Factors determining Success of

Islamic Banking in Pakistan

Ayesha Khan, Sadia bashir, Rohail Riaz & Mudassir Hussain

Army Public College of Management Sciences

Abstract: The purpose of this research is to find out relationship

between the success of Islamic Banking in Pakistan with Interest and
Musharakah Financing. Data was collected with using a self-
administrative questionnaire which is filled by 132 individuals across
Pakistan. Results indicate that Interest and Musharakah have a
strong relationship with the success of Islamic Banking yet they
contribute only 29% in this success. With the help of these results
Islamic Banks can enhance their success by making new policies or
amending the existing one.

Introduction
In Pakistan Islamic banking was started in 1977-78. Pakistan was one
of the three Muslim countries which implemented Islamic banking at
national levels and it becomes more successful during the past few
years. Islamic banking is based on Shariah laws. Islamic Shariah
prohibits Riba (interest) but it does not prohibits all gain on capital
and tries to create an ethical way of doing transactions based upon
moral values.

In this research an Islamic mode of financing Musharakah is in

consideration and the effects of prohibition of Intrerest on the
success of Islamic Banking in Pakistan will be under
focused.According to Khan and Mirakhor (1988) Musharikah as
business in which banks provided the capital to share the profit and
loss.

Except Malasia, Tunisa and Jordon the estimated returns to scale of

Islamic banks is greater than conventional banks (Abdul –Majid, Saal
& battisti, 2009). Some procedures makes Islamic banking different
from the conventional banks as Islamic banks have ethical ways to
achieving their goals/objectives. The availability of service and
facilities offered to debtors and creditors distinguished the modern
Islamic banks from conventional commercial banks ( Naughton &
Naughton, 2000). Riba concentrates wealth in the hands of few which
leads to social injustice. Murabaha, Mudarabah, Musharikah & Ijarah
are the alternatives suggested by Islamic shariah ( Mirza & Halabi,
2003)

In Islamic law transactions with Riba are prohibited ( Zarrokh, 2010).

One of the factors behind the success of Islamic banks is the
prohibition of Riba. It is forbidden to take interest on borrowed or
landed money in Islam and in some other religions also. The trditional
Christian’s condemnation of Usury is related to prohibition of Riba in
Islam that makes non-Muslims to realize the ethical principles of
Muslim finance (Mews & Abraham, 2007). The joint ventures of
capital sharing offered by Islamic financial system in the form of
Mudarabah and Musharikah enables the bank and the customers to
share the profit and loss. Islamic finance considers the sharing of
profit but loss too ( Rammal & Zurbruegg, 2006).The unique muslim
products and Islamic financial instruments like zakat and qard hassan
makes Islamic Banks vital for social development , more than a
finance collector and lender ( Mirza & Halabi, 2003). Incorporate with
Shariah law Islamic banks can widen their activities related to product
innovation and introducing new modes of financing in line with
existing financial markets ( Sraire, 2009).

Many researches have been conducted on Islamic Banking all over

the world. There results are not applicable in Pakistan. Every country
has a different culture, working climate, opportunities to flourish and
threats of failure. Islamic Banking is evolved as a big industry now-a-
days in Pakistan. It gradually gains success and prosperity. The
reasons for this success will be different from the success of Islamic
Banks in any other country. To keeping these banks progressing, the
determinants of this success must be known. This research will
provide the reason behind the success of Islamic banking in Pakistan.

Ethical values of Islam can be learned & admitted by individuals and

organizations in West when they have to invest their money ( Visser
& MachIntosh, 1998). The findings of this research can be helpful for
the banks to know their success gaining financial modes. They can
develop new policies to strengthen their profitability and growth.

Literature Review :

“Shariah should be viewed as a potential tool for innovation and

creativity,
rather than a limiting constraint”. (El-din & Abdulla, 2007)

Interest ( Riba):
“The word 'riba' means 'increase' as interpreted by Imam Razi, which
corresponds to the word 'interest' as defined by Webster's New World
Dictionary”(Noorzoy, 1982). Riba is defined as gaining an excess
profit in any transaction. Those transactions are off exchange of
commodities. Anwar (2003) finds out that a reading of the ahadith
and the Qur'anic verses related to riba shows any gain resulting from
exchange of two similar commodities in different amounts is riba.
According to Hardie and Rabooy (1991) Interest is not allowed in
Islam whether takes the shape of money or services.

Imam Razi concludes that Riba is of two kinds: (1) Riba on exchange
of goods is Riba Fadl and (2) Riba on transactions on credit is Riba
Nasia. Riba is unlawful interest rate mostly charged on credit
transactions (Noorzoy, 1982). Prohibition of riba makes the Islamic
banking different from the modern conventional banks. Modern banks
charges interest which is sometimes unethical too. Khan & Mirakhor
(1990) reveals that Western counterparts are different from Islamic
Banks and Financial Institutions as riba is prohibited in Islamic
banking. As concluded by Chopra (2007) many religions in the world
prohibit interest to avoid the exploitation of the poor and to make
financial systems healthier and stable. According to Vahed and
Vawda (--) Islamic banking and finance express ideas for Muslims to
involve the world in according with other of an Islamic identity .
According to Khan (2008) the interest free banking system was made
in Pakistan under a piecemeal approach with little professional
integrity.

Prohibition of interest provides an ethical way of living. It promotes

the equal distribution of income amongst the richer to the poor ones.
By Ahmad and Hassan (2007) Islamic banking will reduce the cost of
borrowing and due to this reason small and marginal farmers like to
invest. According to Dusuki (2008) prohibition of interest helps in
reducing the illegal activities which are hazardous to social and
environmental well-being with a genuine concern for abolishing
poverty, social injustice and equal distribution of wealth at the same
time. Hussian (2009) concludes that Islam provides guidance not only
for worship but also for the state activities, international relations and
business & economics ethics too. As Lewison (1999) there is a strong
moral and lawful interdiction against the use of interest in both
Judaism and Islam. According to Gleaser and Scheinkman (1998)
restrictions on interest rates divert the income to the people who are
suffering from economic shocks.

As compared to the customers of other banks the clients of Islamic

banks are more interested in the products and services that comply
with Islamic Shariah (Khan, 1986). The interest free system seems to
be attractive to the Muslims. As they can invest and do any business
activity without a question of violation of religious believes. It is also
beneficial to the society as the Islamic banks are providing short term
loans on the basis of Shariah rules. As concluded by Mayer (1985) in
Egypt Islamic banks are providing loans to the clients in order enable
the to run or set up private business and to buy property, just to
raise their living standards. According to Khan (2008) in Pakistan,
there was need to eradicate to explore elements from the socio-
economic life with interest.

When the time period increases, it is for the banking system to be

interest free. So it is sometime disappointing for the customers who
want to invest for long term. Gleaser and Scheinkman (1998)
concludes that newer and more free states are going to involve this
is going to weak the interest- free restrictions as far as the supply of
loans are concerned, it is increasing in those states. According to Roy
(1991) Islamic banks having a turn around activities like trade
financing or import because Shariah requires the profit collected from
economic activities not from the increase in the interest rate and
deposit. According to El-Malik (1993) many Muslims justices have
been said the small or limited scale of riba that permits various form
of interest charging. As concluded by Valibeigi (1992) the Islamic
banks not always results in the abolition of interest from financial
transactions. Hillman (2007) concludes that if Islamic banks do not
learn how to manage themselves as interest free systems, their
behavior will be changed in long-run.

Abolishment of interest can reduce moral hazards but in return it is

forcing the banks to reduce their markup ratio. By Yousef and
Aggarwal (2000) Islamic banks have preferred the low markup in
financing investments and also preferred the low cost- investment
projects mainly in agriculture or industry or in real state. According to
Hossain (2009) Interest act as a dangerous weapon which can
exploits the rights of poor and the needy. As concluded by Balz
(2004) Islamic financing transactions should be considered not only
against the background of traditional Shari rules but within the legal
context of international finance where Islamic banking operate today.
Arbouna (2007) have found out that the prohibition of interest in
different transactions is interconnected.

Some the Islamic banks are running under the interest free system as
well as some characteristics of conventional system. So not always
they are interest free. In such case interest is not the only
determinant of the success of these Islamic banks. As concluded by
How, Abdul Karim and Ver hoeven (2005) there is uniqueness in
Malaysian banking system that it is operating both the conventional
and Islamic interest free mechanism side by side. As concluded by
Kuran (2003) Islamic banks are turning into a commercial handicap
because modern banking laws are providing more opportunities.
Foster (2001) find out that Islamic banks often have to satisfy the
demands of their western guarantees demanding customers. Iqbal
and Mirakhor (1999) have written down the same thing that Islamic
banks are going to be the substitute for the interest-based banks.

Modern interest rate theory is objectionable according to Islamic

point of view (Kula, 2008).According to Jawahitha, Ab-Hamid and
Ishak (2003) the operations of internet banking by conventional and
Islamic banks prescribed certain rules to be adhered, so that interest
of banking customers can be preserved. According to Sarkar (--)
Criticism exists that banks have only changed the names of their
transactions but interest has not been abolished. In the presence of
Islamic banking, interest also prevailed on borrowed amount through
official sanctions or underground markets (Yousefi, Abizadeh &
Maccorinick, 1997). But Beekun and Badawi (2005) concluded that
Islamic ethical system avoids the exploitation and other bad deeds in
giving the rights to stakeholders, it’s a fair system.

Due to inflation and other economic reason Islamic banks often meet
with some shocks or crises. When banks are working under equity
based system then many of these shocks to assets is absorbed.
According to Khan (1986) any shocks to assets are immediately
absorbed in an equity based system as it does not contain
predetermined interest rates. Roy (1991) suggests that for economic
growth we are doing an effort to introduce greater equity and
financial responsibility. According to Shaikh and jalbani (2007) Equity
Based business of Islamic banks are more risk than commercial banks
is well mitigated by Islamic banks through their efficient & effective
distinct risk management procedures.

H1: There is a strong positive relationship between Interest and the

success of Islamic banking.

Musharakah:

Musharakah as business in which banks provided the capital to share

the profit and loss (Khan & Mirakhor, 1988)

Musharakah financing constitutes a promising opportunity for

financing small enterprises for both the lender and the borrower
( Gamal & Abdalla, 1999).Musharakah protects from the affects of
inflation. It is most desirable for the small business. According to
Gamal and Abdalla that depletion of lenders resources caused by the
increased inflation rates, Musharakah is an apparent solution of that
problem.

Musharakah financing is done by two types of partnership contracts.

Civil partnership is hiring the expertise of others and equity
partnership is sharing the capital. Civil partnership is commonly
happen. According to Yasseri (1999) the two important categories of
Musharakah financing are civil partnership and legal or equity
partnership. Civil partnership is more important while the legal
partnership have less importance in practice. As concluded by
Akacem and Gilliam (2002) equity financing is not very much in
practice but it is hoped that this technique will gain enough
acceptance by the Islamic as well as non-Islamic banks.

Because of profit and loss sharing contracts Islamic Banking is

gradually progressing in Pakistan (Siddique, 2008). Musharakah
enables companies to avail the short term benefit as well as the long
tem benefits too. As concluded by Harran (1999) that Musharakah
when spreads to the grass root level and business makes the shape
of an entrepreneurial institute, it leads the Islamic finance towards
success. This concept is also explained by Siddique (2008)
Musharakah will help the banks to regulate in a manner which is
feasible for both short as well as long term projects.

When poor believes that their gains are small as compared to others,
then there is no reduction in poverty (Isfahani, 2009). Musharakah is
very popular amongst the small business especially in the agriculture
sector, Musharakah is availed by the small farmers mostly. According
to Osman (1999) Broad base of Muslim farmers have accepted these
feasible Islamic Financial models. Sadr (1999) concludes that
agriculture banks have to take measures to increase the efficiency of
Islamic banking. Musharakah is suitable for the variable demands in
the agriculture sector so it will be made the essential factor in equity
financing. By Osman (1999) Musharakah made it very clear that
Islamic finances are both feasible and more acceptable by broad of
Muslim farmers specially who adhere to the Islamic teachings that
prohibit usury.

Musharakah financing closely related to the equity participation in

which shares can be a acquired by publics ,banks ,central bank and
the government.(El-Malik,1993). Musharakah financing related to
banks that runs on equity financing is very popular amongst the
general public, central bank and government.
Sometimes Islamic banks show flexibility in recovering the payments
of Musharakah and if the customer is unable to purchase the
partnership then banks give them any other option. Thus they have a
good interaction with the customers. According to Najmabadi (1999)
the length of time may be expanded in Musharakah financing and
repayment periods. If due to any reason the client fails to purchase
the bank's partnership share within the specified time then the bank
stay for the client and negotiate with the client at a new (higher)
price with new date for him.

H2: There is a strong positive relationship between Musharakah and

the success of Islamic banking.

Theoretical Framework:

INTEREST

SUCCESS
OF
ISLAMIC BANKING
MUSHARAKAH

There exists a strong positive relationship between the Interest and

the success of Islamic Banking. It is most desirable for the customers
who want to invest or borrow in an interest-free environment but
sometimes this prohibiton of interest increases the cost of banks.
Musharakah provides opportunities for big as well as farmers and
small business enterprises. Mostly farmers are availing this
partnership mode of Islamic Finance and the customers are
increasing day by day, which results in increasing revenues of Islamic
banking. Thus there exist a strong positive relationship between
Musharakah and the success of Islamic banking.

Research Methodology:

Instrument for data collection:

The data was collected using a self-administrative questionnaire
having four sections. The first section containing six items captured
the Demographic information about the respondents. The data on
interest (Riba) was captured by using seven questions. The
information on Musharakah financing is collected through nine
questions. The last section is about the success of Islamic Banking
which contains eight items to capture the information.
A five point likert scale was used with 1 representing strongly
disagree and 5 representing strongly agree.
A total of 150 questionnaires were distributed and 132 were received
back making response rate of 88%.

Population and Sample:

Population for the present study includes all residents of Pakistan and
data has been collected through convenient sampling. Sample
contains 132 residents of Rawalpindi and Islamabad, which includes
students, teachers, private and public sector employees who are
using banking in there daily life. Sample includes 60% male
respondents and 40% female respondents. Majority of respondents
are Muslims who are familiar with the concept of prohibition of
interest in Islam.

Sample characteristics are described in the given table.

Table 1: Sample Characteristics

Demographics No. of Percentage
respondents
Male 79 59.8
Gender
Female 53 40.2
Muslim 131 99.2
Religion
Non-Muslim 1 0.8
Matriculatio 9 6.8
n
Qualificati Intermediat 5 3.8
on e
Graduation 58 43.9
Above 60 45.5
Student 46 34.8
Jobless 8 6.1
Occupatio Businessma 13 9.8
n n
Employee 59 44.7
Rtd. Person 6 4.5
Up to 5 47 35.6
Monthly
5-10 11 8.3
Income
10-15 14 10.6
(In
15-20 29 22
Rs.000)
Above 20 31 23.5
Account in Yes 12 9.1
 Islamic No 120 90.9
Bank

Results:

1. Mean, S.D and Correlation Analysis:

Table 2: Mean, Standard deviation and Correlation Analysis

S Correlation Analysis
r 1 2 3 4 5 6 7 8 9
. Mea
Variable S.D
n n
o
.
1 1.4 .47 1 - - - - - - - -
Gender
2 1 .09 -.0 1 - - - - - - -
Religion 7

3 3.3 .83 . -.2 1 - - - - - -

Qualificat 13 4
ion 3 (**
)
4 2.8 1.4 -.2 . -.0 1 - - - - -
Occupati
1 13 6
on
(*) 6
5 2.6 1.97 -.2 . . . 1 - - - -
3 10 18 80
Income (** 6 0 1
) (*) (**
)
6 1.9 .39 . -.2 . -.0 -.0 1 - - -
Account 04 1 00 5 5
9 (*) 6
7 3.5 .66 . -.0 . . -.0 -.0 1 - -
16 6 01 13 1 2
Interest
1 5 9

8 3.2 .52 . -.1 . -.0 -.0 -.0 .18 1 -

Mushara
04 7 04 2 2 5 (*)
kah
7 (*) 5
9 3.4 .51 . -.2 -.0 -.3 -.3 .01 .22 .32 1
04 2 5 2 5 (** (**
Success
9 (** (** (** ) )
) ) )

Correlation analysis indicate that interest is significantly associated

with the success of Islamic Banking (0.22**, p< 0.005) and
Musharakah Financing is also significantly associated with the
success of Islamic Banking (0.32**, p<0.01).

2. Regression Analysis:

Table 3: Regression Analysis

Variables beta t significan R-
ce square
Gender - - - .168
Religion - - - .168
Qualification - - - .168
Occupation - - - .168
Income - - - .168
Account in Islamic Bank - - - .168
Interest .255 3.06 .003 .288
6
Musharakah .291 3.66 .000 .288
9
n=132, Gender, Religion, Qualification, Occupation, Income,
Account in Islamic Banks were controlled.
Dependent Variable: Success of Islamic Banking.

Value of R-square (.288) indicates that 28.8% variation in the success

of Islamic Banking is caused by Interest and Musharakah financing
and 71.2% remained unexplained. Independent variables Interest and
Musharakah have a significant impact on the success of Islamic
Banking (t > 2).

Results reject the initial hypothesis H1 becacuse there exists a weak

positive relationship between Interest and the success of Islamic
Banking. This relationship were significant at the p<.005, having a
confidence interval of 99.5%.

H2 is also accepted on the basis of the results of the present study.

There is a strong relationship between Musharakah financing and the
success of Islamic Banking. This relationship is significant at the p< .
01, having a confidence interval of 99%.

Discussions:

Findings of the present study imply that there is vast scope for
Islamic Banks in Pakistan. Reasons for this are, as Pakistan is a
Muslim country and majority of the people are Muslims. They like to
do investment and borrowings, which are in accordance with their
religion. Islamic Banking was started in Pakistan in 1977-78 and are
considered today one of the growing sector of the country.

Now-a-days Ayub Gilgit Islamic Bank Limited, Dawood Islamic Bank

Limited, Dubai Islamic Bank Pakistan Limited, Meezan Bank Premier
in Islamic Bank in Pakistan, Bank Islami Pakistan Limited and
Emirates Global Islamic Bank Limited are running in Pakistan. Some
Other International Islamic Banks are also interested to do business
in Pakistan like Qatar Islamic bank have been decided to open its
branches in Islamabad, Karachi and Lahore in the coming year.

One of the interesting results of the present study is that Interest and
Mushrakah correlate positively with the success of Islamic banks but
contribute almost one-fourth portion in the success of these banks.
As Islamic banks are offering various modes of financing like Ijarah
(lease financing), Murabaha ( sale- purchase plan), Mudarabah and
Qurd-e-Hasan. Customers like to indulge with Islamic banks because
of their feasible financing modes or may be they are satisfied with
some other characteristic of Islamic banks. This phenomenon is
remained un-explained that where does these banks get the
remained three-fourth portion of success.

Findings prove the positive relationship between the interest and the
success of Islamic Banking. Conventional banks are charging the
interest rates on borrowings which includes maturity risk, default risk
and inflation premium too. People mostly like to invest money where
they have to pay a low interest amount. Islamic Banks are providing
them this opportunity and charged interest rate on an agreed margin.

Muslims as well as Non-Muslims like to do transactions with Islamic

Banks. 65% of the respondents are agreed upon this thing that
Islamic banking is not restricted to Muslims. Islamic banks provide
low cost of borrowings risk sharing, transparencies in dealings and
commitment which is attractive for customers belonging to any
religion.

Normally Islamic Banks are running on equity. They generate profit

by efficient management of their assets usually short-term assets like
cash and account receivables. They do not borrow from the State
Bank of Pakistan. So, there equity based system help them to absorb
the cost when market interst rate rate fluctuates.

Majority of the project selected by Islamic Banks are short-term and

contained low cost because they have settled a low margin. If Islamic
Banks increases their interest, then their current assets will be
increased. Their equity will also be increased due to increase in
retained earnings.

Due to prohibition of Interest, the number of customers increases and

the transactions of Islamic banks too. Many of them are interested in
different modes of financing offered by Islamic Banks. With this
increased number of customers in Islamic banks can accumulate
enough capital while taking a low margin. By this Islamic banks are
able to meet their financial obligations and to have a viable business.

Musharakah financing is suitable financing plan for small business.

Mainly farmers and small entrepreneurs are interested to buy that
partnership. Islamic Banks operate under the concept of lender-
borrower relationship and the profits generated through this
relationship are divided between the two parties as per agreement.
Not only profit but loss will also be divided according to the
investment percentage. It is basically a joint venture between two
businesses.

One business provides funds to other and the Islamic Banks are
keeping a very low mark-up which made Musharakah Financing more
appealing to the customers. Success of Islamic Banks increases with
the increase in sales of Musharakah Fianancing.

In Musharakah financing Islamic banks have space to increase the

interest rate and to gain profit. Sometimes financing is done in the
way that one partner is the bank and the other is the buyer of that
partnership. Islamic banks can gain profit by increasing their profit
percentage.

Islamic banks help its customers to choose the right contract. When a
customer can not afford the Musharakah contract, these banks adjust
the contract according to the customer’s need. In short this contract
feasible for every kind of customer whether it a businessman or a
framer as Pakistan is an underdeveloped country where incomes of
people are very low. By this Musharakah helps Islamic banks to grow.

Conclusion:

The present study is based finding the determinants for the success
of Islamic Banking in Pakistan. In findings we have discovered that
29% of the success is determined by Prohibition of Interest and
Musharakah Financing. Both interest and Musharakah have a positive
impact on the success of Islamic Banking. As an Islamic Republic
country there is a wide scope for Islamic banks because they are
abide by the Shariah compliances. People like to do transactions with
such banks and thus increases their sales. Small business owners and
farmers which have very low incomes increase the sales of
Musharakah contract. In short Islamic banks are running successfully
in Pakistan by providing low cost of borrowings and feasible
investments plans to meet the demand of their customers. Hence,
increasing their sales by this increased numbers of customers.

Implication:

The findings of this research show that both Interest and Musharakah
financing have a very strong relationship with the success of Islamic
Banks but they contribute only one-fourth portion of this success.
Islamic Banks can gain more success by planning their operations
efficiently. There is a need for Islamic Banks to revise their plan of
action and amend it in a way to gain success.

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