Growth Opportunities For Islamic Banking in Pakistan

GROWTH OPPORTUNITIES FOR ISLAMIC BANKING IN PAKISTAN
A dissertation submitted in partial fulfillment of the requirements for the Degree of Master of Business Administration
by Salma Khand
Department of Management Sciences Faculty of Computer & Management Sciences Isra University, Hyderabad October 2010
GROWTH OPPORTUNITIES FOR ISLAMIC BANKING IN PAKISTAN
by Salma Khand
Examination Committee
Dr. Asandas Manwani (Supervisor) Professor of Management Sciences Mr. Najeeb Hassan Brohi (Member) Assistant Professor of Management Sciences Mr. Qamaruddin Mahar (Member) Assistant Professor of Management Sciences
ACKNOWLEDGEMENT
I humbly and sincerely thank Almighty Allah, Who bestowed upon me the potential and ability to accomplish my goal successfully. I find no words to express my deepest regards indebted to my dissertation supervisor Professor Dr. Asandas Manwani, for his scholarly guidance, cordial encouragement and giving his priceless time. I am also indebted to Professor Dr. Ghulam Hussain Siddiqi, Director Research, Extension and Advisory Services, for his interest in present study. I wish to express sincere gratitude to my co-supervisors Najeeb Hassan Brohi, Assistant Professor, Department of Management Sciences, Isra University Hyderabad and Qamaruddin Mehar, Assistant Professor, Department of
Management Sciences, Isra University Hyderabad for their help in the planning of the study. I am also indebted to professor Dr. Muhammad Iqbal Bhatti, Dean Faculty of Computer and Management Sciences, for providing his valuable and inspiring guidance during the completion of this dissertation and to Mr. Nizamuddin Memon, Controller of Examinations for his support at times when I needed extra guidance. I am also thankful to my parents, teachers and friends for their full cooperation to me during completion of my task especially to Madam Shabina Sheikh Thanks to Madam Nazia shah as well, who has corrected the manuscript of dissertation. Lastly, a special thanks to my father whose existence is a blessing for me and due to his help I was able to complete my thesis in an excellent manner and on time.
In the last but not the least, I thank Mr. Tariq Samo for his expertise in formatting the write up of this dissertation according to the requirements of Isra University.
ABSTRACT
Present study was conducted to find out the future growth opportunities for Islamic Banking System in Pakistan. For this purpose secondary data collected through various sources was analyzed. The important findings of this study are as follows: The Islamic Banking industry has grown manifold since 2007 and presently it contributes more than 6 % of the banking system in Pakistan. The high growth rate maintained by Islamic Banks in Pakistan indicates growing acceptability of Islamic Banking System as a commercial option for the different stake holders. Total branch network of the industry has also increased from 651 in Dec 2009 to 667 branches in June 2010 with presence in over 84 cities & towns covering all the four provinces, Azad Kashmir, Northern areas and Federal capital. The high growth trends in various components of Islamic banks balance sheet has enabled the Islamic Banks to make further inroads in the overall banking industry in Pakistan. The total assets of Islamic banking institutions (IBIs) in June 2010 compared to June 2009, has increased by Rs. 98 billion, showing an impressive growth of 31%. The deposits spearheaded the growth with 39% increase during the same period. Comparison of the annual financial statements for Meezan Bank Ltd. and Bank Islami Pakistan Ltd. show that both these banks earned appreciable growth in the overall revenues and income in core banking activities, especially in net spread before provisions. Bank Islami in comparison to Meezan bank achieved highest percentage of income from dealing in foreign currencies. However, due to excessive administrative and other expenses owing to branch network expansion by this bank, the bank has
recorded loss after tax. Both the banks also showed increase in total assets including Financing-Net & investments and total liabilities including deposits and other accounts. The Share holders Equity including reserves and share capital was higher for Meezan Bank compared to the Bank Islami. On the basis of the data available, certain
areas/sectors like large unbanked population in rural and semi-rural areas, large unserved agriculture sector and the SME sector have been identified which need to be explored extensively for achieving better growth prospectus for Islamic Banking in Pakistan:
ABBREVIATIONS
Abbreviation Term
AAOIF------------------------Accounting and Auditing Organization for Islamic Financial Institutions ATMs-----------------------------------------------------------Automated Teller Machine BMA-------------------------------------------------------------Bahrain Monetary Agency BNM-----------------------------------------------------------------Bank Negara Malaysia CII--------------------------------------------------------------Council of Islamic Ideology DM------------------------------------------------------------------Diminishing Musharaka GOP---------------------------------------------------------------Government of Pakistan HBFC---------------------------------------------House Building Finance Cooperation IBBs-------------------------------------------------------------Islamic banking branches IBIs-------------------------------------------------------------Islamic banking institutions IBs-------------------------------------------------------------------------------Islamic banks ICP-------------------------------------------------Investment Cooperation of Pakistan IIFM----------------------------------------------International Islamic Financial Market KIBOR------------------------------------------------------Karachi Interbank Offer Rate LMC--------------------------------------------------------Liquidity Management Centre LME---------------------------------------------------------------London Metal Exchange MCB-------------------------------------------------------------Muslim Commercial Bank MoU -----------------------------------------------------memorandum of understanding NCB------------------------------------------------------------National Commercial Bank NIT---------------------------------------------------------------National Investment Trust NPAs----------------------------------------------------------------Nonperforming Assets NPFs-----------------------------------------------------------Nonperforming Financings PACRA ---------------------------------------Pakistan Credit Rating Agency Limited PIRI------Prudential Information and Regulatory Framework for Islamic Banks PLS-----------------------------------------------------------------Profit and Loss Sharing PTCs------------------------------------------------------Participation Term Certificates QoQ----------------------------------------------------------------------Quarter To Quarter SBP-----------------------------------------------------------------State Bank of Pakistan SECP---------------------------Securities and Exchange Commission of Pakistan SME-------------------------------------------------------Small and medium enterprises YoY -----------------------------------------------------------------------------Year To Year
TABLE OF CONTENTS
Page
ACKNOWLEDGEMENTS --------------------------------------------------ABSTRACT---------------------------------------------------------------------ABBREVIATIONS-------------------------------------------------------------TABLE OF CONTENTS -----------------------------------------------------LIST OF TABLES -------------------------------------------------------------LIST OF FIGURES -----------------------------------------------------------CHAPTER I INTRODUCTION ------------------------------------------1. Definition of Islamic banking -------------------------------------------2. Philosophy of Islamic Banking-----------------------------------------3. Factors of Production in Conventional Economics----------------4. Difference between Islamic and Conventional Banking---------5. Problem Definition---------------------------------------------------------6. Objectives of the Study -------------------------------------------------7. Research Methodology--------------------------------------------------8. Scope of the Research Study------------------------------------------9. Limitations of The Research Study-----------------------------------10. Organization of The Study----------------------------------------------CHAPTER II REVIEW OF LITRATURE-----------------------------------1. Economic System in Islam ---------------------------------------------2. Concept of Interest in Islam --------------------------------------------3. Global Scenario of Islamic Banking ----------------------------------4. Islamic Banking in Pakistan --------------------------------------------4.1 Accounts, financing & lending process of islamic banking ----------------------------------------------------------------5. Advantages of Islamic Banking ---------------------------------------6. Benefits of Islamic Banking --------------------------------------------7. Growth and Prospects of Islamic Banking -------------------------8. Future of Islamic Banking-----------------------------------------------9. Survival of Islamic Banking---------------------------------------------10. Standardization of Islamic Financial Products---------------------11. Possible Solutions to Problems Faced by Islamic Banking------
iii v vii viii xi xii 1 1 1 3 4 7 7 7 8 9 10
11 11 11 12 14 14 15 17 18 19 19 20 20
CHAPTER III DEVELOPMENT OF ISLAMIC BANKING SYSTEM IN PAKISTAN-----------------------------------------------------------------------1. Islamic Banking at Global Level--------------------------------------2. Development of Islamic Banking System in Pakistan-----------3. Major Modes of Islamic Banking and Finance--------------------3.1 Murabaha--------------------------------------------------------------3.2 Ijarah--------------------------------------------------------------------3.3 Ijarah-Wal-Iqtina-----------------------------------------------------3.4 Musawamah----------------------------------------------------------3.5 Istisna-------------------------------------------------------------------3.6 Bai Muajjal-------------------------------------------------------------3.7 Mudarabah------------------------------------------------------------3.8 Musharakah-----------------------------------------------------------3.9 Bai Salam--------------------------------------------------------------4. Role of Islamic Banking in Economic Development-------------CHAPTER IV GROWTH OF ISLAMIC BANKING IN PAKISTAN 1. OBJECTIVE 1: Growth Pattern of Islamic Banking System in Pakistan----------------------------------------------------------------------1.1 Current status of Islamic banking in Pakistan-----------------1.2 Industry progress and market share-----------------------------1.3 Performance indicators of Islamic banks-----------------------1.4 Non-performing financing and assets---------------------------1.5 Financing mix----------------------------------------------------------1.6 Investments------------------------------------------------------------1.7 Deposits----------------------------------------------------------------2. OBJECTIVE 2: Growth Pattern of Two Full-Fledged Islamic Banks in Pakistan---------------------------------------------------------2.1 Growth Pattern of Meezan Bank---------------------------------2.1.1 Analysis of financial statements of Meezan Bank Limited------------------------------------------------------------------2.2 Growth Pattern of Bank Islami-----------------------------------2.2.1 Analysis of financial statements of Bank Islami Limited------------------------------------------------------------------3. OBJECTIVE 3: Areas and Products Which Need to be Exploited---------------------------------------------------------------------3.1 Large un-banked population--------------------------------------3.2 Large un-served agriculture sector-----------------------------3.3 The SME sector-------------------------------------------------------
23 23 27 33 33 34 34 34 35 35 36 36 36 37
41 42 42 46 48 49 51 52 53 53 54 59 60 64 65 65 66
CHAPTER V - RESULTS AND DISCUSSION--------------------------- 67
1. 2. 3. 4.
Result and conclusion of objective1----------------------------------Result and conclusion of objective2----------------------------------Result and conclusion of objective3----------------------------------Future Challenges for Islamic Banking & Finance ---------------4.1 Financial innovation in critical areas----------------------------4.2 Competition------------------------------------------------------------4.3 Misuse of Islamic Banking-----------------------------------------4.4 Other challenges for Islamic banking ---------------------------
68 68 73 75 75 75 76 76
CHAPTER VI-RECOMMENDATIONS ---------------------------------------1. General recommendation for Islamic Banking system---------2. Recommendation for Meezan and bank Islami--------------------3. Recommendation for further study------------------------------------REFERENCES -----------------------------------------------------------------
77 77 77 78 79
LIST OF TABLES
Table
I-1 Main differences between conventional banks and islamic banks ------------------------------------------------------------------------Meezan Bank branch network-----------------------------------------Bank Islami branch network--------------------------------------------Industry progress and market share--------------------------------Performance indicators -------------------------------------------------Non-performing financing & assets----------------------------------Financing mix--------------------------------------------------------------Investments----------------------------------------------------------------Profits & loss account of Meezan Bank Ltd. financial year 2007-09---------------------------------------------------------------------Financial Positions of Meezan Bank Ltd. financial year 2007-09----------------------------------------------------------------------Profit & Loss Account of Bank Islami Ltd. financial year
Page
05 09 09 43 47 48 50 51
I-2 I-3 IV- 1 IV-2 IV-3 IV-4 IV-5 IV-6
56
IV-7
57
IV-8
2007-09----------------------------------------------------------------------IV-9 Financial Positions of Bank Islami Ltd. financial year 2007-09----------------------------------------------------------------------V-1 Comparison of profit & loss account of Meezan Bank &BANK ISLAMI Ltd for the year 200809-------------------------------------V-2 Comparison of financial positions of Meezan Bank & BANK ISLAMI for the year 200809-------------------------------------------V-3 Comparison of profit & loss account of Meezan Bank &BANK ISLAMI for the Year 200708-------------------------------------------
61
62
69
70
71
V-4
Comparison of financial positions of Meezan Bank & BANK ISLAMI for the Year 200708-------------------------------------------
72
LIST OF FIGURES
Figure IV _ 1 IV_ 2 Share and growth of Islamic Banking --------------------------Compositions of deposits-------------------------------------------
Page 44 52
CHAPTER I
INTRODUCTION 1. Definition of Islamic Banking
Islamic banking has been defined as banking in consonance with the ethos and value system of Islam and governed, in addition to the conventional good governance and risk management rules, by the principles laid down by Islamic Shariah. Interest free banking is a narrow concept denoting a number of banking instruments or operations, which avoid interest. Islamic banking, the more general term is expected not only to avoid interest-based transactions, prohibited in the Islamic Shariah, but also to avoid unethical practices and participate actively in achieving the goals and objectives of an Islamic economy.
2. Philosophy of Islamic Banking

Islamic Shariah prohibits interest but it does not prohibit all gains on capital. It is only the increase stipulated or sought over the principal of a loan or debt that is prohibited. Islamic principles simply require that performance of capital should also be considered while rewarding the capital. The prohibition of a risk free return and permission of trading, as enshrined in the Verse 2:275 of the Holy Quran, makes the financial activities in an Islamic set-up real asset-backed with ability to cause value addition.
Islamic banking system is based on risk-sharing, owning and handling of physical goods, involvement in the process of trading, leasing and construction contracts using
various Islamic modes of finance. As such, Islamic banks deal with asset management for the purpose of income generation. They will have to prudently handle the unique risks involved in management of assets by adherence to best practices of corporate governance. Once the banks streams of Halal income, depositors will also receive stable and Halal income. The forms of businesses allowed by Islam at the time the Holy Quran was revealed included joint ventures based on sharing of risks & profits and provision of services through trading, both cash and credit, and leasing activities. In the Verse II:275, Allah the Almighty did not deny the apparent similarity between trade profit in credit sale and riba in loaning, but resolutely informed that Allah has permitted trade and prohibited riba. Profit has been recognized as reward for (use of) capital and Islam permits gainful deployment of surplus resources for enhancement of their value. However, along with the entitlement of profit, the liability of risk of loss on capital rests with the capital itself; no other factor can be made to bear the burden of the risk of loss. Financial transactions, in order to be permissible, should be associated with goods, services or benefits. At macro level, this feature of Islamic finance can be helpful in creating better discipline in conduct of fiscal and monetary policies. Besides trading, Islam allows leasing of assets and getting rentals against the usufruct taken by the lessee. All such things/assets corpus of which is not consumed with their use can be leased out against fixed rentals. The ownership in leased assets remains with the lessor who assumes risks and gets rewards of his ownership.
3. Factors of Production in Conventional Economics

In conventional economics factors of production are capital, land, labor, and entrepreneurship on which interest, rent, wages, and profit are respectively paid. Such payments are fixed in relation to time except the last one. In Islam interest is prohibited and other two payments rent and wages fall in same category termed as Ujrah which is used for both human resources per unit of time (wage) and depreciation of fixed assets (rent). Regarding profit generation it should be noted that profit is result of On the basis of natural process of growth without any effort or cost on part of owner. On the basis of merely demand and supply principle without any effort on part of owner of assets. On the basis of human efforts which increases the exchange value of asset. In Islamic economics labor and physical capital are used in production either on ujrah or on profit as the case may be, based on mode and style of ownership/management. Profit is closely associated with decision making and decision maker in Islamic economics is entrepreneur/ decision maker Profit is his net earnings (profit-labor charges). From Islamic point of view that actual factors of production are three instead of four i.e., Capital, Land & Labor as Entrepreneur is not considered as separate factor of production in Islam. In short Islam places the responsibility of taking the risk of loss on capital. The man who invests capital in a risk-bearing business enterprise shall have to take this risk.
4. Difference between Islamic and Conventional Banking

The key difference is that Islamic Banking is based on Shariah foundation. Thus, all the activities in Islamic banking are derived from the Shariah, which lead to the significant difference in many areas of the operations with conventional banking (Mehmood Z, 2005). The main differences between Islamic and Conventional banking are shown in Table I-1.
Table I-1: Main Differences between Conventional Banks and Islamic Banks Conventional Banks Islamic Banks
1. The functioning of conventional banks is based on man-made principles. 2. The investor is assured of a predetermined rate of interest.
1. The functioning of Islamic banks is based on the principles of Islamic Shariah. 2. In contrast, it promotes risk sharing between provider of capital and the user of funds. 3. It also aims at maximizing profit but subject to Shariah restrictions. 4. Islamic banks also perform function of Zakat collection. 5. Islamic banks participate in partnership business Hence understanding the customers business is prerequisite. 6. Islamic banks charge only a small amount of compensation which is later given to charity. 7. It gives due importance to the public interest. Its ultimate aim is to ensure growth with equity.
3. It aims at maximizing profit without any restriction. 4. It does not deal with Zakat. 5. Conventional banks lend money and get it back with addition of interest. 6. Various penalties are imposed on defaulters.
7. Banks focus on their own interest rather making any effort to ensure growth with equity.
8. For interest-based commercial banks, borrowing from the money market is relatively easier. 9. Since, income from the advances is fixed; it gives little importance to developing expertise in project appraisal and evaluations. 10. The conventional banks give greater emphasis on creditworthiness of the clients. 11. The status of a conventional bank in relation to its clients is that of creditor and debtors.
8. For the Islamic banks, it must be based on a Shariah approved underlying transaction. 9. Since, it shares profit and loss, the Islamic banks pay greater attention to developing project appraisal and evaluations. 10. The Islamic banks, on the other hand, give greater emphasis on the viability of the projects. 11. The status of Islamic bank in relation to its clients is that of partners, investors and trader, buyer and seller.
12. A conventional bank has to guarantee all its deposits.
12. Islamic bank can only guarantee deposits for deposit account, which is based on the principle of al-wadiah, however, in case the account is based on the Mudarabah concept, client have to share in a profit/loss position.
13. Conventional banking prices money.
13. Islamic banking prices goods and services which creates real wealth in the society.
14. Does not involve itself in trade and business.
14. Actively participates in trade and production.
15. Depositors get a fixed rate regardless of the banks profitability.
15. Profit is shared with the depositors, higher the banks profit, higher the depositors income.
Source: Mehmood, Z. (2005), Islamic Banking: A performance comparison of Islamic bank verses conventional bank in Pakistan
5. Problem Definition
Pakistan is an Islamic country where conventional banking system has been functioning since its inception. Such type of system has not brought overall benefits to the economy of the country. Therefore, Islamic Banking system was introduced in 2001 to boost up the economy. But it is observed that the growth of Islamic Banking is very slow. So, this research study finds the ways and means to improve the Islamic banking system in Pakistan.
6. Objectives of the Study

Following are the specific objectives of the present study: 1. To find out the growth prospectus of Islamic Banking system in Pakistan. 2. To compare the growth pattern of two full-fledged Islamic banks in Pakistan. 3. To identify the areas and products which need to be exploited to enhance the future growth prospectus for Islamic banks in Pakistan.
7. Research Methodology
This research study is conducted on secondary data and the material is collected from the following sources: Library of Isra University Library of University of Sindh, Jamshoro Library of State Bank of Pakistan, Karachi
Internet Meezan Bank Ltd. Bank Islami Pakistan Ltd. Books on Islamic Banking and Finance Various issues of Economic Survey of Pakistan Various national and international journals
8. Scope of the Research Study

This research study is based on the quarterly reports of the State Bank of Pakistan and the financial statements gathered from annual reports of Meezan bank Ltd and Bank Islami Pakistan Ltd. The branch network of Meezan bank Ltd and Bank Islami Pakistan Ltd are shown in Tables I-2 and I-3 respectively. Table I-2: Meezan Bank branch network MEEZAN BANK SOUTHERN REGION 79 CENTRAL REGION 74 NORTHERN REGION 48 TOTAL 201
Source: Meezan bank annual report, 2010 Table I-3: Bank Islami branch network BANK ISLAMI SINDH PUNJAB BALOCHISTAN NWFP AZAD KASHMIR 37 44 11 8 2 102 TOTAL
Source: Bank Islami annual report, 2010
9. Limitations of the Research Study

The research is being conducted through collection of primary and secondary data. Money and time are required in primary collection of data which creates finance hindrance. Therefore, this research is confined to secondary data.
10. Organization of the Study

The study covers six chapters. The first chapter gives introduction with the definition of problem, objectives, and research methodology. The second chapter is about review of literature. The third chapter describes the Islamic banking at global level and its development in Pakistan. The fourth chapter examines the findings based on objectives of the study. The fifth chapter focuses on the results and conclusions based on objectives of the study. The sixth chapter is about the recommendations.
CHAPTER II
LITERATURE REVIEW
1. Economic System in Islam
Khan M. S. & Mirakhor, A. (1992) stated that economics is one of the most important aspects, as every human being needs involvement in some kind of economic activity for survival. In Islam, Quran and the Sunnah provides complete guidance for economic behaviour and a blueprint for organization of an economic system. According to Dr. Ishrat Hussain (2004), the ultimate objectives of an Islamic economic system are achieving development, based on socio-economic justice, care and compassion for all, in terms of complete human personality. Tools used to achieve the socio-economic objectives of the Islamic economic system are the system of Zakat, prohibition of Riba (interest) and the Islamic Law of Inheritance. Prohibition of Riba is the main economic philosophy of Islam because according to Islam, all types of interest based transactions are haram.
1. Concept of Interest in Islam

Usmani, M.I.A. & Zubairi, Z. (2002) explained that the word Riba means
excess, increase or addition, which according to Shariah terminology means any excess compensation without due consideration. This definition of Riba is derived from the Quran and is unanimously accepted by all Islamic scholars. The meaning of Riba is clarified in the following verses of Quran: O, believers, fear Allah, and give up what is still due to you from interest (Riba), if you are true believers. If you do not do so, then take notice of war from Allah and His
Messenger. But, if you repent, you can have your principal. Neither should you commit injustice nor should you be subjected to it (Surah Al Baqra 278-279). Islam has categorically made a clear distinction between the excess in capital resulting from sale and excess resulting from interest .The first type of excess is allowed in Islam but the second type is forbidden and declared Haram.
3. Global Scenario of Islamic Banking

Kahf Monzer (2001) observed that the first Islamic bank Mit-Ghamr began its operations in Egypt more than four decades ago. This bank had operated between 1963 and 1967 and was closed down due to secularist government politics that branded the founders of such bank as 'people's enemies' Munawwar Iqbal et. al., (1999) reported that the first interest-free institution with 'bank' in its name, Nasser Social Bank, was also established in Egypt in 1971. The creation of this bank attracted the attention of businessmen who had surplus funds. Four years later, in 1975, Dubai Islamic Bank was established and became operational in Dubai, UAE. However, the most important development in Islamic Banking was the setting up of the IDB (Islamic Development Bank) in 1975. The ground work to establish IDB was initiated in December 1973, by a conference of Islamic Ministers in Jeddah, followed by a second conference of Finance Ministers in August 1974. Board of Governors met in July 1975 and by October 1975, the IDB started its function. The period between1975 to 1990 is considered as the most important time in the history for the Modern Islamic banking industry. During this period, the industry matured and was seen as the viable alternative to the conventional method of financial intermediation.
Sharah
compatible
products
were
successfully
launched.
With
the
development of several Islamic banks, the idea attracted the attention of countries such as Iran, Pakistan and Sudan which initiated efforts to establish Islamic banking at respective national level. Throughout the world, the last ten years have seen a surge of interest in the operational aspects of Islamic banking. Thus, a number of Islamic banks, financial institutions, and transactions have emerged all over the world. Recognizing the market potential of Islamic finance, an increasing number of Western banks and financial institutions have also begun providing portfolios, transactions, and instruments that are essentially non-interest based. The feasibility and viability of non-interest based financial transactions, instruments, institutions and systems have been impressive. Equally important has been the growth of scholarly interest in the subject. Today, Islamic financial institutions, in one form or the other, are working in about 75 countries of the world. The instruments used by Islamic financial institutions, both on assets and liabilities, have developed capital market transactions. In Malaysia, Pakistan, Bahrain and a few other countries of the Gulf, Islamic banks and financial institutions are working in parallel with the conventional banks and financial institutions.
4. Islamic Banking in Pakistan

Ahmad Imran (2003) described that in the late seventies, the process of Islamic banking started in Pakistan with the presidential order on September 29, 1977. According to that order the local Council of Islamic Ideology (CII) was asked to prepare a blueprint of interest free economic system. The council comprised of panelists of
bankers and economists submitted their report in February 1980, highlighting the various ways for eliminating the interest from the financial system of Pakistan. This report was a landmark in the efforts for Islamizing the banking system in Pakistan as it recommended elimination of interest from the operations of specialized financial institutions including House Building Finance Cooperation (HBFC), Investment Cooperation of Pakistan (ICP) and National Investment Trust (NIT) in July 1979 and that of the commercial banks during January 1981 to June 1985.
4.1. Accounts, Financing & Lending Process of Islamic Banking

Al-Jarhi M.A & Munawar Iqbal (2001) analysed that all Islamic banks generally have current, savings and investment accounts. These accounts are based on Mudarabah, Musharakah, or on Qard basis. The return on such deposits and the availability or otherwise of capital-guarantee is on the basis of underlying contract. Similarly, Islamic banks use various modes of Islamic finance on its financing side like Murabaha, Ijarah, Wakalah, Salam, Istisna etc. The features of these financing transactions are essentially based on the underlying mode of finance. The main forms of trade financing are mark-up, leasing, hire-purchase, sell-buyback and letter of credit.
5. Advantages of Islamic Banking

Moulana Ahmed Fazel (2010) has described the following advantages of Islamic Banking:
1. Islamic banking provides an alternative financing system that works upon the fair distribution of profit & loss.
2. As in any investment company, Islamic banking distributes the trading duties from the non-skilled and/ or those who do not have the time; to those whose function is professional management. 3. "Maslahah" (Public Utility and Benefit) of the Islamic society depends on the operation of an effective Islamic banking structure. This will enable the preservation of the bonds of Islamic love through mutual trade & co-operation. 4. The ultimate success of Islamic banking is not possible, unless each individual in every Islamic society obligates himself to all Islamic rulings. 5. Islamic banking brings economic empowerment in the areas of operation. It helps Muslim business persons, through financial aid, to remain competitive. It also leads towards the creation of job opportunities for Muslims as well as non-Muslims. 6. It is a basis for expansion into the Islamic Economic System, since the establishment of each new Islamic bank is actually creating a link for international interests to co-operate with others in the International web of Islamic banks. 7. It provides investors with flexibility in the types of accounts within which they could channel their investment. It thus links capital to labor and reduces expenditure to levels, related with the type of investment, the value thereof and its period. 8. Islamic banks enable the saving of monetary resources for the future use as shown by the episode of Yusuf (A.S.) in Quran. Hence, it is a methodology approved by Allah for the protection of wealth. 9. Sponsoring Islamic activity & the mobilization of resources for International Islamic Support will enable to provide:
relief to refugees and victims of war, etc
relief to victims of natural disasters
care and welfare to the poor, orphans and the needy humanitarian aid for educational and social services projects.
6. Benefits of Islamic Banking

Ahamed K.H. Azam 2009 described that the principle of justice is an essential prerequisite for all kinds of Islamic financing. In an Islamic financing, the financier and the beneficiary share the actual or net profit/loss rather than throwing the risk burden only to the entrepreneur. One of the unique and salient characteristics of Islamic banks is the integration of ethical and moral values with its banking operation. Unlike the conventional banks, the financing of Islamic banks are restricted to useful goods and services and refrain from financing alcoholic beverages and tobacco or morally unacceptable services such as casinos and pornography, irrespective of whether or not such goods and services are legal or not in a given country. In contrast to conventional finance methods, the worthiness and profitability of a project are the most important criteria of Islamic financing while the ability to repay the loan is sub-segmented under profitability. Another important characteristic which forms the basis for the development of Islamic banks is the relationship with depositors. Islamic banks deal with their customers on investment grounds rather than on a pre-determined fixed interest rate. They invest the money of their depositors on high profitable projects after going through a strategic analysis in order to give a substantial return to their depositors. Thus, in Islamic banking industry, each bank will attempt to out-perform other banks if it wants to attract funds from investors. This results in a high return on investments for
the investors, which is unlikely in a conventional bank where it deals with their depositors on a pre-determined fixed interest rate. Furthermore Islamic banks eliminate the barrier between those who save and those who invest, and bring them closer to the real market. The nature of the financial intermediation of Islamic banks significantly defers from conventional banks and it is in harmony with real market and developmental changes in it.
7. Growth and Prospects of Islamic Banking

Farooqi, M (2009) stated that Islamic banking is gaining rapid popularity nowadays. Not only a number of foreign and local banks are doing good business in Islamic banking but even the conventional banks have been tempted to open special Islamic banking counters.
Almost all the banks engaged in Islamic banking are working under the umbrella of Shariah Board or Shariah Committee. The problem with these shariah boards or shariah committees is that they may give conflicting opinions or interpretations that may result in confusion or doubt.
In this connection Malaysia has rightly proposed to set up global standards for both Islamic banking and Islamic finance. Such standards would result in a consensus instead of a confusion or conflicting scenario.
Presently, Islamic banking is a very small sector compared to conventional banking world-wide. While conventional banks in West are facing with an
unprecedented banking crisis, the prospect of Islamic banking sector looks bright. With the passage of time more and more people will be inclined to Islamic banking.
8. Future of Islamic Banking

Schmith Scott (2005), focused on the future of Islamic banking. He pointed out that Islamic finance has quickly established itself in several markets, its spread, growth, and ultimately its character, will depend on how it confronts several key challenges, including the general acceptance of Islamic finance, regulatory and soundness compatibility, obstacles to innovation, and other important barriers such as building economies of scale and training professionals in the intricacies of Islamic financial products. Currently, Islamic finance instruments are more expensive and less competitive. Progress of Islamic banking will thus, depend on its ability to innovate in financial instruments .These measures could hold important implications for developing consumer markets and financing trade in Muslim countries.
9. Survival of Islamic Banking

Sayyid Tahir (2003) pointed out that the survival of Islamic Banking & Finance depends on: its economic viability, its stability, its response to challenges to its identity, and its confidence building in customers.
Islamic banking in comparison to conventional banking offers a better financial architecture on economic grounds and is inherently more stable as it spreads risks between bank depositors and bank capital.
10.
Standardization of Islamic Financial Products
Sayyid Tahir (2003) suggested that standardization of Islamic financial products is necessary, and it is bound to happen. This is because the world is a global village. Customers consciousness as well as competition among Islamic banks will le ad to standardization of Islamic financial products. In the long run standardization in the financial instruments will require consensus of fundamental Shariah principles for designing financial contracts. Unless this is done, Islamic banking may become a clash of dogmas.
11.
Possible Solutions to Problems Faced by Islamic Banking
Abdul Jabbar Karimi (2006) stated that, Islamic banking industry has been trying hard to bring Islamic banking to the level of conventional banking. But the absence of Shariàh-compliant legal framework needed to make interest-free banking acceptable (and create sound financial institutions) is the major obstacle behind its low penetration in the financial market. Therefore, attempts should be made to modify the existing structure to provide better products and quality service within the domain of Islamic laws. Some of the most important challenges facing the Islamic banking industry are identified as follows:
(i) Legal support: Islamic law offers its own framework for execution of commercial and financial contracts and transactions. Islamic banking contracts are treated as buying and selling properties and hence are taxed twice. It is therefore, necessary that special laws for the introduction and practice of Islamic banking be put in place. (ii) Islamic prudential regulations: At present, lack of effective prudential regulation is one of the weaknesses of the Islamic banking industry. The nature of risk in Islamic banking is different from those of conventional banking and therefore some special prudential, accounting and auditing standards should be applied to them. (iii)Benchmark: Taking the conventional interest based benchmarks (Kibor etc.,) as the base of pricing; an Islamic financial product puts Islamic banks at the mercy of their conventional peers. Hence, a negative perception is created amongst the customers that there is no prudent difference in Islamic bank products as these are also using the same interest based benchmark. (iv) Shariàh based product: All Islamic financial institutions offer the same basic products i.e., 90 % Murabaha and Ijarah. However, the problem is that each institution has its own group of Islamic scholars on the Shariàh board to approve the product. Consequently, the very same product may have different features and will be subject to different kind of rules in these institutions. (v) Nature of Islamic banking: Islamic banks are offering only Murabaha and Ijarah while leaving the core financial instruments such as Musharakah and Murabaha. It is therefore, necessary to enhance and facilitate the implementation of real Islamic banking activities like promoting risk sharing through equity type facilities on the asset side and profit sharing investment accounts on the funding side.
(vi) Lender of last resort facility: Islamic banks are reluctant to enter into long-term transactions due to the lack of availability of liquidation through secondary market. (vii) Market discipline: In order to ensure consumer protection as provided by Shariàh, there is no proper mechanism of transparency and disclosure to the public. (viii) Islamic future exchange: In conventional system, long-term finance is provided through long-term bonds and equities. As Islamic banks do not deal with interest bearing bonds, hence, their need for equity markets is much higher. To circumvent the risk, they are in need of derivative products and consequently of Future Exchanges. [DAWN NEWS Business, December 4, 2006]
CHAPTER III
ISLAMIC BANKING AT GLOBAL LEVEL AND ITS DEVELOPMENT IN PAKISTAN
1. Islamic Banking at Global Level

Faridi,F.R.(1991) described that over the last three decades Islamic banking and finance has developed into a full-fledged system and discipline reportedly growing at the rate of 15 percent per annum. Today, Islamic financial institutions, in one form or the other, are working in about 75 countries of the world. Besides individual financial institutions operating in many countries, efforts have been underway to implement Islamic banking on a country wide and comprehensive basis in a number of countries. The instruments used by them, both on assets and liabilities sides, have developed significantly and therefore, they are also participating in the money and capital market transactions. In Malaysia, Bahrain and a few other countries of the Gulf, Islamic banks and financial institutions are working parallel with the conventional system. Frenchman, M. (1998), stated that Bahrain with the largest concentration of Islamic financial institutions in the Middle East region, is hosting 26 Islamic financial institutions dealing in diversified activities including commercial banking, investment banking, offshore banking and funds management. It pursues a dual banking system, where Islamic banks operate in the environment in which Bahrain Monetary Agency (BMA) affords equal environment in which Bahrain Monetary Agency (BMA) affords equal opportunities and treatment for Islamic banks as for conventional banks. Bahrain also
hosts the newly created Liquidity Management Centre (LMC) and the International Islamic Financial Market (IIFM) to coordinate the operations of Islamic banks in the world. To provide appropriate regulatory set up, the BMA has introduced a comprehensive prudential and reporting framework that is industry-specific to the concept of Islamic banking and finance. Further, the BMA has pioneered a range of innovations designed to broaden the depth of Islamic financial markets and to provide Islamic institutions with wider opportunities to manage their liquidity. Arif, Muhammad (2002) pointed out that another country that has a visible existence of Islamic banking at comprehensive level is Malaysia where both conventional and Islamic banking systems are working in a competitive environment. The share of Islamic banking operations in Malaysia has grown from a nil in 1983 to above 8 percent of total financial system in 2003. They have a plan to enhance this share to 20 percent by the year 2010. However, there are some conceptual differences in interpretation and Shariah position of various contracts like sale and purchase of debt instruments and grant of gifts on savings and financial papers. In Sudan, a system of Islamic banking and finance is in operation at national level. Like other Islamic banks around the world the banks in Sudan have been relying in the past on Murabaha financing. However, the share of Musharaka and Mudaraba operations is on increase and presently constitutes about 40 percent of total bank financing. Although the Islamic financial system has taken a good start in Sudan, significant problems still remain to be addressed. Ayub, Muhammad (2002), stated that like Sudan, Iran also switched over to Usury Free Banking at national level in March 1984. However, there are some
conceptual differences between Islamic banking in Iran and the mainstream movement of Islamic banking and finance. Owing to the growing amount of capital availability with Islamic banks, the refining of Islamic financing techniques and the huge requirement of infrastructure development in Muslim countries there has been a large number of project finance deals particularly in the Middle East region. Islamic banks now participate in a wide financing domain stretching from simple Shariah-compliant retail products to highly complex structured finance and large-scale project lending. These projects, inter alia, include power stations, water plants, roads, bridges and other infrastructure projects. Bahrain is the leading centre for Islamic finance in the Middle East region. The establishment of the Prudential Information and Regulatory Framework for Islamic Banks (PIRI) by the BMA in conjunction with AAOIFI has gone a long way towards establishing a legal and regulatory framework to meet the specific risks inherent in Islamic financing structures (Samad, Abdus 1999). The BMA has quite recently signed MoU with the London Metal Exchange (LME) to pool assets to develop and promote Shariah compliant tradable instruments for Islamic banking industry. The arrangement is seen as a m ajor boost for industrys integration in the global financial system and should set the pace for commodity-trading environment in Bahrain. BMA has also finalized draft guidelines for issuance of Islamic bonds and securities from Bahrain. In May 03, the Liquidity Management Centre (LMC) launched its debut US$ 250 million Sukuk on behalf of the Government of Bahrain (Khan, M.A. 1989).
National Commercial Bank (NCB) of Saudi Arabia has introduced an Advance Card that has all the benefits of a regular credit card. The card does not have a credit line and instead has a prepaid line. As such, it does not incur any interest. Added benefits are purchase protection, travel accident insurance, etc and no interest, no extra fees with no conditions, the card is fully Shariah compliant. It is more secure than cash, easy to load up and has worldwide acceptance. This prepaid card facility is especially attractive to women, youth, self employed and small establishment employees who sometimes do not meet the strict requirements of a regular credit card facility. Saudi Government has also endorsed an Islamic-based law to regulate the kingdom's lucrative Takaful sector and opened it for foreign investors (Nadeem Inayat, 1993). Accrding to Hassan,M.Kabir(1999), Islamic banks have also built a strong presence in Malaysia, where Standard & Poor's assigned a BBB+ rating to the $600 million Sharia-compliant trust certificates (called sukuk) issued by Malaysia Global Sukuk Inc. Bank Negara Malaysia (BNM) has announced to issue new Islamic Bank licenses to foreign players. The Financial Sector Master plan maps out the liberalization of Malaysia's banking and insurance industry in three phases during the next decade. It lists incentives to develop the Islamic financial sector and enlarge its market share to 20 percent, from under 10 percent now. A dedicated high court has been set up to handle Islamic banking and finance cases. Hussain, I. (2006) described that in United Kingdom, the Financial Services Authority is in final stages of issuing its first ever Islamic banking license to the proposed Islamic Bank of Britain, which has been sponsored by Gulf and UK investors. The United States of America has appointed Dr. Mahmoud El Gamal, an eminent
economist/expert on Islamic banking to advise the US Treasury and Government departments on Islamic finance in June 2004.
1. Development of Islamic Banking System in Pakistan

Banking is the most important sector of any financial system, and its importance remains the same in the Islamic financial operation also. Islamic Banking is an alternative to interest free banking. It derives its aspiration and guidance from the religious edicts of Islam and has to conduct its operations strictly in accordance with the directives of Shariah. Riba commonly known as interest is a certain increase obtained from the debtor as premium or cost irrespective of the outcome of the business. Gains on principal are not prohibited in Islam but profit is recognized as the reward of capital. Islam permits development of gainful surplus resources for the enhancement of their value . The Islamic system is based on a set of principles constituting the concept and philosophy as enunciated explicitly in the Holy Quran. This philosophy provides what can be understood as Islamic system of social justice. Islam also accepts basic concomitants of market economy like the right of innate ownership, freedom of enterprise and competitive environment of business and industry. The Holy Prophet (Peace be upon him) is reported to have allowed competitive price mechanism to balance the demand and supply of goods for dispensation of economic justice, ultimate best benefit of society and efficient allocation of resources. The limitations only take care of some moral, religious and cultural perceptions as well as to suit the aspirations that emphasize the significant role of the state in inculcation of
the desired norms. These limitations are necessary for fulfillment of overall objectives of Islamic Shariah. Right from the time Pakistan came into being as an independent Muslim state, efforts were made to create an interest-free economy. The constitution of 1956, 1962 and 1973 provided for various time spans to ensure total elimination of interest. In September 1977, the then president of Pakistan entrusted the council of Islamic Ideology with the task of preparing a blueprint for an interest-free economic system. In November 1977, the council appointed a Panel of Economists and Bankers (Niehans, 1986) . The banker-members of the panel were assigned the job of drafting a framework for interest-free commercial banking. This sub-committee completed its report in January 1978. The panel presented its full report in February 1980 and adopted it with certain modifications. This was presented to the federal government in June 1980 (Parvez, 1991). Effective from January 1, 1981, all domestic commercial banks were permitted to accept deposits on the basis of profit and loss sharing (PLS). Over the past few years, steps have been taken to develop new non-interest-bearing financial instruments with a view to facilitating investment by PLS deposits (Memon,N.A. 2007). These include commodity operations of government and its agencies, export bills, investment in shares, purchase of participation term certificates (PTCs), provision of loans to specialized credit institutions, (which had already moved to non-interestbearing operations), Musharakah (partnership) lending, hire purchase, and Mudarabah certificates.
New steps were initiated on January 1, 1985, to formally transform the banking system in next six months, thus completing the first phase of bringing the entire financial system under Islamic principles (Aftab, M. 1986). From that date, all finance was provided by banks to government, public sector corporations or private joint stock companies under the specified Islamic (non-interest-bearing) modes of financing. Nevertheless transactions with the government continued to be based on modern commercial interest. The state also obtained financing through the sale of bonds whose purchase by the private sector was facilitated by bank credit at fixed rates. Effective from April 1, 1985, all finance provided to private sector entities, including individuals, became limited to the specified modes (Khan 1990). Accordingly since July 1, 1985, banks have not been accepting any interest-bearing deposits, all existing deposits having become subject to PLS rules. Deposits in current account continue to be accepted as in the past (no share in profits or losses of banks, equivalent to no interest). Foreign currency deposits and loans initiated from abroad, however, continue to remain exempted from the purview of new regulations. These practices naturally served as a facade for the Shariah based banking because the conventional interest-based system also continued side by side. Under the Islamic Banking system, commercial banks have to take equity shares of companies seeking funds. Western economists hold the view that the system has become fantastically complicated and for its operation an army of accountants and specialists will be required. In international transactions, a zero rate of interest may mean a negative rate of return on loans if inflation is taken into account.
Three countries Pakistan, Iran and Sudan backed by experiences of the last few years, claimed that success in replacement of interest rate mechanism with noninterest based modes has ensured financial stability of the system or effectiveness of their monitory policy. They simultaneously emphasized the need for developing global standards for Islamic banking. In Pakistan, three banks, the Meezan Bank, Al Baraka and the recently sanctioned Bank Islami Pakistan have been given full-fledged Islamic Banking Licenses. Nine other banks already have separate branches for purely Shariah based transactions. Hence, only 11 banks are involved in Islamic banking with over 60 dedicated branches (Proctor, D. 1997). The State Bank of Pakistan (SBP) has granted branch-banking licenses to Muslim Commercial Bank (MCB), Citibank, Standard Chartered Bank and an approval in principle has been given for full fledged banking to the Dubai Islamic Bank (Naqvi, S.R. 1993). These bank branches are already functioning on the basis of profit-and-loss sharing. They have recently set the stage for a parallel banking system in the country. According to the State Bank of Pakistan, total assets of Islamic commercial Banks of Pakistan origin had touched the figure of Rs 54 billion, a mere 1.6 per cent of the banking capital but its growth is phenomenal. These assets would expectedly reach Rs 60 billion in a years time. The deposit base of these banks had recorded growth and now these stood at Rs 38 billion (Annual Report 2005, SBP). The non-performing loan ratio of these banks is under control i.e., one percent. The standing of cumulative profit after tax of these banks within two years, at Rs 284 million was a positive sign for prospective investors. The ratio of Murabaha (trade-related financing) was 44% and that of Ijara (leasing) was 34% (Annual Report 2007, SBP). Many foreign and local
commercial banks, planning to enter this market, have been eager to make their impact in the Islamic banking sector. The current market players in the shariah-based system, however, have yet to ensure perfection of the system. The central bank has been granting licenses to Islamic banks but temporarily suspended their issuance on the ground that the country was over-banked. Also, the SBP has promised provision of a level playing field to investors both foreign and domestic venturing into the field. Recently State Bank issued a license to Emirates Global Investment Limited to work in Pakistan as an Islami Bank. The SBP has kept the minimum capital requirement for interest-free banks at Rs2 billion for a full-fledged bank/subsidiary and Rs 50 million for a branch (Annual Report 2004, SBP). It has set the cash reserve ratio with the central bank for Islamic banks at 11 per cent all in cash, while that for conventional banks is 20 per cent, 15 per cent being the statutory liquidity requirement and 5 per cent in cash due to lack of Shariah-compliant government securities. Islamic banks cannot maintain their liquidity requirement by securing government bonds as they are being offered to them at a fixed interest rate, and these rates do not conform with Shariah principles. Thus, Islamic banks can invest the difference between these two at four per cent in lucrative assets to compensate for the foregone return on the government securities (Khan, H. 2005). At this point of time, the SBP is not serving as the traditional lender of last resort for Islamic banking institutions, because it is being evaluated as how much financial support can be provided is the light of Shariah laws. As these springs apparently strong inclination towards Islamic banking system, the SBP is meticulously scrutinizing the personnel capabilities of banks before issuing them permits. The Bank
of Khyber was accordingly not allowed to convert its Nowshera branch to an Islamic bank branch as it suffered from several managerial flaws that needed improvement in performance capabilities of its personnel with a view to strengthening its financial base (Khan, A.Z. 2005). The very recent Bank Islami Pakistan has, in addition to Jehangir Siddiqui and Company the DCD group as its investors. This springs from the Central Banks belief that an internationally reputed foreign group with technical expertise, human resource and capital will serve to strengthen the Islamic banking. Islamic mode of banking is expected to grow in Pakistan as commercial banks are interested in providing facilities based on Islamic principles. Islamic banking and now foreign Islamic banks would be encouraged to establish their Islamic banking business in Pakistan.
2. Major Modes of Islamic Banking and Finance

Ayub, Muhammad (2002) described the following main modes of Islamic banking and finance:
2.1. Murabaha
Literally it means a sale on mutually agreed profit. Technically, it is a contract of sale in which the seller declares his cost and profit. Islamic banks have adopted this as a mode of financing. As a financing technique, it involves a request by the client to the bank to purchase certain goods for him. The bank does that for a definite profit over the cost, which is stipulated in advance.
2.2.
Ijarah
Ijarah is a contract of a known and proposed usufruct against a specified and lawful return or consideration for the service or return for the benefit proposed to be taken, or for the effort or work proposed to be expended. In other words, Ijarah or leasing is the transfer of usufruct for a consideration which is rent in case of hiring of assets or things and wage in case of hiring of persons.
2.3.
Ijarah-Wal-Iqtina
A contract under which an Islamic bank provides equipment, building or other assets to the client against an agreed rental together with a unilateral undertaking by the bank or the client that at the end of the lease period, the ownership in the asset would be transferred to the lessee. The undertaking or the promise does not become an integral part of the lease contract to make it conditional. The rentals as well as the purchase price are fixed in such manner that the bank gets back its principal sum along with profit over the period of lease.
2.4.
Musawamah
Musawamah is a general and regular kind of sale in which price of the commodity to be traded is bargained between seller and the buyer without any reference to the price paid or cost incurred by the former. Thus, it is different from Murabaha in respect of pricing formula. Unlike Murabaha, seller in Musawamah is not obliged to reveal his cost. Both the parties negotiate on the price. All other conditions relevant to Murabaha are valid for Musawamah as well. Musawamah can be used where the seller is not in a position to ascertain precisely the costs of commodities that he is offering to sell.
2.5.
Istisna
It is a contractual agreement for manufacturing goods and commodities, allowing cash payment in advance and future delivery or a future payment and future delivery. Istisnaa can be used for providing the facility of financing the manufacture or construction of houses, plants, projects and building of bridges, roads and highways.
2.6.
Bai Muajjal
Literally it means a credit sale. Technically, it is a financing technique adopted by Islamic banks that takes the form of Murabaha Muajjal. It is a contract in which the bank earns a profit margin on his purchase price and allows the buyer to pay the price of the commodity at a future date in a lump sum or in installments. It has to expressly mention cost of the commodity and the margin of profit is mutually agreed. The price fixed for the commodity in such a transaction can be the same as the spot price or higher or lower than the spot price.
2.7.
Mudarabah
A form of partnership where one party provides the funds while the other provides expertise and management. The latter is referred to as the Mudarib. Any profits accrued are shared between the two parties on a pre-agreed basis, while loss is borne only by the provider of the capital.
2.8.
Musharakah
Musharakah means a relationship established under a contract by the mutual consent of the parties for sharing of profits and losses in the joint business. It is an agreement
under which the Islamic bank provides funds, which are mixed with the funds of the business enterprise and others. All providers of capital are entitled to participate in management, but not necessarily required to do so. The profit is distributed among the partners in pre-agreed ratios, while the loss is borne by each partner strictly in proportion to respective capital contributions.
2.9.
Bai Salam
Salam means a contract in which advance payment is made for goods to be delivered later on. The seller undertakes to supply some specific goods to the buyer at a future date in exchange of an advance price fully paid at the time of contract. It is necessary that the quality of the commodity intended to be purchased is fully specified leaving no ambiguity leading to dispute. The objects of this sale are goods and cannot be gold, silver or currencies. Thus, Salam covers almost everything, which is capable of being definitely described as to quantity, quality and workmanship.
3. Role of Islamic Banking in Economic Development

Islamic banks, while functioning within the framework of Shariah, can perform a crucial task of resource mobilization, their efficient allocation on the basis of both PLS (Musharaka and Mudaraba) and non-PLS (trading & leasing) based categories of modes and strengthening the payments systems to contribute significantly to economic growth and development. Sharing modes can be used for short, medium and long-term project financing, import financing, pre-shipment export financing, working capital financing and financing of all single transactions. In order to ensure maximum role of
Islamic finance in development of the economy it would be necessary to create an environment that could induce financiers to earmark more funds for
Musharakah/Mudarabah based financing of productive units, particularly of small enterprises (Kuran,T. 1995 ). The non-PLS techniques, as acceptable in the Islamic Shariah, not only complement the PLS modes, but also provide flexibility of choice to meet the needs of different sectors and economic agents in the society. Trade-based techniques like Murabaha with lesser risk and better liquidity options have several advantages vis--vis other techniques but may not be as fruitful in reducing income inequalities and generation of capital goods as participatory techniques. Ijarah related financing that would require Islamic banks to purchase and maintain the assets and afterwards dispose of them according to Shariah rules, require the banks to engage in activities beyond financial intermediation and can be very much conducive to the development of fixed assets and medium and long-term investments (Naqvi,S.R. 1993). On the basis of the above it can be said that supply and demand of capital would continue in an interest free scenario with additional benefit of greater supply of riskbased capital along with more efficient allocation of resources and active role of banks and financial institutions as required in asset based Islamic theory of finance. Islamic banks can not only survive without interest but also could be helpful in achieving the objective of development with distributive justice by increasing the supply of risk capital in the economy, facilitating capital formation, and growth of fixed assets and real sector business activities (Siddiqui, S.H. 2009).
Salam has a vast potential in financing the productive activities in crucial sectors, particularly agriculture, agro-based industries and the rural economy as a whole. It also provides incentive to enhance production as the seller would spare no effort in producing, at least the quantity needed for settlement of the loan taken by him as advance price of the goods. Salam can also lead to creating a stable commodities market especially the seasonal commodities and therefore to stability of their prices. It would enable savers to direct their savings to investment outlets without waiting, for instance, until the harvesting time of agricultural products or the time when they actually need industrial goods and without being forced to spend their savings on consumption (Siddiqui, S.H. 2009). Banks might engage in fund and portfolio management through a number of asset management and leasing & trading companies. Such companies/entities can exist in the economy on their own or can be an integral part of some big companies or subsidiaries, as in the case of Universal Banking in Europe. They would manage Investors Schemes to mobilize resources on Mudarabah basis and to some extent on agency basis, and use the funds so collected on Murabaha, leasing or equity participation basis. Subsidiaries can be created for specific sectors/operations, which would enter into genuine trade and leasing transactions. Low risk Funds based on short-term Murabaha and leasing operations of the banks in both local as well as foreign currencies would be best suited for risk-averse savers who cannot afford possible losses, in PLS based investments (Hussain, I. 2006). Under equity based Funds, banks can offer a type of equity exposure through specified investment accounts where they may identify possible investment opportunities from existing or new
business clients and invite account-holder to subscribe. Instead of sharing in the banks profit, the investors would share the profits of the enterprise in which funds are placed with the bank taking a management fee for its work. Banks can also offer open-ended Multiple Equity Funds to be invested in stocks. Small and medium enterprises (SME) sector has a great potential for expanding production capacity and self-employment opportunities in the country. Enhancing the role of financial sector in development of SME sub-sector could mitigate the serious problems of unemployment and low level of exports. The banks may introduce SME Financing Funds with various geographical locations. The corporate sector and the commercial banks may set up a network of such Funds under the aegis of SECP by establishing institutions under syndicate arrangements or otherwise (Kartio, M.A. 2009).
CHAPTER IV
GROWTH OF ISLAMIC BANKING IN PAKISTAN 1. Findings about Objectives Objective 1: Growth Prospectus of Islamic Banking System in Pakistan
Islamic banking emerged as a response to both religious and economic needs. In Pakistan, as a result of relaunching of the Islamic banking initiative guided by a comprehensive legal, regulatory and Shariah compliant framework, three types of Islamic banking institutions were allowed to establish in 2001. These were Full-fledged Islamic banks, Islamic banking subsidiaries of conventional banks, and Islamic banking branches (IBBs) of conventional banks. In addition to above, conventional banks having IBBs could also have Islamic banking windows in their conventional branches. This initiative proved to be a big success as the Islamic Banking Industry has grown manifold since 2001. Currently there are 6 full fledged licensed Islamic banks (IBs) and 13 conventional banks having licenses to operate dedicated Islamic banking
branches(IBBs).(Quarterly Report 2010, SBP) In addition to that, all of the five big banks in Pakistan are providing Islamic banking services.
1.1
Current Status of Islamic Banking in Pakistan
Presently Islamic Banking Industry contributes more than 6% of the banking system in Pakistan. Total branch network of the industry has increased from 651 in Dec.09 to 667
branches in June.10 with presence in over 84 cities & towns covering all the four provinces, Azad Kashmir, Northern areas and Federal capital. The province-wise data reveals that Sindh, Punjab, Balochistan, Khyber- Pakhtunkhwa and Azad Kashmir have 223, 297, 73, 34, and 7 branches respectively, while the rest 32 branches are in the Federal Capital. Of the total 667 branches, 653 are in the banked areas while the remaining 14 are in the unbanked areas. (Quarterly Report 2010, SBP)
1.2 Industry Progress and Market Share

The total assets of Islamic banking institutions (IBIs) in June 2010 compared to June 2009 (Table IV-1), has increased 98 billion, showing an impressive growth of 31%. The deposits spearheaded the growth with 39% increase during the year. (Quarterly Report 2010, Quarterly Report 2009, SBP) The investment and financing however could not show the same pace of growth and have shown only 21% growth. Similarly, the assets, deposits and net investment & financing have shown growth rates of 31, 39 and 21 percent, respectively, as shown in the table as well as in Fig IV-1. (Quarterly Report 2010, Quarterly Report 2009, SBP)
Table IV- 1: Industry progress and market share VARIABLE JUNE 2010 JUNE 2009 GROWTH % SHARE IN INDUSTRY 313 238 194 31.3 39 21 6.1 6.4 4.6
Total assets Deposits Net financing and investment
411 330 235
Source: GoP (June 2009 to June 2010), Annual Report of SBP, Karachi
The high growth trends in various components of Islamic banks balance sheet has enabled the Islamic Banks to make further inroads in the overall banking industry in Pakistan.
Fig: IV-1: Share and growth of Islamic Banking Source: GoP (June 2009 to June 2010), Annual Report of SBP, Karachi
The data for quarter ended June 2010 when compared with the preceding quarter, shows that the asset financing activities of Islamic banks have revived besides substantially higher assets and deposits growth. The profitability indicators (Table IV-1) have also shown marked improvement as compared to the preceding quarter. The financing and investment portfolio of Islamic banks have reached Rs 236.0 billion in June 2010 compared with Rs 229 billion in March 2010, depicting an increase of 3.0 percent during the last quarter. (Quarterly Report 2010, SBP) The shares of assets, deposits and investment & financing increased to 6.1, 6.4 and 4.6 percent respectively during the quarter ended June 2010. (Quarterly Report 2010, SBP) The growing depositors confidence is well reflected in last quarter, which shows an increase of 14.2 percent in the deposits. The deposit base of Islamic banks stood at Rs 330 billion at end-June 2010 compared to Rs 289 billion in the previous quarter-end. Similarly, total liabilities of Islamic banks have increased by 11.9 percent to Rs 368 billion from Rs 329 billion during the quarter. Likewise, the net assets and equity have increased by around 1.5 and 1.9 percent respectively. There is an increase of about 6 percent in the reserves and 62 percent in un-appropriated profits. (Quarterly Report 2010, SBP) Compared to preceding quarter, the financing portfolio of Islamic Banking Industry has increased by 1 percent in June 2010. This is accompanied by a 7.0 percent increase in investment. (Quarterly Report 2010, SBP) Mark-up income is the major source of IBI income, at around 80 %, compared to around 70 percent for the conventional banks. The operating expense to gross income ratio of IBIs is also much higher than the conventional banks industry.
1.3
Performance Indicators of Islamic Banks

The infection ratio, net infection ratio, and NPA to capital ratio, of IBI are better than the industry at end-June 2010. The assets infection as shown by NPFs to financing ratio at 6.5% is almost the half of the industry average which stood at 12.9%. The net NPFs to net financing ratio of 2.8% is also much better than the industry average of 3.8%. Similarly the net NPAs to Capital ratio of IBIs at 11.5% is also better than the industry average of 17.2%. (Table IV-2). Table IV- 2: Performance indicators
1.4
Non-Performing Financing and Assets
During the quarter Apr-Jun 2010 the nonperforming financing has increased substantially YoY basis, although, there is a decrease of around 10 percent on QoQ basis (Table IV-3).
Table IV-3: Non-performing financing & assets
The net non-performing financing shows similar YoY and QoQ trends . The NPAs and net NPAs also have similar inclining trends. However, on a positive note the recovery has improved substantially both on YoY and QoQ basis.
1.5
Financing Mix
Murabaha, Ijarah and Diminishing Musharaka (DM) contributed around 87 % of the financing (Table IV-4). In fact, the Murabaha financing has rebounded during the quarter under review from 37.5% to 44.1% of the financing. It can also be noted from the table that there is a slight decline in DM financing, Salam and Istisna modes.
Table IV-4: Financing mix
1.6
Investments
Regarding the investments, IBIs have shown substantial growth of YoY 46% and QoQ 7.0% in June 2010. The YoY growth primarily represents the Rs 14.4 billion GoP Ijarah Sukuk and Rs 6.8 billion PIA Sukuk issued in September and October 2009, respectively. There is a substantial decline of 12 percent in investment in shares during the quarter, though investments in shares remained marginally positive on YoY basis (Table IV-5).
Table IV-5: Investments
1.7
Deposits
The deposit mobilization remained strong during Apr-Jun 2010. The YoY and QoQ growth in deposits remained robust at 38.5% and 14.1 % respectively. The YoY growth in deposits is largely coming from the customer deposits at 40.6 percent. All the customer deposit typesfixed, saving and currenthave shown close to 40 percent YoY growth. Similar trends have continued during the quarter ended June 2010. The comparative analysis of composition of deposits of IBIs and industry reveals that the behavior of IBI depositors and conventional banks depositors is almost similar (Fig IV-2).
Fig IV-2: Compositions of deposits Source: GoP (June 2009 to June 2010), Annual Report of SBP, Karachi
Objective 2: Growth Pattern of Two Full-Fledged Islamic Banks in Pakistan

The two full-fledged Islamic commercial banks with larger branch networks in Pakistan are Meezan Bank Limited and Bank Islami Pakistan Ltd. The last three years financial statements of these two banks were analyzed to study their growth patterns.
2.1 Growth Pattern of Meezan Bank

Meezan Bank Limited was granted the Nations first full-fledged Islamic Banking license by the State Bank of Pakistan, in January 2002. This bank is now ranked amongst the top 15 banks of the 40 total banks operating in Pakistan. (Annual reports of Meezan bank, 2010). Meezan bank in its short span of eight years has surpassed growth rates of conventional banks. Rapid growth of the bank has been accompanied by good financial performance and specific industry position. The capital to risk-weighted ratio of the bank has invariably remained significantly above the 8 percent of the required level, and NPLs ratios have been considerably low. That has placed Meezan Bank at the top of the Banking industry, a long-term entity rating of A+, and a short-term entity rating of A1. The Meezan Bank has achieved a strong balance sheet with excellent operating profitability, including a capital adequacy ratio. (Meezan bank Annual reports, 2010). Presently, Meezan Bank is the largest Islamic Bank operating in Pakistan with 201 branches in 54 cities (Annual reports of Meezan bank, 2010). The Bank offers a complete range of Islamic products and services including car leasing and home mortgages- all designed with flexible features to meet the requirements of the customers in a Shariah-compliant manner. The bank's retail banking network is supported by 24 hours per day/ 7 days per week , banking services which includes 150
ATMs, Internet Banking and a 24-hour Call Center. The Bank has recently launched its VISA Debit card that allows its customers to shop at more than 30 million merchants globally and withdraw money from their accounts from more than 1.4 million ATM's worldwide. (Meezan bank Annual reports, 2010). 2.1.1 Analysis of Financial Statements of Meezan Bank Limited
As can be noted from table IV-6 profit after tax decreased 35.5 % in the year 2008 as compared to profit in 2007, but showed an impressive increase of Rs 404 million
(65.1%) from Rs 621 million in the year 2008 to Rs 1025 million in the year 2009. Overall revenues reflected a growth of 48.7 % in the year 2008 as against in 2007, and 48.5% in 2009 as against in 2008. The income from core banking activities before provisions increased by 60.4% in the year 2008 compared to previous year and 39.7% in the year 2009 as against in 2008..Similarly, Net spread earned before provisions increased by 75.1% in the year 2008 compared to in 2007 and 38.2% in the year 2009 from Rs 3.71 billion in 2008 to Rs 5.13 billion. Total other income for the bank although decreased 47.5% in the year 2008 as against in 2007, it increased by 125.7% in 2009 and reached to Rs 1597 million as compared to Rs 707 million in the year 2008. Disaggregate fee and commission income and income from dealing in foreign currencies rose by 22.6% and 147% respectively in 2009 as against in 2008, but the dividend income tumbled by 22% mainly owing to weak bourses of the country.
Total other expenses increased by 27.9 % in 2009 as against an increase of 53.8% recorded in 2008 , mainly on the back of administrative costs, which increased 34.4 % and 49.6 % respectively, primarily on account of additional costs associated with new
branches added to the network. This investment has, however, resulted in strong growth in deposits in the year 2009. Increased profitability resulted in growth for earning per share which rose 40.2% from Rs 1.22 in 2008 to Rs 1.71 in the year 2009.
Table IV-6: Profit & loss account of Meezan bank ltd. Financial year 2007-09 Profit & Loss Account Rupees in Million Dec 2009 Profit / return earned on financings, investments and placements Net spread earned before provisions Fee, commission and brokerage income Dividend income Income from dealing in foreign currencies Other income Core banking income before provisions Provision against non performing financing Administrative expenses Total other expenses Profit after tax Earnings per share 10,102 Dec 2008 Dec 2007 Growth % A* 6,803 4,574 48.5 Growth %B* 48.7
5,132 529
3,715 432
2,122 322
38.2 22.6
75.1 34.2
190 753
244 305
104 392
(22) 147.1
133.4 (22.3)
1,598 6,654
708 4,762
1,348 2,968
125.7 39.7
(47.5) 60.4
1,431
428
435
233.9
(1.51)
3,530
2,627
1,756
34.4
49.6
3,471 1,025 1.71
2,713 621 1.22
1,765 964 1.96
27.9 65.1 40.2
53.8 (35.5) (37.8)
Source: Meezan Bank annual report (December 2007 to December 2009)
A*= Percent growth in 2009 compared to 2008. B*= Percent growth in 2008 compared to 2007. Table IV-7: Financial positions of Meezan bank ltd. Financial year 2007-09 Statements of Financial Positions Rupees in Million Dec 2009 Dec 2008 Dec 2007 Growth% A* 100,333 70,234 54,582 42.9 44,188 39,529 34,576 11.8 Growth% B* 28.7 14.3
Deposits Financing Net
Investments Due from financial Institutions Total Assets Bills payable Total liabilities Share Capital Reserves Shareholders Equity
23,290 34,499 124,182 1,249 114,997 6,650 1,050 9,091
14,527 18,108 85,276 1,057 79,301 4,926 845 6,341
10,535 8,850 67,179 1,192 61,472 3,780 721 5,720
60.3 90.5 45.6 18.2 45.0 35.0 24.3 43.4
37.9 104.6 26.9 (11.3) 29 30.3 17.2 10.9
Source: Meezan Bank annual report (December 2007 to December 2009)
A*= Percent growth in 2009 compared to 2008. B*= Percent growth in 2008 compared to 2007.
As can be seen from table IV- 7, assets of the bank have increased by Rs 39 billion resulting in growth of 45.6% from total assets of Rs.85 billion in 2008 to Rs.124 billion in 2009. Total deposits in 2009 crossed Rs. 100 billion compared to Rs.70 billion for 2008, an increase of 43%. Deposits increased in all categories, especially in Current Accounts and Saving Deposits. This growth was achieved without any increase in cost of funds that was maintained at low level, relative to the industry average. This reflects the strong Brand Equity of Meezan Bank.
Dues from financial institutions in the year 2009 increased to Rs 34 .5 billion from Rs 18.1 billion in the year 2008, thereby registering a growth of 90.5%. Investments of the bank also increased by 60.3% in this period and stood at Rs 23.3 billion. Financing on the other hand registered a small growth of 11.8% and increased from Rs. 39.5 billion in 2008 to Rs 44.2 billion in 2009. Tijarah financing was the most popular advances of the year. Other good performance categories were Istisna (132%), running finance (125%), export refinance and diminishing musharka (27%). Total liabilities increased by 45% in 2009 as compared to 29% increase noted in the year 2008. These liabilities increased mainly on back of bill payable and deposit. Deposits have increased by Rs 30 billion from Rs 70 billion in 2008 to Rs.100 billion in 2009 resulting in a growth of 42.9%. Dues from financial institutions increased from Rs 4.0 billion in 2008 to Rs 8.4 billion in 2009. The share capital of the bank registered a growth of 35% from Rs 4.9 billion in 2008 to Rs 6.7 billion in 2009. Reserves of the bank also increased by 24.3% in the same period. Aggregately, equity increased by 43.4% during this period.
2.3 Growth Pattern of Bank Islami Pakistan Limited
Bank Islami-the second full-fledged Islamic Commercial Bank in Pakistan started its Banking operations on 7th April 2006. This bank has now a network of 102 online branches in 49 cities of Pakistan including 37 branches in Sindh, 44 branches in Punjab, 11 branches in Balochistan, 8 branches in Pakhtunkhwa and 2 branches in Azad Kashmir. (Annual reports of BankIslami, 2010)
The Bank offers a complete range of Islamic products and services including new vehicle and used/imported vehicle leasing designed with flexible features to meet the requirements of the customers in a Shariah-compliant manner. The bank's retail banking network is supported by 24 hours per day/ 7 days per week banking services which includes ATM/Debit card, Biometric ATM, Online Banking, Inter Bank Fund Transfer, and Internet Banking. The Bank Islami has been assigned a long term entity rating of 'A' and short term rating of 'A 1' by Pakistan Credit Rating Agency Limited (PACRA), because of its well conceived business strategy and establishment of an effective operating platform to execute the business strategy. (Bank Islami Annual reports , 2010) 2.3.1 Analysis of Financial Statements of Bank Islami limited Table IV-8 shows that after deduction of tax the loss incurred by the bank was 43% in 2008 which rose to 805% in the year 2009. Overall revenues of the bank increased 143.9 % in the year 2008 as against in 2007, and 49.4% in 2009 as against in 2008.The income from core banking activities before provisions increased by 45.1% in the year 2008 compared to in 2007 and 128% in the year 2009 as against in 2008. Similarly, net
spread earned before provisions increased by 147.9% in the year 2008 compared to in 2007 and 31.5% in the year 2009 as compared to in 2008. Total other income for the bank increased 40% in the year 2008 as against in 2007, and 74.7% in 2009 as compared to in the year 2008. Disaggregate fee and commission income, and income from dealing in foreign currencies decreased by 66.2% and appreciably increased by 849.9% respectively in the year 2009 as against in 2008, but the dividend income tumbled due to weak bourses of the country.
Total other expenses of the bank increased by 70.8 % in 2009 as against an increase of 102.5% recorded in 2008 , mainly on the back of administrative costs, which increased 70.7 % and 102.7 % respectively, primarily on account of additional costs associated with new branches added to the network. Increased profitability resulted in growth for earning per share which significantly rose to 583.3% from Rs 0.12 in 2008 to Rs 0.91 in the year 2009.
Table IV-8: Profit & loss account of Bank Islami Ltd. Financial year 2007-09 Profit & Loss Account Dec 2009 2,194 Dec 2008 1,469 Dec 2007 602 Rupees in Million Growth % A* 49.4 Growth %B* 143.9
Profit / return earned on financings, investments and placements Net spread earned before provisions Fee, commission and brokerage income Dividend income Income from dealing in foreign currencies
972 38 278
739 112 1,741 29
298 61 23,150 10
31.5 (66.2) Nil 849.9
147.9 83.2 (92.5) 185.6
Other income Core banking income before provisions Provision against non performing financing Administrative expenses Total other expenses Loss after tax Earnings per share
343 1,312 90 1,756 1,766 (479) (0.91)
196 904 131 1,028 1,034 (53) (0.12)
140 397 28 507 511 (37) (0.13)
74.7 45.1 (31.2) 70.7 70.8 (804.8) 583.3
40 128 360.2 102.7 102.5 43 (7.7)
Source: Bank Islami annual report (December 2007 to December 2009)
A*= Percent growth in 2009 compared to 2008. B*= Percent growth in 2008 compared to 2007.
Table IV-9: Financial positions of Bank Islami ltd. Financial year 2007-09 Statements Of Financial Positions Dec 2009 27,987 13,282 6,813 4,019 34,272 486 29,546 5,280 Dec 2008 12,478 6,528 5,020 40 19,089 354 13,897 5,280 Rupees in Million Dec 2007 9,934 3,963 3,864 625 Growth % A* 124.3 103.5 35.7 9859.6 Growt h%B* 25.6 64.7 30 (93.5) 32.1 316.1 31.1 65
Deposits Financing - Net Investments Due from financial Institutions Total Assets Bills payable Total liabilities Share Capital
14,447 79.5 85 37.3
10,603 112.6 3,200 0
Reserves Shareholders Equity
0 4,725
0 5,192
0 3,845
0 (9)
nil 35
Source: Bank Islami annual report (December 2007 to December 2009)
A*= Percent growth in 2009 compared to 2008 B*= Percent growth in 2008 compared to 2007
As can be noted from table IV-9, assets of the bank have increased by 79.5% in 2009 as compared to in 2008. Total deposits in 2009 recorded an increase of 124.3%. The growth in deposits came almost entirely from retail segment. In this connection, Current and Saving Accounts recorded an impressive growth. Dues from financial institutions decreased to 93.5% in the year 2008 compared to in 2007 but showed a huge increase of 9859.6% in the year 2009 as against in the year 2008. Investments of the bank also increased by 35.7% in 2009 as against in 2008. Financing on the other hand registered an appreciable growth of 103.5%. Total liabilities of the bank increased by 112.6% in 2009 as compared to 31.1% increase noted in the year 2008. These liabilities increased mainly on back of bill payable and deposit. Despite of 124% increase in deposits in 2009, cost of funds actually declined. The share capital of the bank showed no growth in the year 2009. Same was true for the reserves of the bank. Aggregately, equity increased by 35% in the year 2008 as against in 2007 but it decreased by 9% in 2009 as compared to in 2008.
Objective 3: Identification of the Areas/Products for Future Growth of Islamic Banking in Pakistan
The recent crisis in the western financial markets has given a big boost to the acceptability and promotion of Islamic Banking as a more stable and practical system than its conventional counterpart. The consistently high growth trends exhibited by the Islamic banking industry over the last few years is indicative of growing acceptability of Islamic finance as a commercial option for the different stake holders. However, it has been noted that the IBIs financing is concentrated in a few sectors like textile, chemical & pharmaceutical and individuals. The concentration in a few sectors implies concentration of risk as well. For instance, the likely distress to textile sector due to expected higher cotton prices (resulting from losses in massive flooding in the country) may adversely affect the textile sector and its financiers. The Islamic Banking industry thus, has to diversify its product mix by focusing on areas where it has comparative advantage over the conventional system. In Pakistan, there are numerous areas/products which could be focused and exploited more to achieve future growth of Islamic banking over here, some of which are as follows:
3.1 Providing Banking Facility to Large Un-Banked Population

Pakistan with a population of 170-180 million people, 97% of which are Muslims, has a fairly large domestic market, second only to Indonesia. (Pakistan Economic Survey 2009-2010) A large majority of the population is unbanked which is attributable to, among others, low penetration of the banking system particularly in rural/semi rural areas and general dislike of Muslims for interest (Riba). Thus, a huge un-tapped market,
a significant proportion of which is also faith sensitive, is available for IBIs to offer Shariah compliant financial services.
3.2 Providing Service to Large Un-Served Agriculture Sector

Agriculture is strategically an important sector for the economy of Pakistan, having a 20% share of GDP and a major source of livelihood for 65% of the countrys population living in rural areas. (Economic Survey of Pakistan 2009-2010) This sector is largely unserved/under-served by banks; less than 20% of about 7 million farm households in the country have access to bank credit. (Agricultural Statistics of Pakistan 2009). Islamic banks can capture a sizeable proportion of this market by reaching out to the growers. The IBIs are likely to have better acceptance in rural areas as the rural population is believed to be relatively more faith sensitive. Thus, the IBIs have to expand their outreach to smaller towns and rural/semi rural areas and optimally leverage the technology to serve the rural markets.
3.3 Providing Bank Financing to the SME Sector

This is another potential area for Islamic banks to explore. Presently only 0.2 million SMEs out of 3.1 million SMEs across the country have access to bank financing. Presently, the IBIs have just around 2300 SME clients which need to be increased sharply. Similarly, Housing finance is another attractive avenue for Islamic banks. Mortgage loans of only about 1 percent of GDP suggest that a huge un-tapped market awaits banks/IBIs to exploit. (Economic Survey of Pakistan 2009-2010) As the level of awareness and understanding of Islamic Banking remains very low , the IBIs have to focus more aggressively on their awareness campaign throughout the
country together with effective marketing of Islamic banking as offering Shariah compliant returns to the depositors.
CHAPTER V
RESULTS AND CONCLUSIONS 1. Results and Conclusions of Objective1
Objective 1 of present study is to find out the growth prospectus of Islamic Banking system in Pakistan. Analysis of the quarterly reports of the State Bank of Pakistan clearly demonstrates that the growth prospectus of Islamic Banking system is highly bright in Pakistan. Growth in assets of Islamic banking continues to surpass the growth of assets in conventional banking. This consistently high growth trends exhibited by the Islamic banking industry in Pakistan over the last few years is indicative of growing acceptability of Islamic finance as a viable and competitive alternative to the conventional system. However, to sustain the growth momentum, the Islamic Banking industry will need to diversify its product mix by focusing on areas where it has comparative advantage over the conventional system.
2. Results and conclusions of objective 2

Objective 2 of this study is to compare the growth pattern of two full-fledged Islamic banks in Pakistan. In this connection, the financial statements of Meezan Bank Ltd. and Bank Islami Pakistan Ltd. for the years 2007-2008 and 2008-2009 were
compared. As can be noted from Tables V-1 to V-4, both the banks documented appreciable growth in the overall revenues and income in core banking activities, especially in net spread before provisions. Bank Islami in comparison to Meezan bank
achieved highest percentage of income from dealing in foreign currencies. However, due to excessive administrative and other expenses owing to branch network expansion by this bank the bank recorded loss after tax. Both the banks also showed increase in total assets including Financing-Net & investments and total liabilities including deposits and other accounts. The Share holders Equity including reserves and share capital was higher for Meezan Bank compared to the Bank Islami. Table V-1: Comparison of profit & loss account of Meezan Bank & BANK ISLAMI for the year 200809 Profit & Loss Account MEEZAN BANK Growth % Profit / return earned on financings, investments and placements Net spread earned before provisions Fee, commission and brokerage income Dividend income Income from dealing in foreign currencies Other income Core banking income before provisions Provision against non performing financing Administrative expenses Total other expenses Profit/loss after tax 48.5 38.2 22.6 (22.0) 147.1 125.7 39.7 233.9 34.4 27.9 65.1 BANK ISLAMI Growth % 49.4 31.5 (66.2) Nil 849.9 74.7 45.1 (31.2) 70.7 70.8 (804.8)
Earnings per share
40.2
583.3
Source: Meezan Bank& Bank Islami annual report (December 2009 to December 2009)
Table V-2: Comparison of financial positions of Meezan Bank & BANK ISLAMI for the year 200809 Statements of Financial Positions MEEZAN BANK Growth % Deposits Financing Net Investments Due from financial Institutions Total Assets Bills payable Total liabilities Share Capital Reserves Shareholders Equity 42.9 11.8 60.3 90.5 45.6 18.2 45.0 35.0 24.3 43.4 BANK ISLAMI Growth % 124.3 103.5 35.7 9859.6 79.5 37.3 112.6 0 0 (9.0)
Table V-3: Comparison of profit & loss account of Meezan Bank & BANK ISLAMI for the year 200708
Profit & Loss Account
MEEZAN BANK BANK ISLAMI Growth % Growth % 143.9
Profit / return earned on financings, 48.7 investments and placements Net spread earned before provisions Fee, commission and brokerage income Dividend income Income from dealing in foreign currencies Other income Core banking income before provisions Provision financing against non 75.1 34.2 133.4 (22.3) (47.5) 60.4
147.9 83.2 (92.5) 185.6 40.0 128.0 360.2
performing (1.51)
Administrative expenses Total other expenses Profit after tax Earnings per share
49.6 53.8 (35.5) (37.8)
102.7 102.5 (43.0) (7.7)
TableV-4: Comparison of financial positions of Meezan Bank & BANK ISLAMI for the year 200708 Statements Of Financial Positions MEEZAN BANK BANK ISLAMI Growth % Deposits Financing Net Investments Due from financial Institutions Total Assets Bills payable Total liabilities Share Capital Reserves Shareholders Equity 28.7 14.3 37.9 104.6 26.9 (11.3) 29.0 30.3 17.2 10.2 Growth % 25.6 64.7 30.0 (93.5) 32.1 316.1 31.1 65.0 Nil 35.0
3. Results and Conclusions of Objective 3

The 3rd objective of present study is to identify the areas and products which need to be exploited to enhance the future growth prospectus for Islamic Banking in Pakistan. In this regard, following promising areas and products have been identified which need to be explored extensively for achieving better growth prospectus for Islamic Banking in Pakistan: A large majority of the population in Pakistan is unbanked owing to low penetration of the banking system particularly in rural/semi rural areas and general dislike of Muslims for interest (Riba). Thus, a huge un-tapped market, a significant proportion of which is also faith sensitive, is available for Islamic Banking system to offer Shariah compliant financial services. The second potential area for Islamic banks to explore is the SME sector, where Islamic banks presently have just around 2300 SME clients out of 3.1 million SMEs across the country. In a similar way, Housing finance could be another attractive avenue for Islamic banking to explore. Mortgage loans of only about 1 percent of GDP suggest that a
huge un-tapped market waits in this sector. In this connection Islamic Banks can develop partnership with Federal and Provincial governments for building low cost housing schemes, which are on the active agenda of both federal and provincial governments. In addition to this, it has been noticed that the Islamic banking finance is concentrated in a few sectors like textile, chemical & pharmaceutical and individuals. The concentration of Islamic banking finance in a few sectors implies concentration of risk as well. The
Islamic banking industry thus, has to diversify its product mix by focusing on areas where it has comparative advantage over the conventional system. Moreover, in Pakistan 67% of Islamic banks financing is concentrated in the corporate sector through Murabaha, Ijarah, and Diminishing Musharaka. As most corporate clients are still loyal with the conventional banks, the Islamic banks in order to attract them, have to offer significant price discounts. While this may improve the quality of its financing portfolio, it however, can reduce profit margins and hence can decrease its ability to offer better returns to the depositors. However, better return to depositors is possible if the Islamic Banks expand their scope to offer current and PLS deposits for financing short term trade based activities and restricted investment accounts for financing longer term investment banking transactions. This expansion in scope would be instrumental in increasing viability of Islamic banks, improving financial inclusion, promoting entrepreneurial culture, and significantly enhancing the returns to depositors. Furthermore, as Islamic finance promotes risk and reward sharing and encourages financing to promising startups- although a bit riskier business, professional appraisal of the venture, and capacity of the entrepreneur to manage the venture could considerably lower the risk of failure and enable Islamic banks to earn attractive returns that will allow them to pay better returns to their depositors. As the level of awareness and understanding of Islamic Banking remains very low in the country, the Islamic banks have to focus more aggressively on their awareness campaign throughout the country together with effective marketing of Islamic banking as offering Shariah compliant returns to the depositors
4. Future Challenges for Islamic Banking & Finance

Major challenges that Islamic Banks are facing globally are indicated below:
4.1. Financial Innovation in Critical Areas
Progress of Islamic banking will depend on its ability to innovate in the following areas: Financial instruments yielding stable income flows for orphans, widows, pensioners and other weaker segments of the society Financial instruments for meeting governments financing needs Cover or security for financing, in particular Shariah-compliant alternatives for penalty on payment defaults Formulas for pricing of Islamic financial products
4.2
Competition
Islamic banks should be ready to brace not only intra-industry competition but also interindustry competition from interest-based banks. The latter are already offering Islamic financial products. The competition is likely to grow.
4.3
Misuse of Islamic Banking
Unless there are effective checks and monitoring, vested interests may use Islamic banking to bypass the Ahkam on riba. For example, in the existing murabahah financing banks do not directly come into the picture as buyers from the would-be suppliers. This gives dishonest fund-seekers a window for getting credit from the bank through fictitious purchases.
4.4.
Other Challenges for Islamic Banking
Enforcement of contracts is not effective. Inefficient system for early recovery. Ineffective code of conduct for professionals. Development of Shariah compliant government securities. Research and development in the field of Islamic finance and economies. HR development and training to the banks staff on Islamic Banking and Finance. Education and public awareness about Islamic financial system.
CHAPTER VI
RECOMMENDATIONS 1. General Recommendation for Islamic Banking System
There is an urgent need to increase the supply of scholars with dual specialisation in Shariah and finance. In order to meet this need, it is recommended that courses may be introduced for Shariah scholars in economics and finance. Similarly, courses in Shariah especially designed for economists and financial experts may be initiated.
2. Recommendations for Meezan Bank and Bank Islamic
The branch network of both Meezan Bank Ltd. and Bank Islami Pakistan Ltd. is largely concentrated in big cities and banked areas. These banks need to focus more on the unbanked and rural areas so that a larger population can access Islamic banking at their doorsteps.
Both the Islamic Banks have to encourage businesses through macro-economic policies to increase the use of equity finance and decrease their reliance on debt.
Both the Islamic Banks have to focus more aggressively on their awareness campaign throughout country together with effective marketing of Islamic banking as offering Shariah compliant returns to the depositors.
3. Recommendations for Further Study

Study to find out the customer awareness and satisfaction about Islamic Banking System in Pakistan is required. Study to find out the ways and means by which the liquidity problem of Islamic Banking can be resolved
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Growth Opportunities For Islamic Banking in Pakistan

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Growth Opportunities For Islamic Banking in Pakistan

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GROWTH OPPORTUNITIES FOR ISLAMIC BANKING IN PAKISTAN

GROWTH OPPORTUNITIES FOR ISLAMIC BANKING IN PAKISTAN

iii v vii viii xi xii 1 1 1 3 4 7 7 7 8 9 10

CHAPTER V - RESULTS AND DISCUSSION--------------------------- 67

I-2 I-3 IV- 1 IV-2 IV-3 IV-4 IV-5 IV-6

Figure IV _ 1 IV_ 2 Share and growth of Islamic Banking --------------------------Compositions of deposits-------------------------------------------

2. Philosophy of Islamic Banking

3. Factors of Production in Conventional Economics

4. Difference between Islamic and Conventional Banking

12. A conventional bank has to guarantee all its deposits.

13. Conventional banking prices money.

14. Does not involve itself in trade and business.

14. Actively participates in trade and production.

15. Depositors get a fixed rate regardless of the banks profitability.

6. Objectives of the Study

8. Scope of the Research Study

Source: Bank Islami annual report, 2010

9. Limitations of the Research Study

10. Organization of the Study

1. Concept of Interest in Islam

3. Global Scenario of Islamic Banking

4. Islamic Banking in Pakistan

4.1. Accounts, Financing & Lending Process of Islamic Banking

5. Advantages of Islamic Banking

relief to refugees and victims of war, etc

relief to victims of natural disasters

6. Benefits of Islamic Banking

7. Growth and Prospects of Islamic Banking

8. Future of Islamic Banking

9. Survival of Islamic Banking

Standardization of Islamic Financial Products

Possible Solutions to Problems Faced by Islamic Banking

1. Islamic Banking at Global Level

1. Development of Islamic Banking System in Pakistan

2. Major Modes of Islamic Banking and Finance

3. Role of Islamic Banking in Economic Development

Current Status of Islamic Banking in Pakistan

1.2 Industry Progress and Market Share

Total assets Deposits Net financing and investment

411 330 235

Performance Indicators of Islamic Banks

Non-Performing Financing and Assets

Table IV-3: Non-performing financing & assets

Table IV-4: Financing mix

Table IV-5: Investments

Objective 2: Growth Pattern of Two Full-Fledged Islamic Banks in Pakistan

2.1 Growth Pattern of Meezan Bank

3,471 1,025 1.71

2,713 621 1.22

1,765 964 1.96

27.9 65.1 40.2

53.8 (35.5) (37.8)

Source: Meezan Bank annual report (December 2007 to December 2009)

Deposits Financing Net

23,290 34,499 124,182 1,249 114,997 6,650 1,050 9,091

14,527 18,108 85,276 1,057 79,301 4,926 845 6,341

10,535 8,850 67,179 1,192 61,472 3,780 721 5,720

60.3 90.5 45.6 18.2 45.0 35.0 24.3 43.4

37.9 104.6 26.9 (11.3) 29 30.3 17.2 10.9

Source: Meezan Bank annual report (December 2007 to December 2009)

2.3 Growth Pattern of Bank Islami Pakistan Limited

739 112 1,741 29

31.5 (66.2) Nil 849.9

147.9 83.2 (92.5) 185.6

343 1,312 90 1,756 1,766 (479) (0.91)

196 904 131 1,028 1,034 (53) (0.12)