Islamic Banking in Pakistan: Living up to the Hype?

We know that for true development to occur, economic growth has to be gender, linguistically, ethnically, and socio-culturally inclusive of all communities and groups, including those historically marginalised in the past. A necessary aspect of this is obviously financial inclusiveness for individuals and firms from marginalised communities.

Growth Without Development describes many countries, especially Pakistan, and conventional finance does not have a good track record on inclusivity. However, advocates of Islamic Banking and Finance (IBF) have long argued that it is an exception. This is because, to quote Dr Ahmed Mohammed Ali (page xi), President of the Islamic Development Bank Group (the Muslim world’s multilateral development agency), “Islamic finance, built on a foundation of social and economic justice, can contribute to shared prosperity through the principles of inclusive participation and risk sharing.” So even if IBF is really only applicable in Islamic societies, this still covers countries from Morocco to Indonesia, and so affects almost two billion people.

The “inclusive” aspect of IBF comes from its emphasis on “risk sharing” via Profit and Loss Sharing (PLS), essentially Islamic Venture Capitalism, since IBF advocates argue that “In Islam, one does not lend to make money, and one does not borrow to finance business.”   PLS is, thus, IBF’s advocates proclaim, a far superior alternative to conventional finance based on a secured/collateralised loan (hence default risk is covered). The loan uses interest rates to determine the cost of the financial product, and interest costs accrue regardless of the enterprise’s fiscal well-being. In PLS, the financier benefits only if and to the extent that the client prospers, and losses are borne proportionately to investment. Thus IBF is risk sharing while conventional finance is risk displacing since its ‘heads I win and tails I don’t lose’ for the lender. Thus, Islam requires a symmetrical risk:reward financial relationship.

IBF, in Pakistan and elsewhere, is becoming even closer to conventional finance as it drops the pretence of material finality and participatory finance.

So IBF entails PLS, “interest-free” transactions, no financing of haram products/activities or of excessively speculative ones (maysir), and that all transactions must have material finality. Material finality means that only real, i.e., involving actual products, transactions are financed, and purely notional/monetary ones, e.g., foreign exchange or derivatives trading, are prohibited. This encourages directly economically productive activities and discourages speculation, etc.

The early advocates of contemporary IBF characterised PLS as the strong (or desired, i.e., Shariah-based) form of IBF, while all non-PLS forms were characterised as weak (i.e., merely Shariah-compliant) forms but allowable as long as one of the parties incurred some—however infinitesimal—risk on its part. So there is a rhetorical, ideal form of Islamic finance (PLS), and then there is the actual practice of it (non-PLS debt-analogue product; now often termed trade-based finance to avoid opprobrium).

The preferred PLS (or strong) form of Islamic finance has two main variants: mudarabah (participants pooling capital and expertise) and musharakah (direct equity investment). The non-PLS (or weak) type also has two main forms: murabahah (cost-plus sales) and ijara (leasing).

However, IBF’s many critics have long argued that it does not offer an actual alternative to conventional finance but only Shariah-compliant versions of conventional financial instruments.   IBF inefficiently and at high cost duplicates conventional products by adding layers of complexity and transactions costs in order to achieve Shariah arbitrage. This Shariah arbitrage goes to the extent of replacing “interest rate” in financial transactions with a percentage “profit rate” or “profit margin” that is linked to some benchmark interest rate, e.g., LIBOR or its many local equivalents like KIBOR in Pakistan, for pricing. So, if in a murabahah transaction, a bank buys machinery on behalf of a client for PKR 10 million and sells it to the client for PKR 15 million, payable over five years, and secured by a hypothecation charge over the machinery, working out the implied annual loan-equivalent interest rate (8.47%) is a trivial matter.

In 2012, 79.46% of IBF transactions worldwide were murabahah (or de facto equivalents), and 10.82% were ijara (p.69). More recent (2021) data confirms that weak forms continue to dominate global IBF. Pakistani IBF appeared to do somewhat better as (in end-2006) Islamic financing modes were 42% murabahah (or equivalents) and 30% ijarah, but 16% diminishing musharakah (for financing fixed assets, e.g., houses or capital equipment) and 1% other musharakah. However, (by 2021), the picture for Pakistani IBF at least had changed dramatically as murabahah (and equivalents) declined to only 24.8% and ijarah to 4.9%, but diminishing musharakah had risen to 34.2%, and other musharakah (mainly a new product, running musharakah) showed a massive increase to 24.8%.

Thus, it seemed that Pakistani IBF, if not the world’s, had conformed to an early IBF pioneer Dr Ausaf Ahmed’s contention that its functional equivalence to conventional finance was simply a necessary step in the transition to true PLS and that non-PLS would soon be replaced by PLS forms like musharakah. Unfortunately, neither diminishing nor running musharakah are actually participatory/PLS products in any meaningful way.

Let’s first consider a diminishing musharakah (DM, aka an Islamic mortgage) transaction used to finance, say, a house. What makes it a non-PLS product is that it is a straight analogue to a conventional mortgage–with a diminishing principal being financed so as to ensure reducing monthly payments—since a substantial down payment is required and KIBOR is used for pricing (‘profit rate’) and not some concept of ‘fair market value’ for a true rental assessment.

Running musharakah (RM, aka Islamic Running Finance), pioneered by Meezan Bank, Pakistan’s largest and most innovative Islamic bank, is the Islamic equivalent of a conventional line of credit that, of course, lacks any material finality. Like a line of credit, RM allows the client to draw upon it at will and only pay profit on a daily interest accrual basis for the actual amount utilised—this drawdown is the bank’s daily investment in the client. RM avoids murabahah’s inflexibility and cost disadvantage, and it is also on a KIBOR-plus basis, but its true innovation is its two-tiered pricing structure. The two-tier pricing structure eliminates any pretext of profit-sharing since all profits up to the expected (i.e., KIBOR-based) profit rate accrue to the bank, but all further earnings are shared on the basis of 99.99% to the firm and 0.01% to the bank. Theoretically, clients must make a quarterly final profit adjustment that equates expected with actual profits, but given the 9999:1 ratio, this is a purely pro-forma exercise. Such hila (legal subterfuge) to get around Shariah restrictions date back to the very beginning of Islam, as Coulson’s masterwork on Islamic jurisprudence demonstrates. Thus, modern IBF is not doing anything for which there is no compelling precedent in fiqh (jurisprudence).

RM is not likely to be replicated elsewhere since, e.g., the Gulf countries and Malaysia utilise even more problematic financing methods, such as tawarruq (aka commodity murabahah; disfavored by  State Bank of Pakistan) and bai inah (two-party tawarruq), respectively, to provide clients immediate liquidity.

So, IBF, in Pakistan and elsewhere, is becoming even closer to conventional finance as it drops the pretence of material finality and participatory finance. It is thus nothing more than a “piety tax” on devout Muslims rather than a real alternative to conventional finance.

Feisal Khan

Feisal Khan is a Professor at the Department of Economics and the Executive Editor, Asian Affairs: An American Review at the Hobart and William Smith Colleges, Geneva, NY, United States.

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