Islamic Banking in Pakistan

Strategy for Eliminating Interest from the Economy

The gradual process of Islamisation of the banking system in Pakistan started in February 1979 when the President of Pakistan announced that interest was to be removed from the economy within a period of three years (CII 1980). In 1977, the government had appointed the Council of Islamic Ideology (CII) with the responsibility of preparing a blueprint of an interest-free economic system in the light of Islamic teaching. To assist in this task, CII set up a panel of economists and bankers consisting of 15 highly qualified economists, experienced central and commercial bankers and financial experts. Considering the complexity of the task of eliminating interest from the economy, the panel proposed a gradual approach. In the first interim report it recommended immediate removal of interest from those financial institutions whose transactions were relatively less complex and from where interest could be eliminated with the greatest ease. Thus three of the specialized credit institutions - the House Building Finance Corporation, National Investment Trust, and Mutual Funds of Investment Corporation of Pakistan were selected for removing interest from their financing operations immediately (Khan & Mirakhore 1989, p.15).
The final report contained recommendations for eliminating interest from all domestic financial transactions. The panel recognized the difficulty in eliminating interest from foreign transactions all of a sudden and advised reduction of dependence on interest-bearing foreign loans. The CII scrutinized both the reports, brought out changes in them in order to ensure complete conformity with Islamic injunctions, and submitted them to the Government in November 1978 and June 1980, respectively (IPS 1994, p.66).
The CII report emphasized that “the ideal Islamic techniques to replace interest in the banking and financial fields are profit-loss sharing and Qard Hasan. However, it gave due recognition to difficulties that may arise in changing the whole system to profit-loss sharing in one step and also the fact that there are certain spheres where it may not be possible to use the system of profit-loss sharing. It, therefore, gave qualified approval to certain other methods being used in conjunction with profit-loss sharing like leasing, hire purchase, Bai-Muajjal, investment auctioning and financing on the basis of normal rate of return. However, cautioning against the danger that such methods could be a back door for interest, it emphasized that their use should be kept to a minimum and that their use as a general techniques of financing must never be allowed (Ibid, pp.66-67).
The CII report further stressed that lack of proper accounting practice due to illiteracy and tendency to conceal profits on the part of the business concerns would act as a hindrance in widespread adoption of the system of profit sharing by the banks (Ibid, p.67).

Phased Transformation

The government of Pakistan planned to remove interest from the economy within a period of three years starting with the task from House Building Finance Corporation, National Investment Trust and mutual funds of the Investment Corporation of Pakistan. These specialized financial institutions took the necessary steps to re-orient their activities on a non-interest basis within few months of the announcement from the government.
Considering the complexity in converting operations of commercial banks into non-interest based operations, a longer period was envisaged. On July 1, 1979, the government introduced a scheme under which the nationalized commercial banks had to provide interest-free loans to small farmers for meeting their seasonal agricultural finance requirements.
The next major step towards the elimination of interest from the operations of commercial banks was taken in January 1981 when the government ordered banks to set up separate counters for accepting deposits on a profit-loss sharing basis in all five nationalized commercial banks. It was also announced that the deposits received on PLS basis would not be used by the banks in interest-bearing operations and that these accounts would be maintained separately. The parallel system, in which savers had the option to keep their money with the banks either in interest-bearing deposits or PLS deposits, continued to operate till the end of June 1985. In June 1984, the government announced that the parallel system would be discontinued during the course of 1984-85. Accordingly, the entire assets side of the banks was converted into non-interest-based modes of financing, except foreign currency deposits, which continue to earn fixed interest allowing their maturity according to the original terms of the contract. The other exception was foreign loans, which continued to be interest-based and governed by the terms of the loans. No banking company was allowed to accept any interest-bearing deposits after July 1, 1985 with the exception of foreign currency deposits. All banking companies were required to share in profit and loss from that day except deposits received in current account that were not entitled to receive either interest or profit.
It is observed that a circular of the State Bank of Pakistan permitted the use of mark-up technique in wide range of activities in the private sector. However, banks were instructed to discontinue the practice when wide spread criticism mounted on charging of mark-up over mark-up in case of default as it was considered incompatible with Islamic teaching. Other modes of financing specified in the State Bank circular were as follows: loans free of interest but carrying a service charge; Qard Hasan (loans given on compassionate grounds free of interest and repayable if and when the borrower is able to pay); purchase of trade bills on the basis of mark-down or mark-up in price; purchase of moveable property by the banks from their clients with buy-back agreement or otherwise; leasing; hire-purchase; financing for development of property on the basis of a development charge; Musharaka; equity participation and purchase of participation term certificates and Maharaja certificates; and rent-sharing in the case of housing finance (Ibid, p.70).1.3 Legislation
Mudaraba technique of financing was introduced as a result of enactment of the law “Mudaraba Companies and Mudaraba (Floatation and Control) Ordinance” in June 1980 followed up by issuance of implementation regulations in January 1981. Companies, banks, and other financial institutions, under this law, can register themselves as Mudaraba companies and mobilize funds through the issuance of Mudaraba certificates. Funds so mobilized are restricted for use in only such businesses which are permitted in Shariah requiring prior clearance from a religious board established by the government. The law safeguards the interest of the Mudaraba certificate holders by mandating quicker and simpler adjudication of disputed matters by a tribunal specially set up for this purpose. Moreover, the law provides a condition that the auditors will certify that the business conducted by the Mudaraba Company is in accordance with the objects, terms and conditions of the Mudaraba. Promulgation of the Mudaraba law paved the way for new type of financial instrument in the form of Mudaraba certificates and helped in broadening the dimensions of the newly emerging Islamic financial market.
Contending that the existing legal framework in the country could not adequately protect the banks against undue delays and defaults, the government enacted a law called Banking Tribunal Ordinance in 1984. According to this ordinance 12 banking tribunals with specific territorial jurisdictions, and each headed by a high-ranking judge to be appointed by the government and required to dispose of all cases within 90 days of the filing of the complaint, were to be set up. The law also provided for an appeal procedure under which the verdict of a tribunal could be appealed to the High Courts within 30 days.

Non-Banks within Pakistan

Prior to Islamisation of banking, investment companies in Pakistan offered an outlet for long-term funds generated in the economy. They invested in common shares and in long-term debt. As a result of the move to interest-less finance they exchanged the interest-bearing debentures they owned for common shares of the same companies. They thereby became fully-equity-based but were free to acquire Participation Term Certificates (PTC) a new kind of financial instrument developed on the basis of Musharaka. Ownership of their shares is legal for banks and other intermediaries, as well as individuals. New close-end companies formed in the future will add to the amount of long term funds available in the economy, and all companies of this type, old or new, will compete with commercial banks for the available supply of PTCs.

a) Islamisation of Commercial Banking in Pakistan

The Islamisation of the banking system of Pakistan applies only to the domestic activities of its commercial banks: their foreign branches were free to accept deposits and make loans at interest. In their dealings within Pakistan, each of the 17 exchange banks were required to operate under Islamic codes of finance, following regulations of the State Bank of Pakistan.

b) Commercial Banks as Intermediaries

Under the new banking arrangement, commercial banks are to accept funds on a no-interest basis, subject to withdrawal by cheque, and return of the principal amount of each deposit is guaranteed. For services provided in maintaining chequing accounts and in meeting customer needs for other services banks are to charge fees to recover administrative costs. In the case of allowing overdraft, it is required to be interest-free. The argument is that overdrafts allowed to current borrowers or to current account holders to enable them to meet the unspecified needs or in cases of genuine hardship are really benevolent loans.

On funds deposited into PLS accounts, banks participate in profit/loss outcomes with their depositors according to ratios stated in the contracts between depositors and banks. The percentage of profit/loss taken by the bank is supervised by the State Bank of Pakistan, which has the authority to reduce the ratio(s) in effect at a bank. For itself and the depositors, the bank negotiates a sharing of the profit/loss on the use of funds provided to users. This sharing must not be stated as interest or in a form that may be interpreted as interest; for example, the bank may not be guaranteed a stated amount or rate of return regardless of how successfully the funds were used. The share allocated to it and its depositors must always be related to the amount of profit/loss resulting from the use of funds provided (Harrington 1994, p.183).

In addition to funds provided for their depositors, banks also invest their own funds in loans provided to their customers. Banks thereby participate in the profit/loss results of their use, receiving the same proportionate results per unit of capital provided as their capital accounts do (Ibid, p.183).

i) Financing and Credit Operation of Banks

While bank liabilities (other than foreign currency deposits) are composed of either current account deposits, on which the bank distributes no profit, or PLS deposits, three broad categories of non-interest modes of financing have been allowed to guide banks’ asset operations. First, there is financing by lending, that is, loans not carrying interest, on which banks may recover a service charge, and Qard Hasan (interest-free loans on compassionate grounds). Second, there is trade related financing, including mark-up, purchase of trade bills, lending on a buy-back basis, leasing, hire purchase, and financing for development of property on the basis of a development charge. The State Bank of Pakistan fixes minimum and maximum rates of charges from time to time. Third, lending can take place under investment financing, including Musharaka, equity participation and purchase of shares, participation term certificates, Mudaraba certificates, and rent sharing. While the State of Bank of Pakistan determines the ratio for sharing profits, losses are proportionately shared among all the financiers.

ii) Participation Term Certificates

A Participation Term Certificate (PTC) is a transferable corporate instrument with a maximum maturity of ten years and allows for a temporary partnership or Musharaka. It is a financial arrangement between a financial institution and the business entity on the basis of profit-loss sharing over the maturity period of the certificate. It was introduced as an alternative to a debenture (which typically carries a fixed rate of return) for raising medium term financial resources. Conceptually, since the financial and economic relationship envisaged under PTCs is that of a partner in a business venture, portfolio selection for the banks requires extensive knowledge and experience with business involved. Funds under a typical PTC arrangement may be obtained either from a single institution or from a consortium. The business entity is expected to pay to the financial institution or bank, provisionally on a semi-annual basis, an agreed percentage of anticipated profits with a provision for final adjustment at the end of the financial year. In the event of loss, the financial institution shall refund the share of profit that it had received on a provisional basis. However, the loss sustained by an entity in any accounting year will first be adjusted against the reserves of the company, and the remaining loss, if any, shall be covered in the subsequent years by the two parties in agreed proportions. The financial institution is also permitted to convert up to 20 percent of the principal amount of the PTCs into ordinary shares at par value, so long as funds against PTCs are outstanding. Lending is secured by a legal mortgage on the fixed assets of the company.

So far, the specialized credit institutions, including the Bankers’ Equity Limited and the Investment Corporation of Pakistan, have handled most PTC operations. PTCs can be traded on the capital market.

iii) Application of Musharaka in Pakistan

Like PTCs, no statutory definition of Musharaka has been specified. However, a Musharaka contract is bilateral between the financial institution and the user of the funds. Moreover, Musharaka contracts are not negotiable instruments and can be traded like the financial assets on the capital market. While Musharaka companies typically provide long-term capital for industrial investment, they have so far been used to fund the working capital requirements of the industrial and trade sectors not as a loan but as a cash credit or overdraft account in which operations could be carried out by depositing and withdrawing of funds. Musharaka companies are deemed to be temporary partnership under which the commercial bank and the client share in the profit or loss generated by the working capital supplied by each to the project. In practice, the profit sharing arrangement is drawn up on the basis of future profit projections that, in turn, are based on past averages, duly adjusted according to the future plans and projections and overall state of the economy and industry in which the firm operates. The client, for his managerial responsibilities, receives an agreed proportion of projected profits from the partnership, with he balance divided between the bank and the client in a mutually agreed ratio within the maximum and minimum ratios laid down by the State Bank of Pakistan. If a loss results, it is to be shared by the client and the bank in the ratio of their contributions to the funds employed in the project.

iv) Mudaraba as Applied in Pakistan

Under the law authorizing the establishment of Mudaraba companies, Mudaraba can be floated to meet the term-financing needs of the private sectors. Under this arrangement, subscribers participate with their funds, and the manager of funds, with his efforts and skills. Profits on investments made out of Mudaraba funds are distributed among the subscribers on the basis of their contribution, the manager of the fund earning a fee for his services. Conceptually, a Mudaraba is an investment fund for which resources are obtained through the sale of certificates to subscribers. Commercial banks can serve either as managers or as subscribers. There can be two types of Mudaraba: multi-purpose, that is, a Mudaraba having more than one specific purpose or objective, and specific purpose. All Mudarabas, however, are independent of each other and none is responsible for the liabilities of, nor is entitled to benefit from the assets of any other Mudaraba or of the Mudaraba Company. The companies are subject to comprehensive regulations and safeguards under the Mudaraba Company Law including the requirements that (a) each must subscribe at least 10 per cent of the total amount of Mudaraba certificates offered for subscription, and (b) certificate holders must be provided detailed balance-sheets and profit and loss statements of the company at specified intervals.

So far Mudaraba have been managed primarily by the specialized credit institutions, specially the Bankers’ Equity Limited, and have been for specific purposes. The first Mudaraba Company in the private sector was incorporated in November 1982 and floated its first Mudaraba enterprise in early 1985, valued at Rs 25 million. Mudaraba certificates are traded and quoted on the stock exchange.

v) Application of Mark-up in Pakistan

When financing on a PLS-basis is not feasible owing to difficulties in determining profits or the short-term maturity of funds required, banks have been authorized to lend on the basis of mark-up. Under this arrangement, the margin of profit or mark-up to the seller is mutually agreed upon between the buyer and the seller in advance. The bank arranges for the purchase of the goods requested by the customer and sells them to him on the basis of cost plus the agreed profit margin. The payment is deferred and is made either in lump sum or in installments over a specified period. The mark-up is mutually agreed but must be within the minimum and maximum rates specified by the State Bank of Pakistan. The mode is of short-term in nature and oriented towards financing domestic and import trade, as well as financing input requirements.
While banks are authorized to charge a mark-up within the limits specified by the State Bank of Pakistan, they cannot charge mark-up on mark-up in the event of delays in repayment; mark-up on mark-up is viewed as interest.

vi) Choice of Instruments

Although modes of financing are to be determined by agreement between the bank and the client, the authorities recommended certain preferred combinations of modes and types of transactions. Financing for trade and commerce, which is primarily short term, should be handled through mark-up and markdown operations, and through trade and loan on commissions and service charges. Fixed investment in industry, trade and commerce is to be financed through Musharaka, PTCs, leasing, and hire purchase; working capital requirements are to be met through Musharaka and mark-up. Given the varied nature of financing requirements in agriculture, modes available for this sector cover a broader spectrum than in other sectors. While short-term financing is to be provided largely on a mark-up basis, the choice of medium-term and long-term lending modes will depend on the purpose. Leasing and hire purchase are to be the primary instruments for purchase of machinery and equipment, and for dairy and poultry needs. Financing for land, forestry, etc., could be on the basis of development charges, mark-up or PLS modes, depending on the nature of development undertaken. Advances for housing are to be on a rent-sharing basis with flexible weights to banks’ funds, or on a buy-back and mark-up basis; personal advances for consumers durable are to be on a hire-purchase basis. For purchasing consumer products, financing would be solely against tangible security with buy-back arrangements. Basis of financing in Pakistan against types of activity is grouped in Table-1 as below:

Central Banking and Monetary Policy in Pakistan

(a) Functioning of the Central Bank

The Federal Shariah Court judgment does not directly impugn the functioning of the State Bank of Pakistan except for section 22(1) of the State Bank of Pakistan Act, 1956. But this apparently minor repugnance to Shariah involves the most important role of the central bank that governs interest rate chargeable by all the financial institutions in the country, it cannot remain unconcerned with the judgment relating to:

Negotiable Instrument Act XXVI of 1981.
Agricultural Development Bank Rules, 1961.
Banking Companies Ordinance (LVII of 1962).
Banks (Nationalization) Payment of Compensation Rules, 1974.
Banking Company (Recovery of Loans) Ordinance (XIX of 1979).

The court has declared that the sections in the above laws or rules involve charging of interest or mark-up which, according to the court, resemble interest. Interest rate is governed by the bank rate. Mark-up is one of the modes of financing which the State Bank recommended to the banks (Hasanuzzaman 1994, p.197).

(b) Rates of Return and Charges

Rates of return on deposits and charges on bank financing, including profit sharing ratios, are ultimately to be determined by market forces. However, to ensure an orderly transition from the previous system, in which interest rates were closely regulated, the new system provides for a methodology to determine rates of return on PLS deposits and also lays down maximum and minimum charges for various types financing modes; banks and clients are free to negotiate charges within these limits.

Banks and other financial institutions receiving PLS deposits are required to declare rates of profit on various types of liabilities, including PLS deposits on half-yearly basis with prior authorization of the State Bank of Pakistan. To protect the interest of both borrowers and lenders, the State Bank of Pakistan is empowered to establish ranges within which financial institutions, including banks and specialized credit institutions, and borrowers would be permitted to negotiate rates of charges and profit-sharing ratios. The determination of these ranges is also guided by considerations relating to sectoral credit allocation priorities and the need to minimize dislocations arising out of a sharp change in the cost of funding for borrowers. Therefore, the concern so far has been to keep the costs of funding as close to those under the interest-based system as possible, while allowing market forces a greater role.

For financing by lending, where loans do not carry interest, banks may recover a service charge not exceeding the proportionate cost of the operation, excluding the cost of funds, provision for bad and doubtful debts, Qard Hasana and income taxation. The State Bank of Pakistan also specifies ranges of profit that should guide banks and the specialized institutions in their lending operations under both trade-related and investment-type modes of financing. Under the interest-based system, ceiling rates were specified for a wide variety of loan operations; under the new system considerable flexibility is given to the banks and the clients. Despite this flexibility, a large proportion of financing, according to banks, has so far been provided at about the same cost as under the previous system.

Achievements and Failures in Islamising the Banking System of Pakistan

Pakistan initiated a process of the Islamisation of its financial system in 1979. Though the financial system of the country had undergone significant changes since then, the process of Islamisation is yet to take its full course. The measures adopted for this purpose have been characterized by a number of shortcomings and deficiencies. The Federal Shariah Court in November 1991 declared that a number of existing financial laws and practices were repugnant to the injunctions of Islam and called upon the government and other concerned agencies to take appropriate measures to bring them in conformity with the Islamic tenets by the end of 1992.

Over a decade passed away by now that the first step towards Islamisation of the financial system of Pakistan was put forward. The period 1979 to 1985 saw a fairly active policy on the part of the government to Islamise the financial system. The original intention of the government was to eliminate interest from all domestic banking and financial transactions within a period of three years beginning from February 10, 1979. It appears that the time frame was not practicable yet the government was earnest to move speedily towards attaining the goal of an interest-free economy. It has been mentioned that a parallel system was introduced in which savers had the option to keep their savings with interest-bearing mechanism or in profit-loss sharing savings scheme. In June 1984, it was announced by the government that the parallel system would end in course of 1984-85 in so far as operation of commercial banks and other financial institutions were concerned. All banking companies were actually forbidden to accept any interest-bearing deposits as from July 1, 1985, except foreign currency deposits. Banks were also instructed to invest their PLS deposits only in interest-free avenues of investment and financing. Serious consideration was seemingly being given to the issue of eliminating interest from government transactions in 1984-85 as the then finance minister stated in his budget speech that the government proposed to consult scholars on the subject. However, the matter was not pursued vigorously and the movement towards a completely interest-free economy lost its dynamism and even its sense of direction after 1984-85 (Z. Ahmed 1994, pp.71-72).
The movement towards an interest-free economy suffered a setback when in August 1985 banks were allowed to invest even their PLS deposits in interest-bearing government securities. The present position is that the return on PLS deposits contains a substantial element of interest. Since 1984-85, there has been no policy pronouncement as regards elimination of interest from government transactions. To achieve the goal of interest-free economy it is necessary that government should end its dependence on interest-based borrowing. There are no indications so far this aspect has been given due consideration in formulating government budgetary and other policies. In fact, instead of reducing dependence on interest-based borrowing there has been increased resort to such borrowing in recent years.

The Islamisation in the field of banking and finance in Pakistan has been marked by another serious deficiency in that no institutional mechanism exists for a continuous scrutiny of the operating procedures of banks and other financial institutions from the Shariah points of view. Individual scholars examining these operating procedures have pointed out several areas where the actual banking practices show deviation from Shariah even in the case of modes of financing. Thus, even Musharaka agreements, which banks ask their clients to sign, contain features that have been called into question by several commentators. The provision, for example, that in the event of a company suffering a loss in any accounting year, it would be first adjusted against the existing reserves of the company has been found inconsistent with the spirit of the Shariah.

Although the idea of floating PTCs was fine, no legislative framework was provided for standardizing the features of this new financial instrument in the light of principles of Shariah. The CII report had provided a broad outline of the features of such financial institutions but the actual form in which PTCs have been issued does not fully conform to the suggested outline. Some features of PTCs as introduced by certain financial institutions have been widely criticized as being inconsistent with the requirements of Shariah. Provisions made for payment of a pre-production discount rate during the gestation period of a project and the stipulation of the share of profit, equivalent to a percentage of the outstanding PTC funds, have evoked strong criticism in this respect.

Among the 12 modes of financing allowed by the State Bank to replace interest-based lending, banks have made predominant use of what has popularly come to be known as mark-up financing. Mark-up financing has taken two main forms. The first form is similar to Mudaraba financing being practiced by a number of Islamic banks in other countries. Under this form, a transaction takes place in the following manner:

a) The client approaches the bank with the request to purchase for him certain specified goods;
b) The bank makes the purchase;
c) The bank sells these goods to the client at a price, which includes a mark-up over the cost of
the goods and agrees to receive payment at a future date in lump sum or in installments; and
d) The client pays the amount due as agreed in lump sum or in installments and the
transaction comes to an end.

The second form involves a buy-back agreement. The practice followed is that a client sells his goods to the bank for cash and simultaneously buys back the same goods from the bank at a higher mark-up price payable at a future date either in lump or in installments. The second form of mark-up financing has been severely criticized by scholars well versed in Shariah and the Federal Shariah Court in its judgment has held it to be manifestly against the Islamic teaching.

Though it is generally agreed that Mudaraba and Musharaka are the ideal substitutes for interest in an Islamic economy, no special efforts have been made to accord prominence to them in the policies adopted. This seems to have given rise to an attitude of passivity on the part of the banks and led them to use mostly such modes of finance, like mark-up, that are more akin to interest-based banking and require the least modifications in the old lending procedures.

The liability side of the banking system has undergone a comprehensive change since the introduction of interest-free banking in Pakistan. Saving and time deposits no longer earn a fixed return. Banks declare profits payable on these deposits at six-monthly intervals based on their operating results and these vary from period to period and from bank to bank. The rates of profit are worked out by a formula that determines net profit accruing to a bank and allocates them to the remunerable liabilities according to their maturities. Allocations are based on differential weights assigned to liabilities according to their maturities. The system has in general been found to be compatible with Islamic teachings except that, as mentioned earlier, profits declared by banks contain a substantial element of interest.

Experts in Shariah and other writers on Islamic banking have identified certain other challenging features of the present state of the Islamisation of banking in Pakistan that also deserve attention. Some of the observations as reported by Ziauddin Ahmed are as follows:

"A tendency seems to have developed to replace PTCs by TFCs (term finance certificates). As against PTCs, which are based on the concept of Musharaka, TFCs are based on a system of fixed mark-up. This has been considered a retrograde step as the objective should be to expand profit-loss sharing modes of finance rather than to restrict them further".

Financial institutions undertaking leasing business are making greater use of financing lease than of operating leases. Experts in Shariah consider financing leases to be incompatible with Islamic teaching.

Many 'development finance institutions' (DFIs) are mobilizing savings through schemes that give returns, which are hardly distinguishable from interest. Grey areas are developing even in the operation of institutions like National Investment Trust, which were previously thought of having eliminated interest completely. It seems that there is no agency to oversee the working of the various schemes being employed by DFIs to mobilize savings from the viewpoint of Shariah.

Lately, the State Bank of Pakistan has laid down the minimum and maximum rates of profit a bank can share in the case of Musharaka or purchase of PTCs or Mudaraba certificates. Experts in Shariah consider such a stipulation incompatible with Islamic teachings. Due attention has not been paid to eliminate un-Islamic features characterizing the operations of several constituents of money and capital market in Pakistan other than banks and DFIs. Nothing has been done so far, for example, to reform the insurance business and the stock exchange operations in the light of Islamic teaching.