Achievements & Failures: Pakistan Financial System

It is now over a decade that the first step towards the Islamisation of the financial system in Pakistan was taken. The period 1979 to 1985 saw a fairly active policy on the part of the government to Islamise the financial system. The original intention of the government was to eliminate interest from all domestic banking and financial transactions within a period of three years beginning from Rabi-ul-Awwal 12, 1399 (February 10, 1979). Though this time framework did not prove practicable, the government seemed to be in earnest to move speedily towards attaining the goal of an interest-free economy. At first, a parallel system was put in operation in which savers had the option to keep their savings in interest- bearing media or in profit-loss sharing savings media. In June 1984, it was announced by the government that the parallel system would end in the course of 1984-85 insofar as the operations of commercial banks and other financial institutions were concerned. All banking companies were actually forbidden to accept any interest-bearing deposits as from July 1, 1985, except foreign currency deposits. Banks were also instructed to invest their PLS deposits only in interest-free avenues of investment and financing. Serious consideration was seemingly being given to the issue of eliminating interest from government transactions in 1984-85 as the then finance minister stated in his budget speech that government proposed to consult scholars on the subject. However, the matter was not pursued vigorously and the movement towards a completely interest-free economy lost its dynamism and even its sense of direction after 1984-85.

The movement towards an interest-free economy suffered a serious retardation when in August 1985 banks were allowed to invest even their PLS deposits in interest-bearing government securities. The present position, therefore, is that the return on PLS deposits contains a substantial element of interest. Since 1984-85, there have been no policy pronouncements on the part of the government with regard to elimination of interest from government transactions. To achieve the goal of interest-free economy it is necessary that government should end its dependence on interest-based borrowing. There are no indications so far that this aspect has been given due consideration in formulating government budgetary and other policies. In fact, instead of reducing dependence on interest-based borrowing there has been increased resort to such borrowing in recent years.

The Islamisation process in the field of banking and finance in Pakistan has been marked by another serious deficiency in that no institutional mechanism exists for a continuous scrutiny of the operating procedures of banks and other financial institutions from the SharPah point of view. Individual scholars who have examined these operating procedures have pointed out several areas where the actual banking practices show deviation from Shari*ah even in the case of modes of financing which, in concept, are perfectly compatible with Shari‘ah. Thus, though musharakah agreements which banks ask their clients to sign contain features which have been called into question by several commentators. The provision, for example, that in the event of a company suffering a loss in any accounting year, it would be first adjusted against the existing reserves of the company has been found inconsistent with the spirit of the SharPah.

Again, while the idea behind the issuance of PTCs was a sound one, no legislative framework was provided for standardising the features of this new financial instrument in the light of the principles of Shari‘ah. The CII report had provided a broad outline of the features of such financial institutions but the actual form in which PTCs have been issued does not fully conform to the suggested outline. Some features of PTCs as introduced by certain financial institutions have been widely criticised as being inconsistent with the requirements of Shari‘ah. Provision made for payment of a pre- production discount rate during the gestation period of a project and stipulation of share in profit equivalent to a percentage of the outstanding PTC funds have evoked strong criticism in this respect.

Among the 12 modes of financing allowed by the State Bank to replace interest-based lending, banks have made predominant use of what has popularly come to be known as mark-up financing. Mark-up financing has taken two main forms. The first form is similar to murabaha financing being practised by a number of Islamic banks in other countries. Under this form, a transaction takes place in the following manner: (a) the client approaches the bank with the request to purchase for him certain specified goods; (b) the bank makes the purchase; (c) the bank sells these goods to the client at a price which includes a mark-up over the cost of the goods and agrees to receive payment at a future date in lump sum or in instalments; and (d) the client pays the amount due as agreed in lump sum or in instalments and the transaction comes to an end. The second form involves a buy-back agreement. The practice followed is that a client sells his goods to the bank for cash and simultaneously buys back the same goods from the bank at a higher mark-up price payable at a future date either in lump sum or in instalments. The second form of mark-up financing has been severely criticised by scholars well versed in Shari‘ah and the Federal Shari*ah Court in its judgement has held it to be manifestly against the Islamic teachings.

In a country like Pakistan where there is substantial unemployment and under employment there is a vast potential for creating new opportunities for providing employment through the use of the mudarba technique of financing. The mudarbas floated under the new legislation can be of some help in this direction. However, for making a really significant impact on the employment situation it is necessary that banks, which are the largest depository of nation’s savings, make extensive use of mudarba financing. There is little evidence of banks’ involvement in mudarba financing to any appreciable extent so far. Government has recently announced certain schemes for making bank finance available to unemployed persons and people of small means for setting up or expanding their own business. It seems that significant use of mudarba is not contemplated even in these schemes.

It is noteworthy that neither the government nor the central bank of the country provided strong leadership to motivate the banks and other financial institutions to take bold initiatives for breaking away from the traditional banking practices and adopting the Islamic financing techniques based on the concept of profit-loss sharing. Though it is generally agreed that mudarba and musharakah are the ideal substitutes for interest in an Islamic economy, no special efforts have been made to accord prominence to them in the policies adopted. This seems to havq4 given rise to an attitude of passivity on the part of banks and led them to use mostly such modes of finance, like mark-up, as are more akin to interest-based banking and require least modifications in the old lending procedures.

The picture on the liabilities side of the banking system has undergone a comprehensive change since the introduction of interest-free banking. Savings and time deposits no longer earn a fixed return. Banks declare profits payable on these deposits at six-monthly intervals based on their operating results and these vary from period to period and from bank to bank. The rates of profit are worked out by a formula that determines net profit accruing to a bank and allocates them to the remunerable liabilities according to their maturities. Allocations are based on differential weights assigned to liabilities according to their relative maturities. The system has in general been found to be compatible with Islamic teachings except that, as mentioned earlier, profits declared by banks contain a substantial clement of interest.

Other Challenging Issues

This paper has so far noted only major deficiencies and shortcomings of the steps taken for the Islamisation of the financial system in Pakistan. Experts in Shari‘ah and other writers on Islamic banking have identified certain other features of the present situation which also deserve attention. Some of these are as follows:

• A tendency seems to have developed to replace PTCs by TFCs (term finance certificates). As against PTCs which are based on the concept of musharakah, TFCs are based on a system of fixed mark-up. This has been considered a retrograde step as the objective should be to expand profit-loss sharing modes of finance rather than to restrict them further.
• Financial institutions undertaking leasing business are making greater use of financing leases than of operating leases. Experts in Shari‘ah consider financing leases to be incompatible with Islamic teachings.
• Many development finance institutions (DFIs) are mobilising savings through schemes that give a return which is hardly distinguishable from interest. Grey areas are developing even in the operations of institutions like the National Investment Trust which were previously thought of having eliminated interest completely. It seems that there is no agency to oversee the working of the various schemes being employed by DFIs to mobilise savings from the viewpoint of Shari‘ah.
• Lately, the State Bank has laid down the minimum and maximum rates of profit a bank can share in the case of musharakah or purchase of PTCs or mudarba certificates. Such a stipulation is considered incompatible with Islamic teachings by experts in Shari‘ah.
• Due attention has not been given to eliminating un- Islamic features characterising the operations of several constituents of money and capital market in Pakistan other than banks and DFIs. Nothing has been done so far, for example, to reform the insurance business and the stock exchange operations in the light of Islamic teachings.

Professor Khurshid Ahmad

Source: Elimination of Riba, Khurshid Ahmad, Khalid Rahman and Zahed A. Valie. Republished with permission.