Has Islamic banking finally cracked Pakistan?

During the late 1970s the then-government of Pakistan decided to make the whole of the country's existing banking industry sharia-compliant. This process was ostensibly completed by 1985, when all 'interest-bearing' accounts were abolished. The public was not convinced, however, regarding the new regime as a whitewash in which names had changed but the system remained essentially the same.

So a fresh approach was introduced during the 1990s, when the customer was given a choice between a conventional banking counter and an Islamic counter at the same bank. Since then the Islamic model has evolved to the point where banks can select one of three variations.

Meezan's rise

The first of these options is to be a standalone Islamic bank. Though technically not Pakistan's first Islamic bank, Meezan Bank was the first to be awarded a licence as such, in 2002. A Pakistani-Kuwaiti joint venture, it began life in 1998 as an Islamic investment bank.

“The vision was to make Islamic banking the banking of choice [in Pakistan], to be the premier bank,” says Ariful Islam, Meezan’s deputy CEO. “But then we realised the vision was more than the investment banking platform could offer. We decided we had to become a fully fledged commercial bank.”

Meezan took its plan to a sympathetic central bank, the State Bank of Pakistan (SBP). The SBP designed a robust Islamic governance framework – which some say is the best of its kind in the world – and gave the reinvented Meezan its Islamic licence.

Meezan enjoyed not only first-mover advantage but also six good years in which to establish itself before the global slump of 2008/09. It has been profitable throughout. “We have been the fastest growing bank in the country for the past 10 years, with a compound annual growth rate in assets of about 40%,” says Mr Islam. “In the early years it was higher.”

Meezan is already one of Pakistan’s top 10 banks by deposits. ”If it continues its growth rate it will be in the top five in a few years,” says Omar Mustafa Ansari, Islamic financial services partner at Ernst & Young in Karachi.

Mixed picture

Meezan’s success did not go unnoticed and attracted other players into the Islamic market. Today there are another four independent Islamic banks – Dubai Islamic Bank (DIB), BankIslami, Al Baraka Bank and Burj Bank. Most have a strong Middle Eastern presence on their share registers. However, most of these banks did not enter the market until shortly before the slump, and they all suffered in varying degrees.

BankIslami racked up substantial losses from which it is only now recovering. Bahraini-owned Al Baraka merged with Emirates Global Islamic Bank in 2010, after disappointing growth. DIB had a cost control problem but is now better managed, according to one Karachi banker. Burj, of which more later, is up for sale.

Adding to the pressures for rationalisation is the SBP’s demand that all Pakistani banks raise their minimum paid-up capital to Rs10bn ($97.2m) by the end of 2014.

Broken window?

The second option for conventional banks is to have an Islamic 'window' or separate Islamic banking division. That was the original strategy of Pakistan’s four biggest commercial banks – Habib Bank, MCB Bank, National Bank of Pakistan (NBP) and United Bank. Most have since decided that the window model can be confusing for customers – is it really untainted Islamic banking? – and some are now going for the third variation, which is to have an Islamic subsidiary.

The decision requires a certain amount of confidence. As Mr Ansari points out: “You need Rs10bn of capital from day one and it’s a double hit on your capital ratios. So only very strong and very large banks can do it.”

MCB considered buying Burj Bank, but has since walked away and is starting its own Islamic subsidiary. NBP is currently doing its own due diligence on Burj. Two other conventional banks are converting themselves into purely Islamic operations – Summit Bank, itself the result of multiple mergers, and Faysal Bank.

Islamic banks had originally hoped to capture 12% of Pakistan’s banking market by 2012. The crisis slowed them down, but at last count they had 10.7% (Rs872bn) of its deposits and 9.4% (Rs1016bn) of its assets, according to the SBP. There are now more than 1300 Islamic branches, of which 767 are operated by independent Islamic banks. Meezan owns 349 of those. The largest Islamic window is operated by Bank Alfalah, which has 140 branches.

Zubair Haider Shaikh, head of corporate and investment banking at Dubai Islamic Bank Pakistan, notes that Islamic deposits have been increasing at least twice as fast as those in the conventional sector. “Growing assets is the challenge,” he says. “Documentation of Islamic advances is a bit more complicated than conventional products, and corporate customers can find it difficult and time consuming. It’s a learning curve.”

If corporate customers find the documentation irksome, they have less trouble with the pricing of Islamic loans, which are keenly competitive. The result is that Pakistani subsidiaries of multinationals such as Unilever and Nestlé all borrow from Islamic banks.

“Islamic banking has been instrumental in bringing down lending spreads,” says Mr Islam. “Five years ago the average was Kibor plus 100 to 150 basis points [bps]. The top corporates can now borrow at Kibor plus 25 to 50bps.”

Sukuk shortage

While conventional banks in Pakistan invest heavily in government bonds, which offer generous spreads to their funding costs, government sukuk are few and far between – and rather less generous. Bidding in a recent auction for a government sukuk was so competitive that it priced 200bps inside Treasury bills.

“We have developed an Islamic product to operate in the interbank market, where we place money with a conventional bank for three to six months,” says Mr Islam. “They make good money out of it. But government sukuk are in very short supply. It’s almost a crisis situation.”

The government is aware of the problem. Its efforts to encourage the sector include the appointment of an additional SBP deputy governor with a specific brief to grow Islamic banking. Recently, it brought religious scholars, bankers and government officials together on a new Committee for the Promotion of Islamic Banking.

Finance minister Ishaq Dar told the committee that the government was thinking of Islamic banks when it priced a recent Eurobond issue, Pakistan's first for seven years. Given that the issue was oversubscribed more than 14 times, the government could have printed up to $5bn, he said, adding: “But we only took up $2bn so that additional financing could be done by issuing sukuk."

The SBP’s plan for Islamic banking included further improvements in the legal, regulatory and taxation environment, together with refinements to the sharia governance regime. The central bank has also been drawing up a liquidity management framework to support the development of an Islamic interbank money market. This includes allowing banks to place surplus funds with the SBP under a mudaraba-based facility.

Diversity drive

Another initiative under way in Pakistan is the move to foster more diversity in Islamic products and markets. The SBP has acknowledged a “dire” need for Islamic microfinance and identified a lack of adequately trained human resources as a “major stumbling block”. It has been working with academic institutions on the establishment of a centre of excellence in Islamic finance.

“The centre would not only help in providing a steady stream of skilled human resource for the industry, but would also significantly augment its research capacity,” says SBP deputy governor Saeed Ahmad.

Yet another SBP objective is to raise awareness of Islamic banking and exactly what it does and does not do. There is a perception in some quarters, for example, that Islamic banks pay less for deposits and charge more for loans than conventional banks. Islamic bankers say this is a myth which needs to be dispelled. They are keenly aware that they will continue to grow market share only if, in addition to the offer of sharia-compliant products, customers see that all other things are equal.

Last year, the SBP ran a press and radio campaign to promote Islamic banking, and banks themselves are continuing to broadcast a positive message. “Most banks now accept that this is an idea with a future,” says Muhammad Raza, Meezan’s head of consumer banking and marketing. “The challenge is to raise awareness among people. We’re working on it, but there is a still a long way to go.”