ISLAMIC BANKING IN PAKISTAN; COOPERATION WITH

CENTRAL BANK AND CONVENTIOANL BANKS

SUBMITTED BY:MOHAMMAD MAJID SHAIKH

SUBMITTED TO: DR. ANWAR SHAH

SCHOOL OF ECONOMICS,
QUAID-I-AZAM, UNIVERSITY
ISLAMBAD, PAKISTAN.
INTRODUCTION

The banking sector plays a key role in economic development and well-being of any community.
Banking is crucial for a healthy economy, which leads to the list of developed countries.
Industrial revolution during the 18th century, expanded trade and business at large scale
activities. Banks play a vital role in mobilizing funds and stimulating investment for productive
projects. It accepts deposits from the general public and provides loans to entrepreneurs to
promote investment activities, which are inevitable for a healthy economy. Banks develop the
relationship between units of surplus and deficit for the promotion of trade and business
activities.

There are two types of banking systems that exist in Pakistan, Islamic Banks and Conventional
banks. Islamic Bank (IB) and Conventional Bank (CB) vary depending on the goals and
practices of Riba and Risk sharing.

Islamic Bank generates revenue and profit varies, while Conventional Bank operates on a fixed
interest rate. The risks are shared between the lender and the borrower in Islamic Bank, while in
Conventional Bank all the risk is transferred to others. IB is a business-oriented unit, while the
CB functions purely as a financial intermediary to deal on the basis of interest.

The State Bank of Pakistan (SBP) elaborates Islamic banks as "bank in accordance with the
ethics and the value system of Islam, and in addition to the standards of good governance and
management of traditional risks that are governed by the principles “Islamic shariah"

The question of my research is whether SBP fully cooperates or support Islamic Banking in
order to increase its market share and provide Islamic banks a proper room in our economy?
Also I want to discuss the cooperation between conventional and Islamic banks and how it
affects our economy.

Islamic Banking

The Islamic Bank is an institution to carry out all known banking business, including credit and
interest-free loans. It mobilizes funds on the basis Mudarbah or wakalah and accept deposits, and
also provide interest-free loan. Functioning of the funds on the basis of profit and loss, or can
progress on the basis of the creation of the debt according to the principles of Shariah to be the
investment manager. It is clear that Islamic banks are more focused towards the fair and
equitable distribution of resources compared to traditional banks (Siddiqui, 1985). Islamic Bank
works as “Mudarib” invest savers' money in the general investment fund or specific investment
funds and accepting deposits essentially interest-free. Islamic Bank can also performs the
function of the investment manager (wakalah) and generate fee income for providing services.
While in traditional banking investors are guaranteed a predetermined interest, which aims to
maximize the performance ratio, even at the expense of the community or other stakeholders. In
traditional banking, there can be excessive use of credit and debt financing which leads to
financial problems and enhance the physical attitude leads to exploitation, which is fatal to
society.

Islamic banks play a vital role in an economy to encourage productive activities that promote
economic growth and prosperity. Islamic banks ensure a stable economy, equitable distribution
of income, reduce injustice, risk sharing, reduce financial crisis, and facilitate the production and
business activities.

Pakistani Banking Sector

The State Bank of Pakistan is Pakistan's central bank, which regulates the banking sector through
the development of monetary policy according to the changing environment. Pakistan's banking
sector has demonstrated outstanding performance in recent years due to increased participation
of foreign investors and the private sector. The services sector is a growing component of gross
domestic product (GDP) in all parts of the world, as is evident from recent decades. Pakistan has
also witnessed an unprecedented growth in the banking sector due to its increasing contribution
to the GDP. There are more than 50 banks operating in Pakistan to provide high quality services
to meet customers' expectations. (Arby, 2003) investigated the performance of commercial banks
of Pakistan. It shows that the profitability of state-owned banks reduced compared to private
banks with the passage of time. The financial sector, especially the banking industry enjoys
many benefits from the structural transformation of state banks to private banks. Currently, there
are many banks that offer services to customers in accordance with the principles of Shariah. In
late April 2007, there were six Islamic banks with 108 branches and 13 conventional banks with
58 branches offering interest-free products in Pakistan (SBP, 2007). Commercial banks have
shown outstanding performance in recent years, and have attracted a great deal of foreign direct
investment (FDI) in this sector. The banking sector has witnessed the expansion of its branch
network and the size of total bank assets. Total number of branches reached at 8233 with an
increase of 343 branches in six months. Similarly total assets of banking industry were Rs. 5155
Billion, with an increase of Rs, 203.1 billion in the first six months of 2007-08 (Economic
Survey of Pakistan, 2007-08).

History and Development of Conventional and Islamic Banking in Pakistan

Al-Meezan Investment bank received license in January 2002 and began operations under the
name Meezan Islamic Bank, the first Islamic bank on March 20, 2002 (SBP, 2002).

Islamic banks affect the monetary system by adjusting the forces of supply and demand for
money. It was found that the Islamic banking system is better than the traditional banking
system, as it ensures the financial sector more stable (Khan, 1986).

Prohibition of Interest in the Holy Quran

Riba is prohibited step by step by Allah Almighty by conveying its pros and cons in the Sura-e-
Rome (30:39) and finally declared haraam in the Sura-e-Al-Bakara (2:275).

This is the first step to express the advantages and disadvantages of Riba. In this verse, Allah
Almighty gives to know the pros and cons of Riba and ordered to spread the charity. People
consider only the external characteristics of Riba, and ignores the fatal results of the core of
Riba. Often you must distribute charity, Zakat and Sadaqaat among people who deserve it. Do it
for increase in income and success in this world and the hereafter.

Functions of Islamic Bank

Islamic banks perform two types of tasks, fund-based and non-fund. Fund based activity is on the
first priority of any Islamic bank, accepting deposits from savers on profit/loss basis and lend
money to deficient people/ business units based on profit/loss basis. Islamic Bank accepts
deposits on savings and current accounts. It accepts deposits in exchange for investment/savings
accounts to generate the expense of a certain investment income or investment in general.
Islamic Bank invests this amount in different profitable companies and act an agent, and sharing
the results.
Bank may accept deposits from individuals under the current account and do not pay any
interest, but may charge a fee for their services. Islamic banks lend to borrowers in the short
term, medium term and long-term investment (Musharika, Mudariba, Ijara, Salam, Murabaha
and others) on the basis of profit and loss. Thus, depositors, banks and borrowers share risk
according to the sales contract properly. It creates strong economy on the principles of
transparency and accountability.

IB performs some jobs on non-fund basis e.g. agency services, and general public utilities. IB
can serve as an agent to provide various kinds of services such as check cashing, and the
collection of profits, and the implementation of standing orders, buying/selling securities. It also
performs Public utility services, for example, collection of utility bills. Foreign remittances,
providing Hajj facilities, exchange offices and ATM services, etc.

Activities of Islamic Banks

Individual banks differ in their application. These differences are due to several reasons,
including the country's laws, and the goals of the different circumstances and experiences of
banks from each bank, in particular, the need to interact with other banks based on interest rates,
etc. We will define salient features of. All banks in common.

All Islamic banks have three types of deposit accounts: current, savings and investment

1. Current accounts: Current or deposit accounts to the opinion is almost the same as in all the
traditional banks. Guaranteed deposits.
2. Savings Accounts: Deposits in Savings Accounts work in different ways. In some banks,
depositors are allowing banks to use their money, but they get a guarantee for the full amount of
the payment from the bank. Banks adopt different methods to induce customers to deposit, but
any profit is not promised.

3. Investing account: Investment deposits are accepted for a fixed term or indefinite time and
investors agree in advance to participate in the profit (or loss) in a certain proportion with the
bank. It is not guaranteed in the capital.

Contribution of Islamic banking

The actual practice of Islamic banking to work in the past three decades and the emergence of
Islamic banking as a new type of bank unveils three innovations in banking traditions:

(1) A new type of relationship between banks and depositors.

(2) Integration of financial and real markets in funding.

(3) Integration of ethics and moral values in investment decisions.

Difference between Islamic Banks and Conventional Banks

Conventional financial system mainly focuses on the economic and financial aspects of the
transaction, and the Islamic regime stresses on an equal footing on the ethical, moral, social and
religious dimensions, to promote equality and justice for the benefit of society as a whole. This
system can fully appreciated only in the context of the teachings of Islam in the work ethic, and
the distribution of wealth and social and economic justice, and the role of the state.

The following is a brief discussion of the differences in the nature of the fundamental work
between Islamic and conventional banking or business are as follows:

First, the Conventional commercial banks or intermediates are financial institutions that stand
between savers and investors. On the other hand, the Islamic banking is a mix of internationally
known work not only as savings banks and traditional financial institutions, but is also similar to
the finance companies to the extent that it can be financial support for high-risk projects
progress. It also can work for or open a closed investment funds [or] banks.
Second, the form of the Islamic Bank and conventional bank: IB is more than a conventional
bank works like any other bank specializing (such as industrial banks, agricultural banks).
Finance projects in all the areas mentioned above, in addition to the fact that you can work like
any other investment bank, as it is interested in the creation of long-term projects.

Third, conventional banks do not participate in the buying and selling or even keep the goods,
but under certain conditions. Also these banks, according to its statute, cannot buy capital goods
or fixed assets that are not used by the bank itself. As for Islamic banks, it can trade with all
types of raw materials and can maintain the capital assets and the establishment of companies or
other types of companies.

Fourth, the conventional bank agreed to pay fixed rates on their deposits, regardless of whether a
profit or loss. IB, however, is not an entitlement; if it is to make any profit during the period that
will give depositors at an agreed price. On the contrary, if the bank made losses, depositors will
be burden-sharing with the bank.

Fifth, any conventional bank or commercial bank can be issue excellence share that put profit
ratio, but the Islamic bank cannot do it, because they are of limited interests.

Sixth, all reserves of conventional banks are deducted from the net profit, but in an Islamic bank
they will be deducted from net income only ear-marked for the shareholders.

Seventh, large portion of the funds from a Conventional bank are directed to obtain commercial
loans (business), but most of the money in an Islamic bank is going to finance Sukuk Company
(co-financing or associated companies), and the financing of speculative (finance speculative) or
resale with specification of gain or other.

Eighth, regardless of the rate of return, Islamic banks prohibit trade with the production of
certain goods and services forbidden in Islam, such as:

- Financing beer factories or meat manufacturing companies which deal with the pigs.

- Funding from the gambling casinos.

Ninth, one of the distinctive features of Islamic Banks is the presence of called “Al-Zakat Fund”.
This aims to entrench the principle of social equality. These funds are in Kuwait Finance House
(KFH), Jordan Islamic Bank (JIB) and many other Islamic banks. And is funded by taking 2.5%
of the bank's capital each year, with the bank's customers are given the option to pay zakat to the
bank.

Finally, the importance of 5CS (capital, capacity, collateral, character and condition): Islamic
banks offer different degrees of importance to the elements of 5Cs to that of conventional banks.
Conventional Bank can give a priority to collateral, while the Islamic bank gives priority to
character of client. Conventional Bank is probably more interested in the capital than capacity,
but it was found on an Islamic bank to be more interested in Capacity than in the capital. On the
other hand, there may be some similarities between the conventional bank and an Islamic bank in
the matter of giving priority to the safety and health of any project submitted to the bank for
financing.

Aspects of Developing Cooperation between Islamic Banks and Conventional Banks on

Islamic Basis

This is due to the increased variety of tools and Islamic financial instruments that represent an
important part of the international banking business volume and increased Islamic banking
operations, and the quality of performance. It reflected another aspect of this positive presence in
the direction of conventional banks and banking institutions capable, whether inside or outside
the Muslim world some of the introduction of Islamic banking services in the operations. In
addition, other initiatives taken by research centers and universities in Europe and the United
States, especially at Harvard University, and the University of the Sorbonne and the universities
of Birmingham, the establishment of departments to conduct research in Islamic economics and
Islamic banking principles.

These forms of cooperation can be divided to the three main points:

A) Cooperation at the level of institutions dealing with the monitoring, planning and
development, legislation and laws and regulations in both systems (i.e. central banks, institutions
and monetary authorities as well as institutions and authorities that control the Islamic banking
operations); the relationship between the Islamic banking and central bank was discussed earlier
in the details.
B) The level of cooperation with banking units in conventional and Islamic both systems, and

C) The level of cooperation in the units of the Islamic banking system and regulatory bodies in
their host countries.

Current cooperation is manifest in the following:

1. Islamic banks with conventional banks cooperates at the local and international levels to
provide mutual banking services, such as checks and commercial bills collection, processing and
clearing operations and local and international transfers, acceptance and issuance of bank
guarantees and letters of credit and bank checks and mutual credit and documentary opened, and
various electronic banking operations and all accounts relevant way that does not violate Islamic
law.

2. The unit of both systems to participate in the establishment of a number of investment projects
in the economic activities in addition to investment funds in their own regional and international
equities.

3. Cooperation between Islamic banks and branches of the Islamic subsidiaries of conventional
banks in terms of introduction of systems, consulting, training, and the training of staff required,
and the performance of the mutual banking services of others.

The Relationship between Central Banks and Islamic Banks

Central banks play a leading role in monitoring activities. Central banking activities include
monitoring processes that manage banking units operating within the borders of their own
countries they govern. Examine the books and records in order to verify the assets and operations
of sound health of an economy. They are also involved in the development of standards and
principles of the relevant banking in general, and set the scope to deal with the activities and
specific customers. The role of central banks is not limited to these activities; it also allows you
to determine the interest rates of credit and debit, with established fees for banking services that
would apply to all banks under their authority.

Since Islamic banks began in the mid-1970s, they have always adhered to the rules, regulations
and decisions issued by the central banks. Recently, it was observed that the nature of the
relationship between Islamic banks and central banks differ from one country to another. This
depends on the legal framework governing Islamic banking situation in these countries.

Although the industry has shown rapid growth, there are still areas that require concerted efforts
and proactive stakeholders to develop and promote the industry. To increase the current pace of
growth and lead the industry with the highest level of professionalism, and improve system
performance SBP has prepared "Strategic Plan for-profit Islamic banking industry in Pakistan,
2014-2018." The plan focuses on the necessary initiatives to improve the public perception of the
work of Islamic banking and to promote it as a distinct and viable sector to meet the need for
financial services in the general community and the business sector in a given system. SBP in the
next five years in collaboration with stakeholders will keep its focus on key areas/objectives to
facilitate and stimulate stable and distinct growth of Islamic banking in Pakistan. Following are
the objectives/Strategies:

A. Activate environmental policy

Enable the framework of liquidity management, the organizational legal system of financial
control and financial accounting and reporting framework

B. Shariah Governance & Compliance

The focus in this area remains to unify and coordinate law practices, as well as the establishment
of various Islamic banking products and services.

C. Awareness and Capacity Building

Efforts will be made for coordination and cooperation between internal and external
stakeholders, and promote awareness of Islamic finance, and build the capacity of stakeholders.

D. Market Development

Adoption of various initiatives to diversify products and financial inclusiveness with

collaboration of stakeholders.

Functional strategies and an action plan has been developed to meet the targets in each area in
consultation with the Islamic banking institutions and their advisors, members of SBP Shariah
board members, academics and departments of internal SBP, the Securities and Exchange
Commission of Pakistan (SECP) and the Institute of Chartered Accountants of Pakistan (ICAP).
It is expected that with the implementation of this strategic plan, the Islamic banking industry is
expected to grow wisely and clearly with the increasing acceptance and trust of the general
public that contribute to the economic development of the country.

Future Perception of the Relationship between Islamic Banks and Central Banks

It should be recognized that the Islamic banks do not prevent the supervision of the Central
Bank. Welcome, but they expect to be dealt through framework that caters to the specific nature
and understand their role. It became clear that Islamic banking units, after a long period of
Islamic Banking they managed to produce a distinct type of banking services and activities that
they have met with great success and recognition of large number of the bank's customers. Banks
requires that the Central Bank should facilitate the work of these units, and support them in
doing their job to play positive role in sustainable development in the countries where they
operates.

We are convinced that in order to establish a positive relationship between the monetary
authorities (represented by the central banks) and Islamic banks as well as the reason for this
monitoring Islamic banks to be of interest to national economy and bank customers, the future
vision of the relationship between the two parties within the current dual system can include two
main steps:

1. Central banks should now start making some changes to the conventional control methods that
are suitable for the position of Islamic banks, based on recommendations from the development
of the Sub-Committee of the Organization of Islamic Conference, an expert in power. The
following points are the most important measures that can be considered in this regard:

A) Design patterns and forms require regular Islamic banks that will be developed and approved
by the central banks and representatives of the Islamic banker’s data. These new forms should be
consistent with regulatory objectives and meet the nature of the work of Islamic banks.

B) Divided human resources within the monitoring systems of the central banks usually into
groups, each of which oversee the specified number of banks agree tasks.
C) Thinking in the cash reserve as far as the investment accounts in Islamic banks and the policy
of the credit limit policy, especially that there are laws within the dual system and exempt banks
and investment business of these two instruments, taking into account the nature and importance
of their work.

D) Conduct research on the availability of an approved method by Islamic law, which aims to
take advantage of the Central banks in their role as the last resort of the Islamic banking units
operating under the supervision of Central banks cause; or, more precisely, in fact it is the best
bank in cases of liquidity deficit which could pose as a setback in Islamic bank operations.

2. Banking systems and laws and regulations for Islamic banks must be developed and
implemented.

CONCLUSION

Islamic banking is a young concept in the world. However, it has already been applied. There are
Islamic banks in many Muslim countries and a few in non-Muslim countries as well. In spite of
the success acceptance, there are also problems. With only minor changes in their practices,
Islamic banks can get rid of all their complex and expensive and questionable forms in some
cases, it can perform as clean and efficient banking without interest. All the necessary
components are already in place there. IB will use only two regulation forms of financing – loans
with a service fee and the financing of speculative participation, both of which are completely
accepted by Muslim writers. From all above statements by different writers and by statements
and Strategic plan of SBP it is being shown that SBP fully cooperates with Islamic Banks and
support it to uplift this system in Pakistan’s economy, providing the feasibilities for Islamic
banking to increase share in market and contribute towards the development of country.
Moreover we have also seen that cooperation between Islamic banks and Conventional banks is
improved which will leads towards the competition and ultimately towards the growth of
banking industry, which in return will increase economic growth of Pakistan. This system
provides an effective banking system, where Islamic banking is mandatory and strong alternative
to conventional banking where coexist alike. In addition, the system of this kind will have no
problem in obtaining a license for working in non-Muslim countries.
RECOMMENDATIONS

• Development and implementation of banking laws and regulations of Islamic banks in order to
establish an independent monitoring system issued by the legal structure with explicit text and
full and detailed prospects of rights and duties and the nature of Islamic banking also organize
operations in conventional Islamic bank branch, or at least determine the full role of this issue
within the framework of banking laws and credit systems in different countries.

• Human resources required necessary participation in training programs and courses prepared
for study specifically for this purpose.

• Introduce new products/services according to Islamic Shariah, and should improve service
quality in order to meet customers expectations for long term profits.

• Design and forms required regular Islamic banking data patterns. This should be developed and
approved by the authorities of the Islamic Development Bank and the Central So that these
patterns and shapes to meet the requirements Control objectives on the one hand, and they adapt
to the nature of the Islamic Banking on the other.
REFERENCES

1) Arby, M.F. (2003). Structure and Performance of Commercial Banks in Pakistan,State

Bank of Pakistan.
2) Khan, M. (1986). Islamic interest-free banking: a theoretical analysis, International
Monetary Fund Staff Papers.
3) Economic Survey of Pakistan, (2007-08), Ministry of Finance, Government of Pakistan.
4) Siddiqui, M.N. (1985). Partnership and Profit sharing in Islamic Law, Leicester: The
Islamic Foundation.
5) Ashfaq Ahmad, (2009). A Comparative Study of Islamic Banking in Pakistan: Proposing
and Testing a Model.
6) Muhammad Hanif, (2011). Differences and Similarities in Islamic and Conventional
Banking: International Journal of Business and Social Science.
7) Dr. Zeinab Mohamed El-Gawady (6th October, 2007). Possibility of Cooperation between
Islamic Banks and Conventional Banks.
8) Strategic Plan Islamic Banking Industry of Pakistan, (2014 – 2018), State bank of
Pakistan.
9) Pakistan’s Islamic Banking Sector Review (2003-07). Islamic banking department , State
bank of Pakistan.