Islamic Banking in Pakistan

(Introduction, history, formation, statutory requirements,  and accounting standards)

Introduction and History of Islamic Banking:

In the early stages of 20th century, the Islamic banking was only limited to models and modus operandi.  The full-fledged system of Islamic banking was introduced in 1960s by an Egyptian bank 'Myt Ghamr'The earliest Islamic banks faced serious challenges ranging from general suspicions about their viability to a common mistrust about their intentions. Since then, the Islamic banks have been steadily growing to a remarkable level at this stage. During the last decades, financial instruments used by Islamic banks have developed significantly, both on assets and liability sides. Many instruments have been developed to mobilize financial surpluses. A number of Islamic banks have launched investment instruments in the form of certificates with short-term maturities or have established funds earmarked for certain investments.  Accordingly, at present, there are around 70 countries in which the Islamic financial institutions are operating in full-fledged or in part.  Recently six countries including Bahrain, Saudi Arabia, Malaysia, Indonesia, Brunei and Sudan have signed a memorandum of understanding (MOU) for establishment of the first International Islamic Financial Market (IIFM) in co-operation of Islamic Development Bank (IDB).  IIFM is designed to provide a co-operative framework among around 200 Islamic banks and financial institutions all over the world.  A Liquidity Management Centre (LMC) is also working in Bahrain which addresses the critical need for liquidity management by Islamic banks in line with the Shariah principles.

The Islamic Financial Institutions (IFIs) can be divided into two broad categories:

  1. Islamic commercial banks; and
  2. Islamic investment institutions and international holding companies

Legendary names of Islamic finance are as follows:

Banks / Financial Institutes Countries
Darul-Mal Al-Islami Switzerland
Dallah Al-Baraka Group Saudi Arabia
Bahrain Islamic Investment Bank Bahrain
Al-Rahji Banking and Investment Corporation Saudi Arabia
Al-Meezan Bank Pakistan
Faisal Islamic Bank Egypt
Jordan Islamic Bank Jordan
Islami Bank Bangladesh
Bank Islam Malaysia Berhad Malaysia
Dubai Islamic Bank UAE
Kuwait Finance House Kuwait
Al-Baraka Islamic Investment Bank Pakistan

Islamic financial institutions are diverse and becoming increasingly innovative. Value of their assets has reportedly exceeded $200 billion with a steady growth rate of 10-15 percent per annum. They represent a small but dynamic market, no longer confined to its original strongholds in the Middle East and South East Asia. In USA, UK and a number of other European countries, various Islamic funds have existed for a number of years. Some conventional financial institutions of international standing have established Islamic banking subsidiaries and windows. Many banks, both in the Muslim world and outside, are offering Islamic financial products and take active part in capital market transactions. Liquid instruments are emerging through Securitization by way of Islamic finance like equity/mutual funds. There is also Dow Jones Islamic Market Index.

In Pakistan, the process of Islamic financing and banking started with the reforms in specialised financial institutions like NIT, ICP and HBFC in conformity with the Islamic principles.  From 1st July, 1985 all the commercial banking operations were made 'interest free'.

Estabilishment of Islamic Bank as per to the Requirements of State Bank of Pakistan:

Recently, State Bank of Pakistan has allowed the formation of full-fledged Islamic banks in the private sector.  The existing scheduled commercial banks were also authorised to open subsidiaries for Islamic banking operations.  Such subsidiaries shall be considered as the Islamic Banking Subsidiaries and shall have a separate body of governance.  It is a statutory requirement for the bank to appoint a Shariah Adviser / Shariah Supervisory Committee consisting of Shariah scholars of repute to advise the Islamic bank on matters pertaining to Shariah.  Shariah Adviser / Committee will be responsible to vet all agreements, and products offered by the Islamic bank.  The detailed criteria for setting up Islamic Banking Subsidiaries has been issued by the State Bank, which are highlighted as below:

  1. The proposed subsidiary shall be a Public Limited Company and shall be listed on the Stock Exchange;
  2. The banking subsidiary (Islamic) are required to conduct the banking activities strictly in accordance with the Shariah principles;
  3. To commence the business, the subsidiary shall have a minimum paid up capital of Rs. 1 billion; and
  4. At least 51% of the total paid up capital shall be subscribed by the (parent) banking company, and a maximum of 49% of shares shall be offered to public.

Islamic Banking Division: The bank shall be required to set up an Islamic Banking Division (IBD) at the head office / country office in Pakistan.  The bank is also required to prepare a full detail of the organisational structure of the IBD and submit to State Bank.  The responsibilities of IBD are as follows:

        (a) To manage and be responsible for the operations of Islamic Banking Branch (IBB) including policy and procedural matters;

(b) To liaise with other departments in the bank and the Shariah Adviser / Committee to ensure smooth operations of IBB;

(c) To ensure that all funds pooled into the Islamic Banking Fund (IBF) are channelled into Shariah complaint financing and investment activities;

(d) To arrange training of staff on Islamic banking;

(e) To arrange for compilation and submission of such returns, as may be required to be submitted to State Bank from time to time;

(f) To ensure that all directives and guidelines, particularly those applicable to Islamic banking, issued by State Bank are strictly complied with;

(g) To maintain the Statutory Cash Reserve and Liquidity Requirement with State Bank as prescribed by State Bank from time to time; and

(h) Other roles and responsibilities as determined by the bank or State Bank from time to time.

Islamic Banking Fund (IBF): The bank shall be required to maintain a minimum fund of Rs. 50 million or 8% of risk weighted assets of IBB, whichever is higher.  The funds of Islamic Banking shall be funded by the head office or its country office and controlled by the IBD for the operations of IBB.

Shariah Compliance: Obviously, the sole purpose of the Islamic bank is to conduct banking strictly in accordance with the Shariah principles, as outlined in Holy Quran and Sunnah.  The bank is required to ensure the Shariah compliance on all the agreements, and products and services offered and handled by the IBD and / or IBB.  The responsible authority for the Shariah compliance is the Shariah Adviser / Committee consisting of Shariah scholars having sufficient related knowledge, qualifications and experience.  The Shariah adviser or Shariah Supervisory Committee, appointed by the bank, shall advise the IBD on all of the business matters pertaining to Shariah.

Islamic Financial Accounting Standard:

Recently the Institute of Chartered Accountants of Pakistan (ICAP) has issued the first Islamic Financial Accounting Standard (IFAS) 1 - Murabaha.  The purpose of this Standard is to provide guidance for the transactions regarding Murabaha.  Murabaha is a particular kind of sale where seller expressly mentions the cost he has incurred on the commodities to be sold and sells it to another person by adding some profit or mark up thereon which is known to the buyer.

Thus, Murabaha is a cost plus transaction where the seller expressly mentions the cost of a commodity sold and sells it to another person by adding mutually agreed profit thereon which can be either in lump-sum or through an agreed ratio of profit to be charged over the cost, thus resulting in an absolute price.  According to IFAS 1, Murabaha should fulfill the following conditions:

(a) The thing or commodity is in existence;

(b) It is owned by the seller;

(c) The bank must have a good title to the commodity before it sells it to its clients; and

(d) The commodity must come into the possession of the bank, whether physically or constructive, in the sense that the commodity must be its risk, though for a short period.

For a Murabaha transaction, the bank itself may purchase the commodity and keep it in its possession.  But, as soon as the client purchases the commodity from the bank, the ownership, as well as the risk, passes to the client.  According to this Standard, for a valid Murabaha transaction, the financing must be in accordance with Shariah principles.

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