The case for Islamic banking in Pakistan
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Pakistan’s federal Minister for Finance and Revenue, Muhammad Ishaq Dar, has announced an ambitious goal of converting the country’s existing banking system to an Islamic one within the next five years.
The fundamental difference between the Islamic banking system and the traditional banking system is that the former is based on Islamic law and prohibits interest as well as speculative trading. Instead of charging interest, Islamic banking has a system of sharing profits and losses.
Islamic banking is asset-based; therefore, each business activity must be backed by an asset. This leads to better risk management compared to traditional banking systems which often suffer from excessive risk-built up due to complex operations. An important point to mention here is that the global financial crisis of 2008-10 was mainly caused by complex financial products and excessive risk-taking by the financial sector.
Given this backdrop, there is no denying the fact that Islamic finance could be an extremely beneficial financial system based on equity and inclusive growth. Moreover, in countries where penetration of traditional banks is low because of religious reasons among others, Islamic banking can ensure financial inclusion. According to a report by Fitch Ratings in June 2022, only 21 percent of adult Pakistanis had a bank account in 2017. Also, traditional banks have a limited reach in populated rural areas where 63 percent of Pakistan’s population lives. Moreover, Islamic banking can promote the growth of small and medium enterprises, which is crucial for the growth of the overall economy, as this sector is often ignored by traditional banks.
Another challenge Pakistan has to deal with is the lack of Islamic banking experts-- essentially a talent pool who understands Shariah laws as well as the complex world of finance.
Hissan Ur Rehman
Now the question is, are we ready to shift to a complete Islamic banking mode in the next five years?
At this moment, shifting to a completely Islamic banking system in five years is a highly ambitious goal if not impossible. There are opportunities and challenges. Pakistan is home to the second-largest Muslim population in the world with a very low banking penetration. By the end of 2021, the share of Islamic banking in the Pakistani banking sector reached 18.6 percent (compared to 12.4 percent by the end of 2017). The underserved market provides a huge opportunity for Islamic banks to expand aggressively. The State Bank of Pakistan wants Islamic Banks to contribute 30 percent to overall banking assets and deposits by 2025.
There are multiple challenges the country needs to overcome to build a national Islamic banking system. The primary roadblock in the way is a lack of visible intent and a clear roadmap by the government. A contrast can be drawn here with Malaysia, a country which has slowly become the epicenter of Islamic finance in the last three decades.
Malaysia went on to develop the first Islamic bank following the enactment of the Islamic Banking Act of 1983. Going further, the Financial Sector Masterplan launched in 2001 pushed the Islamic banking movement in Malaysia. The government set a clear roadmap with specific targets and associated deadlines. Moreover, Malaysia built supporting institutions to nurture the Islamic banking system while Bank Nagara, the country’s central bank, played the role of a mentor. The scene is opposite in Pakistan where the Central Bank last week increased the key interest rate by 100 bps to 16 percent.
Another challenge Pakistan has to deal with is the lack of Islamic banking experts-- essentially a talent pool who understands Shariah laws as well as the complex world of finance. The lack of this skilled workforce can stifle the government’s ambitious plans and allows religious preachers, who often lack knowledge of banking and finance, to dictate Islamic banking practices. As a result, many practices (for example fixed interest rates) of so-called Islamic banks actually mislead people as they are not according to Islamic banking principles.
Some other issues that need immediate attention are building Shariah-compliant institutions, developing an Islamic interbank market, and a holistic regulatory framework and risk-management framework.
It cannot be denied that some progress has been made, as Dar cited that Meezan Bank has increased its Islamic banking branches from 100 in 2013-2017 to 1,000 at present. Also, the assets of Islamic banks rose to PKR7 trillion as of September 2022 compared to total banking assets of about PKR30 trillion. Despite limited progress, there is a lot of road to cover. Let’s be hopeful.
- Hissan Ur Rehman is a graduate of Lahore University of Management Sciences (LUMS) and MBA in Management Consulting. He teaches financial markets in Pakistan.
Twitter: @Hissan3hissan
