Pakistan has pledged to become fully Shariah-compliant in its banking services by December 2027 under a Federal Shariat Court order. The court had given the government five years to adopt a Shariah-compliant mode of the financial system, both domestically and internationally, to convert the country into an “equitable, asset-based, risk-sharing and interest-free economy”.
Given the challenges and the limited timeframe allowed by the court for conversion, the ambitious task appears to be quite daunting, even if not outrightly impossible to pull off. Although the banks have already submitted their conversion plans with the State Bank of Pakistan (SBP), providing timelines for meeting the tight deadline, the bankers concede that they ‘may not be able to adhere to it’.
The first Shehbaz Sharif government had agreed to implement Islamic finance under pressure from religious parties and groups, with its then-finance minister Ishaq Dar telling the State Bank and the National Bank to withdraw their appeals to the Shariat Court against the ruling. The private banks were also advised to follow suit and adopt Shariah-compliant modes.
Pakistan’s Islamic finance sector still remains relatively small in spite of serious attempts made in the last two decades to ‘Islamise’ the banking system, starting with the establishment of the Meezan Bank in 2002. Islamic banking assets have since grown to Rs9.88 trillion, or 19 per cent of the country’s total banking assets, as of September 2024. The deposits of Rs7.59tr form nearly 24pc of the total banking deposits. The share of Islamic banking in the overall industry has risen at an average of slightly less than 1pc per year.
Large-scale Shariah-compliant banking will require the government to switch to asset-backed borrowing instead of the present interest-based financial system
Still, the present Shariah-compliant banking share falls far short of the SBP’s strategic plans for 2023-2028, which includes transforming existing conventional banks into Islamic banks and targeting 30pc of assets and deposits by 2025. At its current industry share, the country’s Islamic banking sector lags behind many Muslim nations. Saudi Arabia boasts 85pc Shariah compliance, Malaysia 45pc, and Bangladesh is at around 30pc.
The banks’ commitment to the conversion plans notwithstanding, the transition towards Islamisation of the banking industry is strewn with formidable challenges, which reverberated recently at the first Pakistan Banking Summit organised by the Pakistan Banks’ Association (PBA) last week in Karachi.
The challenges in the way of the Islamisation of the banking industry were directly raised before Finance Minister Mohammad Aurangzeb and SBP Governor Jameel Ahmed by PBA Chairman Zafar Masud in his welcome remarks. These were again brought up, though indirectly, at a separate session on Islamic banking where Rafe Haneef, Group CEO of MBSB Berhad, provided his insights into the gradual and well-planned fifty-year journey made by Malaysia towards Shariah-compliant banking and finance.
The biggest challenge to this wholesale move to Islamic banking comes from government borrowings and its conversion into Shariah-compliant securities, said Mr Masud. At present, according to the PBA boss, the banks are meeting almost 100pc of the government’s deficit financing requirements due to diminishing external financing options for the government. “In order to transform the government’s existing and future debt, we need an asset-light Sukuk structure.”
At present, the government borrowing from banks does not require any real assets under the interest-based financial system. An interest-free system will require real assets against which the borrower can get Shariah-compliant financing from a bank, as all financial activities under the Islamic financial system must be asset-backed.
“Unless the government debt becomes Shariah-compliant, the conversion of the banking sector will remain a challenge,” Mr Masud said.
“Besides, the government and the regulator need to figure out how correspondent banking arrangements will work. We also need to figure out how to deal with international agencies like the Asian Development Bank, the World Bank, and the International Finance Corporation so that they give us climate- and trade-related funding facilities.
“How are we going to treat foreign banks operating in the country or Pakistani banks owned by foreigners? When we talk about the Islamisation of our banking sector, they will not be converting. Will we have to make exclusions and exceptions for that? We have to think over these issues and challenges and find solutions to them. Take the example of Malaysia; they have converted 45pc of their financial ecosystem into a Shariah-compliant system in 50 years and hope to increase its share to 60pc in the next 10-15 years. If they cannot achieve 100pc conversion despite being more liberal than us, how shall we?” he wondered.
More importantly, the PBA chairman added, the entire financial ecosystem — insurance and financial markets (equities, derivatives, asset management, and so on) — will have to be converted into a Shariah-compliant model if the banks are to complete this transformation.
According to a January 2024 Fitch Rating report, Pakistan’s diverse Islamic finance ecosystem consists of Islamic banking assets (55pc), followed by outstanding Sukuk (37.6pc), Islamic non-bank financial institution assets (7pc), and Takaful assets (0.4pc).
“The banks don’t lack commitment; we are all moving in this direction of meeting the deadline. However, others will also have to increase their efforts to achieve this end. Besides, we will also need to look at how the world has done it. There may be some exclusions; there may be some exceptions. Perhaps, we will require those exclusions and exemptions to meet the deadline,” Mr Masud concluded.
Mr Haneef’s presentation on the Malaysian journey towards the Shariah-compliant financial ecosystem was quite instructive. It showed that our policymakers should look for different methods of compliance that have a mixture of conventional and Shariah banking rather than looking for a fully Islamic system.
Starting with the establishment of a comprehensive regulatory framework in 1983, Malaysian authorities have moved towards the Islamic financial system very discreetly and gradually without causing a disruption in the overall ecosystem.
Pakistan also has the choice of either risking a disruption or following a mix of conventional and Shariah banking until the entire financial ecosystem becomes compliant.
Published in Dawn, The Business and Finance Weekly, March 3rd, 2025
