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European Journal of Social Sciences – Volume 17, Number 1 (2010)

Banking Developments in Pakistan: A Journey from


Conventional to Islamic Banking

Ashfaq Ahmad
Corresponding Author: Assistant Professor, Department of Business Administration
University of Sargodha, Sargodha, Pakistan
E-mail: ashfaquos@gmail.com

Muhammad Imran Malik


PhD Scholar, (FUIEMS) Foundation University, Islamabad, Pakistan

Asad Afzal Humayoun


PhD Scholar, (FUIEMS) Foundation University, Islamabad, Pakistan

Abstract
This study reflects a historical background of Pakistani banking sector since its
independence on August 14, 1947 from British rule. It indicates the journey of Pakistani
banking sector from the establishment of SBP on July 1, 1948 as central bank. During
1950s and 1960s banking sector got expansion due to development projects. In 1974, banks
operating in Pakistan got nationalized and came under the direct control of the Govt. of
Pakistan. The Govt. of Pakistan is required to eliminate interest based transactions from the
country according to its constitutions (i.e.1956, 1962 and 1973). In 1992, Govt. started
privatization process of the financial sector especially banking sector. However, the
inception of 21st century came with Islamic banking practices across the globe to facilitate
the different segments of the economy. Islamic banking practices in Pakistan proved a
successful experience due to growth and expansion of the banking sector. This study
reflects a picture of Pakistani banking sector since its creation. It enables the readers,
academician and bankers to have a look about banking developments in Pakistan.

Keywords: Islamic Banking, Conventional Banking, Pakistan, Banking Developments.

1. Introduction
Every country of the world has its recognition due to its specific religious attachment, socio-cultural
features or economic attributes. Economic prosperity and sound economy is the symbol of success in
these days. Similarly, economic soundness is the only outcome of positive interaction of
macroeconomic variables to attain specific objectives by beautiful blending of resources i.e. physical
resources, human resources, financial resources and informational resources. Banking sector is an
important component of financial sector for proper management of financial resources across the
globe.
This study presents a glossary of historical developments in banking sector of Pakistan to a
very sophisticated banking system of recent age. Initially, Pakistan was unable to control its financial
system due to absence of sound banking system and eventually it became the most attractive banking
industry of the globe. It is reported that banking and financial services are the integral part of services
industry and its contribution is increasing with the passage of time (Mishkin, 2001). However,
expansion of global and integrated banking sector has to face many challenges of legislation,
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European Journal of Social Sciences – Volume 17, Number 1 (2010)

technological and structural changes (Angur et al. 1999). Some of the countries including Pakistan
appeared on the map of the world as an ideological state. Pakistan came into existence as the first
Islamic republic created in the name of Islam on August 14, 1947. The government of Pakistan is
bound to follow the instructions of Allah Almighty according to Objective Resolution, passed in 1949.
Islam was declared as official religion of Pakistan according to the first constitution of Pakistan in
1956 and all rules/ regulations should be in consistent to the instructions of the Holy Quran and
Sunnah.
The Constitution of 1956 requires an immediate elimination of riba based transactions
according to Article 28. Similarly, the Council of Islamic Ideology was established under the
Constitution of 1962, to eliminate the interest from the economy especially from banking sector.
Interestingly the Constitution of Pakistan (1973) also requires a prompt elimination of interest (riba)
from the economy as shown by the article 2A, 31, 37, 38 (F) and 227 of the said constitution. The
council consulted a large number of bankers and economists to recommend some alternatives to
replace interest-based financial structure in the economy during 1980s. In 1991, Full Bench of
Supreme Court of Pakistan ordered the elimination of riba from the economy until June 30, 1992.
Finally, Islamic banking activities were initiated in December 2002 due to untiring efforts of State
Bank of Pakistan (SBP, 2002).

2. Establishment of Commercial Banking System (1947-1973)


Pakistani banking sector has witnessed drastic changes over a period of 61 years since its
independence. Initially it suffered from acute shortage of resources and uncertainty due to prevailing
political and socioeconomic conditions. Lack of trained human resource and professionals resulted into
poor quality of products and services. State Bank of Pakistan was established as the central bank on
July 1, 1948 to control the financial sector. Subsequent amendments were made to extend the control
and functions of SBP through State Bank of Pakistan Act 1956. SBP encourages the private sector to
establish banks and financial institutions in the country. It resulted into unhealthy competition and
unlawful practices due to bribe and corruption during the decades of 1950s and 1960s. It is reported
that financial reforms and changes in governance have improved the performance of Pakistani banking
sector over time (Burki & Niazi, 2003).

3. Nationalization of Banks (1974-1978)


In 1974, all the existing banks were nationalized by the Govt. The performance of nationalized banks
deteriorated due to government protection to employees. It resulted into the provision of inferior
products and poor services. It also discouraged the private investors and foreign financial institutions.
There are drastic changes in Pakistani banking sector due to strong competition among public, private
and foreign banks. Private sector banks dominated during 1950s and 1960s but they were nationalized
in 1974 due to separation of Bangladesh and bad economic conditions. Nationalized banks showed
very poor performance due to inferior products/services that resulted into the privatization of banking
sector in 1992 (Ahmad et al. 2010).

4. Initiatives for Islamization of the Banking Sector (1979-1992)


In Egypt the first modern Islamic bank was established in 1963 according to the principles of Islamic
finance. The Organization of Islamic Conference (OIC) also supported the Islamic financial system in
1973 at Jeddah, Saudi Arabia. Similarly a number of Islamic banks were established as Philippine
Amanah Bank in 1973; Dubai Islamic Bank in 1975; the Faisal Islamic Bank of Sudan in 1977; the
Faisal Islamic Bank of Egypt in 1977; the Bahrain Islamic Bank in 1979, and Meezan Islamic bank of
Pakistan in 2002. In Malaysia, Islamic Banking Act was passed in 1983 to transform the interest-based
conventional banks into Islamic banks.
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The Govt. of Pakistan has taken a number of initiatives during 1979-1992 to introduce interest
free products in the market especially in the banking sector. In 1979, National Investment Trust (NIT),
Investment Corporation of Pakistan (ICP) and House Building Finance Corporation (HBFC) started
interest free transactions. Similarly, during 1980 a number of actions were taken as Mudarbaha
companies were established, Participatory Term Certificates (PTC) was launched and Zakat ordinance
was announced. In addition, nationalized banks were required to open interest-free counters for their
customers in 1981. However, Usher ordinance came into force in 1983 throughout the Pakistan. In the
same year, financial services ordinance was amended to introduce non-interest system. SBP was
assigned the duty for transition of interest based financial institutions into interest-free financial
institution till 1985 (Zaidi, 1987; Hussain, 2006; Hassan, 2007).
During the decade of 1990s, Islamic banking practices were initiated all over the world
especially in the Muslim dominated parts of the globe. SBP issued detailed criteria in December 2001
for the establishment of full-fledged Islamic bank in the private sector. Al Meezan Investment Bank
received the license from SBP in January 2002 and started its operations with the name of Meezan
Islamic bank as the first Islamic bank from March 20, 2002 (SBP, 2002). The Islamization efforts were
unable to achieve its objective due to a number of reasons: firstly the transitional process was
revolutionary instead of evolutionary; second there was lack of flexibility due to rigid system, thirdly
there is lack of appropriate Shariah compliance mechanism and finally there is lack of interest from the
stakeholders (SBP, 2007).

5. Privatization Process of Banking (1992-2000)


Financial liberalization and deregulation during 1990s encouraged local investors and motivated
foreign banks to start their operations in Pakistan. It stimulated the competition among banks due to an
expansion of the banking industry. A large number of banks has initiated their operations in Pakistan
and try to attract the maximum number of customers. It is reported that government ownership of
banks could be discouraged due to slower financial development, low productivity and slow economic
progress (La Porta et al. 2002). Similarly, State Owned banks are unable to monitor their progress due
to absence of clear objectives and responsibility (Clark et al. 2003). However, it is found that
privatization may not be successful due to the limitations and environmental constraints of a specific
economy. It is reported that privatization of banks in low and middle income countries did not created
improvements due to overstaffing and debt burden (Otchere, 2003). Interestingly, it is found that there
is lesser improvement in the financial health of banks as result of financial liberalization and
privatization in Pakistan (Khalid, 2006).

6. Inception of Islamic Banking Practices (2002)


The inception of 21st century heightened the competition among banks regarding service quality to
have satisfied customers for better profitability. SBP plays an active role to establish a sound Islamic
banking system in Pakistan according to principles of Sharia’h as mentioned in its mission statement
that read “To promote and develop Islamic Banking industry in line with best international practices,
ensuring Sharia'h Compliance and transparency”. In 2002, Islamic banks have started their operations
in Pakistan and experienced stiff competition from its peers as well as from conventional banks.
Islamic bank offers a wide range of products on the basis of profit and loss according to principles of
Sharia’h. It develops the sense of collective welfare by sharing the risk among different stakeholder.
While the interest is the central tenet of the conventional banking and it maximizes the return even at
the cost of other stakeholders by transferring the burden of risk to other parties. Islamic banks are
primarily concerned to eliminate Riba from the economy by promotion of risk sharing practices for
economic prosperity.

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European Journal of Social Sciences – Volume 17, Number 1 (2010)

SBP has undertaken a number of initiatives to ensure stability, transparency and flexible
legislation. The regulatory framework encourages “financial sector growth, diversification and
innovation; healthy competition and risk taking to ensure a sustainable and aggressive income stream;
opportunities for enhancing the franchise value of banks; prudent behavior and effective risk
management and loan provisioning requirement are stringent enough to discourage infection of the
loan portfolio; safeguarding social obligations and consumer interests” (Economic Survey of Pakistan,
2007-08).

7. Current Status of Pakistani Banking Sector


Pakistani banking sector is continuously improving with diversified pattern of ownership due to an
active participation of foreign and local stakeholder. It resulted into an increased competition among
banks to attract a greater number of customers by the provision of quality services for long-term
benefits. Now there are 6 full-fledged Islamic banks and 13 Conventional banks offering products and
services according to principles of Sharia’h in different parts of the country. They are competing in a
highly competitive environment for the provision of quality services according to customers'
expectations. It is reported that customers of Islamic bank have greater perception of service quality as
compared to customers of conventional bank in Pakistan (Ahmad et al., 2010).
Now bank customers are much concerned regarding the quality of services due to increased
awareness. They continue to deal with their current bank only if they feel satisfied; otherwise they feel
no hesitation to switch to other banks. Islamic banks work within the limits prescribed by Sharia'h to
stimulate business and trade activities. It experienced an expansion in its network, size and structure
due to beautiful blending of commercial banks, micro finance institutions and Islamic banks in the
country. The performance of Pakistani banking system from a period of 2000-2006 is shown in figure
1.

Figure-1: Total Assets of the Banking System

CY: Calendar Year; PSCBs: Public Sector Commercial Banks; LPBs: Local Private Banks;
FBs: Foreign Banks; CBs: Commercial Banks; SBs: Specialized Banks
Source: SBP, 2007

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European Journal of Social Sciences – Volume 17, Number 1 (2010)

The existence of two bank streams i.e. conventional banks and Islamic banks poses some
questions about service quality and customers' satisfaction in Pakistan. Islamic banks have opened new
avenues for acceptance of deposits on interest free-basis and extend credit facilities excluding interest
e.g. Qarz-e-Hasana etc. (Najajmabadi, 1991). It was found that relationships with bank personnel are
important criteria for selection of bank (Abratt & Russell, 1999). Similarly, it is documented that
Islamic banks have shown an excellent performance and they should diversify their products/services
to meet customers’ expectations (Ebrahim & Joo, 2001). However, there is a significant relationship
between service quality and financial performance (Duncan and Elliot, 2002). So it is concluded that
superior delivery of services results into superior profitability (Kotler, 2003). Pakistani banking sector
witnessed a major change due to key role of private sector having about 80% of banking assets
(Economic Survey of Pakistan, 2007-08). Finally, bankers should concentrate on service quality to
have satisfied customers as it is evident that service quality has greater and strong positive impact on
customer satisfaction in case of Islamic banks as compared to conventional banks in Pakistan (Ahmad,
Rehman & Saif, 2010).

8. Summary and Conclusive Remarks


This study depicts a historical background of Pakistani banking sector since its independence on
August 14, 1947 from British rule. It indicates the journey of Pakistani banking sector from the
establishment of SBP on July 1, 1948 as central bank to support and monitor the banking sector.
During 1950s and 1960s banking sector got expansion due to development projects and an active
participation of private sector. In 1974, banks operating in Pakistan got nationalized and came under
the direct control of the Govt. of Pakistan. Nationalized banks have shown poor performance due to
Govt. protection and lack of competition. The Govt. of Pakistan is required to eliminate interest based
transactions from the country according to all the constitutions (first constitution 1956, second
constitution 1962 and the third constitution 1973). Similarly, in 1992 the Supreme Court of Pakistan
also ordered to stop interest based transactions from the economy.
The Govt. of Pakistan has started financial liberalization process by privatization and
deregulation of the financial sector especially banking sector in 1992. The inception of 21st century
came with Islamic banking practices across the globe to facilitate the different segments of the
economy. SBP developed detailed criteria in 2001 and registered Meezan Bank as the first Islamic
bank in 2002. The inception of Islamic banking practices in Pakistan came with blending of
opportunities and challenges in the existence of conventional banks to reap the long term benefits.
Finally, Islamic banking practices in Pakistan proved a successful experience due to growth and
expansion of the banking sector. This study reflects an updated picture of Pakistani banking sector
since its creation. It enables the readers, academician and bankers to have a look about banking
developments in Pakistan as the journey from conventional banking to Islamic banking to enhance
their understanding.

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European Journal of Social Sciences – Volume 17, Number 1 (2010)

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