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MF
34,10

Financial contracts, risk and

performance of Islamic banking
Anjum Siddiqui
Director, Center for Research and Development,
Gulf University for Science and Technology, Kuwait

680
Abstract

Purpose The purpose of this paper is to focus on various modes of Islamic finance and examines
their risk and other characteristics by conducting a selective literature review.
Design/methodology/approach Due to the Islamic prohibition of interest and in compliance
with injunctions on permissible trade contracts, the savings and investment contracts offered by
Islamic banks have a different risk profile than those of conventional banks. This gives rise to a
number of regulatory issues pertaining to capital adequacy and liquidity requirements. Operational
issues also arise as Islamic banks are limited in their choice of risk and liquidity management tools
such as derivatives, options and bonds. All these issues are theoretically examined and various
performance indicators of two Islamic banks are also examined to compare them with traditional
banks that practice mark up pricing.
Findings The balance sheets and various performance indicators show that there is evidence that
Islamic banks in Pakistan tend to engage in little long-term project financing. However, on the plus
side these banks have shown good performance with respect to the returns on their assets and equity
and have also demonstrated better risk management and maintained adequate liquidity.
Research limitations/implications A larger set of banks across various countries needs to be
examined before any substantive conclusions can be reached about the relative performance of
Islamic versus conventional banks.
Practical implications These largely pertain to central bank prudential regulations which must
ensure that a level playing field is created for Islamic banks to compete with traditional banks.
Originality/value The paper is a commentary on the risk characteristics of Islamic banks and
also analyzes for the first time the performance of the only two purely Islamic banks currently
operating in Pakistan.
Keywords Islam, Banking, Financing, Equity capital, Partnership, Moral hazards
Paper type Research paper

Managerial Finance
Vol. 34 No. 10, 2008
pp. 680-694
# Emerald Group Publishing Limited
0307-4358
DOI 10.1108/03074350810891001

1. Introduction
Over the last decade, the demand for Islamic banking and finance products has grown
strongly. In mid-2004, the Islamic financial market had 265 banks with assets of more
than $262 billion and investments of more than $400 billion (IOSCO, 2004)[1]. From
simple profit and loss sharing (PLS) savings accounts, Islamic savings and investment
products have now progressed to hedge funds, bonds and derivatives. The
proliferation of Islamic banking products to more than 50 countries including USA and
Europe is understandable as international banks can see a profit opportunity by
tapping into the large and growing banking needs of the Muslim population in Middle
East, Asia and elsewhere.
Islamic banks are prohibited to pay or receive any interest in their lending and
investing transactions. They also face a supply side shortage of appropriate Islamic
instruments which can serve the liquidity, risk management and hedging needs of
customers or the banks themselves. Such instruments are offered by traditional banks
in the form of derivatives (forward and futures contracts) and options (put and call).
The comments of an anonymous referee of this journal are gratefully acknowledged.

Under various (though not all) interpretations of Islamic law all such instruments are
forbidden as they include the element of risk (gharar)[2]. The risk of these futures
instruments is that at the time the contract is executed, (which is the current period),
the object/commodity to be sold does not usually exist. Insurance is also ruled out both
on the grounds of risk and also as it includes an element of riba (interest) because
insurance companies invest their funds in a number of fixed income securities which
earn interest. Insurance also has an element of gambling in the sense that the insured
party could collect a large amount of money after paying a few or just one installment
of insurance premium or on the other hand they may make many payments without
ever getting the state contingent return from the insurance company.
The injunctions of no interest, and no uncertainty and risk in contracts do not imply
that an Islamic financial system is inconceivable and that markets cannot develop to
provide financing and risk hedging instruments. In fact, such a system has been
designed and is in operation with varying degrees of success in a number of countries
including Pakistan and Malaysia[3]. It has also been theoretically demonstrated that
futures contracts constructed on permissible Islamic commodities are Pareto-optimal
and if adopted could lead to financial deepening (Ebrahim and Rehman, 2005).
To get around the prohibition of interest, Islamic business contracts are based on
equity participation. Nevertheless, Islamic futures and forward contracts for various
state contingent payoffs are not easy to develop as they not only have to avoid interest
but also uncertainty, as well as comply with various ethical codes enjoined in Islamic
contract law. Despite these restricting Islamic compliance injunctions on contracts,
Islamic banks have provided some historical and some new instruments with
derivative like properties[4].
In this selective review article on Islamic banking, section 1 presents a brief
description of the more common Islamic savings and investment contracts to set the
stage for a discussion of the risk and regulatory issues pertaining to contracts in
section 2. Section 3 examines data from two Islamic banks in Pakistan to evaluate the
practice and performance of Islamic banks and the conclusion in section 4 summarizes
the findings with some policy implications.

2. Financial contracts
Islamic financial instruments are based on the principles that they exclude interest
(riba), not possess major uncertainty ( gharar) and not have gambling like features
(Maysir). Due to the prohibition of interest, Islamic banks or traditional banks with
windows for Islamic products cannot have fixed interest debt instruments. The Islamic
financial system instead proposes equity participation and risk sharing on the part of
banks and debtors (investors).
We provide a brief overview of some widely used Islamic banking contracts[5]
which are commonly used to provide Shariah[6] compliant (i.e. based on Islamic
principles) products for savings, trade and investment. Like traditional banks Islamic
banks also offer a range of financial services and products. These are consumer
financing, trade related financing and investment type of modes of financing. Such
modes of financing take the form of cost plus sales (Murabaha)[7], credit sales (bay bithaman ajil), leasing (Ijarah), partnerships (Modaraba and Musharakah) and some
forward contracts (Salam and Istisna). In addition there are zero interest loans for poor
farmers and needy students referred as Qard-e-Hasna (benevolent loan).

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2.1 Murabaha (trade with mark up or cost plus sale)

This type of Shariah (Islamic law) compliant contract is one of the most widely used
modes of financing by the Islamic banks. This instrument is being used for financing
of consumer durables, real estate and in the industry for purchasing raw materials,
machinery or equipment. However it is most common and popular use is in short-term
trade financing including the financing of letters of credit. One can think of a
Murabaha facility to be akin to the consumer loans, lines of credit and working capital
facilities provided by conventional banks.
Although the Murabaha contract is signed between the bank and the purchaser there
are three parties involved: the seller of the good to the bank, the buyer (banks debtor) who
could be an ordinary consumer, factory owner or a trader, and the bank which acts as an
intermediary trader and facilitator between the buyer and the seller. The Murabaha sale
contract between the bank and the purchaser (debtor) is based on the prior promise to
purchase contract signed initially between the same two parties. Under the Murabaha
sale contract the bank purchases the goods desired by the purchaser from the seller and
sells to the purchaser on his promise to purchase at a price which includes the cost of the
purchase plus a pre-agreed profit thus this is a cost plus sale contract. Murabaha
contracts have flexible repayment terms, competitive pricing, some minimum limits on
Murabaha finance and variable tenors of loan financing for such loans.
The vast majority of the financial transactions of Islamic banks are based on the mark
up or cost plus sale contract. One can view this mark up sale contract to be an interest
based contract as it in fact charges interest but calls it pre-agreed profit in this case it is
ex-ante profit and not realized profit as was originally stipulated under Islamic law. Islamic
scholars have defended this practice by stating that while Islam recognizes trading and its
associated profits it does not accept the concept of fixed return loan contracts.
2.2 Bay bi-thaman ajil (credit sales)
The cost plus profit (Murabaha) contract is hardly ever executed on spot through
immediate payments by the purchaser. A spot payment of the full amount of the loan
by the purchaser would mean that the bank loan is immediately paid off and the bank
is simply performing the role of an intermediary trader facilitating the delivery of
goods from seller to buyer and charging a profit mark up over cost for its middleman
services. The financial intermediary role i.e. the traditional role of banks and money
lenders for centuries can only be played by the bank if the loan[8] payments are
through installments or in other words the bank is extending credit.
This is exactly what happens in the actual practice of Islamic banking in which the
more common and usual mode of payment for goods, machinery or equipment is
deferred payments through installments. These deferred payments at a higher price
than the cost price (incurred by the bank) can be interpreted to mean that Islamic
finance of deferred payments is very much like traditional loan installments charged at
an interest where the interest is the cost plus component (i.e. profit) of the Murabaha
contract. Not so, say Islamic jurists who allow for increase in price due to deferment;
see Usmani (1998) for legal explanations.
2.3 Musharaka (partnership or joint venture)
If the debtor (purchaser) does not seek hundred per cent bank financing of the project
but contributes some of his own equity capital, then such a contract is referred as
Musharakah. Even in this partnership a cost plus sale (Murabaha) contract will be
signed between the bank and the purchaser. However, now the purchaser (debtor) will

be exposed to the risk of capital loss on the capital committed by him, whereas the
debtor had no risk when 100 per cent of the capital was financed by the Islamic bank.
The two parties are again involved in a profit and loss sharing agreement in
conformity with Islamic principles of risk and reward sharing. The profits are shared
in accordance with pre determined ratios while the losses are borne in proportion to
equity participation. Musharaka financing is used by banks for financing trade,
imports and to issue letters of credit and also in agriculture and industry.
2.4 Modaraba (profit and loss sharing)
This is also like a partnership contract except that in this there is no equity partnership
but only profit and loss sharing. Its counterpart in conventional business structures
would be limited partnership. One can think of bank deposits as a case of a Modaraba
contract between the bank and the customer. In this contract the bank lends the entire
capital to the investor/consumer (debtor) and the financial losses of the debtor
entrepreneur are borne entirely by the bank. Only in the event of mismanagement or
neglect is the customer held liable for the losses.
The Modaraba contract is reflected in the balance sheet of the bank on both the
asset and the liability side. On the liability side it is an unrestricted Modaraba in which
the depositors agree that the bank is free[9] to choose the investments that it will make
with their deposit money and agree to share the profits earned by the bank. On the
asset side it is a restricted Modaraba contract because the bank agrees to finance a
particular (restricted) investment need of the customer and to share a percentage of the
projects associated profits[10].
2.5 Salam (sales contract)
Salam is a sale of a commodity whose delivery will be in a future date for a cash price,
which means, it is a financial transaction in which price is advanced in cash to the
seller, who abides to deliver a commodity of determined specification on a definite due
date. The deferred is the commodity sold and described (on liability) and the immediate
is the price. In other words a Salam sale contract is a futures contract.
The practical steps in the Salam sale are as follows. The bank: pays the price in the
contract to the seller so that he can have the immediate use of funds to cover his financial
needs. The seller abides by the contract to make a delivery of the commodity on the
specific due date. At the time of delivery on the specific due date the bank has several
options to choose from: the bank receives the commodity on due date, and sells it either for
cash or on credit; or it can authorize the seller to sell the commodity on its behalf against
fees (or without fees); or it can direct the seller to deliver the commodity to a third party
(the buyer) according to a previous promise of purchase, where the promise is that the
buyer will purchase from the bank. Once the delivery has been arranged by any of the
above mentioned options, the commodity is sold through a sale contract between the bank
and the buyer. In this contract, the bank agrees to sell the commodity for cash or a
deferred price higher than the Salam purchase price paid by the bank to the seller. The
buyer agrees to purchase and to pay the price according to the agreement.
The Salam sale can be used to meet the capital requirements as well as cost of
operations of farmers, industrialists, contractors or traders as well as craftsmen and
small producers.
The bank benefits from entering into a Salam contract with a seller because usually
a Salam purchase by the bank is cheaper than a cash purchase. Due to this reason the
bank is secured against price fluctuations, barring those extreme circumstances of a

Islamic banking

683

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684

price deflation or a market crash when post Salam prices could dip lower than
currently contracted Salam sale prices.
2.6 Ijara ( leasing contract)
As is well known, leasing is designed for sale of vehicles, equipment or property for
conducting business. Unlike traditional banking where the bank allows the customer
(buyer) to lease goods at fixed interest rates, the Islamic leasing facility has two sub
contracts. First, the bank signs a purchasing contract with the seller for the commodity
which the buyer wishes to lease. The bank pays the seller and then gets the commodity
delivered to the buyer from the seller. Second, the bank signs a lease contract with the
buyer in which commodity is leased to the customer allowing him the ownership (or
simply the use) of the asset after payment of lease installments and residual charges.
The lease option is commonly used for transactions in real estate, cars, computers,
machinery and equipment.
2.7 Qard-e-Hasna ( benevolent loan or interest free loan)
Islamic banks provide such a facility on a limited scale to poorer sections of society
such as needy students or small rural farmers. Such loans would have negative NPVs
for the banks. Traditional banks do not have any such benevolent loan structures[11].
Any benevolence is only manifested through charities and grants or scholarships, but
not through non-returnable zero interest loans. The next section outlines the risks
associated with various Islamic modes of financing discussed above.
3. Risks of financial contracts
A typical bank faces a number of risks in its banking operations: credit risk,
benchmark risk, liquidity risk, operational risk, legal risk, withdrawal risk, fiduciary
risk, displaced commercial risk.
The traditional banks (those banks which follow non-Islamic banking practices) pay
the depositors a fixed return (interest) on their deposits which the banks first earn
thorough their investments in loans or in other assets such as real estate or various
mutual funds. While the traditional bank would be exposed to market risk or an interest
rate risk it does not take any investment specific risk with respect to its loans other than
the risk of default by the debtors, which may have been partially covered by pre-loan
collaterals. The investment risk from the borrowed money is borne by the debtor while
he is liable for the payment of principal and interest to the lending bank at the end of the
loan tenure. The relationship between lender and debtor is straightforward: the bank is
the owner of capital and the debtor pays the bank a return (interest charges) on the
borrowed money. The bank determines that interest rate or return by assessing the
markets prevailing opportunity cost of capital. A bank financed investment project is
thus a debt-equity contract where the banks exposure is on the debt part.
To protect themselves against loan losses, banks operating under a conventional
banking system will garnish the wages of the wage earner if he is the defaulting
debtor, or have the first right on the assets of the corporation in case of loan default by
a corporation. Under Islamic banking the collateral has already been established at
the time of the loan. When the Islamic bank gives a loan to a company it becomes the
owner of the assets that the company intends to purchase with the debt and if a default
occurs it confiscates those collateral assets, which it owns anyway, for the tenor of the
profit sharing loan contract. The ownership of the assets by the lending bank continues
till such time that the principal and its associated profit are outstanding. Thus by

eliminating fixed interest payments and substituting them with profit and loss
payments, riba (interest) is avoided under an Islamic banking framework.
While Islamic banks do not pay interest they pay a rate of return to depositors on their
savings. Islamic banks periodically declare a return on deposits, based on the profits
actually earned on investments financed by their PLS deposits. Because banks could
theoretically suffer a loss, this means that depositors principal as well as return are both
at risk under the PLS system. In practice, banks announce expected PLS rates in advance,
so depositors have a good estimate of their rate of return before making a deposit[12].
Like traditional banks, Islamic banks also face credit risk. In case of profit sharing
modes of financing (Modaraba and Musharakah), the credit risk would be nonpayment of the banks share by the lender entrepreneur. This situation arises due to
asymmetric information available to borrowers and lenders in this case the borrower
would have inside information about the proposed projects and their profitability
which the bank would not have access to. Under other contracts such as Murabaha
(cost plus sales or sales with mark up) the rate of return is fixed and predetermined and
such adverse selection and moral hazard problems would not arise. However, credit
risk in Murabaha contracts remains in the form of counterparty risk due to nonperformance of the trading partner (musharik). The non-performance may not be the
fault of the partner but could be due to external systematic forces.
Whether Islamic banks have less or more credit and liquidity risk as compared to
conventional banks depends on institutional arrangements prevalent in a particular
country for example the availability of an Islamic Money Market and central bank
regulations on capital and liquidity requirements for Islamic banks. The evidence for
Malaysia shows that banks engaging in Islamic financing have lower credit and
liquidity risks, but higher interest rate risks than conventional banks. One reason for
lower liquidity risks is that unlike other Islamic countries Malaysian Islamic banks can
use the central bank as a lender of the last resort ( How et al., 2005).
Those Islamic contracts which are based on equity participation will minimize the
adverse selection and moral hazard problems. This is so because under joint ventures
and equity participation schemes there is much more disclosure of a companys books
and investments. However, the agency problems (principal agent problems) will still be
there due to asymmetric information and costly monitoring (Sarker, 2000). However,
one would expect that there will be some reduction in agency problems due to
representation of the equity partners on the Board of Directors of the company.
In developing economies such as Pakistan, most businesses continue to maintain
multiple books of accounts, thus making it very difficult for banks to monitor the true
profitability of various clients. Due to this asymmetry of information the risk of default
increases and also the monitoring costs increase. Documentation of the economy is a huge
challenge for the government of Pakistan where only 1.2 million income earners pay tax
out of a total population of 140 million and 60 per cent of whom are wage earners[13].
In traditional (non-Islamic) banks, interest rate swaps are used as a hedging
instrument against illiquidity which can arise if payment liabilities against deposits
exceed receipts against loans and other assets. In Malaysia, 85 per cent of the Islamic
banks assets are based on fixed rates of return as measured through profit rates, while
90 per cent of the liabilities are on floating profit rates. In the event that cost of funds
increases the banks could find themselves in liquidity shortages even leading to
bankruptcy and a run on the bank. The reason that so far we have not seen such a
situation is that the cost of funds has not fluctuated much. Another reason that Islamic
banks are maintaining their solvency is that a number of banks offering Islamic

Islamic banking

685

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products have also been operating conventional banking products and using
conventional hedging instruments (Baqar, 2005).
Traditional banks use forward contracts and futures contracts to hedge price risks.
Futures contracts were an improvement over forward contracts in that counterparty
risk (risk of default by a party) is eliminated by the futures exchange by means of the
margining process and by daily marking to market. The incentive to default is reduced
as the futures exchange requires the contracting parties to make an initial deposit
(another name for initial margins) and requiring the losing party to pay up (adjusting
the margins) as losses occur. Through this method of margining and marking to
market the counterparty risks (defaults) have been reduced to negligible rates.
Traditional banks have also used another derivative instrument, that is, of options,
to manage contingent liabilities or contingent claims. Since call and put options allow
one to purchase the right to act or not to act (non-obligation) such non-obligation to
exercise the buying or selling of the asset allows more flexibility and allows further
hedging, risk management and improving cash flows.
Islamic scholars have some reservations[14] on options especially pertaining to the
part relating to trading of call and put options and the charging of premiums, which are
viewed as interest (riba), and are forbidden. Kamali (1996) and Bacha (1999) give
arguments in favor of options and contend that its premiums and its trading are an
extension of the basic trading model allowed in Islam.
In order to manage risk of the banking sector as a whole central banks of Islamic
countries have stipulated various capital adequacy and reserve requirements which are
not uniform to all Islamic banks in various regions of the world (for a general review of
risk analysis, see Khan and Ahmed (2001)).
Here mention must be made that since Islamic banks do not have a large portion of
their assets in fixed income interest bearing assets, as conventional banks do, they
should theoretically budget for a larger capital adequacy ratio and a larger liquidity
ratio. Based on this logic, the Basel Committee has stipulated higher minimum capital
requirements for Islamic banks.
3.1 Risk regulation by the Central Bank
There are two issues related to the relationship of commercial banks with the central
banks. First, central banks pay interest to commercial banks on the reserves kept with
them and secondly central banks are lenders of last resort to the banking sector. The
lending involves an interest penalty for running out of reserves. Islamic banks cannot
take interest on their reserves that they park with the central bank and also cannot
benefit from the liquidity facility provided by the central bank as a lender of the last
resort. By not being able to receive a return on their deposits with the central bank,
Islamic banks lose earnings and profitability and by not being able to pay interest for
liquidity reserves obtained from the central bank, the banks expose themselves to
higher priced money market funds or running short on liquidity in crucial times. This
problem cannot be resolved unless the central bank develops an Islamic deposit facility
which pays a rate of profit to commercial banks on their deposits and the commercial
banks similarly develop an Islamic loans instrument which is profit and loss based
( Iqbal and Molyneux, 2005). Another suggestion has been given by Chapra (1985) that
commercial banks should pool funds to assist liquidity constrained banks. However, it
seems unclear why profit oriented commercial banks would partake of their profits by
participation in such a scheme.

A related problem in the relationship of commercial and central banks is the issue of
open market operations through sales and purchases of government interest bearing
securities. In the absence of Islamic structured government bonds, countries in Middle
East and Pakistan have found a way around this limiting factor by allowing their
banks to operate a hybrid banking operation based on traditional interest based
savings and investment instruments and Islamic windows.
As Islamic banks cannot borrow on the overnight money market or from the central
banks as these carry interest charges, they would be forced to keep higher non-earning
liquidity reserves and thus loose profitability.
Another issue relates to central banks regulatory standards for managing the risks
of Islamic banks as opposed to traditional banks. Central banks already have various
prudential regulations in place to monitor the risk exposure of financial sector. These
relate to capital, assets, management, earnings and liquidity and represented by the
acronym of CAMEL. As Islamic banks have PLS as the primary mode of financing
they carry much higher risks and should have higher capital adequacy ratios (Errico
and Farahbaksh, 1998). While Islamic banking does not guarantee the principal of
various financing contracts, such capital requirements would impart greater solvency
and protect the principal liabilities of depositors and investors.
Another general factor contributing to Islamic banks risk exposure is related to the
business environment in which they operate. South and West Asia and Middle East are
marked by underdeveloped financial markets, political instability and weak property
rights and legal structure. In the case of Pakistan, the weak legal structure is seen from
the fact that the Supreme Court ruling on prohibition of interest has been challenged
and quashed and the matter has still not been resolved by the Shariat (Islamic) Court.
4. Islamic banking in practice: a case study of Pakistan
Previously Sarker (1999), Bashir (1999), Samad (1999) and Iqbal (2001) have analyzed
the performance and efficiency of Islamic banks but these studies were not on
Pakistan. This section examines selective data on the performance of Islamic banking
from Pakistan. We first analyze some consolidated macro statistics on the overall
banking performance of those banks which are engaged in Islamic modes of financing.
We then engage in a more detailed ratio analysis to gauge the profitability, liquidity,
risk and solvency and long-term financing exposure of two fully Islamic banks that
have been given Islamic banking licenses[15].
Islamic banking in Pakistan started in its infancy in 1979 and by 2004 there were 25
Islamic banking branches in operation. While Islamic banking had been initiated two
decades ago without a supporting legal infrastructure, the landmark (riba judgment) of
the Supreme Court in 1999 was to prove instrumental in accelerating Islamic banking in
the country. The court observed that existing banking and finance practices of banks
were non-Islamic and ordered that the total banking and financial system be made
Shariah compliant and all interest (riba) be prohibited in the financial transactions[16].
We initiative this exploratory study by looking at some consolidated State Bank of
Pakistan (SBP) data of all scheduled banks engaged in Islamic banking. We follow this
with bank specific balance sheet data on two fully licensed Islamic banks: Meezan
Bank and Al-Baraqa Bank. The lack of a consistent and disaggregated consolidated
data set on Islamic banking precludes a more in-depth analysis; however, some central
bank data allows us to make a few observations.

Islamic banking

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Table I.
Sources and uses
of funds

4.1 Scheduled banks data

Table I shows that the primary source of funds for Islamic banks[17] in Pakistan
remains their deposit liabilities. Deposits as a percentage of total sources of funds have
increased from 65 per cent in 2003 to 68 per cent in 2004. These deposits have been the
primary source for extending credit (financing-deposit ratio is 90 per cent). The high
credit deposit ratio can be viewed as over exposure in loans by Islamic banks and
hence risky. However, the eventual balance sheet risk depends on the tenor of loans and
investments committed by the bank (see evidence below). In deposits, we note that
banks continue to draw the largest chunk of their deposits through savings accounts
which constitute 41 per cent of the total deposit base of the banking sector. This is so
because of availability of alternative savings products, for example National Savings
Certificate (NSC) Schemes of the government. While interest rates on the NSCs have
reduced they are still greater than typical savings accounts returns.
Table II shows a breakdown of the modes of financing extended in the banking
system. The SBPs Banking System Review (Banking Supervision Department, 2004)
reveals that cost plus or mark up financing (Murabaha) constitutes 57 per cent of the
total financing extended by the Islamic mode of financing followed by leasing (Ijarah)
at 25 per cent. Since leasing contracts are also cost plus based, we have evidence that

Sources of funds
Deposits
Borrowings
Capital and other funds
Other liabilities
Total
Uses of funds
Financing
Investments
Cash, bank balance and other placements
Other assets
Total

2003 (%)

2004 (%)

65.1
14.7
15.4
4.8
100

68.4
14.9
11.6
5.1
100

67
9.6
15.3
8.1
100

62.4
4.5
27
6.1
100

Source: State Bank of Pakistan (Banking System Review, 2004)

Modes of financing
Modaraba and Musharakaa
Murabaha
Salam
Istisna
Ijarah
Others
Total
Table II.
Modes of financing

Note: aAlso includes diminishing Musharaka

Source: State Bank of Pakistan (Banking System Review, 2004)

Allocation (%)
6.0
57.1
1.0
0.4
24.8
9.8
100.0

more than 80 per cent of the financing is mark-up based. Using data up to 1985, Khan
and Mirakhor (1990) had earlier observed that Islamic banks do not take long-term
financing exposure whose income is non-mark up based. Two decades after that
observation, the situation remains the same. Musharaka contracts ( joint venture or
partnership) constitute only 10 per cent of their total loan exposure in 2004.
Further evidence on the continued practice of short-term financing by banks is seen
in the behavior of mark up income over the period 2003 to 2004. Net mark up income
has registered a three-fold increase in absolute terms, and as a percentage of mark up
income it has increased from 53.6 to 55.2 per cent.

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4.2 Islamic banks balance sheets

To further investigate whether the degree to which Islamic banks engage in different
tenors and modes of financing we examined the data from the balance sheets of two
Islamic banks in Pakistan which are fully Islamacized or Shariah compliant.
Table III shows the composition of short- and long-term loans the banks have
defined short-term to be a period of less than one year and the long-term is in excess of
one year. In 2003, long-term loans of Al-Meezan Bank and Al Baraqa bank were 15 and
11 per cent of their total loans. In 2004, the situation was not much different. While AlMeezan bank increased its long-term loan proportion to 30 per cent, Al Baraqa reduced
it even further to 10 per cent.
The same is also visible from an alternative representation of short and long-term
financing by way of modes of Islamic finance. Of all the modes of Islamic financing the
Musharaka finance contracts are usually of the longest tenor than short-term financing
modes such as leasing (Ijarah), Murabaha (mark up financing), export refinance, etc.
Leasing can be short or long-term depending on the commodity in question. For
example TVs and refrigerators are usually short-term lease and cars are for long-term
lease exceeding one year.
4.3 Risk, liquidity, and asset performance
We now look at the evidence on the performance of the two Islamic banks by examining
various performance ratios. We restrict our inferences to the two year period 2003-04, as
these banks have recent licenses for fully Islamacized banking (Tables IV and V).
To review the performance of the selected Islamic banks, we compute various
standard ratios of earnings and profitability, capital adequacy, liquidity and asset
composition from their annual accounts and compare those ratios with the
consolidated ratios of the scheduled banks of Pakistan using those as an indicator of
the attained industry average.
Al Baraka Bank
2004
Short-term
Long-term
Total

6,258.81
732.56
6,991.36

Meezan Bank
2003

0.90
0.10
1.00

5,308.64
673.49
5,982.14

2004
0.89
0.11
1.00

8,583.18
3,756.56
12,339.74

Source: Respective Banks Annual Financial Statement 2003-2004

2003
0.70
0.30
1.00

6,290.71
1,106.37
7,397.08

0.85
0.15
1.00

Table III.
Composition of shortand long-term financing
(million Rs.)

MF
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690

Table IV.
Trend in modes of
financing (million Rs.)

Table V.
Selected performance
indicators

Modes of
financing

Al Baraka Bank
Meezan Bank
2004
2003
2004
2003
Amount Percentage Amount Percentage Amount Percentage Amount Percentage

Murabaha
financing
4,104.57
Export
refinance
1,661.90
Musharakah
financing
55.06
Net investment
in Ijarah
financing
671.85
Other
497.98
Total
6,991.36

58.7

3,638.08

60.8

4,856.08

39.1

4,678.81

62.7

23.8

1,555.45

26.0

2,705.28

21.8

988.97

13.3

0.8

571.76

4.6

294.66
493.95
5,982.14

4.9
8.3
100.0

3,221.48
985.14
12,339.74

25.9
8.6
100.0

9.6
7.1
100.0

95.700
1,440.35
193.25
737.08

1.3
19.3
3.4
100.0

Source: Respective Banks Annual Financial Statement 2003-2004

Capital adequacy
Capital/RWA
Net worth/total assets
Asset composition
NPL/gross loans
NNPL/capital
Earning and profitability
ROA
ROE
Liquidity
Cash deposit ratio
Liquid assets/total assets
Liquid assets/total deposits

Meezan Bank %

Al Baraka Bank %

Industry %

10.0
12.0

18.8
16.0

10.5
6.5

0.5
4.0

2.8
11

11.6
28.8

1.5
29.0

1.2
8.9

1.2
19.5

19.0
22.0
32.0

27.0
36.0
53.0

13.0
36.5
46.3

Sources: Banking System Review (2004), SBP; Meezan Bank and Alabama Bank

4.4 Earning and profitability ratios

The profitability is commonly judged by Return on Asserts (ROA) and Return on Equity
(ROE). The ROA shows how a bank can convert its assets into net earnings. A higher
ratio shows better management abilities to convert the assets into net earnings. Similarly
ROE shows net earnings per unit of equity capital. The ROA and ROE for both banks are
at least equal to or better than industry standards. Of the two selected banks Meezan
Bank shows better performance on both criteria of earnings and profitability.
4.5 Liquidity ratios
Banks and other depository institutions have to face liquidity risk because either
checking or savings deposits can be withdrawn at any time. Liquid assets can take the
form of cash and short-term securities. It includes cash and balances with banks, call

money lending, lending under repo and investment in government securities.

Consequently we are using two different ratios to assess liquidity.
The Islamic banks are relatively liquid and have maintained larger cash balances
than traditional banks as is visible in the industry average cash deposit ratio of 13 per
cent. Similarly the liquid assets to total assets ratio shows that Al-Baraqa bank
maintained enough liquid assets as per industry standard while Meezan bank was
carrying a larger proportion of its assets in higher earning more illiquid assets. This is
one of the reasons that earnings and profitability of Meezan bank are better than AlBaraqa bank.
4.6 Solvency and risk exposure ratios
The capital adequacy ratio is the amount of risk based capital as a per cent of risk
weighted assets. The risk based capital system includes all tiers of capital on the
banks balance sheet including fully paid up capital, general reserves, un-appropriated
profit, undisclosed reserves, subordinated debt, etc. The total risk weighted assets of a
bank are the sum of credit risk weighted assets and market risk weighted assets. The
idea behind capital adequacy ratios is that banks should not only use depositors
money to make risky investments but should also commit their own capital to take on
such risk. The higher the banks own injected capital the less risk it would take.
The higher the capital adequacy ratio the more solvent the bank as that would
reflect that the bank has more paid up capital and other reserves. Banks strive to keep
the half yearly and annual capital adequacy requirements of the SBP as there are heavy
penalties for non-compliance. A number of factors can contribute to the increase in
capital adequacy ratio, which includes better profitability, fresh injections of capital,
and an increasing share of government securities in banks portfolios, which bear a zero
risk weight. Foreign banks have maintained much higher capital adequacy ratios (18
per cent) than the SBPs prescribed minimum of 8 per cent. Both Islamic banks in our
sample have fulfilled the SBP requirement and Al-Baraqa has exceeded the overall
industry average of scheduled banks of 10.5 per cent. With the expected
implementation of Basel 2 in 2007, the capital adequacy ratios of all banks will rise and
Pakistani banks will have to show more efficiency. Similarly the ratio of net worth to
total assets is an indicator of the solvency and strength of the balance sheet of a bank.
Both ratios of capital adequacy are higher than the industry average.
Finally, the proportion of non-performing loans (NPLs) on a banks balance sheet
should be as low as possible. However, due to business failures and bankruptcies or
even fraud all loans are not recovered by the banks. Consequently all banks carry some
proportion of these non-earning assets in their loan portfolio. The Pakistani banking
industry has five large local banks whose loan portfolios carry a large percentage of
NPLs and therefore the industry average of NPL/Gross Loans is quite high at 11.6 per
cent. Asset quality of the five largest banks is generally poor, with the ratio of gross
NPLs to total loans ranging from 15 to 35 per cent. Only recent SBP provisions for
generous NPL write offs have improved the balance sheets of commercial banks. The
two Islamic banks have done very well in terms of their sectoral distribution of their
loans and project due diligence before loan disbursement. Care must be exercised in not
inferring too much from this performance ratio. The national commercial banks have
traditionally carried huge NPLs a large majority of which were the result of political
interference in the banks. The two Islamic banks face no such pressures.

Islamic banking

691

MF
34,10

692

5. Conclusion
Islamic banks are different from traditional banks in the modes of financing that they
represent. The risk and equity sharing contracts (Modaraba and Musharaka) are
associated with various investment risks which are the consequence of information
asymmetries leading to moral hazard and adverse selection.
A 100 per cent Islamacized bank is neither supposed to offer or take any interest
earnings from any of its investments. In practice, Islamic banks engage in a hybrid
model of traditional and Islamic savings and investment instruments.
The differing opinions of Islamic scholars on the meaning of Shariah compliance
and permissibility of derivatives and options have impeded the development and
adoption of Islamic futures, derivatives and option contracts in Pakistan and Middle
East. The adoption of modern futures contracts in Indonesia, Kazakhstan, Malaysia
and Turkey has facilitated the expansion and competitiveness of Islamic banks and
other Islamic countries can benefit from developing similar futures products.
Islamic banking in Pakistan is slowly progressing to incorporate PLS based contracts
and is behind the much faster paced developments in Middle East and Malaysia.
However, a preliminary and exploratory analyses of bank data of the two Islamic banks
shows that these banks have met or exceeded industry performance standards in capital
adequacy, profitability and risk management. Much more research is required to asses
whether Islamic banks are optimally leveraging their assets and managing their risks for
which risk adjusted performance measures need to be computed.
Some key policy implications are that Islamic banks will have to be regulated in a
manner that they do not merely engage in short-term trade related financing but also
assist in longer term capital for economic growth. However, the central bank will have to
create a level playing field for both the Islamic and conventional banks and not burden
the Islamic banks with stringent Basel Committee capital and liquidity requirements.
The Securities and Exchange Commission and the central bank will have to create
the laws for the establishment of an Islamic Money Market in Pakistan and other
Islamic countries as has been established in Malaysia. Finally, Islamic banking cannot
take off in Europe and North America without finding a way to guarantee savers
deposits as is the regulatory condition for granting a license to a bank.
Notes
1. Dow Jones Islamic Market Index now has over 1,600 companies with a market
capitalization of $9 trillion. This index excludes those companies which deal in goods
and services prohibited in Islam.
2. Gharar is defined as activities that have elements of uncertainty, ambiguity or
deception. It refers to either the goods or prices of goods, or deceiving the buyer on the
price of goods. It needs clarification that a non-excessive element of gharar is
considered normal and unavoidable. A large element of gharar in a commercial
transaction according to Shariah as it may affect the legality of the transaction.
Insurance, for example, is considered a transaction involving excessive gharar, because
the amount of compensation paid out by the insurance company is uncertain and is
also contingent on specific events in the future.
3. Malaysia has developed hedging instruments by way of 3, 5 and 10 year futures
contracts, an interest rate swap and a KILBOR instrument. If the KILBOR interest rate
rises, a loss in the underlying cash position is offset by a profit in the futures position.
4. For details on Istijrar as a derivative instrument, see Bacha (1999).

5. These are general Islamic contracts and are not limited for use in the financial industry.
These contracts are rooted in Islamic tradition and have been modified to accommodate
modern trade and economic activity.
6. Shariah is Islamic cannon law derived from three sources: the Quran, the Hadith
(sayings of the Prophet Mohammed) and the Sunnah (practice and traditions of the
Prophet Mohammed).
7. The Arabic names with the same meaning as in English are given in parentheses.
8. For the sake of clarity it should be emphasized that Islamic banks do not make loans,
they rather finance various trading and business activities through various profit and
loss sharing contracts.
9. If the bank is truly Islamic then free here means free to choose those investments which
are in compliance with Islamic principles in which investments should earn zero interest,
have no excessive uncertainty and possess no gambling like investment properties.
10. In the event that the bank is financing a pure consumption need, it will sign a leasing
contract (Ijara) if the customer wishes to lease any consumption good usually a
consumer durable or it could enter into a Murabaha contract where it acts as an
intermediary to sell the good to the debtor at a mark-up through a Murabaha contract
or it can finance the pure consumption of small and needy borrowers through a
benevolent loan contract i.e. Qard-e-Hasna.
11. Traditional (non-Islamic) banks in Canada give interest free loans to students for a
certain duration of their studies but do charge them interest usually after six months of
their graduation.
12. Dar and Presley (2000) list a number of reasons for lack of popularity of PLS deposit
accounts. An important theoretical reason is the agency problem whereby the principal
has an incentive to report less profit as it has to be shared with the agent, the depositor.
Another reason is that that secondary markets for Modaraba and Musharaka do not
exist and Islamic banks thus find it hard to mobilize resources.
13. This statistic reveals that businesses generally show false losses in their tax returns or
simply do not file returns. Source: Central Board of Revenue, Pakistan.
14. Usmani (1998) argues that options are invalid as they incorporate a purchase or sale at
a future date. Secondly, in most futures contracts delivery of the commodities or their
possession is not intended and that transactions end up with settlement in difference of
price only which is not allowed in Shariah. Usmani is not correct in ruling out forward
trading as the Prophet Mohammed had allowed such trade provided that such a trade
was of a specific tie period, specific commodity and its specifications of quality and
quantity; also see Khan (1995).
15. At the writing of this article only two banks, Meezan Bank and Al-Baraqa Bank had
been issued full-fledged licenses by the State Bank to operate as Islamic banks.
However, nine other banks also have licenses to offer Islamic financing products while
they also offer conventional banking products for savings and investments. The major
business of these other banks still revolves around conventional banking products.
16. On 24 June 2002, and in response to the review petition filed by United Bank Ltd, the
Supreme Court quashed its earlier judgment on riba of 23 December 1999 and referred
the case to the Federal Shariat Court for their judgment. While the reversing of the
judgment introduced uncertainty, the government has directed the SBP to speed up the
implementation of Islamic banking.
17. The data consolidated by SBP is for two fully Islamized banks with 23 branches plus
nine branches of other banks offering Islamic banking products. In addition, about 40
other Modaraba companies offer limited products but that data is not included here as
they are not scheduled banks.

Islamic banking

693

MF
34,10

694

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Corresponding author
Anjum Siddiqui can be contacted at: anjum economist@yahoo.com

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