II Islamic Banking in the Islamic Republic of Iran and in Pakistan
- Abbas Mirakhor, and Zubair Iqbal
- Published Date:
- March 1987
All Muslim countries have practiced Islamic credit arrangements to varying degrees. Interest-free banks have also been operating in several non-Muslim countries. The experiences of the Islamic Republic of Iran and of Pakistan—two countries that have recently attempted to implement Islamic banking on a comprehensive scale—are drawn upon here to assess implications of such a banking system. It is important to note that these two countries have approached the process of transformation from two different directions. The authorities in the Islamic Republic of Iran chose to convert their banking system to an interest-free system at one time by passing the comprehensive Law for Usury-Free Banking in 1983. Pakistan, on the other hand, chose to introduce an interest-free system gradually.
Owing to this difference, the experiences of the two countries have, in several respects, been quite distinct. While both have opted for outwardly similar non-interest modes for deposit and asset generation to effect changes in the banking system, the characteristics and specific application of chosen instruments are sufficiently different to merit separate analysis for each country.
It is too soon to assess the full impact of new regulations on the operations of the banking system, monetary policy, and the economy at large. Nevertheless, it is clear that problems have been encountered in moving away from traditional short-term trade financing operations and toward profit-sharing medium- and long-term equity-financing operations. Similarly, issues regarding bank financing of the government sector remain to be addressed. Banks have, in general, adapted well to the new procedures, but speedy progress may have been hampered by the time-consuming process of retraining staff. The effectiveness of monetary policy in both countries has remained largely unaffected. The authorities recognize, however, that a further transformation of the banking system, that is, toward equity-based profit-and-loss-sharing operations, would not only entail considerable structural changes in the financial sector but also require a new legal framework and a change in the attitudes of banks, their clients, and the policymakers toward implementing the new system.
Islamic Republic of Iran
Following the revolution in 1979, the Iranian authorities took steps to bring the banking system’s operations into correspondence with the requirements of Islamic law. In February 1981, certain administrative steps were taken by Bank Markazi (the central bank) to eliminate interest from banking operations; as a result, interest on all asset-side transactions was replaced by a 4 percent maximum service charge and by a 4 percent to 8 percent minimum “profit” rate, depending on the type of economic activity. Interest on the deposits was also converted into a “guaranteed minimum profit.”38 In the meantime, preparations got under way for submission of comprehensive legislation to bring the operations of the entire banking system into compliance with the Shari’a. The legislation, prepared by a high-level commission (composed of bankers, academics, businessmen, and religious specialists), was passed by the Parliament in August 1983 as the Law for Usury-Free Banking, henceforth referred to as “the Law” (see Appendix). The Law required the banks to convert their deposits in line with the Shari’a within one year, and their total operations within three years, from the date of the passage of the Law, and specified the types of transactions that must constitute the basis for asset and liability acquisition by banks.
The implementation of the new system was constrained by diverse economic developments, associated with the weakening of the quality of banks’ asset portfolios since the mid-1970s, political upheavals, the freezing of Iranian assets held abroad, economic recession, and war.39 The banking system at the time of the revolution was characterized by a large number of newly established banks, which were saddled with high levels of nonperforming assets and of debt obligations to both Bank Markazi and foreign creditors. The position of these banks reflected, in large part, a lack of banking and management experience, as well as inadequate regulatory controls. The resulting inherent weakness of banks’ asset portfolios, leading to lower overall profits, has continued to hamper the effective transformation of the banking system.40
Characteristics of Bank Liabilities and Assets
Bank Liabilities Under the New Law
According to the new Law, liabilities acquired by the banks must be based upon two kinds of transaction.
Qard al-Hasanah deposits. In the context of the Law, Qard al-Hasanah constitutes current and savings deposits (as in the conventional banking system), except that they earn no returns. The banks can, however, offer incentives to attract such savings deposits and can include one or all of the following: nonfixed prizes and bonuses in cash or in kind; an exemption from, or a discount in, the payment of commission and fees; and priority in use of banking facilities.
The purpose of these accounts, from the point of view of the customers, would be to serve as a means of transaction, payment, and liquidity. Moreover, the banks are to consider these deposits (both current and savings) as “their own resources” in their utilization, but no profits are to be passed on to the depositors. The full nominal value of the deposits, however, is required to be guaranteed by the banks.
Term investment deposits. Banks are authorized to accept two types of investment deposits, short-term and long-term. The deposits differ with respect to the minimum required time limits, three months for short-term and one year for long-term deposits, and with respect to the minimum amount required, Rls 2,000 for short-term and Rls 50,000 for long-term accounts.
Although the banks can use their own resources, that is, their capital plus Qard al-Hasanah deposits, the priority must be given to investment deposits, that is, depositor resources. The banks can also use a combination of their own and depositor resources in an investment project, in which case the bank and the depositor share the resulting profits. A third possibility is for the bank to place the depositor’s funds in an investment project, that is, to serve as a trustee, in which case the entire resulting profits as well as any capital gains are returned to the depositors and the bank charges only a commission to cover the expense of administering the accounts. In this case the bank can guarantee and insure the principal amount of depositors’ resources.
When combined resources of the bank and the depositors are invested, the return to depositors is, in principle, calculated in proportion to the total amount of investment deposits (while the required reserve portion is subtracted from the base amount). The banks are required to announce their profit rates at the end of each six months of their operation, at which time the shares of the depositors’ profits are to be paid into each account. No profits are earned by deposits if they are either withdrawn before the minimum time required or reduced below the required minimum.
Financing and Credit Operations
The Law provides various modes of operation upon which the financing transactions of the banks must be based. A brief description of these modes follows.
Partnership (Musharakah). The Law recognizes two different forms of partnership: civil and legal. The first is a project-specific partnership of short duration in commercial, production, and service activities in which each partner provides a share of the necessary capital, and the assets and properties thus acquired are held as community property until the end of the life of the partnership. In these cases, the banks’ share in the partnership cannot exceed the share of the manager-entrepreneur initiating or directing the project.
The second form of partnership is a firm-specific venture of longer duration in which the bank provides a portion of the total equity of a newly established firm or buys into an existing corporation. The banks can take equity positions in such partnerships only after the technical, economic, and financial viability of the firm (or the project) has been appraised and the minimum expected rate of return from investment is deemed high enough to warrant such actions by the bank. Bank Markazi must determine the maximum amount of equity participation by the bank and the minimum amount of participation by other partners in the venture. The banks are allowed to sell shares that they have thus purchased whenever they deem it appropriate.
Direct investment. Banks can undertake to invest directly in any economic activities they choose so long as the following requirements are met: (i) banks cannot undertake to invest directly in projects in conjunction with the private sector and in projects that lead to the production of luxury and unnecessary commodities; (ii) the ratio of the initial capital of these ventures to total funds needed must not be less than 40 percent; (iii) the total fixed capital necessary for undertaking these projects must be provided for by long-term financial resources; (iv) undertakings of direct investment by banks must be based on well-documented evaluation and appraisal of the project, and use of bank resources and investment deposits in direct investment projects is allowed if, and only if, the expected return from these projects is sufficient to meet the minimum required rate designated by Bank Markazi; (v) banks must report to Bank Markazi the amount of their own, as well as depositors’, resources allocated to direct investment projects; (vi) once the projects in which the banks have directly invested have begun their productive activity, banks can sell shares to the public; and (vii) Bank Markazi is authorized to investigate and audit direct investment projects in which banks have invested.
Mudarabah. This transaction is considered a short-term commercial, contractual partnership between a bank and an agent-entrepreneur according to which financial capital is provided by the bank and managerial effort by the entrepreneur in order to undertake a specific commercial project. Banks are required to give priority in their Mudarabah activities to cooperatives. Moreover, banks are not allowed to engage in Mudarabah financing of imports with the private sector.
Salaf transactions. To provide firms with the needed working capital, banks can prepurchase their future output so long as the product characteristics and specifications are determined at the time of the purchase and the agreed price does not exceed the market price of the product at the time of the transaction.41 Banks, however, cannot sell the product until they have taken physical possession of the same. The delivery date of the product, which is to be established at the time of the transaction, cannot exceed one production cycle or one year, whichever is shorter.
Banks are authorized to purchase raw materials, machinery and equipment for firms and resell the same to them on installment. The volume of raw materials cannot exceed that necessary for one production cycle and the repayment period for same cannot exceed one year. The price of the product subject to the transaction is to be determined on a cost-plus basis. The repayment period for machinery and equipment cannot exceed their useful life, which is considered to begin on the date of their utilization in the production process and the duration of which will be determined by the central bank. Residential housing can also be built and sold by banks on installment.
Banks can purchase the needed machinery and equipment, or other movable and immovable property, and lease the same to firms. At the time the contract is entered into, firms have to guarantee to take possession of such property at the end of the contract period, if the conditions of the contract are fulfilled. The time period involved in this transaction cannot exceed the useful life of the property (to be determined by Bank Markazi). Banks, however, cannot engage in transactions in which the useful life of the subject property is less than two years.
Jo’alah (transactions based on commission)
Banks may provide or acquire services whenever they are needed and charge or pay commissions or fees for such services. The service to be performed and the fee to be charged must be determined at the time of the transaction.
Banks may provide agricultural lands that they own or are otherwise in their possession (e.g., as a trust) to farmers for cultivation for a specific period and a predetermined share of the harvest. Banks may also provide seed and fertilizer along with the land if they so choose.
Similarly banks may provide orchards or trees that they own or that are otherwise in their possession (e.g., as a trust) to farmers for a specific period of time and a predetermined share of the harvest.
Qard al-Hasanah loans
Banks are required to set aside a portion of their own resources in order to extend interest-free loans to (i) small producers, entrepreneurs, and farmers who would otherwise be unable to find alternative sources of financing investment and working capital and (ii) needy consumers. Banks are permitted to charge a minimum service fee to cover the cost of administering these loans.
In addition to the above modes of financing, banks are permitted to purchase debt instruments of less than one year’s maturity, but only if the debts are issued against real assets.
General Regulations Governing Asset Acquisition by Banks
The Law for Usury-Free Banking not only provides regulations to cover specific modes of transactions but also specifies additional regulations that govern asset acquisition by the banks.42 The most important of these regulations are the following:
- Banks can only extend credits when they are reasonably assured that the principal sum granted and resulting profits are returned within a specific period of time.
- Banks are responsible for the control and supervision of the activity to which their own resources and/or the resources of their depositors are contractually committed.
- Credit can be extended, conditional upon observance of proper procedures that ensure the security of the financial resources extended by the banks.
- Banks must ensure that the value of physical assets obtained through the use of their resources by their clients and the value of collateral is, at all times, equal to the remainder of outstanding principal. To this end, banks may take steps to ensure the value of such assets or collateral during the lifetime of the project.
- While banks may engage in joint venture projects with other banks, one specific bank must assume the responsibility of supervision and control of the project undertaken.
- Banks must take necessary steps to ensure that their clients understand that contracts mutually consented to are binding legal documents and will be treated as such by the courts.
Supervision of the Banking System
The Law has placed the responsibility of the supervision of the banking system of the country with Bank Markazi and accordingly it has specified the following means for exercising authority. Bank Markazi is required to determine (a) legal reserve requirements for various types of bank deposits of the banks; (b) bankbybybank credit ceilings on aggregate and sectoral credit; (c) minimum and maximum expected rates of return from various facilities to the banks; (d) minimum and maximum profit shares for banks in their Mudarabah and Musharakah activities; (e) maximum rates of commission the banks are to charge for investment accounts for which they serve as trustees; (f) the minimum ratio of liquid assets to short-term liabilities; (g) the maximum amount of credit facility granted by banks to each applicant; (h) the ratio of credit facilities granted by each bank to that bank’s capital; (i) the acceptable ratio of credit facilities granted by each bank to various deposits; and (j) the maximum amount of commitment made by each bank emanating from opening letters of credit, endorsements, issuing guarantees, as well as the type and amount of collateral for such commitments.43 Moreover, Bank Markazi is authorized to audit and inspect banks’ accounts and documents and is further empowered to devise additional regulations to enhance its supervisory authority as the need arises, to ensure and safeguard against threats of banks’ insolvency. Bank Markazi has developed procedures based on these guidelines for commercial banks to follow in their transactions.
Implementation of the Law
The Law for Usury-Free Banking implements the portion of Article 43 of the Constitution of the Islamic Republic of Iran that prohibits riba (interest) in banking operations.44 Its most significant economic aspect is its attempt to forge a closer relationship between financial intermediation and real economic-asset creation without resort to an interest rate; at the same time it has created safeguards designed to assure sound banking practices. To this end, it has provided an apparatus that designates specific Islamic modes of financing that can facilitate necessary financing for needed transactions in various lines of economic activity. (These modes, corresponding to each line of activity, are summarized in Table 1.) Hence, the Law has made it the responsibility of the banking system to take the lead in implementing and fostering Islamic modes of financing throughout the economy.45 To this end, the role of banks has been broadened far beyond that prevailing under a conventional financial system. This is a clear recognition that, at least throughout the transitional phase, the banking sector will have to play a crucial role as a vehicle through which economic relationships can be transformed into Islamic forms. The centralization of the banking system, facilitated through the Bank Nationalization Act and the Bank Management Bill, provides managerial control to Bank Markazi to direct the banking system in performance of this role.
|Type of Activity||Permissible Mode|
|Production (Industrial, mining, agricultural)||Musharakah, lease-purchase, Salaf transactions, installment sales, direct investment, Muzara’ah, Musaqat, and Jo’alah|
|Commercial||Mudarabah, Musharakah, Jo’alah|
|Service||Lease-purchase, installment sales, Jo’alah|
|Housing||Lease-purchase, installment, Qard al-Hasanah, Jo’alah|
|Personal consumption||Installment sales, Qard al-Hasanah|
Considering the comprehensive nature of the Law, it is too early to judge the effectiveness of its implementation, but the data available from the first full year of operation of the banking system under the provisions of the Law permit analysis of some aspects of the implementation phase. Comparative figures for major items in the balance sheet of the banking system for the period March 20, 1984 to March 20, 1985 show that private sector deposits with the banking system increased by 5.7 percent and that a major portion of old deposits were transferred into new accounts (Table 2). Although the banking system has been successful in converting its liabilities into Islamic forms, the asset side shows a much slower pace in this conversion. A more detailed breakdown of assets of banks (Table 3) indicates that the banking system in its first year of operation extended Rls 754.7 billion in new banking facilities to the private sector, of which Rls 591.3 billion was allocated from term investment deposits and the remainder from banks’ resources (Qard al-Hasanah deposits). Additionally, the commercial banks’ share in extension of new banking facilities was 77.3 percent of the total, while that of the specialized banks was 22.7 percent. This implies that, first, the banking system has been able to employ only about 38 percent of the available term investment deposits. Second, of the credit facilities extended to the private sector, a major portion has been concentrated in short-term facilities, a fact which suggests that financial resources have been allocated largely to commercial and trade transactions.
|Item||March 1984||March 1985|
|Private sector deposits||5,600.6||5,918.3|
|Qard al-Hasanah savings||—||(780.0)|
|Credits to the private sector||4,256.6||4,500.7|
|Loan and credits (old)||4,256.6||3,746.0|
|Mode of Transaction||Amount||Share of Each Mode in Total Facility|
|(In billions of Iranian rials)||(In percent)|
|Total transactions affecting the profit of investment deposit||591.3||78.3|
|Qard al-Hasanah loans||78.4||10.4|
|Total transactions not affecting the profit of investment deposits||163.4||21.7|
|Total of transactions||754.7||100.0|
Both of these factors can be explained by the various bottlenecks that exist in the system. The most important is the lack of trained personnel. The authorities have indicated that this is partly a problem inherited from the old system, in which the rapid growth of the banking system in years immediately preceding the revolution did not permit orderly recruitment and training of bank personnel. Consequently, Bank Markazi data gathered after the reorganization of the banking system indicated that only 7 percent of the banks’ personnel had college degrees, the majority had high school degrees or less, and 75 percent had less than nine years of banking experience.46 By March 20, 1985, about one third of the personnel were trained in Islamic modes of banking. Although attempts have been made, through in-house training and Bank Markazi’s efforts, to speed up the training of the other two thirds, they are not sufficient. Lack of trained personnel remains an obstacle for banks to overcome in trying to attract, appraise, and then finance investment projects in accordance with the provisions of the Law.
The best-trained personnel in terms of project evaluation appraisal and monitoring are concentrated in the specialized banks, but the Law has made it attractive for the commercial banks to attempt to attract trained personnel away from the specialized banks, thus exacerbating the personnel bottleneck problem. Traditionally, long-term investment financing in various sectors of the economy was concentrated in specialized banks. Hence, these banks were able to attract and train personnel for project financing. Commercial banks generally specialized in short-term financing and credit facilities. Although the new Law permits all banks to engage in project financing, the extent of commercial bank activities in long-term investment financing is limited by the ability of their personnel, as well as their traditional organizational bias in favor of short-term trade facilities. Additionally, and at least for the short run, banks are allowed to borrow funds at a fixed rate from Bank Markazi and from one another. Hence, this fixed rate establishes a minimum opportunity price for risk avoidance on the part of the commercial banks, thus making them reluctant to make resources available to the specialized banks either in a partnership or a joint venture basis.
Specialized banks, on the other hand, have found innovative means by which they have managed to package financing in a way that tailors funding to the needs of their clients. One such innovation has been for these specialized banks to break down the total financing requirements of a particular project into its various components in accordance with the size of each required amount of financing and with the gestation period. The component is then matched with a particular mode of financing.
Effectiveness of Monetary Policy
Oil revenues and budget policies of the Government to a large extent determine the monetary base in the Iranian economy. During the postrevolutionary period, the budget has increasingly relied on central bank financing. Bank Markazi data for 1973, for example, suggest that the three components of the monetary base—net foreign assets, central bank claims against the Government, and the central bank’s claims against the banking system—were, respectively, 54.6 percent, 28.3 percent, and 17.2 percent of the total. The same data for 1984 suggest a major shift in the composition of the monetary base to 19.5 percent, 68.1 percent, and 12.4 percent, respectively, for its three components. Historical data show further that the money multiplier, which can serve as another avenue for monetary policy influence (e.g., through variations in the reserve requirements), has remained stable.47 These results lead to the conclusion that, at present, fiscal policy has dominated the conduct of monetary policy in recent years.
Monetary policy is formulated by the High Council on Money and Credit, which specifies the maximum level of credit expansion consistent with policy targets. Overall credit is then allocated between the Government and the private sector, among banks, and by economic activity. Bank Markazi can supplement this allocation through variations in reserve ratios, moral suasion, and “modified open market operations” under which banks are required to hold 30 percent of their assets in short-term government securities at a fixed rate of return. However, credit allocation, through which monetary policy and development policy objectives are coordinated, has remained the primary instrument of control (both before and after the introduction of Islamic banking), and its implementation has been enhanced by the nationalization of banks. There have been no substantial changes in bank supervision, but controls have become stronger since the introduction of the new system. Bank Markazi has become more closely involved in the choice of asset portfolios by banks. In combination with a restrained fiscal policy, which reduced government deficit, the restrictive credit policy helped in reducing inflation from 17.7 percent in 1983 to 10.5 percent in 1984 and an estimated 7.6 percent in 1985.
The process of Islamization of the financial system was initiated in 1979/80 when the specialized credit institutions in the public sector reoriented their financial activities toward non-interest-bearing operations. Effective January 1, 1981, all domestic commercial banks were permitted to accept deposits on the basis of profit-and-loss sharing (PLS). Over the next three years, steps were taken to develop new non-interest-bearing financial instruments in which PLS deposits could be invested. These include commodity operations of the Government and its agencies, export bills, investment in shares, purchase of participation term certificates (PTCs), provision of loans to the specialized credit institutions (which had already moved to non-interest-bearing operations), Musharakah (partnership) lending, hire purchase, and Mudarabah certificates.
New steps were instituted on January 1, 1985 to formally transform the banking system over the following six months to one based on no interest, thereby completing the first phase of bringing the entire financial system under Islamic principles. As of that date, all finance provided by banks to the Government, public sector corporations, and public or private joint stock companies is to be only on the basis of the specified Islamic (non-interest-bearing) modes of financing.48 Transactions with the Government, however, are still based on interest; moreover, the Government obtains financing through the sale of bonds, purchase of which by the private sector is facilitated by the provision of bank credit at fixed rates. Effective April 1, 1985, all finance provided to private sector entities, including individuals, is also limited to the specified modes. As of July 1, 1985, no banks can accept any interest-bearing deposits, and all existing deposits become subject to PLS rules.49 Deposits in current account continue to be accepted as in the past, that is, with no share in the profits or losses of banks (equivalent to no interest previously). Foreign currency deposits and loans from abroad, however, continue to be exempted from the new regulations. The State Bank of Pakistan specifies broad ranges of charges for the various modes of lending as guides for commercial banks; a formula is used to determine rates of return to depositors. The stress has been on introducing new modes of financing without, as far as possible, altering the basic functioning and structure of the banking system.
It is too soon to quantify the impact of new regulations on the operations of the banking system, economy, and monetary policy. The transformation of the banking system, however, has led to the generation of a number of financial instruments, which have probably facilitated financial deepening and may have enhanced the potential for increased intermediation. Moreover, there has been some deregulation of the banking system, especially with regard to the determination of charges on loans. Nevertheless, owing to institutional and legal constraints, banks have continued to concentrate as in the past on short-term finance and the provision of working capital on a markup basis. So far, there has been only limited progress toward the development of the equity-oriented instruments central to Islamic banking.
Although introduction of new modes of financing has required a shift in the procedures underlying lending operations of banks, the shift appears not to have disrupted lending activity. The cautious pace of transition to the new system has facilitated the transformation. Nevertheless, there has been some difficulty in lending to smaller firms, owing to the introduction of more rigorous procedures and enhanced monitoring by banks. By and large, corporate borrowers have insisted on ensuring that the net cost of borrowing should remain unchanged, and banks, by opting for lending on a markup basis where markup rates are virtually identical to the interest rates prevailing prior to the introduction of the new system, have been able to accommodate their clients. Such accommodation is viewed by the authorities as essential for an orderly transition to the rigors of the new system. The elimination of interest rates has had no adverse effects on the accumulation of bank deposits, and the rates of return offered by banks have generally tended to be higher than deposit rates prevailing prior to the introduction of the new system.
There have been no changes in the instruments and effectiveness of monetary policy; bank supervisory and regulatory controls have also remained broadly unchanged. Based on guidelines issued by the State Bank of Pakistan, commercial banks have modified their procedures and practices to accommodate the new system.
The first phase of transformation, that is, shifting from interest-based to non-interest-based banking, has been largely completed without major problems. However, further shifts toward a system based entirely on PLS principles (rather than on markup), equity-participation, and the absence of guarantees on deposits and loans, will entail basic changes in the economy and the society—changes that will be time-consuming and difficult to implement. Important prerequisites for such a transformation would be a further deregulation of the banking system and increased competition, changes in the attitude of banks toward medium-term and long-term lending, comprehensive retraining of staff to handle project-type lending operations, reform of the auditing systems to more accurately determine true profit levels, establishment of an efficient capital market, growth of a secondary financial market including specialized investment banking institutions, the establishment of an efficient judicial arbitration system, and a new legal framework to allow speedy settlement of disputes and protection for borrowers.
Financing and Credit Operations of Banks
While bank liabilities (other than foreign currency deposits) are composed of either current account deposits, on which no profit is distributed by the bank, or PLS deposits, three broad categories of noninterest modes of financing have been allowed to guide banks’ asset operations. First, there is financing by lending, that is, loans not carrying any interest, on which the banks may recover a service charge, and also Qard al-Hasanah (interest-free loans on compassionate grounds). Second, there is trade-related financing, including markup, purchase of trade bills, lending on a buy-back basis, leasing, hire purchase, and financing for development of property on the basis of a development charge. Maximum and minimum rates of charges on these are fixed by the State Bank of Pakistan from time to time. Third, lending can take place under investment financing, including Musharakah (partnership) equity participation and purchase of shares, participation term certificates, Mudarabah certificates, and rent sharing. While the State Bank of Pakistan determines the ratio for sharing profits, losses are proportionately shared among all the financiers.
Over the last four years, the following primary financing instruments have evolved.
Participation Term Certificates
Participation term certificates (PTCs) are transferable corporate instruments with a maximum maturity of ten years and allow for temporary partnership or Musharakah. There is, at present, no statutory definition of a PTC but it may be viewed as a financial arrangement between a financial institution and the business entity on the basis of profit-and-loss sharing over the maturity period of the certificate. It was introduced as an alternative to a debenture (which typically carries a fixed rate of return) for raising medium-term financial resources. Conceptually, since the financial and economic relationship envisaged under PTCs is that of a partner in a business venture, portfolio selection for the banks requires extensive knowledge and experience with businesses involved. Funds under a typical PTC arrangement may be obtained either from a single financial institution, including the specialized credit institutions, or from a consortium. The business entity is expected to pay to the financial institution or bank, provisionally on a semiannual basis, an agreed percentage of anticipated profits with a provision for final adjustment at the end of the financial year. In the event of loss, the financial institution shall refund the share of profit that it had received on a provisional basis. However, the loss sustained by an entity in any accounting year will first be adjusted against the reserves of the company, and the remaining loss, if any, shall be covered in the subsequent years by the two parties in agreed proportions. The financial institution is also permitted to convert up to 20 percent of the principal amount of the PTCs into ordinary shares at par value, so long as funds against PTCs are outstanding. Lending is secured by a legal mortgage on the fixed assets of the company.
So far, most PTC operations have been handled by the specialized credit institutions, including the Bankers’ Equity Limited and the Investment Corporation of Pakistan. PTCs can be traded on the capital market.
Like PTCs, no statutory definition of Musharakah has been specified. However, the Musharakah contract is bilateral between the financial institution and the user of funds. Moreover, Musharakah contracts are not documented in the form of a negotiable instrument and cannot be traded like other financial assets on the capital market.
While Musharakah companies typically provide long-term capital for industrial investment, they have so far been used to fund the working capital requirements of the industrial and trade sectors not as a loan but as akin to cash credit or overdraft accounts in which operations could be carried out by depositing and withdrawing of funds. Musharakah companies are deemed to be temporary partnerships under which the commercial bank and the client share in the profit or loss generated by the working capital supplied by each to the project. In practice, the profit-sharing arrangement is drawn up on the basis of future profit projections that, in turn, are based on past averages, duly adjusted according to the future plans and projections and overall state of the economy and the industry in which the firm operates. The client, for his managerial responsibilities, receives an agreed proportion of projected profits from the partnership, with the balance divided between the bank and the client in a mutually agreed ratio within the maximum and minimum ratios laid down by the State Bank of Pakistan. If a loss results, it is to be shared by the client and the bank in the ratio of their contributions to the funds employed in the project.50Musharakah agreements have occasionally accorded a greater weight to the bank than justified by its contribution, thus enabling the bank to claim a higher percentage of profit compared with the actual investment. This is viewed as a safeguard to protect the interest of the investing bank. Banks also have the right to recall their investment earlier than the agreed period.
Under the law authorizing the establishment of Mudarabah companies, Mudarabah can be floated to meet the term-financing needs of the private sector. Under this arrangement, subscribers participate with their funds, and the manager of funds, with his efforts and skills. Profits on investments made out of Mudarabah funds are distributed among the subscribers on the basis of their contribution, with the manager of the funds earning a fee for his services. Conceptually, a Mudarabah is an investment fund for which resources are obtained through sale of certificates to subscribers. Commercial banks can serve either as managers or as subscribers. There can be two types of Mudarabah: multipurpose, that is, a Mudarabah having more than one specific purpose or objective, and specific purpose. All Mudarabahs, however, are independent of each other and none is liable for the liabilities of or is entitled to benefit from the assets of any other Mudarabah or of the Mudarabah company. The companies are subject to comprehensive regulation and safeguards under the Mudarabah Company Law including the requirements that (a) each must subscribe at least 10 percent of the total amount of Mudarabah certificates offered for subscription, and (b) certificate holders must be provided detailed balance sheets and profit-and-loss statements of the company at specified intervals.
So far Mudarabahs have been managed primarily by the specialized credit institutions, especially the Bankers’ Equity Limited, and have been for specific purposes. The first Mudarabah company in the private sector was incorporated in November 1982 and floated its first (multipurpose) Mudarabah enterprise in early 1985, valued at PRs 25 million. Mudarabah certificates are traded and quoted on the stock exchange.
When financing on a PLS basis is not feasible owing to difficulties in determining profits or the short-term maturity of funds required, banks have been authorized to lend on the basis of markup. Under this arrangement, the margin of profit or markup to the seller is mutually agreed upon between the buyer and the seller in advance. The bank arranges for the purchase of goods requested by the customer and sells them to him on the basis of cost plus the agreed profit margin. The payment is deferred and is made either in a lump sum or in installments over a specified period. The markup is mutually agreed but must be within the minimum and maximum rates specified by the State Bank of Pakistan. Given the characteristics of banks’ asset operations, which are largely short term and oriented toward financing domestic and import trade, as well as financing input requirements, they are amenable to markup lending operations. This is the most popular mode of financing in Pakistan at present.51
While banks are authorized to charge a markup within the limits specified by the State Bank of Pakistan, they cannot charge markup on markup in the event of delays in repayment; markup on markup is viewed as interest.
Under hire purchase, banks and other financial institutions can provide funding for the purchase of fixed assets, which could be entirely owned by the financier or in joint ownership with the client; sole control and use of the fixed assets is, however, with the client. In addition to repayment of principal, banks would receive rent or a share of the profits earned on the assets. After the amount of acquisition value and the agreed rent is paid in full, the ownership is passed on to the client. Given its nature, the hire-purchase mode of financing has been used primarily for the acquisition of equipment, machinery, and consumer durables. Since banks cannot increase the amount of installment to cover losses in the event of delays in payments, there is room for misuse of this mode, thus necessitating closer scrutiny of loan applications by banks.
In addition to instruments summarized above, banks and other financial institutions are permitted to invest under leasing and buy-back arrangements. While the former is particularly useful for medium-term and long-term financing, the latter is particularly suitable when profit-and-loss sharing and other alternatives are not feasible. This is especially relevant for meeting financial requirements for working capital of industry and agriculture, as well as import trade financing.
Choice of Instruments
Although modes of financing are to be determined by agreement between the bank and the client, the authorities have recommended certain preferred combinations of modes and types of transactions. Financing for trade and commerce, which is primarily short-term, should be handled through markup and mark-down operations, and through trade, and loan on commissions and service charges. Fixed investment in industry, trade, and commerce is to be financed through Musharakah, PTCs, leasing, and hire purchase; working capital requirements are to be met through Musharakah and markup. Given the varied nature of financing requirements in agriculture, modes available for this sector cover a much broader spectrum than in other sectors. While short-term finance is to be provided largely on a markup basis, the choice of medium-term and long-term lending modes will depend on the purpose. Leasing and hire purchase are to be the primary instruments for purchase of machinery and equipment, and for dairy and poultry needs. Financing for the development of land, forestry, etc., could be on the basis of development charges, markup, or PLS modes, depending on the nature of development undertaken. Advances for housing are to be on a rent-sharing basis with flexible weights to banks’ funds, or on a buy-back and markup basis; personal advances for consumer durables are to be on a hire-purchase basis. For purchasing consumer products, financing would be solely against tangible security with buy-back arrangements.
Rates of Return and Charges
Rates of return on deposits and charges on bank financing, including profit-sharing ratios, are ultimately to be determined by market forces. However, to ensure an orderly transition from the previous system, in which interest rates were closely regulated, the new system provides for a methodology to determine rates of return on PLS deposits and also lays down maximum and minimum charges for various types of financing modes; banks and clients are free to negotiate charges within these limits.
Banks and other financial institutions receiving PLS deposits are required to declare rates of profit on various types of liabilities, including PLS deposits on a half-yearly basis with prior authorization of the State Bank of Pakistan. These rates are worked out by a formula that determines net profits accruing to the 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 smallest weight is accorded to special notice deposits followed by savings accounts, PLS call deposits from other banks, and term deposits. The highest weight is assigned to equity. In view of differences in the composition of liabilities and net profits, banks would offer different rates of return to depositors even if the average maturity structure were the same. Thus, more efficient banks would offer higher returns than other banks. The authorities believe that the differential rates of return would encourage competition. However, large variances in rates of return would be discouraged to avoid possible destabilizing shifts in deposits among banks. Even though the depositor-bank relationships are based on PLS, there appears to be an implicit understanding between the bank and the depositor that the deposits will not incur any losses in practice. A comparison of the interest rate and rates of return offered by banks on PLS deposits prevailing prior to Islamization shows that the returns on PLS deposits have been generally higher (Table 4). Rates of return offered by banks have shown variances of up to 10 percent. Although no data are available on shifts in the size and maturity composition of individual banks’ liabilities, differences in their rates of return may have generated transfer of funds among banks, thus encouraging competition.52
|Notice Deposits||Savings Deposits||Six-Month Deposits||One-Year Deposits||Two-Year Deposits||Three-Year Deposits||Four-Year Deposits||Five-Year and Above Deposits|
|7 days||30 days|
Rates of return offered by the nationalized banks, which constitute about 95 percent of the banking sector.
Rates of return offered by the nationalized banks, which constitute about 95 percent of the banking sector.
To protect the interests of both borrowers and lenders and to ensure a smooth transition from the highly regulated interest-based system to market-oriented financing, the State Bank of Pakistan is empowered to establish ranges within which financial institutions, including banks and the specialized credit institutions, and borrowers would be permitted to negotiate rates of charges and profit-sharing ratios. The determination of these ranges is also guided by considerations relating to sectoral credit allocation priorities and the need to minimize dislocations arising out of a sharp change in the cost of funding for borrowers. Therefore, the concern so far has been to keep the costs of funding as close to those prevailing under the interest-based system as possible, while allowing market forces a greater role.
For financing by lending, where loans do not carry interest, banks may recover a service charge not exceeding the proportionate cost of the operation, excluding the cost of funds, provisions for bad and doubtful debts, Qard al-Hasanah, and income taxation.53 The State Bank of Pakistan also specifies ranges of profit that should guide banks and the specialized credit institutions in their lending operations under both trade-related and investment-type modes of financing. Estimated rates of profitability arising out of different modes serve as a basis for determining these ranges. Table 5 summarizes these ranges as they apply at present. In principle, profits earned by a bank should not (actual profits of the client permitting) be less than the specified minimum profit. Should losses occur, they are to be shared by all the financiers in proportion to the respective amounts provided by them. In the case of trade-related modes of financing, there cannot be a compounding of overdue profit, markup, or service charge. Under the interest-based system, ceiling rates were specified for a wide variety of loan operations; under the new system considerable flexibility is given to the banks and their clients. Despite this flexibility, a large proportion of financing, according to banks, has so far been provided at about the same cost as under the previous system.
|Range of Profit|
|For exports under the Export Finance Scheme||—||6.0|
|Financing under the Scheme for Financing Locally Manufactured Machinery|
|Postshipment stage||7.0||no maximum|
|All other, not specified elsewhere|
|Investment-related finance||10.0||no maximum|
It is too early to assess fully the impact of the new system on the operation of banks, in particular, and the economy, in general. For instance, detailed data are not yet available on the shifts in banks’ asset-liability structures. Profit-and-loss-sharing deposits have grown sharply since their inception in 1981 and at the end of June 1985 stood at PRs 38 billion, or the equivalent of 28 percent of total deposits (Table 6); effective July 1, 1985, all deposits were converted to a noninterest basis. Time PLS deposits rose faster than demand deposits, accounting for 65 percent of total PLS deposits at the end of June 1985. Moreover, most PLS deposits up to the time of compulsory conversion to a PLS basis were personal deposits.
|PLS deposits/total deposits (in percent)||9.2||15.4||18.6||26.3||18.7||27.6|
|PLS deposits/return-bearing deposits (in percent)||11.9||19.4||23.1||32.3||22.6||…|
Data on the use of PLS funds, available only for 1984, indicate that PLS deposits were not fully utilized under the non-interest-based modes of financing (Table 7). This probably reflected limited experience with these modes of financing and the availability of interest-based alternatives. Nevertheless, PLS investments accounted for about 13 percent of total bank credit and investments at the end of 1984. Over 80 percent of such investments were, however, short term and were undertaken on the basis of markup and markdown methods of financing. Equity participation and Musharakah accounted for less than 15 percent of the total, owing in part to a lack of appropriate institutional and legal infrastructure, experience, and trained staff needed to evaluate projects requiring participation by the banks. In view of the predominance of the short-term markup-based operations, bank managements did not encounter serious adjustment difficulties; the basis of banking operations is still the bankers’ knowledge of their clients and familiarity with their creditworthiness rather than the expected profitability of the activity for which financing is sought.
|June 1984||December 1984|
|(In millions of rupees)||(In percent)||(In millions of rupees)||(In percent)|
|Markup and markdown||17,318||86.7||16,263||83.0|
|Documentary inland bills||298||1.5||377||1.9|
|Rent sharing (housing loans)||130||0.6||198||1.0|
|Investment (equity participation)||1,593||8.0||1,970||10.1|
|Total PLS deposits||22,088||29,684|
|PLS financing/PLS deposits (in percent)||90.4||66.0|
|Total bank credit and investments||140,206||147,928|
|PLS financing/total bank credit and investments (in percent)||14.2||13.2|
These data cover only nationalized banks, which account for over 90 percent of the total banking sector’s assets and liabilities.
These data cover only nationalized banks, which account for over 90 percent of the total banking sector’s assets and liabilities.
The specialized credit institutions, which initiated the conversion of their operations toward non-interest-based modes much earlier than banks, have, by and large, transformed all of their operations to the Islamic system. The National Investment Trust (NIT), Investment Corporation of Pakistan (ICP), and the House Building Finance Corporation of Pakistan (HBFC) were the first institutions to switch their operations from an interest to a PLS basis in July 1979. The HBFC shifted its new lending operations to sharing in the anticipated rental income of the property in proportion to its share in the investment instead of charging a fixed rate of interest. To safeguard its investment, HBFC has the property assigned to it under a deed of assignment for the maturity period of the loan. As with the lending operation, if the co-owner falls behind in making payments of rental income, penalties are imposed; in delinquent cases, HBFC may foreclose on the property. After ceasing investment of its funds in interest-bearing securities in 1979, the NIT confined its operations to equity participation. In particular, investments are concentrated in Mudarabah, Musharakah, PTCs, trading, and PLS accounts with commercial banks. Despite a slowdown in net sales after 1980 owing to declining demand, returns paid to subscribers continued to rise and stood at about 12.8 percent in 1984, compared with 11.5 percent prior to the Islamization of its operations.
Transformation of the ICP followed a more gradual approach, reflecting the greater diversity of ICP’s financial operations. ICP’s activities in the past had focused on (1) the establishment and operation of closed-end mutual funds with the objectives of providing equity and debt financing to manufacturing firms and investment opportunities for small savers; (2) an investment management program under which ICP managed the portfolios of individual private investors, while providing the investor with interest margin loans up to one third the value of the portfolio; (3) the provision of bridging finance for new industrial undertakings through the underwriting of their shares and debentures; and (4) the arrangement of commercial bank-lending consortia to meet the fixed investment and working capital financing needs of new industrial undertakings. In July 1979 the ICP mutual funds ceased purchasing interest-bearing assets and began to divest those in their portfolios; beginning October 1, 1980, a new program was initiated to convert ICP’s Investor Scheme to a Sharing Account Scheme that operated on a PLS basis. Under the new scheme the ICP undertakes joint investments with its account holders. Effective January 1, 1981, the remaining operations of ICP, including underwriting of public issues, bridging loans, and debenture financing, were replaced by PTCs.
The Small Business Finance Corporation (SBFC) also eliminated interest from its operations by converting to nonloan operations in June 1980. This was done through the introduction of hire-purchase arrangements and sales on a markup basis to finance machinery and equipment, as well as other PLS mechanisms such as the purchase of PTCs. Under the hire-purchase system, SBFC buys the equipment and rents it to the client against a 40 percent down payment. The client becomes the owner at the expiration of the specified period and the full payment of installments. In the interim period, a monthly rental is paid, which at present is 11 percent a year. The Bankers Equity Limited (BEL), which was established in 1979 to meet the diverse requirements of industrial financing in the private sector and commenced its operations in January 1980, undertakes its lending operations through direct equity support, underwriting of public issues, purchases of participation term certificates, and Mudarabah. Most of its financing has so far been provided through PTCs.
Impact on Monetary Policy and Bank Regulation
Monetary policy in Pakistan is characterized by direct and selective control of growth and distribution of domestic credit. Annual credit plans and specific credit targets are formulated on the basis of the objectives of the annual development program. Credit is allocated to government and nongovernment sectors on the basis of annual credit plans. Given the predominance of direct controls on the creation and allocation of credit, little use is made of indirect instruments to regulate credit expansion. The minimum cash reserve requirements and liquidity ratios for banks are utilized primarily for prudential purposes. Similarly, the redis-count rate policy of the State Bank of Pakistan has been of limited use, since bank borrowing from the State Bank of Pakistan has, in general, been restricted to certain specific refinancing facilities. Accordingly, the bank rate has not been changed since June 1977.
The elimination of fixed interest rates has not weakened the effectiveness of monetary policy, which continues to be implemented through direct credit allocation. The bank rate policy has been replaced by a regulation that provides for State Bank of Pakistan financing on the basis of profit-and-loss sharing for commercial banks and the specialized credit institutions to ease temporary liquidity difficulties. The rate of profit derived by the State Bank of Pakistan from such finance is equal to the rate of return that the borrowing bank paid on its savings account. If the bank does not maintain any savings accounts, then the rate of profit shall be the rate of return paid on its deposits of six months’ maturity. The State Bank of Pakistan can also provide finance to the specialized credit institutions on a PLS basis with appropriate weights for its funds (which in principle would be more than proportionate to its financial contribution). In the case of profits, they are to be shared by the various financiers based on relative weights attached to their financial contributions. In the event of loss, the amount of loss will be shared by all the financiers, including the State Bank of Pakistan, in proportion to their respective amounts contributed. If new government borrowing modes consistent with PLS principles are developed, this would doubtless affect the size and cost of borrowing, thus requiring additional monetary as well as budgetary policy actions.
The evolution of the banking system since the implementation of noninterest banking has not necessitated changes in procedures and regulations governing bank supervision. Most bank transactions continue to be short term and are based on markup rather than on taking long-term equity positions. The risk exposure of banks has therefore remained virtually unchanged. Hence, it has not been necessary to alter liquidity and cash reserve requirements. Procedures for dealing with delays in repayment and delinquent loans, however, have been changed. Under the former system, banks could impose interest on interest when there were delays in payments. The new system does not permit assessing markup on markup in the event of delays in payments. Instead, a system of fines for late payments is in effect imposed by 12 banking tribunals, which must render their decisions within four months. The likelihood of delayed payments and settlement may make commercial banks more cautious in their lending. Moreover, for the system to be effective, an active legal machinery would be needed to implement fines promptly and implement decisions of the banking tribunals.
Even when they participate in Musharakah and Mudarabah operations, banks will continue to be authorized to obtain security and collateral in order to safeguard against defaults and misuse of resources. It is recognized that until such time as business ethics improve and the banks develop sufficient capability to monitor and audit enterprises so that they can be assured of the accuracy of their clients’ financial statements, stricter security and collateral requirements will stay in place.
The interbank market has not been affected by the new system except that transactions in this market have to be based on non-interest-bearing instruments; banks have to negotiate the rate of return applicable to such transactions. So far this rate has been between the PLS savings rate and that paid on PTCs. The reporting requirements for banks have not been changed thus far.
The banks have been encouraged to develop their own procedures to implement broad guidelines issued by the State Bank of Pakistan. Since most of the transactions are on a markup basis, the banks have had little difficulty in accommodating their existing procedures. However, it is recognized that any further transformation of the system requiring a shift in lending toward equity participation would require more substantial changes in procedures and the acquisition of skills for designing and monitoring such operations. Similarly, stricter and more effective legal safeguards would be necessary to protect the interests of both lenders and borrowers.