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Friday, 13 February 2009

Islamic banking in Pakistan

by Saifullah

Banking sector is considered to be one of the important and essential pillars of nation's economy. Present banking system, which is based on the principles of interest, is highly criticised, as it could not offer the appropriate benefits to society. Thus this system is undesirable for lacking to serve human beings and any society. Particularly for Muslims this system is a threat as it operates against the principles and teachings of Islam. Muslim world is one of the major areas where Muslims are struggling and looking for improvement in this field of life. In this regard the elimination of interest from the financial sector is considered to be a major breakthrough. Muslim scholars and many other economists of the world who understand the negative impacts of interest are trying to promote the concept of interest-free banking system as taught by teaching of Islam. By prohibiting interest, Islam has endeavoured to do away with a hideous form of tyranny and injustice prevalent in human society. The institution of interest is a great challenge to all those who are trying to reconstruct the Islamic way of life in modern times. Efforts have been made to develop Islamic banking system and many of the banks operate on the basis of Islamic principles. Yet due to non-availability of the monetary system and Riba-free investment opportunities the Islamic banking system is not free of critics and considered dependent on interest-based system. -Islamic banking system faces a number of challenges. Among the agitating issues the foremost one is that they have not yet been successful in devising an interest-free mechanism to place their funds on a short-term basis. They face the same problem in financing consumer loans and government deficits. Second, the risk involved in profit sharing seems to be so high that most of the banks have resorted to those techniques of financing which bring them a fixed assured return. As a result, there is a lot of genuine criticism that these banks have not abolished interest but have in fact only changed the nomenclature of their transactions. Islamic finance has failed to capture the interest of western writers and it has been developed in isolation from its western counterpart. This deficiency can be rectified by reference to support for prohibition of interest in western literature, in the capitalist economies and evidence on attitudes towards Islamic finance. In Islam, interest is prohibited because the interest on the loan is an augmentation of capital without effort and a false creation of value. The increase of income must result from investment, labour and other activities. There are many arguments about prohibition of interest in Islam. The first argument is that interest rates have no moral foundation. The second is that abstinence from consumption is not a justification of rewards. The third reason is that there is no risk to justify the supplement payment for capital lending if loan is guaranteed. The creditor/debtor relationship is redefined in Islam with the creditor or provider of the funds becoming a partner in the project, assumes the risk activity with the entrepreneur and shares profit at a pre-agreed proportion. It is fairer for the creditor and debtor that they have a share of profits and losses. The creation of incremental wealth justifies the share of profit between the borrower and the lender of money but not fixed return. The banking system of Islamic countries based on Islamic economic principles is fast developing. This system is important due to growth of investment amount in Islamic banks and the consideration given to the system by the Government. Islamic banking is growing rapidly not only in Pakistan but also throughout the world. Islamic banking has a great potential to grow in future in Pakistan and State Bank is committed to the development of this industry. Pakistan has provided a supportive policy and regulatory framework for Islamic banking due to which investors of international repute are coming to establish new Islamic banks in country. The State Bank has set up a dedicated Islamic banking department for the promotion and regulation of this industry. SBP impresses upon the heads of Islamic banks to meet the growing challenges in the development of Islamic banking. The SBP has clarified to the industry there is a level playing field for Islamic Banks and has agreed to look at approaches to develop Islamic interbank market. Steps for Islamization of banking and financial system of Pakistan were started in 1977-78. Pakistan was among the three countries in the world that had been trying to implement interest-free banking at comprehensive/National level. We know that it is a mammoth task; the switchover plan was implemented in phases. Islamic banks face a number of challenges. First, they have not yet been successful in devising an interest-free mechanism to place their funds on a short-term basis. They face the same problems in financing consumer loans and government deficits. Second, the risk involved in profit-sharing seems to be so high that most of the banks have resorted to those techniques of financing which bring them fixed assured return. As a result, there is a lot of genuine criticism that these banks have not established interest but have in fact only changed the nomenclature of their transactions. Of course, it has to be kept in mind that these issues are at their elementary level of discussion. Much work has to be undertaken in terms of procedures, infrastructure and allowing a new framework to develop and mature. The new banking system of Islamic countries based on Islamic economic principles is fast developing. This system is important due to growth of investment amount in Islamic banks and the consideration given to the system by Governments. The developments have encouraged many studies on the Islamic banking system. However, little importance is given to application of modern finance theories to Islamic banks. Islamic economic principles are characterized by the application of managerial techniques and models advanced in the conventional financial framework. Islamic banks operate on a set of principles based on the Islamic law (Shariat). These principles are different from those of conventional banks. Instead of charging a fixed interest rate, Islamic banks use profit sharing principles (PLS) through its two varieties: Musharaka and Mudaraba. Key findings of relating Islamic banking are listed as under: 1. There is a shortage of short-term liquidity management tools and lack of capital markets in the interest-free industry. This hinders the fast growth of the sector. 2. Public appreciate efforts of the State Bank of Pakistan in promoting interest-free banking and wants the government of Pakistan to further facilitate this industry. 3. The current efforts by the government are not sufficient for the industry. Government should take further steps in promoting interest-free banking. 4. Interest-free banking industry has made a promising start with a lot of room for improvement and development. This sector has a great potential of further growth. 5. Results indicate that there is a lack of availability of wide range of interest-free banking products in Pakistan. 6. All the stakeholders of interest-free banking industry in Pakistan prefer interest-free banking to conventional banking system. 7. Interest-free banking requires time to challenge conventional banking in terms of market share and industry volume. 8. To eliminate interest from society, overall economy of Pakistan should be shifted to an interest-free base. 9. Conventional banking system can be converted into interest-free banking system. 10. The two parallel banking systems should run simultaneously and interest-free banking should further be facilitated. 11. People of Pakistan are not satisfied with the Islamic nature of products being offered by the interest-free banking industry and their true compliance with Shariah rules. Interest-free banking is not a new concept anymore. There are financial institutions in the world, which are operating without charging any interest. Even in Pakistan such institutions are in action. However there are hurdles and hindrances, which need to be removed to accelerate the growth of this industry in Pakistan and the world over. While many important issues were highlighted in this paper, it is strongly felt that it would be very helpful for the Islamic banking sector to address the following issues: 1. Planned and scheduled approach: A methodical and market driven approach towards the development of interest-free banking industry involving all the key constituents (including banks, regulators, securities & exchange commission, the Central Board of Revenue, and the Government of Pakistan) should be adopted. This should also facilitate in articulating the short- and long-term growth targets and the expected roles for these targets of this sector. Such a blueprint, publicly available and developed by participation of all stakeholders would be of immense help in growth of the industry. 2. Shariah compliant product range: The interest-free industry should expand its product line to create opportunities for Islamic banks in new markets. There are 12 Islamic modes of financing approved by the State Bank of Pakistan but only a few are functional so far. Innovative steps should be taken to introduce new products based on all the approved modes and consequently identifying new sources for profitable growth of this sector. 3. Capital Market Institutions: In addition to the creation of traditional consumer and commercial banks, efforts should also be made to encourage the creation of other Islamic finance institutions (e.g., investment banks, securities and market firms) and help interest-free banks mange their liquidity in a professional manner. 4. Innovation in Islamic liquidity management: Due to liquidity problems, interest-free banking sector faces a significant strategic and operational disadvantage. A creative focus is required to find ways and needs of Islamic liquidity management. Adopting an integrated Islamic capital market approach might be the right way through which cross border marketability of sukuks and other asset-backed securities. Similarly, integration of conventional and interest-free capital markets as carried out in Arab states would also help in this regards. 5. Partnership with world and institutions: Close relations with other Islamic states of the world should be established to promote this concept and learn from each other's experiences. Also, it would be highly beneficial for Islamic banking sector in Pakistan to maintain close relationship with IDB and IDB-sponsored infrastructure institutions to ensure that we are able to build upon the learning of these infrastructure institutions and, to the extent possible, work with these institutions in developing this sector. 6. Socio-economic factors: The conversion of economy of Pakistan to an interest-free base would have a catalytic effect on the growth of interest-free banking. In this case, both economy and banking would boost each other up resulting in a greater momentum towards growth. Honesty, trust-worthiness, simplicity, truthfulness spirit of sacrifice (Islamic brotherhood) in few important and required traits that should prevail in a society that wants to eliminate the evil of interest. Islamic principles of interest are concerned with issues of fairness and justice rather that of efficiency narrowly defined. These principles focus on the necessity of sharing risk in a fair and stable society, and upon problems of exploitation in markets where power is asymmetric; this is the real Riba Issue. There is a wide scope for interest-free banking system as modern banking system has failed to fill up the income gap and bring socio-economic equability among people, society and even countries and nations. Muslim world is about 25% of world's told population occupying nearly 20% of total area. They own 40% of oil and gas resources; hence there exist a big market for interest-free banking. There is a problem in terms of the lack of Islamically compliant short-term liquidity instruments. There needs to be a truly global-sized liquid inter-bank market where institutions can park their liquidity reserves. Highly ethical, well-regulated and beneficial Islamic financial architecture is possible. Indeed, working in this field with more transparency, with effective corporate governance and with better interaction with relevant international, regional and national institutions, will definitely help all (those) who want to contribute to the welfare of their community as well as to the welfare of the world as a whole. If proper attention and honest efforts are made there is no doubt that an interest-free banking system would increase savings which will result in more investment, more economic growth and above all equal distribution of wealth in Pakistan.

(The Frontier Post)

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