Islamic banking in Pakistan: A case of vested interest?

Pakistan faces an uphill task to transform its financial system to accommodate strict Islamic principles, while staying within modern banking practices.

Senior government officials are now suggesting they are not fully prepared for Islamic banking and more time is needed to research to develop a variety of products and instruments dealing with different financial transactions.

The Shariah Appellate Bench of the Supreme Court of Pakistan in 1999 declared the payment of interest (Riba) as repugnant to Islam, and directed that all such laws be scrapped by June 30, 2001.

Shariah is Islamic cannon law derived from three sources – the Koran; the Hadith (sayings of the Prophet Mohammad); and the Sunnah (the practices and traditions of Mohammad). Riba literally means an increase or addition. Technically, it denotes any increase or advantage obtained by a lender as a condition of a loan. Any risk-free or “guaranteed” rate of return on a loan or investment is riba. Riba, in all forms, is prohibited in Islam. In conventional terms, riba and “interest” are used interchangeably.

Advocates of Islamic banking believe the opportunities for the growth of Islamic finance are immense, with the 10 largest Muslim countries having a combined gross domestic product of US$1.2 trillion. At present, Islamic banks have a total capital of $7 billion and deposits of more than $120 billion, catering to a large variety of clients by offering equity-based financing.

However, the Islamic system faces major structural challenges, such as fragmentation of the global Islamic banking industry, differing interpretations of banking practices, the absence of a strong regulatory framework, a narrow view of Islamic financing in regional, rather than in global terms, and an inadequate understanding of the principles and practices, which are prerequisites for transforming the system.

Since the Riba judgement of 1999, three independent bodies have been working to evolve an Islamic Financial System (IFS) in Pakistan. But the Shariah scholars, experts and economists dealing with the subject have failed to find Islamic alternatives to the existing large stock of domestic debt. Foreign debt obligations have been given full protection by the Court.

Pakistan’s existing debt stock of almost more than 100 percent of its GDP is a major stumbling block. It owes more than $35 billion to foreign creditors and about Rs1.7 trillion ($28 billion) to domestic creditors. With a narrow revenue base and highly inelastic expenditures, average budget deficit figures remained in the range of 7 percent of GDP during the 1990s, forcing the state to raise large sums of money, both from domestic and foreign lenders, to fill the gap.

Under the Islamic financial system, however, there is little room for raising loans simply for deficit financing or for debt servicing. And even if the foreign loans are excluded, the revamping of existing domestic debts is a challenging task. The authorities would need to rewrite all domestic debt covenants in terms of Shariah norms, which require collaterals. After pledging assets to existing lenders, the government would need to work out rental values of these assets, which is permissible under the Islamic system. These rental values would then be used as benchmarks to determine the rates of return on investments.

However, officials tasked with working on the subject says this system, known as Diminishing Musharaka, does not suit local economic conditions. They feel that even after pledging all national assets, a large number of existing loans would remain outstanding.

Under Diminishing Musharaka, a financier and his client participate either in the joint ownership of property or equipment, or in a joint commercial enterprise. The share of the financier is further divided into a number of units and it is understood that the client will purchase the financier’s units one by one periodically, thus increasing his own share until all the financier’s units are purchased, making the client the sole owner of the property, or the commercial enterprise, as the case may be.

The state-run House Building Finance Corporation (HBFC) is in the process of introducing new loans under this system, which would mean a joint ownership of the asset until the loan is fully cleared by the borrower. The rate of return is determined by the rental value of the particular premises.

Senior bankers suggest Islamic rules need to be introduced in specialized institutions before the full transformation of the whole system. Similarly, they suggest the need for Islamic banking windows in existing nationalized commercial banks (NCBs) and private banks to allow them to gain sufficient experience to develop their knowledge and skills.

The HBFC example could be used as a good case study, as well as and some small banking networks, such as Al-Meezan Investment Bank and Al Baraka Bank, which offer totally Riba free financial services in the country. However, their share in the banking sector is negligible.

The sector as a whole is plagued by bad loans due to political interference in the past, corruption and lack of accountability. This leaves little room for experimentation. Non-performing loans outstanding for more than 90 days account for almost 25 percent of the total loan portfolios of all banks.

The government is working with international financial institutions to restore financial health to the banking sector, but it is finding it hard to convince lenders, and official bilateral creditors at the Paris Club meeting recently questioned the Pakistani government’s policy. Finance Minister Shaukat Aziz, who is spearheading the loan rescheduling talks, had to give his word the government would not do anything beyond prudent banking practices. Pakistan has also signed an official agreement with the International Monetary Fund that it will honor all international transactions as they presently stand. It has also pledged that all international debt obligations will continue to be serviced.

Senior government officials working on the format of the IFS say the government may come up with a policy statement on the subject to clarify its future course of action. This could involve filing for a review of the court’s initial decision. There have also been reports that the government may use the United Bank Limited (UBL) as a test case. The UBL had filed an application with the court seeking more time.

However, backtracking at this crucial stage would be politically suicidal for the one-and-a-half-year-old government of General Parvez Musharraf, who is facing intense political pressure for the restoration of democracy, and the international community is unwilling to show any flexibility to the military regime.

Religious parties in the country, in particular, are very vocal on the question of Islamic banking as they believe it will help Pakistan escape its debt trap by saying no to the dictates of the IMF and the World Bank.

Experts believe the success of the system requires consistency in evaluation and interpretation in all issues relating to Islamic banking, the necessity of adopting globally accepted standards and procedures that cater to both Shariah principles and conventional banking practices, transparency in banking operations, and above all, a liquidity cushion and the injection of professionalism – key requirements that will not be met quickly.

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