Islamic Banking and Profitabiltiy in Pakistan

1. Introduction

In the last two decades, Islamic banks have grown in size and number around the world. Islamic banks operate in over 60 countries, but in Iran, Pakistan and Sudan, the entire system has been converted to Islamic banking. In other countries, banking systems are dominated by secular/conventional banking institutions operating parallel to Islamic banks, yet Islamic banking is the fastest growing segment of the credit market in Muslim countries (that have Islamic banks). Since the 1970’s, their market share has risen from 2% to about 15% today as measured by assets in the banking system. The market’s current annual turnover is estimated to be $70 billion, compared with a mere $5 billion in 1985, and was projected to hit the $100 billion mark by 2000. This trend began with the oil booms of the 1970’s and 1980’s, but now Islamic banks are generally the product of private initiative in non-oil-exporting countries .

It is therefore imperative to study the growth of this sector in Pakistan and how it is affecting profitability of the banking sector since this has far reaching implications on its implementability and sustainability in the emerging financial services sector in Pakistan

1.1 Background: The Evolution of the Pakistani Banking Sector

Islamic banking is a financial innovation, and has come to be seen as the most 'visible' aspect of Islamization. In Pakistan it was introduced with the wave of Islamization in the mid eighties and finally in December 1999, the Supreme Court banned riba in banks, saying it was not in the spirit of Islam (Hassan, 2002). The Islamic financial system is founded on the absolute prohibition of the payment or receipt of any predetermined, guaranteed rate of return. This closes the door to the concept of interest and precludes the use of debt-based instruments. The system encourages risk-sharing, promotes entrepreneurship, discourages speculative behavior, and emphasizes the sanctity of contracts. Islamic law prohibits the act of Riba, which literally means an excess or an increase. The prevailing interpretation of this is that interest is prohibited, though there are Islamic economists who argue that this refers to the ancient tradition of doubling the principal once an individual defaults. But for the purposes of this paper, we will work with the prevailing interpretation that interest is prohibited. The implications for the banking sector if interest is prohibited are that all debt contracts would be unlawful, and that financial instruments should emphasize on profit and loss sharing (equity).

The Pakistani experience differs from the others in that Pakistan had opted for a gradual islamization process which began in l979. In the first phase, which ended on l January l985, domestic banks operated both interest-free and interest-based 'windows'. In the second phase of the transformation process, the banking system was geared to operate all transactions on the basis of no interest, the only exceptions being foreign currency deposits, foreign loans and government debts. The Pakistani model took care to ensure that the new modes of financing did not upset the basic functioning and structure of the banking system. This and the gradual pace of transition, according to Hardy and di Patti (2001), made it easier for the Pakistani banks to adapt to the new system . The rate of return on profit-and-loss sharing (PLS) deposits appears not only to have been in general higher than the interest rate before islamization but also to have varied between banks, the differential indicating the degree of competition in the banking industry. The authors noted that the PLS system and the new modes of financing had accorded considerable flexibility to banks and their clients. Once again the study concluded that the effectiveness of monetary policy in Pakistan was not impaired by the changeover .

The IMF, however, expressed considerable uneasiness about the concentration of bank assets on short-term trade credits rather than on long-term financing. This was found to be undesirable by many analysts, not only because it is inconsistent with the intentions of the new system, but also because the heavy concentration on a few assets might increase risks and destabilize the asset portfolios .

Non-Islamic banks operating in Muslim countries are able to offer debt contracts involving interest to firms. Even in countries that have claimed to Islamized their banking systems, such as Pakistan, there are legal loopholes which allow them to work around this problem, creating a parallel banking and monetary structure, complementing the traditional banking sector. The creation of such vibrant sub-economies, in the view of Kuran (1995), does not create inefficiencies within the banking sector (it offers services of an ecclesiastical