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«The Roots & Development of Islamic Banking in the World & in Pakistan Muhammad Aqib Ali Director and Country Head, International Islamic Finance & ...»

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South East Asia Journal of Contemporary Business, Economics and Law, Vol. 7, Issue 1 (Aug.)


ISSN 2289-1560

The Roots & Development of Islamic Banking in the World & in Pakistan

Muhammad Aqib Ali

Director and Country Head, International Islamic Finance & Insurance Institute

Ph. D (Islamic Banking & Finance) Scholar,

University of Management & Technology, Lahore, Pakistan



The paper attempts to explore the roots of Islamic Banking in the world in general and in Pakistan in particular to assess the evolution and development/growth of Islamic Banking worldwide and especially in Pakistan. The paper highlights the chronology of Islamic Banking globally and in Pakistan and also traces the progress of Islamic Banking internationally with special reference to Pakistan. The facts reflect an encouraging global Islamic Banking outlook. The findings also show that the progress of Islamic Banking in Pakistan has been consistent and quite encouraging. As the time passed the quantum of Islamic Banking in the country expanded and is continuing to move in the right direction. From a new initiative in the 1970s, Islamic Banking is now a force to reckon with, the annual growth rate of more than 16% proves this fact.

Keywords: Islamic Banking, Islamic finance, Pakistan, Evolution, Development, Growth, Roots of Islamic Banking Introduction & Overview of Islamic Banking Islamic economic and financial system is based on the idea of collective welfare which is driven by virtue and goodness of both worlds. This idea of Islamic economic system is greatly in contrast to the modern interest based economic system which is driven by the principles of capitalism, unbridled resource consumption and materialism. Islamic system of finance emphasizes risk sharing which provides Islamic financial methods like murabaha, mudaraba, ijarah, musharakah, salam and istisna – guided by the Islamic principles derived from Holy Quran and the Sunnah (sayings and acts) of the Holy Prophet (SAW) to eventually facilitate trade and business in the society and to consequently bring economic well-being and prosperity. This is incredible to note that Islamic sacred texts from the times when paper money was not even invented offered guidance on intricate financial issues. Besides this, Islamic principles also provide guidance on the architecture of a system that is economically just and fair and is based on the schema of socio-economic welfare of all and not just certain wealthy individuals or groups. (Zaman 2013) Whereas, the conventional economic system, emphasizes on the principles of time value and money. This is explicitly mentioned in the second chapter of the Glorious Quran that dealing in Interest is tantamount to waging war against God and His messenger PBUH. Islamic mode of business financing is laid on the tenant that the use of Riba (interest) is forbidden in all transactions (Gerrard and Cunningham, 1997). This prohibition is based upon Sharia guidelines and laws which are derived from two divine sources i.e. Quran & Hadith. According to the fundamental divine rulings of Islam, Muslims can neither collect nor disburse Riba (Interest), so they are incapable to deal and transact with conventional financial institutions and including both banking and non-banking financial organizations. (Jaffe, 2002). To cater to the needs of this segment that represents those Muslim clients, who avoid Interest because of their religious beliefs, which forms a massive market, Islamic banking and non-banking organizations have developed a diverse group of shariah-compliant and riba-free banking and financing products that fulfill the relevant Shariah rulings, and hence, are suitable to their Muslim customers. (Rammal, 2004).

Tracing the Roots of Islamic Banking in the World

The Islamic system of economy – long established approximately 1400 years ago is a broad structure of principles, institutions and clearly defined injunctions. Holy Prophet Muhammad PBUH himself was a trader by profession and hence he knew the importance of trade and business along with other economic issues. Islamic mode of partnership finance i.e. Mudarabah was one of the driving forces of business and trade in the medieval times. With the passage of time, industrialization and institutionalized commercial banking reached the Muslim populations, where at that time; it was not somehow possible for the Muslims to reject the interest-based system of banking, as there was no pragmatic and concrete alternative available. It was in the 19 th century that Muslims started to realize that the current system of banking and economy was based on Riba that is interdicted in Islam and is categorically forbidden in all its shapes whether commercial or non-commercial; and there should be an alternate system which conforms to the principles of Shariah. The primary project that paved way for a promising future of Islamic banking was “Mit Ghamr” in Egypt. In the meantime, another initiative was taken in the shape of “Tabung Haji” in Malaysia (Laldin 2008). A major challenge in the establishment of Islamic banking set-up was to develop Shariah compliant products and services, for which Islamic banks established Shariah Advisory Committees and Religious Boards, who authenticated the products and services of the Islamic banks and whose main objective was to judge, whether these products and offerings conform to the tenets of Shariah. These boards comprised of Islamic scholars who came from diverse backgrounds and belonged to various schools of thought. This was a positive prospect as banks could benefit from the vast knowledge and innovative ideas of these scholars.

There was also difference of opinion among these scholars but mutual consultation was the guiding force to finalize the

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decisions. As the time passed, Islamic financial institutes grew in numbers and magnitude. The first international Islamic financial institute was the Islamic Development Bank (IDB) in 1975. This was a landmark in the history of Islamic banking.

Some countries including Pakistan, Iran, Sudan, Malaysia and Bahrain initiated efforts to implement Islamic banking at larger scales in their respective countries during 1980s. In the next decade some of the conventional banks also introduced Islamic banking products and services by operating separate Islamic banking units and divisions.

After the foundations of Islamic banking in countries like Egypt and Malaysia, it became evident that Islamic banking will have a vivid future. Swiftly after the introduction of Islamic financial services by the conventional banks, Islamic banking started to make its mark on the global financial landscape. (Khan & Bhatti 2008) Several Islamic investment and holding companies were established and many international and large-scale financial institutes introduced Islamic financial services. With the passage of time, Islamic finance flourished, innovative and diverse products and services like sukuk, Islamic mutual funds, and takaful fortified Islamic finance at international level. The rapid expansion of Islamic finance and the discovery of new and innovative Sharia compliant products and services facilitated Islamic finance to compete at a global scale with the competitive interest based banking and financial set-up. A number of international and large-scale entities like Islamic Development Bank, The Islamic Finance Services Board (IFSB), Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), and International Islamic Rating Agency are making their due contribution in the growth and development of Islamic finance at a global scale. Today Islamic finance is a thriving and dynamic force in the global financial setup.

Islamic Development Bank established in 1975, being the first international Islamic financial institution played a role of a pioneer to make Islamic banking and finance a global phenomenon. The bank played a vital role in the economic growth and development of its member countries keeping in view its primary objective of narrowing the gap between the rich and the poor member countries. The IDB is distinguished from other similar institutions like the World Bank or the Asian Development Bank in a way that it is committed to follow the tenets of Shariah in all its operations and is dedicated to avoid Riba or interest in all its dealings. The IDB plays a crucial role in the economic development of member countries and Muslim communities around the world by performing key functions like financing the public and private sectors of member countries; raising, operating and maintaining various funds like trust funds, special funds and other specific funds; accepting deposits and capital contributions;

making investments and trade financing; providing technical assistance, co-operation and training facilities to member countries;

promoting and assisting foreign trade among member countries; insurance, information and other ancillary services; facilitating research and training in areas of Islamic economics, banking and finance by providing scholarships etc. Other functions which guarantee the IDB, a distinctive Islamic character, are the participation in the equity capital of projects in member countries and the investment in social infrastructure projects in member countries. The IDB has proved its mettle at the international level as the first developmental-aid institution operated in accordance to Shariah principles. The role played by the bank in the economic development of its member countries has been momentous. The IDB has transformed from a single unit into a group of five entities, its capital has increased manifold and the credit ratings and financial position of the bank, even during the recent global economic and financial crisis, has been phenomenal. Today the IDB is one of the few multilateral development financial institutions with excellent credit ratings, which confirms its financial stability and progressiveness. The IDB continues to play the critical role in its member countries, by reducing poverty and fostering economic development.

Islamic finance industry has expanded swiftly in the past thirty years expanding its horizon in terms of operations and territory by reaching out to many parts of the world from Arab countries to Middle-East to Asia and Europe. The dynamics of Islamic finance industry as discussed earlier emerged with the establishment of the Small Savings Association of Mitghamr (Egypt) in

1963. The capacity and vigor of the industry has now reached to more than 500 banking and financial entities having operations in over 90 countries with the aggregate gross assets approximately more than 1.6 trillion US dollars which is likely to double by 2016. (Humayun 2013). The growth rate stands at a staggering more than 16% a year. According to Kapur (2008), most of the large Islamic finance entities including Islamic banks have outperformed and outpaced their conventional counterparts – the conventional interest based banks with the assets growth rate of more than 26.6 per cent with assets growth standing at an amazing 350 billion US dollars approximately, as compared to the mainstream banks who stood at an asset growth rate of 19.3 per cent. This performance as reflected in the growth rates shows the great potential and amazing progress of Islamic finance institutions when we match these rates with the estimated rates of 15-20% per annum, which were forecasted by most of the analysts globally. Nearly all of the major interest based conventional banks have either already developed their Islamic banking units and divisions or are in the process of establishing their Islamic banking groups to tap the new and great emerging market.

The greatly speedy and encouraging increase in the growth rate of Islamic banking and finance around the world, beyond any doubt proved to be a wave of fresh breathing air for those who wished to be a part of modern banking and economic organizations including both banks and non-bank institutes, to participate in the economic process and to reap the benefits in shape of Shariah compliant returns and profits. The industry growth provided a great opportunity to Muslims to be a part of modern market economy while also being in conformity with their religious beliefs by not dealing in interest and speculation businesses, directly or indirectly. (Usmani, Taqi, 1999). It was in the year 1973 that a meeting of foreign ministers and delegates of almost all the major Muslim states decided to set-up an Islamic monetary authority in shape of Islamic Development Bank with the purpose and intentions of nurturing financial prosperity and socio-economic development of Muslim countries in consonance with the tenets of Islamic Shariah. The event actually signaled the major initiative collectively taken by Muslim countries to facilitate Islamic finance sector (Saad, 1998). As time passed, many Muslim countries strengthened their own Islamic banking and finance structures. The magnitude of success in this regard differed but progress on this account was surely made by many countries particularly by Bahrain, Oman, Malaysia, Egypt, Pakistan, Saudi Arabia & UAE.

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Origin of Islamic Banking in Pakistan The Islamization process in Pakistan concurred with the movement of Islamic finance in the world in the second half of 1970s.

But it had its genesis in the very creation of the country. Pakistan came into being by partition of the India in 1947 in response to the demand of the Indian Muslims to establish an independent homeland where they could practice Islamic teachings. As a result, successive constitutions of the country have reiterated the intention of implementing the law and culture of Islam in true spirit. The foremost expression of the will to practice Islam had been to find a viable solution to refashion the financial institutions of the country on interest-free basis. It had always been in the subconscious of the ordinary Muslims that Islamic way of life naturally meant an interest- free economic system; though very few even understood the vast implications of such a belief.

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