financing. Islamic banks are expected to engage in these activities only on a profit and loss sharing (PLS) basis. This is where the banks' main income is to come from and this is also from where the investment account holders are expected to derive their profits. And the latter is supposed to be the incentive for people to deposit their money with the Islamic banks. And it is precisely in this PLS scheme that the main problems of the Islamic banks lie.

With only minor changes in their practices, Islamic banks can get rid of all their cumbersome, burdensome and sometimes doubtful forms of financing and offer a clean and efficient interest-free banking. All the necessary ingredients are already there. The modified system will make use of only two forms of financing loans with a service charge and Modaraba participatory financing both of which are fully accepted by all Muslim writers on the subject.

The only exception in Islamic Banking from conventional banks seems to be in the case of letters of credit where there is a possibility for interest involvement. However, some solutions have been found for this problem mainly by having excess liquidity with the foreign bank. On the deposit side, judging by the volume of deposits both in the countries where both systems are available and in countries where law prohibits any dealing in interest, the non-payment of interest on deposit accounts seems to be no serious problem. Customers still seem to deposit their money with interest-free banks.


The main problems faced by the Banking Sector in Pakistan are:

* Most of the financial assets and deposits are owned by nationalised commercial banks (NCBs) which suffer from a highly bureaucratic approach, overstaffing, unprofitable branches and poor customer service.

* NCBs along with specialized banks such as ADBP, IDBP and Development financial institutions such as NDFC have a high ratio of non-performing loans.

* Banking industry faces a high tax rate which is at 50%, which affects its profitability and attractiveness for new entrants.

* There is a proliferation of banks and some of them are undercapitalised, poorly managed with a scanty distribution network.

* Agriculture, small and medium enterprises, housing sectors are underserved and have limited access to credit.

* Banks have typically focused on trade and corporate financing with a narrow range of products and have not diversified into consumer and mortgage financing for which there is an ample unsatisfied demand.


The recent mushrooming of banks in the country could have become a boon if the growth in the economy had been proportional. Unfortunately, the growth in the industry has been slow and hence banks have had to fight for customers. The financial sector has failed to keep pace with other markets in the region. The race for intensifying deposits has already started and the trend in 1996 shows that people are moving away from long -erm deposits making it increasingly difficult for the smaller banks to develop a strong deposit base. With the economy so far not showing any substantial and fundamental improvement and with retardation in industrial growth, banks should not be looking at a significant growth in the short-term. However, with prospects of an improvement in the operational side as well as the hope that industrial growth will pick up, banking is looking at a bright future in the country.

In comparison with other emerging economies, Pakistan has a relatively underdeveloped financial sector in terms of the depth of the financial system and the extent of financial intermediation. The depth of a financial institution refers to the use of money and close money substitutes such as savings and time deposits, which is very low in Pakistan.

Many of the newer banks have no provisions in their portfolios for bad debts, which might not appear important at present but in a period of say three to four years, when loan recovery starts this shortcoming in the portfolio could become a serious threat to earnings. The prospective investor should definitely keep this in mind when playing the Stock Market. Perhaps it would be prudent if the State Bank of Pakistan makes it mandatory for all banks to make their portfolios public.

With the steps being taken to improve financial infrastructure in the country, the drive to streamline the large public sector banks has a greater probability of being implemented. The steadily growing economy will also create a more dynamic role for banks' policies. Human capital is adequately placed to assume its role in this reform process. Although there are concerns in certain areas that the outlook for the sector is positive.

To effectively carry out banking reforms, problems related to non-bank financial institutions (NBFIs), corporate governance; accounting and audit practices have to be addressed simultaneously. Without a legal environment that enables the enforcement of contracts banking sector reforms do not work. However, since the 1997 banking sector reforms situation is improving now. The system of risk-weighted capital was introduced and banks advised to maintain capital at least 8 per cent of risk-weighted assets effective from December 1997. The Capital Adequacy Ratio (CAR) for commercial banks was at 12.1 per cent at the end of 2003, far higher than the International Basel Capital Accord.

In Pakistan, 90 per cent of total bad loans are loans of government banks, which historically granted loans at government behest and which in general, performed much more poorly than private sector banks. Stringent provisioning standards, however, have helped bring down the net NPL ratio steadily to the present single-digit levels in both India and Pakistan.

During 2003, Pakistani banks made handsome gains, showing major recovery in deposits and advances, and booked huge capital gains on their equity and fixed income investments. After tax profits of the banking sector grew by 76 per cent (an increase of Rs 12.1 billion) in 2003 to reach Rs 28.2 billion, as compared to Rs 16 billion in 2002. Before tax profits reached Rs 46.3 billion in 2003, showing growth of 51 per cent (Rs 15.7 billion) over Rs 30.6 billion last year. Net interest income of the banking sector increased by Rs 7.5 billion (13 per cent), and reached Rs 65 billion in 2003. Non-interest income reached Rs 44.7 billion in 2003, an increase of Rs14.8 billion (49 per cent). Total expenses of the banks increased to Rs 62.9 billion, an increase of Rs 6.4 billion or 11 per cent.

Due to the emerging need of quality management system implementation in banking industry now is the time for to move about "paradigm shift." The commercial banks must pay attention to this shift and start thinking strategically for providing high quality products and services to customers. They should determine where improvement is needed, how service can be improved and where operating system breakdowns occur, why they occur and how they can be avoided.