Islamic finance system can serve better than conventional banking: SBP

August 12, 2010

The Islamic financial system has potential to serve better than conventional banking system, a top official of the central bank said on Thursday.

Addressing the inaugural session of the Islamic financial news road-show on Islamic banking, State Bank of Pakistan Acting Governor Yaseen Anwar said that the Islamic financial system has the potential to provide better banking and financial services than the conventional system provided it capitalises on its own inherent strengths and avoids following the conventional system.

Anwar said that the current Islamic banking paradigm, both in Pakistan and elsewhere in the world, is based on replication of conventional banking products.

“While the replication of conventional products to make them Shariah compliant does pass the Shariah permissibility test, it is insufficient to achieve the larger objectives of the Islamic financial system, particularly the broad-based and equitable distribution of economic gains,” he said.

The acting governor said that reliance of Islamic banks on debt-based fixed income products and minimising the risks to almost close to those of the conventional system is not only blurring the distinction between Islamic and conventional finance, but also making Islamic banks relatively less efficient than their conventional counterparts.

“Thus, to sustain the growth momentum, the industry will have to diversify its products mix by focusing on the areas where it has comparative advantage rather than blindly following the conventional system,” he said.

He said that 67 percent of the Islamic banks’ financing in the country is concentrated in the corporate sector through Murabaha, Ijarah, and diminishing Musharaka. With most of the corporate entities having banking relationships with conventional banks, the Islamic banks have to offer significant price discounts to attract corporate clients, he said.

“This improves the quality of their financing portfolio, reduces their profit margins and inhibits their ability to offer better returns to the depositors,” the SBP acting governor said.

It also restricts the access to finance to the well-established businesses and corporates and leaves the small and medium enterprises (SMEs) and start-up businesses financially excluded, he said.

“This is contrary to the natural business model of Islamic finance, which promotes risks and reward sharing and encourages financing to promising start-ups that is critically important for promoting entrepreneurial culture,” said Anwar.

He said that the present scope of Islamic banks’ business model is confined to that of conventional banks, which generally caters to the short-term financing needs of the real economy through interest bearing instruments and facilities.

“While this scope is in line with the business model and deposit streams of conventional banks, it is not sufficient for the Islamic banks, which were originally conceived for catering to the genuine financing needs of the real economy through risks and reward sharing instruments,” he said.

“Islamic banks with this narrow scope will find it difficult to compete with the conventional banks, which are giants as compared with the Islamic banks and are highly efficient and flexible in catering to such financing needs of the real economy,” he said and reiterated that the Islamic banks will have to expand their scope to offer both commercial and investment banking services to be financed by different streams of deposits.

Anwar said that there are numerous areas and sectors, which could be explored to sustain and even accelerate the growth momentum of the Islamic banking industry.

Agriculture is strategically an important sector of Pakistan’s economy with 20 percent share in the GDP and a major source of livelihood for 65 percent of the country’s population living in rural areas, he said.

ìThe sector is also largely un-served or under-served by banks as less than 20 percent of about seven million farm households in the country have access to bank credit,” he said.

He suggested that the Islamic banks can capture a sizeable proportion of this market by reaching out to the growers either directly or through the non-governmental organisations (NGOs) or microfinance institutions.

“The Islamic banking institutions are likely to have better acceptance in the rural areas as the rural population is believed to be relatively more faith sensitive,” he said.

At present, Islamic banking institutions largely concentrate in large urban centres and they would need to expand their outreach to smaller towns and rural and semi-rural areas and optimally leverage the technology to serve the rural markets, he said.

Similarly, he said, there is also a great potential in the SME sector, while Islamic banks can also have partnership with the federal and provincial governments in developing and building low-cost housing projects, which are on the priority agenda of the federal and provincial governments.

Anwar said that the central bank fully recognises and appreciates the potential of Islamic banking in increasing the depth and breadth of the banking system and making it more diverse and stable.

“It is an important component of the SBP’s strategic goals and we are actively engaged with the industry as the regulator-cum-partner to catalyse and facilitate development of the industry on sound footings,” he said.

“We have plans to further improve our legal and regulatory framework to provide the necessary support and flexibility to this budding industry and enhance its commercial viability. There are additional plans to strengthen the Shariah compliance framework to improve the Shariah compliance levels in the industry and give comfort to the masses about the Shariah permissibility of Islamic banks’ operations,” he added.