Islamic banking dilemmas

In a groundbreaking move, the State Bank of Pakistan (SBP) has committed to converting the country’s entire banking system into a Shariah-compliant Islamic model by December 2027.

This ambitious step follows the Federal Shariat Court’s 2022 ruling declaring interest-based banking (riba) un-Islamic and unconstitutional. The plan reflects Pakistan’s long-standing constitutional and societal aspiration to align economic practices with Islamic principles. However, while there is strong momentum and clear benefits to Islamic banking, the path toward full Islamisation is riddled with operational, financial and strategic challenges that demand honest reflection.

Islamic banking’s growth in Pakistan over the past decade has not only been driven by religious sentiment but also by compelling commercial advantages, particularly on the deposit side of the balance sheet.

A core strength of Islamic banks has been their ability to attract deposits at significantly lower cost, thanks to a large segment of the population that prefers to avoid riba and is willing to accept lower returns in exchange for religious compliance. This demand has fueled the rapid growth deposit base of Islamic Banks and Islamic Windows operated by conventional banks.

In addition to religious reasons, a key regulatory advantage came from the SBP’s imposition of a Minimum Deposit Rate (MDR) on conventional banks, mandating them to pay returns of not less than 1.5 per cent below the SBP policy rate on all deposit accounts (except current accounts). With policy rates exceeding 20 per cent in recent years, this squeezed conventional banks’ margins, making most deposit products financially unattractive.

For a long time, Islamic banks were exempt from MDR, allowing them to operate with greater pricing flexibility. Although SBP has now extended MDR to Islamic banks, their profit-and-loss-sharing models still offer relatively better margins, making Islamic banking more commercially viable in many segments. These factors — religious motivation and strong profitability — have led to exponential growth in Islamic banking. Meezan Bank, for instance, is now the most profitable bank in Pakistan with the highest market capitalisation, while other banks like Bank Islami and Islamic windows of conventional banks such as HBL, UBL, ABL, NBP, Bank Alfalah continue to show impressive performance.

The SBP now requires all banks to complete their conversion to Islamic banking by December 2027, and for this purpose, the banks have already submitted their conversion plans to the SBP by December 2024. To support this, it is working on developing Islamic liquidity management tools; expanding capital markets via sovereign Sukuk; enhancing Shariah board capacities; and increasing the availability of trained Islamic finance professionals.

This marks the most decisive push in Pakistan’s financial history towards a completely Islamic banking system.

While deposit-side advantages are evident, the greater challenge lies on the asset side: developing a full suite of Islamic lending and financing products that are Shariah-compliant, commercially viable, and risk-mitigated.

Islamic financing must be structured through asset-backed or partnership-based modes such as: Murabaha (cost-plus sale); Ijarah (leasing); Mudarabah (profit-sharing); Musharakah (joint venture).

Unlike conventional loans that provide predictable fixed returns, Islamic finance requires risk-sharing, making margins more volatile and documentation more complex — especially if contracts are implemented in substance rather than form.

Banks now face the challenge of creating products that offer stable and competitive margins; are scalable, legally enforceable and truly Shariah-compliant; minimise moral hazard — prevent borrowers from misusing Shariah principles.

A significant concern is recovery in loss scenarios. In contracts like Mudarabah and Musharakah, losses are also borne by the financier unless gross negligence or fraud can be proven. This exposes banks to strategic defaults and potential abuse, especially in Pakistan’s volatile business climate.

Without a strong legal and judicial framework to distinguish genuine business losses from opportunistic defaults, Islamic banks may face higher credit risk and non-performing assets, threatening long-term viability.

Complicating matters further is Pakistan’s external debt, now exceeding $120 billion, owed to the IMF, World Bank, and ADB; bilateral lenders (such as China, Saudi Arabia); and international commercial banks and bondholders.

Almost all of this debt is interest-based, and none of these entities operate under Islamic financial frameworks. This creates a fundamental contradiction: how can Pakistan operate a fully Islamic financial system while remaining part of the global interest-based financial architecture?

Islamising domestic banking does not change international obligations. Moreover, given Pakistan’s recurring balance-of-payments issues, external financing is essential for economic survival. A pressing question arises: Can Pakistan afford to isolate itself from the global financial system in the name of Islamisation?

In a world of interconnected global financial system, capital markets, trade finance systems, and investment flows, cutting off from conventional finance could restrict finance from multilateral donors like the World Bank, Asian Development Bank, IMF and commercial credit from international banks, financial institutions and other lenders. It could also trigger capital flight; erode sovereign creditworthiness; and undermine macroeconomic stability.

Unless Pakistan can negotiate Islamic alternatives with international lenders — an unlikely prospect in the foreseeable future — full Islamisation remains aspirational rather than achievable. While the goal to eliminate riba is considered noble for a major segment of the population and constitutionally rooted, a phased, pragmatic and dual-track approach is far more sustainable. A more pragmatic approach should be to continue organic Islamic banking growth, supported by market demand and MDR incentives. Or to modernise laws to support true Islamic financial contracts. And strengthen Shariah governance to improve credibility and compliance. Or negotiate more Islamic financing lines from friendly nations and the Islamic Development Bank; and maintain a hybrid banking system during the transition, allowing both Islamic and conventional instruments to coexist

The SBP’s Vision 2027 is bold and ambitious. Islamic banking offers clear commercial and ethical benefits, and its growth trajectory — especially in deposit mobilisation — proves its relevance. But achieving full-scale Islamisation by the deadline faces headwinds from asset-side complexity, borrower risk, legal limitations, and the unavoidable reality of global financial interdependence.

The goal should be to build a credible, transparent and scalable Islamic banking ecosystem that flourishes within a connected global economy -- gradually, sustainably and with integrity.

The writer is a former managing partner of a leading professional services firm and has done extensive work on governance in the public and private sectors. He tweets/posts @Asad_Ashah