Doing business in Islamic way requires Muslims to undertake transactions free of Riba (interest), Gharar (uncertainty), Maisir (gambling) and non-Halal (prohibited) activities. Islamic banks are, therefore, forbidden from taking or offering interest or usury. Unlike in conventional banking, a lender in Islamic finance should shares the risk of the project with the borrower, as neither the borrower nor lender controls the outcome of the venture. This risk sharing in financial contracting by replacing ex-ante fixed return, with an ex-post uncertain return based on a profit-sharing principle, differentiates Islamic from conventional banking. Under this profit and loss sharing (PLS) paradigm, only the profit-sharing ratio between the financer and borrower is determined ex-ante.
In practice, however, Islamic finance institutions offers both PLS and non-PLS products. A financier could opt for direct equity stake, based on participatory financing (or PLS), or non-participatory financing (or non-PLS) with no take on equity. The important participatory forms are Mudaraba, and Musharaka. In former contract, a ‘sleeping’ partner contributes capital while active partner contributes expertise/knowledge. In latter contract, a financier also participates into the activities of the venture. Important non- participatory financing form includes Murabaha (‘markup’ or cost-plus sale), Ijara (lease), Bay’ salam/Istisna (deferred delivery), Bai muajjal (deferred payment), Jo’alah (service fee), and Qard al hasana (charity/beneficence loan).
A large number of institutions offer interest free banking based on Islamic products in predominantly Muslim, as well as, in non- Muslim countries. Only Iran, Pakistan, and Sudan are referred to as countries with full Islamic banking. Despite PLS banking introduced in Pakistan in 1980s, banks never shared losses with the depositors neither their depositors received any share in the windfall profits, which the banks in Pakistan are making. Moreover, the contract these banks are making with their client are based on ex-ante fixed rate and are benchmarked with the interbank market or policy rate, which makes them conventional instead of PLS based Islamic banks. Only designated Islamic banks established following the recommendation of Commission for Transformation of Financial System (CTFS) and Pakistan’s Supreme Court ruling in June 2002. Since 2002, State Bank of Pakistan (SBP) issued licenses for Shariah compliant Islamic banks only, with their own Shariah board that ensures its operational consistency with Shariah requirements.
Islamic finance competes with the conventional banks and often follows the conventional banks while setting the prices of their retail products. SBP regulation requires conventional banks to price their products with reference to certain benchmarks. For example, lending rate is required to be linked with the relevant tenure Karachi Interbank Offered Rates (KIBOR) and deposit rate with the SBP Repo rate. As Islamic banks are yet to develop their own benchmark for lending purposes, the SBP instructions on pricing of lending products remains the guiding framework for loaning business in Islamic banks’ as well. Nevertheless, products based on participatory financing (Musharakah, Mudarabah and Wakalah) is exempted from KIBOR benchmarking.
Pricing of the deposits is more complicated in Islamic banking system. Unlike conventional banks, Islamic banks are not required to benchmark the deposit pricing with the SBP Repo rates. On contrary, Islamic banks are required to share their profits from financings, investments and placements with the depositors, as their deposit mix is mostly Mudaraba based. Islamic banks in Pakistan pool funds from depositors similar to asset management companies. These pools are identified by their risk and reward features. Each pool works like a virtual enterprise having explicitly demarcated sources of funds, ownership of specific assets, and income and expenses.
There is a strong spillover between the prices of two systems; Islamic banks are following (leading) the conventional banks in pricing the lending (deposit) products. Islamic banks have acquired advantage in the deposit pricing by tapping the religious depositors, which also has promoted financial inclusion in the economy. However, excess liquidity significantly affects the spillovers of prices between the systems which suggests that the Islamic banks are investing in government securities indirectly via conventional banks.
Therefore, an assessment of the policy transmission should incorporate factors specific to the Islamic financial system, such as presence of excess liquidity, prohibition of interest payments and price spillover from conventional to the Islamic financial system. Specifically, presence of excess liquidity in Islamic system may distort the conventional interbank rates. Interbank market of Pakistan has experienced this phenomenon in recent past, where overnight call rates frequently swung to discount, from premium to the repo rate, under the influence of Islamic banks’ excess liquidity. Such a distortionary effect may have repercussions for transmission of policy shocks, not only through conventional banks but also through Islamic banks.
[box type=”note” align=”” class=”” width=””]The writer is a Karachi based freelance columnist and is a banker by profession. He could be reached on Twitter @ReluctantAhsan[/box]