The financial institutions are the most critical in today’s competitive and indeterminate economic environment. They propel the indolent assets in various productive channels of the economy. Therefore, it is important for every country to have efficient financial institutions for continuous growth. They can do both: improve their efficiency with the production of high outputs and /or by reducing their input costs.
There are many types of efficiency concepts:
1- The Technical Efficiency: It determines the ability of financial institutions to maximize their outputs with the utilization of lower inputs.
2- The Profit Efficiency: It examines that how profitable a firm to its rivals.
3- The Cost Efficiency: It determines how close a firm’s cost to a best performer’s cost.
Leasing and Modaraba companies as financial institutions are also contributing in the economic development of Pakistan as like the other financial institutions. On one hand, Leasing companies by providing the heavy machinery on lease facilitate the small businesses to save their funds since small businesses mostly have constraints on their financial resources. Moreover, small businesses also enjoy various financial benefits associated with the lease finance such as; they charge periodic payments on the use of a specific fixed asset, which are allowed to subtract from the taxable profits of the business firm.
Historical Decision by FSC
The Islamic finance industry in Pakistan is expected to continue its growth trajectory over the medium term, driven by strong government push and steadily rising public demand for Islamic products. However, the industry faces key challenges that could slow its growth such as the still-developing Islamic finance regulatory framework. In April 2022, the Federal Shariat Court of Pakistan (FSC) stated in a decision that ‘Riba’ or interest is prohibited in Islam, including relating to banking transactions. The FSC directed the government to adopt sharia-compliant modes while borrowing from domestic or foreign sources in the future. The FSC set an implementation timeline of five years to convert the economy of Pakistan into “equitable, asset-based, risk sharing and interest-free economy” by end-2027.
Pakistan’s Islamic Financial Industry
The Islamic finance industry faces multiple other challenges. This includes still-developing Islamic finance regulatory framework, limited supply of sharia-compliant products and gaps in the distributional channels, with limited outreach in the populous rural areas where 63% of the total Pakistani population resided in 2020, according to World Bank. The financial sector in general also remains under-developed, with a challenging business environment.
The size of the Pakistani Islamic finance industry is estimated to have crossed USD42 billion at end-1Q22. Islamic banks are the largest contributor to the Islamic finance industry at 67% (total assets), followed by Sukuk at 26% (outstanding amount), Islamic funds at 6% (total assets) and Takaful at 1% (total contributions).
At end-2021, Islamic banking share reached 18.6% of banking sector assets (end-2017: 12.4%) and 19.4% of deposits (end-2017: 14.5%). State Bank of Pakistan targets the Islamic banking sector to contribute 30% to the overall banking industry assets and deposits by 2025. In 2021, Islamic banks’ total assets experienced a sharp growth of 30.6% yoy to PKR5,577 billion (USD32 billion). Islamic branches of conventional banks contributed significantly to the banking system, with a 45.7% share of overall Islamic banking assets by end-2021. The domestic market share of Takaful reached 12% at end-2020. The Islamic funds sector had a global market share of 1.9% at end-2020.
In a developing country like Pakistan, it is highly essential to have an efficient leasing sector to support the businesses in the country. On other hand, modarabas provide various Islamic products but within the limits of Sharia law such as; Musharika, Modaraba, Murabaha and leasing activities etc. In Pakistan, leasing and Modaraba firms are providing medium to long term financing facilities and contributing a lot towards the development of the financial sector in Pakistan.
The NBFI & Modaraba Sector showed growth inspite of multiple economic challenges and Covid19, during the period ended 9une 2021. A net loss of PKR 1,127 million last year was converted into overall net profit of the Sector of PKR 2,208 million in FH2020-21. Total Equity also increased from PKR 34,997 million in FH2019-20 to PKR 40,583 million in FH2020-21 showing a robust increase of PKR 5,606 million, which indicates confidence of the investors in the sector. Although the Asset base of the sector increased marginally from PKR 90,195 million in FH2019-20 to PKR 91,025 million in FH2020-21, Dividend announced substantially increased to PKR 2,084 million as compared to PKR 1,674 million paid out in the corresponding period last year.
Modaraba, like previous years, was the best performing segment in the sector. Trading and financing Modarabas posted a profit of PKR 1,852 million in FH2020-21 in comparison to PKR 951 million in the corresponding FH2019-20 showing robust growth in profit of about 100%. First Treet Manufacturing Modaraba, the only manufacturing Modaraba in the sector also performed well and reduced its loss to PKR 618 million in FH2020-21 from PKR 2,985 million in the FH2019-20 despite financial constraints and health. Allied Rental Modaraba followed by BRR Guardian Modaraba, First Habib Modaraba, Orient Rental Modaraba and ORIG Modaraba were the major contributors of profit to the total net profit of the sector. Out of twenty-seven (27), nineteen (19) members announced cash dividend of PKR 1,212 million which in percentage terms ranges from 1% to 155 %.
The sector also showed significant increase in Assets to PKR 55,625 million in FH2020-21 from PKR 51,505 million in FH2019-20 registering an increase of PKR 4,020 million. Equity of the Modaraba sector also increased to PKR 26,623 million in FH2020-21 from PKR 17,406 million showing a significant increase of PKR 9,217 million.
The Leasing Sector maintained its financial results but the overall decline in the overall numbers is due to the departure of Sindh Leasing Company Limited from the sector and its merger with Sindh Bank Limited. Primus Leasing Limited remained the top performer with a profit of PKR 66 million with 5.50 dividend this year as compared to 6.50%, last year.
Investment Finance Services also performed well and their profit increased to PKR 953 million in FH2020-21 from PKR 779 million in FH2019-20 with a net increase of PKR 174 million registering percent increase of 8%. Equity stood at 12,572 million in FH2020-21 as compared to PKR 12,205 million showing an increase of PKR 367 million and Assets base moved up by PKR 1,630 million with assets of PKR 29,423 million in FH2020-21 and PKR 27,785 million in FH2019-20.
The Market Capitalization of the total sector as at 9une 30, 2021 was PKR 29,192 million in FH2020-21 as compared to PKR 17,306 million as at 9une 30, 2020 which is due to increase in the paid-up capital of First Treet Manufacturing Modaraba, Finja and OLP Financial Services Pakistan Limited (formerly ORIG Leasing Pakistan) which shows confidence of the sponsors in these entities and augurs well for the 87,628 (FH2020-21 vs 89,612 in FH2019-20) shareholders which constitute a significant part of the Pakistan stock market investors/shareholders.
While the external environment remains challenging, we expect some stabilization in the economy in the medium term. Pace of recovery will be dependent on improvement in external flows, geopolitical environment and global commodity prices. NBFI and Modaraba sector results demonstrate strong business fundamentals.
Modaraba has established itself as a well understood Shariah compliant instrument of financing in Pakistan. It has been practiced for the last 32 years and we have gained a lot of experience in its operations and management. An institutional framework has been developed which is acceptable to the scholars and also clarified the initial confusion regarding the regulatory responsibilities. The dual structure between SECP and SBP has given way to a single regulatory agency which is SECP. It is logically expected that Modarba will provide a transit point in our path towards Islamic financial system. One should apply the experience gained from this mode of financing and scale it up and replicate it throughout the system. However, that Modarabas haven’t taken off so far in this country despite such a long standing and their contribution in the financial sector has been insignificant. The total market capitalization is still a tiny fraction of financial sector cap.
What should be done?
1- The governance structure of the Modarbas has proved to be inadequate and the interests of the investors and certificate holders have not been adequately protected. The concentration of powers in the hands of managers particularly when the standards of transparency and disclosure are not that rigorous does leave a lot to be desired.
2- We need much greater transparency in our operations to inspire confidence. Liberal use of Central Depository and disclosure standards need to be improved and upgraded so that the ordinary prospective investor is assured that his money is not only safe but is being managed in the most professionally desirable manner. We should strive to achieve and maintain the same standards of disclosure and transparency which are applicable to other financial institutions in Pakistan. By doing so we would be at par in terms of attracting investment to Modarabas.
3- The Risk management practices in Modarabas should be reviewed to find out if the managers are optimizing the returns for the given level of risk. There is an urgent need to determine if the tools and techniques being adopted by them represent the best practice in the industry keeping the constraint of complying with sharia in place. The only credible way to expand this mode of financing is by demonstrating that the reward-risk relationship under Modaraba is not inferior compared to other instruments.
4- Although the regulatory dualism has been sorted out by giving the SECP the exclusive responsibility for regulation over the Modarabas, so it looks that the oversight has not always been exercised with utmost vigilance. We should consider some alternative such as some elements of market-based regulation combined with self-regulation.
5- The Modarabas have not been able to diversify their products or differentiate from other market players such as leasing companies. Today 75% of their business is concentrated on leasing which does not provide any 4 market niche or comparative advantage to them. The leasing portfolio mostly covers traditional industries such as textiles, light engineering, cement etc. New activities have by-passed the leasing sector so far.
6- There are many savers who do not want to use the banking system and are looking for Shariah compliant products. We should try to attract them and thus add to the overall national savings pool of the country.
7- Seventh, the Modarabas have very little geographical dispersion outside the big cities only. We should establish presence in smaller towns and have a distribution network which is extensive.
8- The minimum capital requirements of Modaraba sector should also be raised to levels which allow for more rapid asset growth. At the time other non-bank financial institutions are expanding their capital to do more business.
Trend of Growth & Total Assets of Modarabas & NBFCs
- The total assets of Modarabas & NBFCs have grown from PKR1,192bln in FY17 to PKR2,023bln at the end of 1HFY22 representing a CAGR of 11%.
- Mutual Funds & Plans have the highest share of ~58% while Modarabas have a share of ~3% in the total assets of Modarabas and NBFCs
Share of Sariah compliant assets have remained at an average of 31% over the last 5 periods. CAGR of Conventional and Sariah assets from FY17- 1HFY22 was 13% and 7% respectively.
The author, Nazir Ahmed Shaikh, is a freelance columnist. He is an academician by profession and writes articles on diversified topics. Mr. Shaikh could be reached at [email protected]