Evolution Of Islamic Banking In Pakistan Finance Essay

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This research will help us to understand the initiation and development phase of Islamic Banking in Pakistan. This research aims to answer questions about the launch of Islamic Banking in Pakistan. It will help to highlight the factors that have paved the way for its development. It will also elaborate upon the process through which this system has flourished in our country. The purpose of this study is to review and understand the various factors associated with the evolution of Islamic Banking system in Pakistan.

Research Objectives

More specifically the objectives will be:

To review the history and development of Islamic Banking in Pakistan since the time of its inception. This will help to analyze the evolution of this system during various political and military regimes.

To emphasize on the growth trends of Islamic banking system in comparison with the Conventional banking system. This will consequently help to gauge the level of recognition and popularity, this sector enjoys in Pakistan.

To highlight a variety of factors or variables and analyze their positive or negative influences upon the evolution of Islamic Banking in Pakistan.

To understand the role of the government and other state institutions in providing an enabling environment for the development as well as the implementation of Islamic Banking system in our country.

To gauge the level of acceptance and attractiveness of Islamic Banking for local or foreign conventional banks.

To analyze the corporate and individual customers' attitude towards Islamic Banking as well as the level of awareness of the public regarding Islamic Banking concepts and practices, in order to evaluate the success of this system in Pakistan.

Khan (2009); is of the view that the concept of Islamic Banking emerged in Pakistan as a response to both religious and political factors. Efforts for a complete elimination of Riba based system were initiated during the 1970s and most of the practical steps were taken in 1980s. However due to the lack of political insight and an absence of Shariah compliance mechanism this system had to face major hurdles. In any case this effort was extremely helpful because it provided a valuable experience which was conducive in the development of the present State Bank's policies for the re-launch of Islamic Banking in the country.

Khan (2009); believes that the initiative to re-introduce the Islamic Banking system was launched in 2001. In 2001 the government developed a consensus for a gradual promotion of this system as a parallel and compatible system in line with the best international practices. This flexible approach aims at developing a broad financial system in the country that is targeted towards the masses belonging to all segments of the population.

For this research Khan utilized primary as well as secondary resources for data collection. He evaluated the financial statements of various major banks in the country and he also analyzed the reports of the State Bank of Pakistan over the years. For the primary research he carried out surveys from bank customers of both the Islamic and conventional banks in order to understand market trends and practices. Some interviews were also carried out with banking professionals to develop a thorough understanding of this system.

According to Khan (2009); the set of variables that have influenced Islamic Banking in Pakistan, primarily include extensive religious pressures and political motives. In conclusion Khan (2009); states that over the years the results prove that the strategy for the introduction of Islamic Banking has worked really well due to careful planning and hard work.

Lodhi and Kalim (2005); have identified a variety of other factors that have influenced the development of Islamic Banking in Pakistan which were not included by Khan in his research. They have explored the strategic policy orientation needed for the promotion of Islamic Banking. Contrary to Khan's proposition (2009) about the credible measures taken by the SBP for the development of this system, Lodhi and Kalim (2005) have hypothesized that the current policy measures are not facilitating Islamic Banking in Pakistan. The authors have discussed the development of Islamic Banking in Pakistan with primary focus upon the progress made in this sector.

Lodhi and Kalim (2005); have also highlighted the factors impeding the development of this system in Pakistan. Moreover the authors have discussed the strategic directions and have presented the views of different bankers, related to the obstacles in the execution of Islamic principles in the Banking Sector. Lastly the paper concludes by discussing the impact of various policies that may improve the Islamic Banking system in our country.

The broad set of variables; that have influenced Islamic Banking in Pakistan; explained by Lodhi and Kalim (2005); include Political Resolve, Judicial Rulings and State Bank's policy measures. They believe that the concept of Islamic Banking in Pakistan was brought into lime light during Zia-ul-Haq's Islamist Regime. In the era of 1980s interest free banking in Pakistan on profit and loss sharing (PLS) basis was initiated officially. Moreover the Federal Shariah Court's original ruling in 1999 declared all forms of interest charged during financial transactions as Riba, which is prohibited in Islamic teachings. Therefore the court ordered the government to finish all dealings based upon interest. Furthermore the Commission for Transformation of Financial System (CTFS) was founded in the year 2000, under the supervision of the State Bank of Pakistan, to launch a new financial system based upon the Shariah principles.

Moin (2008); discovered that the modifications in the financial system to issue new interest free instruments, development of an ordinance for the establishment of Mudaraba companies and flotation of Mudaraba Certificates, constitution of Commission of Transformation of Financial System (CTFS) and the establishment of an Islamic Banking Department are some of the key decisions by the State Bank of Pakistan which have paved the way for smooth development of Islamic Banking System in the country.

Moin (2008); stated that although Islamic Banking system developed its roots in the 1970s, however the most notable efforts were made quite recently through the policy measures laid down by State Bank of Pakistan in the year 2000 and onwards. These policy measures include the issuance of the first Islamic Banking License to Meezan Bank Limited in January 2002.

This study is aimed at exploring the comparative performance of Islamic Banking when compared with conventional banking system of Pakistan. Therefore the author has analyzed the financial ratios of various banks in the country. These ratios have been broadly categorized into four groups, namely, solvency ratios, liquidity ratios, profitability ratios risk and efficiency ratios. The overall analysis between various banks reveals that conventional banks are indeed doing good business, however Islamic banks are catching up at an excellent pace.

Moin (2008); stated that, although Islamic Banking is still in its nascent stage yet the future appears to be bright. Some of the major Islamic Banks in the country rival with conventional banks in terms of diversity of products and large customer base. If the trend continues and the SBP keeps on providing an enabling environment to the Islamic Banking sector, then in the near future both banking systems would run parallel in terms of financial success and there is a strong probability that Islamic Banking may even outweigh the Conventional Banking system.

Hassan (2007); has elaborately analyzed the measures taken by the government for Islamizing the economy, specifically financial and banking institutions in Pakistan. A scrupulous examination of the nature, effects and the impacts of strategic measures by the government reveal that the political resolve of some leaders has fostered Islamic Banking system in Pakistan. [Hassan (2007)]

However, according to Hassan (2007); certain factors have also hindered the Islamization process in Pakistan. These factors include absence of authentic political support, lack of professional management, and exploitative socio-economic atmosphere of the country.etc. On the other hand certain factors have indeed endorsed the development of Islamic Banking system in Pakistan such as decentralization of administrative power, economic growth and participation of Islamic/Religious parties in politics.etc. The variables identified by Hassan (2007); include political resolve, judicial rulings, State Bank's policy initiatives and pressure of religious political parties and other groups.

Turning through the pages of history Hassan (2007); stated that the ulema of the subcontinent played a vital role in the inception of Pakistan. Therefore they had a political standing even before the partition. They influenced the Objectives Resolution as well as the constitutions. Eventually these ulema stepped into formal politics and developed a party named as Jamaat-e-Islami. These parties and other pressure groups have widely influenced Islamic banking in Pakistan and have provided this system with a lot of support and political backing.

Mehmood (2002); indicated that interest is the linchpin of the modern economic system. The world is so entrenched in this system that it is hard to imagine for any country to eliminate interest. However Pakistan stands among those audacious nations who have the distinction of categorically expressing the desire of ending this inequitable system. To turn this dream into reality the government and certain non government institutions have played a major role to establish an Islamic Economy by eliminating interest and incorporating the principles of Zakat and Ushr.

According to Mehmood (2002); Pakistan has definitely made some progress on the road to Islamization. However after the decision of the Shariah Appellate Bench of the Supreme Court of Pakistan the progressive status of Islamization process suffered a severe setback. The deadlines that were enforced for a complete transition from an interest based economic system to a shariah approved system were lifted. Due to this very reason Pakistan landed on the same base from which we started off in the 1970s. But the present state of affairs merit hopes because recently the government has expressed its policy commitment to the introduction of a parallel Islamic Banking system in the country. As long as unnecessary political intervention is avoided it is hoped that Pakistan would not be detracted from this revived promise.

Mehmood (2002); evaluated that there is an extensive need for research based development of Islamic Banking in the country so that a firm foundation can be established from the start. Lack of research and knowledge development would ultimately lead to chaos. This system should also be in conformity with the opinions of learned Muslim scholars in order to avoid any ambiguities. Moreover the people must understand that the government might not be able to enforce this system alone therefore other public and private sector institutions should come forward and work together for the development of this system.

Wouters (2008); has shed light upon the Islamic Banking sectors of three countries namely Turkey, Indonesia and Pakistan. The author developed a comparative analysis of two secular economies .i.e. Turkey and Indonesia with Pakistan.

Highlighting various differences in the approach; adopted by the governments of these countries; towards the development of Islamic Banking, Wouter (2002); stated that Islamic Banking began in Turkey by the launch of 'Albaraka Turk' in 1985. The focus of Islamic Banking was upon the population as a whole and not upon the 'convinced' Muslims only. On the other hand, in Indonesia Islamic Banking started with the opening of Bank Muamalat Indonesia. From the very start Islamic Banking products were aimed at 'convinced' Muslims. The government had also taken impressive initiatives to help this sector flourish alongside the conventional banking.

Wouters (2008); highlighted that although Islamic Banking had been introduced in Pakistan since the 1980s, yet the first Islamic Banking license was granted in 2002. Pakistan adopted an aggressive approach to Islamize the economy and the banking sector, during Zia's Regime. However due to various technical, legal, political and infrastructural constraints Islamic Banking couldn't develop deep roots.

Wouters (2008); discovered that the State Bank's policy measures and initiatives taken by conventional banks are the major driving force in the development of Islamic Banking system. Under the Islamic Banking policy (December 2001) of the State Bank, Islamic Banking is promoted parallel to conventional banking. Moreover Implementation of AAOIFI and IFSB standards is on the way. Various conventional banks have also taken the initiative and opened up Islamic banks subsidiaries and even stand alone Islamic Banking branches.

Inayat (1993); stated that since the initiation of interest free financial instruments there has been minimal progress in the sphere of Islamization of the whole Banking System. This is primarily due to the fact that we have adopted a fragmented approach to Islamize banking without understanding the complexities involved in this process and without taking into account the pre-requisites of the Islamic Economic Order. Therefore Pakistan has been able to develop Islamic Banking system only on the surface.

Inayat (1993); concedes to the fact that the most important requirement of an Islamic Economic system is the eradication of interest. However he is also of the view that elimination of interest is not the conclusive condition for a successful operation of Islamic Economic System.

Inayat (1993); stated that Islamic Banking started in Pakistan in 1979, however the process of Islamization was not initiated with proper planning. While highlighting the problems impeding the development of Islamic Banking system, Inayat (1993); concluded that inconsistent government policies and lack of public awareness are at the fore-front. But the problem can be resolved by rectifying the institutional changes that deal with the legal framework, providing extensive training to the banking staff about shariah practices, formulating a shariah compliance mechanism.etc. More importantly a total commitment to the cause is required which should be in complete consistency with the Divine Law.

Inayat (1993); evaluated that the State Bank of Pakistan has made extensive efforts to make Islamic Banking system compatible with the present economic environment. Moreover the Judicial Rulings by the Federal Shariah Court is another move in the right direction. These efforts have resulted in enhancing the confidence of the masses with this new system. Thus several Islamic Banks are in the process of inception and it is believed that the new millennium would be earmarked as an era of Islamic Financial system.

Zaher and Hassan (2001); stated that the initial recognition of the principles of Islamic Finance can be indicated by the development of a savings bank in Egypt in the year 1963. In Pakistan, Islamic Banking system was initiated in the early 1980s under Zia-ul-Haq's regime. Since then Judicial Rulings, popular sentiments and the State Bank's policies have influenced the evolution of this sector. Presently the SBP is working to establish a regulatory framework for better management of Islamic Banks.

Zaher and Hassan (2001); are of the view that in the modern times extensive training of banking professionals, bank customers and the general masses is of utmost importance, if we intend to promote this system. For Pakistan some of the major problems in the development of this system include the issue of managing liquidity for banks and monetary management by the SBP.

Zaher and Hassan (2001) evaluated that Political Resolve, Court Rulings and Policy decisions by the State Bank are the primary factors that have positively influenced the development of Islamic Banking system in the country. In this regard an ordinance was issued which sanctioned the development of Mudaraba companies and permitted the flotation of Mudaraba Certificates. A modification was introduced in the Banking companies Ordinance (BCO) in 1962 to allow markup pricing, permit the provision of money on PLS basis and allow lease agreements. Separate counters free from interest started operations in 1981. Moreover the State Bank under the guidance of Court rulings decided that Pakistani Economy would shift from an interest based economy to a shariah compliant economy gradually, in order to avoid any inconveniences. For this purpose SBP considered setting up Islamic Banking subsidiaries by conventional banks, specifying branches exclusively dealing in Islamic products and setting up full-fledged commercial bank to carry out banking business based on proposed Islamic products.

Hussain (2004); discussed that the tools that are required to achieve socio-economic objectives of the Islamic Economic system are based upon the principles of the Quran. These tools include the system of Zakat and prohibition of interest. Hussain (2004); also highlighted various measures taken for Islamization of the Economic System in Pakistan such as the creation of the Council of Economic Ideology in 1962, the introduction of zakat and ushr, the establishment of a full-fledged Islamic Banking Department in the State Bank.etc.

Hussain (2004); stated that Islamic Banks by nature were less likely to engage in money laundering, larceny or other illegal activities. In the present times the role of Islamic Banks is not limited to a passive financier concerned only with timely interest payments rather an Islamic bank is a partner in trade and it has to concern itself with the nature of the business and profitability position of its clients.

Hussain (2004); identified three major variables that have positively influenced the development of Islamic Banking system in the country, these were, State Bank's policy measures, introduction of zakat and ushr and the development of a legal framework. State Bank of Pakistan took sufficient measures and introduced a Shariah board comprising of three experts in the areas of banking and accounting, two shariah scholars as well as legal framework was established. The zakat and ushr ordinance of 1980 also stimulated the development of an Islamic Economic system which eventually led to the creation of Islamic Banks. State Bank also issued the criteria for establishment of Islamic banks in private sector, subsidiaries and stand-alone branches by existing commercial banks to practice Islamic Banking in the country. Legal Framework was also provided by the Objectives Resolution. Moreover the Council for Transformation of Financial System was setup by the State Bank to ensure a smooth transition from the interest based system to a shariah complaint interest free system.

Siddiqi (2006); stated that the 1960s saw the establishment of the first interest free bank in Karachi. However the bank could not survive for long because at that time it was still a totally new concept and it couldn't gain momentum with the general masses. Later on the Islamic Development Bank started operation in 1975. This bank was solely designed to serve Muslim countries and communities by arranging finance for trade and development on non-interest basis. This indicates that initially Islamic Banking developed solely on the basis of promoting interest free financial instruments.

Siddiqi (2006); believes that the most significant development took place during the early 1980s with the advent of Mudaraba and Murabahah based financing. This was the time when Pakistan officially committed itself to interest free financial system. Siddiqi (2006); stated that the primary reason for the development of Islamic Financial system is based upon our religious commandments that declare interest or riba based transactions as 'haram'. The second reason is based upon morality which entails that instead of the materialistic, capitalistic pursuit of money and wealth we need to learn the principles of sharing and giving to our fellow brethren.

According to Siddiqi (2006); public awareness and demand has enhanced the popularity of Islamic banking in the country. Due to this reason nowadays many conventional banks are operating Islamic Banking branches alongside their conventional branches. Moreover various religious factions have also expressed their desire every now and then for the inception of an Islamic Economic system in the country, solely based upon Islamic Financial instruments and Profit and loss sharing basis.

Siddiqi (2006); evaluated that the present trends would prove to be fruitful for the success of this system as a large number of people are growing dissatisfied from the interest based system.

Theoretical Framework


H0: Political Resolve did not have an impact upon the evolution of Islamic Banking in Pakistan

H0: Judicial Rulings did not have a positive impact upon the development of I.B System

H0: SBP's policy measures did not affect the formation of Islamic Banking System in Pakistan

H0: Public Awareness and Demand did not significantly affect the development of I.B System

H0: Initiatives by conventional banks did not affect the formation of Islamic Banking System

H0: Pressure of Religious groups did not have a positive impact upon the growth of I.B System