Islamic Banking in Pakistan: The Road Ahead?

The Islamic banking industry has seen significant growth in recent years, with many countries implementing regulatory frameworks to accommodate Islamic financial institutions. In Pakistan, the shift towards Islamic banking has been slower, with traditional riba-based banking still dominant. However, there is a growing movement towards a riba-free Pakistan, with proponents citing the ethical and fair principles of Islamic finance as reasons for making the switch.?

But the road to a riba-free Pakistan is not without its challenges. There are a number of barriers that must be overcome in order for Islamic banking to thrive in the country. These include a lack of understanding and awareness about Islamic finance, the high cost of implementing the necessary infrastructure, and resistance from traditional financial institutions.?

Despite these challenges, there are also a number of solutions that can help pave the way for the growth of Islamic finance in Pakistan. These include educating the public about the benefits of Islamic finance, supporting the development of Islamic financial institutions, and working towards the creation of a more enabling regulatory environment.?

But what is Islamic banking, and how does it differ from traditional riba-based banking? At its core, Islamic banking is based on the principles of the Islamic faith, which prohibits the charging of interest (riba) on financial transactions. Instead of earning profits through interest, Islamic financial institutions generate income through the sharing of profits and losses with their clients. This profit-and-loss sharing model aligns the interests of the financial institution with those of its clients, promoting ethical and fair financial practices.?

In 2002, the Federal Shariat Court in Pakistan issued a ruling that all financial transactions in the country should be free of riba, or interest. This ruling set a deadline of December 2027 for the complete Islamization of Pakistan's economic and financial system. However, the slow progress of Islamic banking in the country over the past two decades has raised doubts about whether this deadline will be met. As of June 2022, the share of Islamic assets in commercial banking stood at just 19.5 percent, and it has been increasing at an average rate of 1 percent per year. At this pace, it will take until 2052 for Islamic banking assets to surpass those based on interest. The primary challenge to achieving the goals of the court's ruling lies in the transformation of government, domestic, and external debt into Shariah-compliant securities such as sukuk. This process has so far been slow, with just 5 percent of the PKR 47.8 trillion (about $300 billion) in federal government debt having been transformed as of the end of June 2022. Other challenges include the lack of real assets owned by the federal government and the need to change the Constitution to make land a federal subject.?

With the December 2027 deadline set by the Federal Shariat Court for the elimination of riba (interest) in Pakistan's economic and financial system, the question now arises as to whether the country will be able to meet this mandate. Will the necessary changes be made in time to fulfill the court's ruling, and what challenges will need to be overcome for this goal to be achieved? It remains to be seen how the government and financial institutions will navigate this complex issue and what steps will be taken to implement the court's ruling. History suggests that this timeline may be unrealistic. What are the obstacles to transforming the country's economy into a riba-free system? How quickly has the Islamization of banks in Pakistan progressed so far? To address the latter question, the first serious effort to Islamize the banking system began in 2002 with the establishment of Meezan Bank. Although the Islamic banking sector experienced rapid growth, the proportion of Islamic assets in relation to conventional banking assets increased at a sluggish pace. From zero percent in 2002, to 8.2 percent in 2012, and to 19.5 percent in June 2022, the share has increased at an average rate of almost 1 percent per year. If this share continues to rise at this pace, Islamic banking assets will surpass interest-based banking assets around 2052, at which point half of Pakistan's banking system would have been Islamized.?

The actual speed of Islamization will depend on how quickly the challenges are overcome. The main challenge does not lie in converting interest-based banks into Shariah-compliant institutions, but in transforming government, domestic, and external debt into Shariah-compliant securities such as sukuk. It is only after this transformation that the banking and financial sector will find it easier to move towards a riba-free system. This is easier said than done. The value of federal government debt (excluding IMF debt and State Bank foreign exchange liabilities) was PKR 47.8 trillion at the end of June 2022. It has since crossed PKR 50 trillion. Without the transformation of domestic debt, it will be impossible for banking and financial institutions to become Shariah-compliant.?

While the transformation is not impossible, it will be extremely difficult to achieve by 2027. Why? Under the current interest-based financial system, government borrowing from banks does not require any real assets from the federal government. A riba-free system requires real assets against which the borrower can obtain Shariah-compliant financing from an Islamic bank. Islamic finance mandates that all financial transactions should have a tangible asset as collateral. This is also one of the main differences between Shariah-compliant and interest-based activity. Linking the latter to a real asset is a direct exercise, not a remote one. Since financial activities, whether interest-based or Shariah-compliant, appear similar, people may mistakenly think they are the same. However, Islamic financial activities are always different, despite their appearance.?

The challenge of making government debt Shariah-compliant has so far been met to the extent of about 5 percent (of PKR 47.8 trillion) through the successful issuance of ijara sukuk by the government, valued at PKR 2.3 trillion at the end of June 2022. This 5 percent transformation was achieved over two decades. It is anyone's guess how many decades it will take for the federal government to transform the remaining 95 percent of its debt. The government has its own genuine problems in undertaking this massive transformation. It does not have real assets (totaling PKR 50 trillion) primarily because land is a provincial subject. As a result, most of the land in the country is owned by the provincial governments.?

While it is not clear how much land is owned by the federal and provincial governments, The federal government has not conducted an asset survey or census to estimate its ownership of land, but a comparison with the United States shows that 28 percent of land in the US is owned by the federal government and 72 percent by the state governments.?

The State Bank of Pakistan faces a challenge in its efforts to become Shariah-compliant. It currently owns approximately PKR 6.1 trillion in Pakistan Investment Bonds (PIBs), compared to its real estate assets of PKR 165 billion. Once the government succeeds in converting its PIBs to sukuks, the central bank must also convert its interest-based securities to become Shariah-compliant. To its credit, the State Bank has already developed a Shariah-compliant version of open market operations for injecting liquidity into Islamic banks as needed. A modaraba-based standing facility is also in place for injections, though mop-up facilities or open market operations are still pending. The State Bank will be ready to implement its monetary policy in a Shariah-compliant financial system once both of these facilities are operational.?

The pricing of Shariah-compliant securities is not currently a challenge, but it will need to be modified once these securities surpass interest-based securities. At present, the pricing (profit rate) of Islamic financial products is linked to interest rate benchmarks such as the State Bank policy rate or Kibor. This has been allowed by Shariah scholars because, during the formative stage of Islamic finance, independent pricing must take into account competition and profitability in the dominant interest-based banking sector. However, once Islamic banking assets surpass interest-based assets, this reasoning will no longer be valid and the need for an independent Islamic finance benchmark profit rate will become necessary. It would be absurd if dominant Islamic securities continued to use an interest rate benchmark, especially since this link currently raises suspicions about the authenticity of Islamic securities, despite their compliance with Shariah principles.?

Establishing this benchmark is the responsibility of the State Bank, and it is a challenging but achievable task. Quarterly surveys can be conducted to estimate the current profit rates in the real sector and in important sub-sectors like real estate for ijara sukuk, which are backed by land or property. The State Bank can then select an appropriate benchmark for future policy rates.?

The slow progress of Islamic finance in Pakistan over the past two decades, despite widespread skepticism about its authenticity, is still a significant accomplishment. This skepticism stems from the inherent similarity between financial products and the reluctance to examine the thoroughly documented and transparent structures of Islamic modes of financing for each type of transaction.?

In conclusion, the Islamization of Pakistan's economic and financial system by 2027, as mandated by the Federal Shariat Court, faces numerous challenges. The slow pace of the adoption of Islamic banking, the transformation of government and domestic debt into Shariah-compliant securities, and the lack of real assets owned by the federal government are all major obstacles to achieving this goal. However, the transformation of the country's financial system into a riba-free system is feasible, even if it may take a long time to achieve. The State Bank of Pakistan also has a role to play in this process, including the conversion of its own interest-based securities into Shariah-compliant ones and the establishment of an independent Islamic finance benchmark profit rate. Despite the challenges, the progress made so far in the Islamization of Pakistan's financial system is still significant, and with continued effort and determination, it may yet be possible to fully achieve the goals set by the Federal Shariat Court. The challenges faced in achieving the Islamization of Pakistan's financial system are significant, but with determination and innovative solutions, it is possible to build a stronger, more equitable and sustainable economic model for the country.?

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Thank you all for reading. Please feel free to share your thoughts and perspectives in the comments. As the shift towards Islamic banking in Pakistan continues, it's important to stay informed about the latest developments in this field. To keep up with the latest news, analysis, and insights on Islamic banking in Pakistan, be sure to follow me. I look forward to continuing this conversation with you.

Danish Ali Gohar

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