This document provides an overview of Islamic banking in Pakistan, including: 1. It briefly discusses the historical development of Islamic banking in Pakistan from the early 20th century through various government initiatives starting in the 1970s-1980s. 2. It outlines the current strategy being pursued, which takes a gradual phased approach to transitioning to an interest-free economy through expanding Islamic banking options. 3. It discusses the establishment of the State Bank of Pakistan Shariah Board to advise on Islamic banking regulations and oversee Shariah compliance.

1. ISLAMIC BANKING Historical and Current Perspective

2. OUTLINE Islamic Finance – The rationale Brief History of Islamic Banking in Pakistan Current Strategy for Transformation and Approach Industry Status

3. ISLAMIC Finance – The Rationale The functions of financial institutions 1. Financial intermediation 2. Help removing budget constraints 3. Remove the mismatches in size and maturity 4. Financial institutions provide wide array of facility like money transfer, safe custody, ATM, Credit Cards, Agency services, acceptance of utility bills etc. 5. Creating broad array of assets and liabilities of various risks and maturity profile 6. Efficient resource allocation. Why Islamic Banking – The Rationale

4. Principles of Islamic Finance In Islamic jurisprudence there are two types of Ahkam (rulings) i. Ibaadaat (worship) ii. Mu’amlaat (mutual dealings)

5. Principles of Islamic Finance Ibaadaat (worship) governs the relationship between man and Allah. The general principle is that nothing is permitted unless explicit or analogical permission by the Law Giver. Mu’amlaat (mutual dealings) governs the relationship among mankind. The General principle is that everything is permitted unless clearly prohibited by Allah SWT.

6. Principles of Islamic Finance Islam permits the contracting parties to agree on any conditions as long as they do not violate any Shariah ruling. Hadith “ All the conditions agreed upon by the Muslims are upheld, except a condition which allows what is prohibited or prohibits what is lawful” (Sunan Abu Dawood, 1981)

7. Principles of Islamic Finance Few prohibitions relevant to constructing financial contracts: Prohibition of Riba Prohibition of Gharar Prohibition of Maysir

8. Islamic Banking – Historic Track From an early stage of Islamic History there had been a system ….. Professor S.D. Goitein viewpoint. Shift in Economic activity Muslim scholars expressed serious reservations on the interest based economic system Credit Societies and Cooperatives were providing the banking needs in colonial states.

9. Islamic Banking – Historical Track

11. Islamic Banking – Global Outlook

13. ISLAMIC BANKING IN PAKISTAN

14. Brief History of Islamic banking in Pakistan Islamic Provisions in the Constitution of Pakistan: Islam was declared state religion (1973 constitution) All the three constitutions say: “ Steps should be taken to enable the Muslims {of Pakistan}, to order their lives, in individual and collective spheres, in accordance with the teachings and requirements of Islam as set out by Quran and Sunnah”

15. Brief History of Islamic banking in Pakistan Islamic Provisions in the Constitution of Pakistan: Features of Islamic Provisions It was further affirmed that: State shall eliminate Riba as early as possible {Article 38(F)} and that All existing laws shall be brought in conformity with the injunctions of Islam and no law shall be enacted which is repugnant to these injunctions {Article 227}

16. BRIEF HISTORY OF ISLAMIC BANKING IN PAKISTAN Quaid-e-Azam, the father of the nation, in his speech at the occasion of the inauguration of State Bank of Pakistan, had expressed the desire for evolving an Islamic system of banking.

17. History of Islamic banking in Pakistan The process of economy wide Islamization of the banking system in Pakistan was initiated after a declaration by then president in February 1979. Govt. plans to remove the interest from economy within three years. The operations of HBFC, ICP and NIT were re-oriented in 1979.

18. History of Islamic banking in Pakistan 1981 – Ordinance promulgated for the establishment of Modaraba Companies and floatation of Modaraba Certificates. Amendments were made in BCO 1962 for the incorporation of financing on Musharaka and PLS mode basis. Bank of Oman (foreign bank) accepted deposits on PLS basis.

19. History of Islamic banking in Pakistan 1981 - Deposit Counters on PLS basis All the deposits so received would be used for financing the commodity operations. The export bills would be accommodated on exchange differential basis. Shifting of financing to CECP, RECP and TCP (Trading Corp. of Pakistan) to markup basis.

20. History of Islamic banking in Pakistan From July 1, 1982 banks were allowed to provide finance for meeting the working capital needs of trade and industry on a selective basis under the technique of Musharaka. From July 1, 1985, all commercial banking in Pak Rupees was made interest-free. From that date, no bank in Pakistan was allowed to accept any interest-bearing deposits and all existing deposits in a bank were treated to be on the basis of profit and loss sharing.

21. History of Islamic banking in Pakistan The State Bank of Pakistan had specified 12 modes of non-interest financing classified in three broad categories namely: Loan Financing Trade Related Financing Investment Mode of Financing

22. Ruling of Federal Shariah Court (November 14, 1991) Procedure adopted for the Islamization of the financial system was declared un-Islamic. Various operations were declared repugnant to the injunctions of Islam. Govt. and some banks appealed to the Shariah Appellate Bench of Supreme Court against aforesaid verdict of FSC.

23. Supreme Court Judgment (19 th December 1999) The SAB delivered its judgment on December 23, 1999 rejecting the appeals and directing that laws involving interest would cease to have effect finally by June 30, 2001 . In the judgment, the Court concluded that the present financial system had to be subjected to radical changes to bring it into conformity with the Shariah. It also directed the Government to set up, within specified time frame, a Commission for transformation of the financial system and two Task Forces to plan and implement the process of the transformation. The Court indicated some measures, which needed to be taken, and the infrastructure and legal framework to be provided in order to have an economy conforming to the injunctions of Islam.

24. Post Judgment Measures CTFS was constituted in January 2000 in State Bank of Pakistan. A Task Force was set up in the Ministry of Finance to suggest the ways to eliminate interest from Government financial transactions. Another Task Force was set up in the Ministry of Law to suggest amendments in legal framework to implement the Court’s Judgment.

25. Composition of CTFS Mr. I.A.Hanfi (former Governor SBP) Mr. Muhammad Yunus Khan (Add. Secretary, MoF) Chairman SECP Mr. M. Ashraf Janjua (Chief Economic Advisor, SBP) Mr. Salman Shah (Economist) Mr. Pervez Hassan (Advocate) Mr. Zakir Mahmood (President HBL) Mr. Amar Zafar Khan (president UBL) Mr. Ebrahim Sidat Maulana Rafi Usmani (Islamic Scholar) Mr. S. Muhammad Hussain (Chartered Accountant)

26. Post Judgment Measures The CTFS constituted a Committee for The development of Financial Instruments and Standardized Documents in the State Bank To prepare model agreements and financial instruments for new system.

27. Post Judgment Measures First Interim report- prior actions e.g. creating conducive legal infrastructure, massive education and training program for bankers and their clients & effective campaign through media for the general public to create awareness about the Islamic financial system. 2 nd Interim report-identified major Shariah compliant modes of financing, their essentials, model agreements draft seminal law captioned ‘Islamization of Financial Transactions Ordinance, 2001’and guidelines for conversion of products and services of banks and financial institutions. Dealt with major products asset and liability

28. FAILURE OF PREVIOUS EFFORTS Absence of Shariah compliance mechanism in financial institutions. Non-availability of Shariah compliant government securities. Ineffective enforcement of contracts and inefficient system for early recovery. Ineffective code of conduct for professionals. Lack of continued research and development in the field of Islamic finance and economics.

29. FAILURE OF PREVIOUS EFFORTS (contd.) Inadequate training to the staff of SBP and banks. Disoriented education system devoid of Islamic principles. Lack of public awareness about Islamic economic system. Adoption of free market economic (capitalistic) policies. Social and cultural factors. Weak political resolve of successive governments for Islamization of economy.

30. CURRENT STRATEGY Policy Decision:- It was decided that the shift to interest free economy would be made in a gradual and phased manner and without causing any disruptions. This decision was made in a meeting held on September 4, 2001 under the Chairmanship of the President of Pakistan, attended by officials of the Ministries of Finance and Law, Governor State Bank of Pakistan, Chairman and some members of the Council of Islamic Ideology and the Chairmen of the CTFS and the two Task Forces.

31. CURRENT STRATEGY Gradual approach for Transformation of economy Full fledged Islamic banks be established in Private sector Islamic banking Subsidiaries in existing banks be allowed Stand alone branches for Islamic banking be allowed in existing banks

32. POLICY OBJECTIVES Introduce, promote and implement Islamic Banking in Pakistan as a parallel banking system comparable and compatible to conventional banking system and Shariah compliant In the long run let people “vote through their wallets”

33. Difference between Islamization of 1984 and current efforts

34. SBP APPROACH Parameter based vs. Straight jacketed system Model vs. Standard Agreements Essentials of Islamic Modes Modes of Finance Shariah compliance mechanism Essentials of Islamic modes Shariah Advisor Internal Shariah Audit Report of Shariah Advisor SBP Shariah Compliance Inspection SBP Shariah Board

35. SBP Shariah Board Central Shariah Board established at SBP which advises SBP on the procedures, laws and regulations pertaining to Islamic Banking in the light of Shariah principles. Current membership consists of five persons Two Shariah scholars One Chartered accountant One lawyer One banker

36. SBP Shariah Board Role and Responsibilities Review and approve for Shariah compliance the products/instruments developed by SBP for conducting its central banking and monetary management functions under the Islamic modes. Advise SBP on PRs developed for Islamic banking sector. Approve the fit and proper criteria for appointment of SAs. Conflict Resolution in Shariah Rulings.

37. SBP Shariah Board – Major Achievements Approved Essentials of Islamic Modes of Financing Approved Model Agreements Approved Fit & Proper Criteria for Shariah Advisors Approved structure of Govt. Ijara Sukuk Approved Instructions & Guidelines Approved SC Inspection Manual Adoption of AAOIFI Shariah Standards

38. Strengthening Regulatory Framework Adoption of IFSB Prudential Standards Adoption of AAOIFI Shariah Standards Adaptation of AAOIFI Accounting Standards Shariah Compliance Inspection Shariah Advisor’s Forum Performance Review Meetings

39. Islamic Modes of Financing

40. A margin of profit based sale where the seller expressly mentions the cost of commodity and adds agreed margin of profit. Price must be fixed in an unambiguous manner. If deferred, due date should be known and specific. MURABAHA

41. MURABAHA Subject of sale must exist and it should be in ownership of the seller at the time of sale. Bank makes purchases through agent; Payment to supplier and issuance of invoice by him; Price once agreed cannot change; Penalty in case of delay. To go to charity; Buyer may be asked to furnish security; No rollover is possible; Buyback arrangement is prohibited All conditions of sale must be met

42. IJARAH (LEASING) Ijarah is an alternative to financing in which a financer buys and rent a productive asset to a person short of funds and is in need of such asset. The aim of such arrangement is to obtain the rentals and proceeds by receiving the benefits of the assets through time.

43. IJARAH (LEASING) - Lessors’s ownership; - Delivery of assets to lessee essential to claim rentals; - Lessor’s ownership during the entire term of lease; - Rental in absolute terms. -- - Predetermined lease period - Penalty for delay; - Damage to the Asset, With or Without Lessee’s fault; - Lessee bear the operating expenses; - Unilateral promises

44. A mode of sale, being an exception to the norm, whereby an order is placed by the buyer, with the seller, to assemble, construct or manufacture, or cause so to do, anything to be delivered at a future date, at an agreed price. ISTISNA

45. ISTISNA - Known and specified commodity; - Fixation of price in absolute/unambiguous manner. - Flexibility in manner of payment. - Obtaining of material cannot be the buyer’s responsibility; - Buyer’s refusal to accept goods; - Penalty for delay.

46. A sale where the seller agrees to supply specific goods by a future date in consideration of a price fully paid in advance, at the time of contract. It is suitable for the finance of agricultural operation. SALAM

47. SALAM - Full payment of price at the time of contract a must - Firm agreement on quality, quantity, specifications - Date and place of delivery must be specified - Commodities which can be offered in Salam - Availability of commodity; - Salam cannot be tied - No buy back with the Seller - Security can be asked for

48. An arrangement where one or more persons participate with their investment and other(s) with their efforts/skills to participate in profit in a predetermined ratio. The Manager (Mudarib) can be a natural person, a group of persons or legal entity. MUDARABA

49. MUDARABA - Nature of investment and it to be at the disposal of the Mudarib (Manager); - Conduct of business within a framework; - Sharing of profit in agreed proportion; - Financial loss on capital only; - Liability of investor limited to his investment;

50. Relationship established under a contract through mutual consent of the parties for sharing of profits, losses from a joint enterprise, venture. Investment comes from all partners. GENERAL: - All assets joint property of all partners; - Capital contribution in terms of money or species at an agreed valuation. SHARING OF PROFITS: - in strict proportion, mutually agreed - no lump sum payment for anyone or at a rate tied to capital invested; SHARING OF LOSS: - Losses to be shared in strict proportion of investment; MUSHARAKA

51. INDUSTRY PROGRESS (2003 – 2009) Sept 2003 One full fledge bank and one conventional bank with one stand alone Islamic banking branch Sep. 2009 - 6 full fledge Islamic banks and 13 conventional banks with Islamic Branches. Islamic banking is available through 551 branches in all four provinces of Pakistan. 6 Full-Fledged Islamic Banks 407 Branches (Meezan Bank, Bank Islami, Dubai Islamic, Emirates Global, Dawood Islamic Bank, Bank Albarakah) 13 Conventional banks – 144 Branches (MCB, HBL, Bank of Khyber, Soneri, Bank Alfalah, Bank Al Habib, Habib Metropolitan Bank Ltd, Standard Chartered Bank, UBL, ABN Amro, Askari Bank and Faysal Bank.)

52. Industry Progress and Market Share Description Sept - 2009 Dec- 2008 Dec- 07 Dec-06 Dec-05 Dec-04 Dec-03 Total Assets (Bn. Rs.) 323 276 205 118 72 44 13 %age of Banking Industry 5.3% 4.9% 4.2% 2.9% 2.1% 1.4% 0.5% Deposits 245 202 147 83 50 30 8 %age of Banking Industry 5.5% 4.8% 4.1% 2.8% 1.9% 1.2% 0.4% Financing. & Invest. 198 186 106 72 48 30 10 %age of Banking Industry 4.2% 4.3% 4.2% 2.4% 1.8% 1.3% 0.5% Full fledged Islamic Banks 6 6 6 4 2 2 1 Conventional Banks with IBBs 13 12 12 12 9 7 3 No. of Branches Licensed 551 515 289 150 70 48 17

53. Jazak Allah