BANKING WITH FAITH

The promise and potential of Islamic banking in Pakistan has never been underestimated. It was in 2008 that the State Bank of Pakistan (SBP) announced the first five-year strategic plan for the industry, popularly known as ‘12 by 12’. The plan outlined initiatives aimed at enabling the industry to achieve a 12% share in the overall banking industry by 2012, with agriculture, SMEs and microfinance expected to be the main drivers. The plan focused on five areas, which included the development of a comprehensive regulatory framework; expansion in the scope of Islamic banking products; increased emphasis on Shariah-compliant procedures; greater involvement of industry stakeholders and Shariah advisors along with the need to train people to serve in the Islamic banking industry.

Despite the optimism and a healthy year-on-year growth, according to SBP’s Islamic Banking Bulletin October-December 2011, the target was missed by more than four percentage points. In 2012, Yaseen Anwar, Governor, SBP (at the time) stated that although the initial target had been missed, given recent developments, Islamic banks were poised to achieve a 16% share by 2017.

A review of SBP’s Islamic Banking Bulletin July-August 2017 (the latest available), shows that despite encouraging growth in both the asset and deposit base, Islamic banks’ share in the overall industry (in terms of assets) is still 11.9%, well below the predicted 16%.

Banking experts interviewed by Aurora were of the opinion that if Islamic banking is to achieve its true potential, key challenges will need to be resolved. However, before delving into the issues constraining growth, it is important to take a step back and examine where the industry stands and the reasons behind its consistent growth.

Industry overview

SBP’s Islamic Banking Bulletin July-August 2017 states that the total assets of the industry crossed the two-billion mark at the end of September 2017, standing at Rs 2,083 billion; this figure means that assets registered a year-on-year (YoY) growth of 16.5%. The industry’s performance on the deposit side has been as impressive, with deposits reaching Rs 1,729 billion, indicating a YoY growth of 17.1%. Given that at the end of 2008, assets accounted for a mere 4.9% of the industry and deposits 4.8%, the increase is significant.

Although SBP issued the first license for a full-fledged Islamic bank in Pakistan in 2002 to Meezan Bank, it wasn’t until overseas investment began pouring into the sector (most significantly from the Middle East) that local conventional banks started taking an interest in Islamic banking and focused on establishing and expanding Islamic banking window operations.

Currently, there are five full-fledged Islamic banks – AlBaraka Bank, Bank Islami, Dubai Islamic Bank, Meezan Bank and MCB Islamic Bank – and 16 standalone Islamic banking branches of conventional banks. The number of players is likely to increase. Faysal Bank announced, in mid-2014, their decision to transition into a full-fledged Islamic bank and according to Yousaf Hussain, President, Faysal Bank, “significant progress has been made in terms of product development, staff training, system development and growth. In the past two years, we have established 125 new Islamic banking branches and almost 50% of our branches have shifted entirely to Islamic banking.” Another development is Askari Bank’s launch in January of their Islamic banking operations under the name ‘Ikhlas’. The increasing industry and investor interest in Islamic banking is hardly surprising given that SBP has projected that growth in Islamic banking will continue to outpace that of its conventional counterpart.

Growth drivers

Despite the fact that the industry has missed its growth targets, the double-digit YoY growth, combined with increased outreach (as of September 2017, there are 1,220 Islamic banking branches and 1,014 window operations within conventional banks) is impressive. Part of this growth can be attributed to the expansion and consolidation of Islamic banks between 2008 and 2012. Although SBP issued the first license for a full-fledged Islamic bank in Pakistan in 2002 to Meezan Bank, it wasn’t until overseas investment began pouring into the sector (most significantly from the Middle East) that local conventional banks started taking an interest in Islamic banking and focused on establishing and expanding Islamic banking window operations.

In addition to the consolidation, regulation and standardisation that have characterised the industry in the last few years, Aurora’s interviews with banking experts revealed that other factors have also contributed to this growth. The most commonly cited is Pakistan’s burgeoning population, which according to the latest census is approximately 208 million and the majority of which is Muslim. According to Muhammad Raza, Senior Executive VP, Group Head Customer Support, Meezan Bank: “According to a SBP study, approximately 76% people expressed preference for Islamic banks. This indicates the considerable latent demand for riba-free banking that can be tapped into.”

The research titled Knowledge, Attitudes and Practices (KAP) of Islamic Banking in Pakistan, commissioned by the SBP, provides statistical evidence proving this statement to be true beyond doubt. Research findings indicated that 88.41% of banked respondents view interest-based banking as being against the principles of finance and trading specified in Islam and over 93% of the unbanked population (across rural and urban areas) expressed the same view. These figures indicate that a substantial market exists for Islamic banking products.

In this regard, SBP continues to play an extremely supportive role. The creation of a separate and centralised Shariah board, which has made Shariah audits compulsory across all Islamic banks and window operations, in addition to issuing precise guidelines for the appointment of Shariah advisors at individual banks, are initiatives for which the SBP has been greatly appreciated, not only by local industry stakeholders, but internationally as well.

Earlier this year, SBP was voted as the Best Central Bank in Promoting Islamic Finance by a poll conducted by the International Finance News (IFN), an arm of Red Money Agency, Malaysia. This marks the second time that SBP has received this award. Furthermore, to address the concerns of the industry, as well as consumers, in 2017, SBP issued detailed guidelines outlining the process of converting from a conventional to an Islamic bank; introduced amendments in the Shariah Governance Framework (which made external auditing mandatory to ensure greater transparency in operations); tax neutrality for Islamic transactions was introduced and a new SME finance policy to promote entrepreneurship was launched. In the view of Mohammed Adil Sami, Senior VP, President, Head of Marketing, Meezan Bank, “these measures have not only improved the efficiency, service and structuring of Islamic banks and windows, they are also a step in the right direction in levelling the playing field.”

A pertinent question to ask at this point is why, despite tremendous consumer demand, a potential target market of millions of people, increasing FDI and the continued support of the SBP, does the industry continue to miss the forecasted growth and market share targets?

Challenges and constraints

There is no question that the consistent and considerable growth of the industry is impressive. However, as banking experts point out, in a population in excess of 200 million, only 13% (SBP figure) are banked, and the proportion of Islamic banking customers is a limited subset of this. This means that there is still a considerable – yet untapped – market that Islamic banks can capture if they are able to overcome crucial challenges.

A question of perception and awareness

SBP’s KAP research states that in Pakistan, there is an 18% incidence of voluntary financial exclusion when it comes to finance and banking. The two factors reported to have the most bearing on this are the belief that conventional banking goes against the principles of Islam (7.5%) and a lack of awareness of banking transactions and products (4%). Further compounding this is the fact that of the religiously-sensitive, financially excluded group, a majority (65%) are of the view that Islamic banking (as it is practised in Pakistan) is not Shariah-compliant. In Raza’s view, this perception stems from a lack of awareness about the Islamic banking model, the guidelines that Islamic banking transactions are required to follow and the fact that SBP allows conventional banks to operate Islamic banking windows. To this, Sami added that since conventional and Islamic banking products ‘look’ the same, it tends to cause confusion as to what differentiates both.

In a population in excess of 200 million, only 13% (SBP figure) are banked, and the proportion of Islamic banking customers is a limited subset of this.This means that there is still a considerable – yet untapped – market that Islamic banks can capture.

The Islamic banking experts interviewed admitted that a small percentage of people are aware that the most basic difference between both banking models is that Islamic banks work on equity-participation, which is why a predetermined rate of return cannot be guaranteed, while conventional banking is based on a combination of debt and equity, primarily driven by interest (riba). Raza explained that while an auto finance loan from a conventional bank might appear to be structured in exactly the same way as an Ijarah agreement, the underlying conditions for both contracts are different. “If a customer has not been using a car leased through Meezan Bank for a certain period, then the Ijarah contract does not allow us to charge rent for the vehicle for that period. This is not the case with conventional banking.”

There has been a realisation that in order to clarify misconceptions, industry stakeholders need to pool their resources and create clarity about Islamic banking by pointing out the differences both clearly and comprehensively. While there has been an increase in the number of Islamic banking campaigns rolled out, experts say more needs to be done.

Customer satisfaction is key

Prior to SBP’s KAP study, the perception was that the most significant factor contributing to the demand for Islamic banking was people’s belief. However, it is now established that it is the level of customer satisfaction that has the most impact on people’s willingness to adopt Islamic banking (39%), with religion coming out a distant second (23%). This suggests that if Islamic banks are to increase their share of the pie, there is an immediate need to launch innovative products and services that are not perceived as imitations (albeit Shariah-compliant ones). This will not be an easy undertaking because the participatory modes of investment that are at the core of Islamic banking and finance are inherently risky because, although there is a possibility of generating higher returns, there is an equal chance that losses may be incurred. In other words, this means that banks will have to inform customers that there is a possibility that their starting capital may compromised. Introducing such products in Pakistan, where people tend to be risk averse when it comes to entrusting banks with their money, may put Islamic banks at a disadvantage. Therefore, it would not be incorrect to assume that it is going to take some time for Islamic banks to move away from offering ‘me too’ products and compete with conventional banks on the basis of a distinct, Shariah-compliant portfolio.

The road ahead

The growth and development of the Islamic banks in Pakistan is an internationally-acknowledged phenomenon. To ensure that they maintain their growth trajectory, certain measures will need to be implemented.

Firstly, there is an immediate need to increase outreach to second-tier cities and semi-urban areas because this is where the demand for Islamic banking products is the most. At the moment, the presence of Islamic banks and window operations outside the major cities is limited. Raza points out that one of the strategic objectives of Meezan Bank is to increase their footprint in smaller cities, as “there is a huge demand-supply gap and the presence of a large number of high net worth individuals who are averse to using non-Islamic banking.” Secondly, it is important that there be no shortage of skilled human resources, with a strong academic background in Islamic banking and finance principles. Higher education institutions in Karachi, Lahore and Islamabad have recognised this gap and have now introduced graduate and post-graduate degrees in Shariah-compliant banking.

Thirdly, the greatest challenge will be to figure out a way of providing a finance management system, in line with Islamic principles, while ensuring that their product portfolios, quality of customer service and most importantly, rates of return are superior to that of conventional banking.