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MF
34,9
Main features of the interest-free
banking movement in Pakistan
(1980-2006)
660 M. Mansoor Khan
Business and Regional Enterprise, Mount Gambier Regional Centre,
University of South Australia, Mount Gambier, Australia
Abstract
Purpose – The main objective of this paper is to highlight the main features of interest-free banking
theory and practice in Pakistan over the last three decades. It explores the country-wide interest-free
banking movement since its inception in 1980 to its demise in 2002, and the reasons for such outcome.
Moreover, it addresses the question why interest-free banking has been recently reinstated by the
government of Pakistan under the dual banking system and more importantly, would it be any real
and big success?
Design/methodology/approach – The paper explores concepts, model, strategies and practical
issues related with the Islamic banking and finance system. It holds a conceptual approach. It is
designed as a case study that provides comprehensive analysis over the contributions made by
political, government, financial, legislative and religious institutions of Pakistan in setting-up the
interest-free banking and finance system in the country.
Findings – The findings of the paper hold that all intellectual, practical, institutional, political,
constitutional and regulatory measures undertaken by the government and top policy makers of
Pakistan to transform the banking system of the country Shariah compliant were devoid of real urge
and effectiveness, only piecemeal solutions. The interest institution got very firm roots in the
financial sector of Pakistan and strongly supported by other exploitative agents and systems that
prevail in the socio-economic life of the country. There is a dire need to take revolutionary steps with
strong political and public support and commitment to uproot interest along with its allies from
Pakistan economy and society. After all, Pakistan is an ideologically-based Muslim country that
holds the constitutional responsibility to eliminate interest from its economy and establish a fair and
just socio-economic order.
Research limitations/implications – The paper envisages the main concepts, models and
strategies adopted in implementing the Islamic economic and finance system in Pakistan. However, it
does not deal in quantitative data and statistical tools to support its findings by empirical evidence.
Rather it entails subjective analysis and critique work.
Originality/value – The paper provides the deeper insight of highly technical, complex and
mammoth job of eradicating interest from Pakistan economy that was deeply rooted and also
strongly supported by other exploitative forces prevailing in the socio-economic life of the country,
causing gross distribution of wealth and concentration of resources and powers in the hands of few. It
explains that the need for a major change in one institution or system entails the demand for bringing
radical changes in the whole set-up of country. This paper undertakes longitudinal view to analyze
the institutional, financial, judicial and political developments that took place in Pakistan to
restructure its economy on Islamic lines. It lays down all relevant facts and issues systematically to
provide a clear-cut assessment over the past, present and future of interest-free banking movement in
Pakistan.
Keywords Banking, Islam, Interest, Pakistan
Paper type Research paper

Managerial Finance 1. Introduction

Vol. 34 No. 9, 2008
pp. 660-674 The interest-free banking movement had acquired a significant shape in the globe
# Emerald Group Publishing Limited
0307-4358
by the late 1970s. However, no initiative was taken by any Muslim country to
DOI 10.1108/03074350810890994 transform the national economy and financial sector on Islamic lines. A major
breakthrough occurred in September 1977, when the President of Pakistan General Banking
Mohammed Ziaul Haq directed the Council of Islamic Ideology (CII) to formulate a
blueprint for an interest-free economy within three years. The CII appointed a panel of
movement in
experts to examine technical aspects of restructuring the economic and financial sector Pakistan
of Pakistan on Islamic lines. In February 1980, the panel submitted its final report, titled,
‘‘Report on the Elimination of Interest from the Economy 1980’’. The CII made necessary
changes in the report before submitting it to the government of Pakistan. The CII’s report
was supposed to be adopted in the banking sector of Pakistan by no later than 1984. In
661
the beginning, some serious efforts were made to institutionalize the interest-free
banking system but then retardation occurred with the passage of time and eventually
the whole process lost its significance. This paper provides a critical account of the
interest-free banking movement in Pakistan since its birth to this present date.
The paper has been divided into nine sections. The following section evaluates the
CII’s report. The third section appraises the efforts made by government to evolve
interest-free banking systems in Pakistan. The fourth section reviews main features of
the 1991 Federal Shariat Court (FSC) Judgement on Riba (interest). The fifth section
deals with the efforts made by the Commission for Islamization of Economy (CIE) to
revive the interest-free banking movement in Pakistan. The sixth section explores the
role of Pakistan judiciary in enforcing the Islamic economic and financial system in the
country. It highlights the main features of the 1999 Supreme court (SC) judgement on
Riba (interest) and the 2002 SC Judgement on Riba (interest) case review. The seventh
section assesses the future of interest-free banking in Pakistan under the prevailing
conventional banking environments of Pakistan. The eighth section investigates major
reasons for the failure of interest-free banking in Pakistan. The final section presents
core findings and conclusions of this paper. (The Appendix lists a glossary of Arabic
words and terms used in this article.)

2. The CII’s banking model

The CII approved eight policy instruments to replace interest from the banking sector
of Pakistan (Figure 1). It recommended the profit and loss sharing (PLS) system as an
ideal alternative to replace ‘‘interest’’ from the financial sector of Pakistan. However, it
argued that due to inadequate institutional support and business ethics constraints, a
widespread practice of the PLS system may cause harm to the economy of Pakistan
and therefore, the following secondary interest-free policy instruments may be used for
a transitional period so that the government could develop proper regulatory and
institutional set up for the adoption of PLS banking on a large scale.
The CII proposed lease financing as an important tool to promote risk-sharing
financing. However, lease financing is a hybrid of debt as well as equity and it might
exhibit the debt-based characteristics if PLS instruments are not predominately used in
overall financing operations (Council of Islamic Ideology (CII), 1980, p. 13). As a matter
of fact, lease financing appeared like any conventional-based activity during the
interest-free banking practice in Pakistan. In proposing investment auctioning, the CII
ignored the very core fact that selling a project on credit basis by a person or financial
institution without holding its plant and machinery is a speculative transaction or sale
of the loan for the higher loan – just an interest-based activity (Council of Islamic
Ideology (CII), 1980, p. 14). Bidding is a highly expensive exercise that encourages a
handful of business elites to emerge as big winners (Laffont and Tirole, 1993; McAfee
and McMillan, 1987). Due to its complex nature, investment auctioning remained only a
theoretical option. The CII’s approval of bai muajjal was highly questionable because of
MF
34,9

662

Figure 1.
Policy instruments of the
CII’s banking model

its high propensity to harbour interest (Council of Islamic Ideology (CII), 1980, p. 15).
Later this instrument played a key role in ruining the true spirit of interest-free
banking practice in Pakistan. The CII recommended hire-purchase which was a far
better option than bai muajjal because it obliges the bank to undertake active part in
real economic activities (Council of Islamic Ideology (CII), 1980, p. 16). However, when
bai muajjal was already on the card hire-purchase did not get any representation in the
interest-free banking practice in Pakistan.
The CII approved the instrument of financing on the basis of normal rate of return
which contained an interest-bearing provision to allow the bank to charge a normal or
minimum (fixed) rate of return from the borrower (Council of Islamic Ideology (CII),
1980, p. 16). Similarly, the CII approved the time multiple counter-loans, which is in fact
a crystal-clear case of a two-tier interest-based model (Council of Islamic Ideology (CII),
1980, p. 17). The condition that the borrower should deposit some funds for the bank’s
use for the period longer than the loan contract amounts to charging of an excess in
term of premium or favour or gift or service to the lender in consideration of loaning is
an explicit case of interest, called riba al-nasiáh. The given schemes did not get close to
the actual practice of interest-free banking in Pakistan. The CII recommended special
loan facility that allowed banks to provide finance to poor farmers on the principle of
charging an extra sum over and above the principal, which is riba (Council of Islamic
Ideology (CII), 1980, p. 18). The CII disapproved service charges and indexation of bank
deposits and advances by calling them interest-bearing and un-Islamic instruments
(Council of Islamic Ideology (CII), 1980, pp. 11-13).
 Some of the CII’s proposals for eliminating interest were either unrealistic or Banking
controversial. The CII’s proposal to replace debentures with participation terms movement in
certificates (PTCs) was not realistic (Council of Islamic Ideology (CII), 1980, p. 36). The
risk-sharing features of PTC could not be ascertained due to practical hurdles like the Pakistan
risk-averse nature of industrial borrowers and financial institutions, lack of a wide
range of risk-sharing instruments and an absence of secondary Islamic markets. The
CII’s proposal that banks should charge a variable rate of commission from the client in 663
advance for collecting trade bills might precipitate interest under the cover of banks’
commission or fee (Council of Islamic Ideology (CII), 1980, pp. 37-8). The CII proposed
the PLS-based daily product method to eliminate interest on bank deposits, which
almost ensured the predetermined and risk-free rate of return for deposits under the
conventional concept of time value of money (Council of Islamic Ideology (CII), 1980,
pp. 48-9).
The CII proposed the central banking mechanism within an Islamic framework
(Figure 2). It suggested that the ‘‘bank rate’’ system may be replaced by the mechanism
wherein the SBP will fix PLS ratios on its financial assistance to banking institutions.
The SBP will also determine the maximum and minimum range of PLS ratios for
banks in relation to their financing to clients (Council of Islamic Ideology (CII), 1980,
pp. 71-9). By increasing or decreasing the share of profit of banks, the SBP will be able
to influence the demand for the bank credit in a similar fashion that it had been doing
by manipulating bank rates under the conventional banking system (Council of Islamic

Figure 2.
Policy instruments of the
CII’s central banking
model
MF Ideology (CII), 1980, pp. 74-9). The practical success of the proposed tool demanded the
predominant use of the PLS system in the economy and banking industry, which
34,9 seemed to be a remote possibility. As a matter of fact, the SBP could be obliged to
prescribe PLS ratios for banks’ investments as a proxy to the ‘‘bank rate’’ or interest
rate. The CII’s proposal that the SBP should replace interest-bearing government
securities with ‘‘variable dividend securities’’ to perform the open market operations
could not succeed because there would be very little use of the PLS system in market
664 (Council of Islamic Ideology (CII), 1980, pp. 80-1). There is not a well-established Islamic
secondary inter-bank money market in Pakistan to ensure the effective use of these
securities. The majority of interest-based government securities are held by small
savers who are highly risk-averse and they cannot afford to have uncertain earnings
for their livelihood (Ministry of Finance of Pakistan, 2002). The CII proposed the
evolutionary plan to phase out interest from the economy of Pakistan within three
years (Council of Islamic Ideology (CII), 1980, pp. 26-7).
The CII should have made it compulsory for banking institutions in Pakistan to
perform their operations based on the PLS system. It should have clearly mentioned
the ‘‘exceptional cases’’ where secondary interest-free instruments could be used. But
the CII refrained from doing so and thereby it laid down the foundation for interest-free
banking practice based on secondary interest-free instruments, which subsequently
turned out to be a cover to retain the conventional banking practice. Being expert in the
principles of Islamic Shariah, the CII relied heavily on the panel of conventional
economists and bankers, who tried to resolve the problem of interest within the context
of a conventional framework. The CII did not offer any solution to eliminate interest
from government borrowings, international trade and commerce, which proved to be a
serious hurdle in the adoption of interest-free banking practice in Pakistan.

3. Interest-free banking practice in Pakistan

In 1980, the government assigned the task of implementing the CII’s report to the
Ministry of Finance. The ministry relied on its two special organs, namely the State
Bank of Pakistan (SBP) and the Pakistan Banking Council (PBC) to embark upon the
Islamization task. The PBC constituted a ‘‘Superior Task Force’’ of experts and
professionals who proposed major changes in the 1962 Banking Companies Ordinance
so as to allow banks to perform their operations on the basis of PLS, mark-up in price
(bai muajjal/murabaha), leasing and hire-purchase. A separate Mudarabah companies
and Mudarabah (flotation and control) ordinance 1984 was promulgated to allow the
operations of mudarabah companies in the corporate sector. A number of other
banking and corporate laws were also amended to provide operational grounds for the
newly created interest-free instruments such as PTCs and others.
From January 1981, 7,000 domestic branches of national banks started to accept
deposits on a PLS basis. On 1 January 1981, the very first day, banks mobilized
PKR92.6 million on the PLS basis (Faruqui and Habibullah, 1983). The PLS deposits
increased from PKR6.5 billion at the end of 1981 to PKR33.3 billion by March 1985
(Ahmed, 1987). The rates of profit on PLS deposits were higher than returns on
interest-based deposits during the period from January 1981 to July 1985 (Nomani and
Rahnema, 1994). From 1 July 1979, non-banking financial institutions such as National
Investment Trust, Investment Corporation of Pakistan and House Building Finance
Corporation had already adopted interest-free financing operations based on the 1978
CII’s Interim Report (Faruqui and Habibullah, 1983). The SBP established four
committees namely, documentation committee, system and auditing committee, legal
committee and training committee to develop the legal and institutional frameworks Banking
for the interest-free banking system. The documentation committee prepared the draft movement in
documents for practising murabahah (mark-up) financing under the guidance of their
Islamic Shariah advisory boards. However, the PBC disapproved them without giving Pakistan
any plausible reason. Afterwards, the PBC prepared its own legal documents 1B-1 to
1B-32, and all except 1B-7 and IB-32 were related to a mark-up mode of financing with
buy-back agreement. The PBC described other approved modes in broad general terms 665
and advised banks to develop their own model agreements and documents for
practising them, which were beyond their resources and capacity. After the issuance of
BCD circular no.13 of 20 June 1984, banks dropped their plans to finance on the basis
of musharakah, leasing and hire-purchase and started to rely heavily on mark-up mode
of financing (Zaidi, 1987).
The actual practice of mark-up financing was a fictitious transaction of sale and
purchase of goods. The bank performed its trade-related functions on papers only. The
SBP allowed banks to include an additional mark-up for 210 days on the original price
of a mark-up contract as a cushion against any likely delay or default in the repayment
of a loan. By making such ‘‘adjustments’’ banks were able to earn almost fixed rates of
return on their mark-up contracts (Zaidi, 1987). In 1984, the investment portfolios of
banks were concentrated in mark-up financing by 86.7 per cent of the total banking
operations. The overall representation of the PLS system amounted to 3.1 per cent of
total financing operations of Pakistani banks in 1984 (Ahmed, 1987). The SBP’s PLS
schemes like mudarabah companies and PTC financing were not truly based on the
risk-sharing mechanism. They were abandoned after some time because of accounting,
tax, legal and other structural constrains. Banks invested a large portion of PLS
deposits in interest-based venues and other fixed mark-up investments. They paid
almost risk-free and predetermined rates of return to PLS depositors. In 1985, the SBP
permitted banks to invest their PLS funds in interest-based government securities
that seriously retarded the process of Islamization of the banking sector in Pakistan
(Zaidi, 1987).
The SBP did not establish its own internal research and development and Islamic
Shariah advisory faculties to seek help over the Islamization process that was highly
complex and needed a deep insight on many technical and Islamic Shariah issues.
There was a lack of proper Islamic Shariah training for bankers. No efforts were made
to bring rigorous reforms in accounting, tax, legal and other state institutions so as to
create conducive socio-economic environments for the interest-free banking practice.
The SBP played a key role in ruining the cause of interest-free banking. It introduced
many interest-based schemes such as Khas (special) deposits, national certificates,
monthly income schemes, National Defence Finance Certificates that were yielding
higher rates of fixed return than the interest-free avenues of investments (Rahman,
1997). A large number of Islamic scholars showed serious concerns over the practice of
mark-up financing in Pakistan. Kadri (1996) stated that mark-up financing is a
concealed form of charging interest on banking transactions. Lashkar (1991) critically
remarked that the practice of mark-up financing in Pakistan amounts to hypocrisy.
Uzair (1997) argued, ‘‘A new word came in use, i.e. ‘mark-up’ which is just a ‘mark-up’
for the word ‘interest’’’. In 1985 the President of Pakistan Mohammad Ziaul Haq who
took the initiative of introducing interest-free banking in Pakistan, admitted before the
National Assembly of Pakistan that he had been unsuccessful in eliminating interest
from the economy and financial sector of Pakistan (Nienhaus, 1988).
MF 4. FSC judgement on Riba (interest) in 1991
The Federal Sharirat Court (FSC) received number of petitions over the years
34,9 challenging the interest-free banking practice in Pakistan. On 14 November 1991, the
FSC announced the verdict on riba and banking practice in Pakistan. The FSC
observed that any stipulated increase on capital whether it is high or low, simple or
compound, taken for personal or private or productive or consumption purposes, or for
short or long-term, between two Muslims or between a Muslim and non-Muslim or
666 between a citizen and state or between two states comes under the ambit of riba
(Federal Shariat court (FSC) of Pakistan Judgement on Riba (Interest), 1991,
paragraphs 93-111). The FSC decreed that the bank interest unquestionably falls
within the definition of riba (Federal Shariat court (FSC) of Pakistan Judgement on Riba
(Interest), 1991, paragraphs 131-163). The FSC resolved that the practice of mark-up
(bai muajjal/murabaha) with buy-back arrangement at the banking and finance sector
of Pakistan involves excess on the principal amount and thereby constitutes interest
(Federal Shariat court (FSC) of Pakistan Judgement on Riba (Interest), 1991,
paragraphs 249-278). The FSC adjudged 20 banking and fiscal laws that contained the
provisions of interest and ‘‘mark-up’’ as repugnant to the injunctions of Islam. The FSC
resolved that government securities, prize bonds and bearer certificates are interest-
based instruments and government should cease its reliance on interest-based
borrowings from local and foreign lenders (Federal Shariat court (FSC) of Pakistan
Judgement on Riba (Interest), 1991, paragraphs 323 and 383). The FSC ordered the
government of Pakistan to bring the laws into question in full conformity with the
Islamic Shariah by 30 June, otherwise they will cease to be effective as on and from
1 July 1992.
The FSC judgement was a landmark in the history of interest-free banking in
Pakistan. It revived the case of interest-free banking that had lost significance due to a
lack of political will. It invoked a mixed reaction in the polity of Pakistan. Financial
institutions in Pakistan and their depositors were against the FSC judgement because
its implementation was harming their interests. Borrowers were supporting the FSC
judgement because its implementation was meant to be an automatic cancellation of
accrued interest on their liabilities towards banks. Foreign parties were nervous about
the FSC judgement and in response a sharp decline in foreign investments, aids and
loans was observed. It was estimated that more than 204 main debt projects were
seriously affected. The religio-political parties demanded to enforce the FSC judgement
in the country. The so-called modernists suggested challenging the FSC judgement in
the SC of Pakistan. Eventually, the government of Pakistan and its financial
institutions lodged their appeals against the FSC judgement at the SC. The looming
controversies over the FSC judgement revealed that people of Pakistan did not hold
any consensus of opinion and willingness for abolishing interest from the banking
sector of Pakistan (Khan, 2003).

5. CIE’s models on interest-free banking in Pakistan

In 1991, the government of Pakistan constituted the CIE. The basic purpose of the CIE
was to make recommendations for improving the credibility of the interest-free
banking practice in Pakistan (Commission of Islamization of Economy, 1992, p. 3). In
June 1992, it submitted the first report, i.e. ‘‘Report on Banks and Financial
Institutions’’ to government. The CIE observed some serious un-Islamic features of the
banking practice in Pakistan. It registered that banks’ investments in money at call and
short notice, trade bills and all types of government securities were based on a fixed
interest (Commission of Islamization of Economy, 1992, p. 6). The mark-up (bai muajjal/ Banking
murabaha) financing system with a buy-back agreement was widely practised by
banks and that was an interest-based activity. Financial institutions had abandoned
movement in
the application of rent-sharing for mark-up financing with a buy-back agreement Pakistan
(Commission of Islamization of Economy, 1992, p. 15). A large part of banks’
investments and PLS deposits were invested in interest-based government securities
and other un-Islamic investment avenues (Commission of Islamization of Economy,
1992, p. 6). The return-bearing deposits and foreign currency deposits were paid
667
interest under the SBP’s instructions. The banks’ borrowings mainly comprised of
borrowings from the SBP, other banks and foreign lending agencies on the basis of
interest (Commission of Islamization of Economy, 1992, pp. 16, 34).
The CIE made a few main recommendations for restructuring the banking system
of Pakistan on Islamic lines. It argued that the bank and the client should be given full
freedom to decide about the PLS ratio and other relevant matters of musharakah
contract. The SBP should not fix the minimum and maximum rates of profit on PLS
schemes because it is against the spirit of Islamic economics (Commission of
Islamization of Economy, 1992, p. 32). The client should submit regular progress and
annual reports to the bank on musharakah investment. A provisional share of profit on
musharakah investment should be paid to the bank at regular intervals. The client
should pay the bank’s share of profit before distributing any dividend among
shareholders. All losses incurred on account of poor management and
misappropriation should be solely borne by the client (Commission of Islamization of
Economy, 1992, p. 35). The CIE suggested a temporary arrangement to replace interest-
based securities with interest-free securities based on rebate in income tax. It further
argued that financial institutions should abandon all interest-based investment
schemes (Commission of Islamization of Economy, 1992, p. 36). It demanded that trade
bills should be collected as prescribed in the 1980 CII report (Commission of
Islamization of Economy, 1992, pp. 9-10).
The CIE’s recommendations reflected the pro-banking mentality, aiming to promote
the welfare of financial institutions. The CIE showed heavy reliance on bai muajjal by
recommending it for short and long-term investment projects, such as agriculture farm
inputs, imported merchandise, development finance of agriculture, house building
finance, financing for construction of building and acquiring of machinery
(Commission of Islamization of Economy, 1992, pp. 24-7). The CIE report was a 40-page
document only and most often it was either repeating itself or the basic concepts of the
CII report with some additions and modifications. It did not reflect any creativity,
practicality and true scholarship to deal with the problem of interest in the given socio-
economic context of Pakistan. The CIE members were pre-occupied with their prime
duties in different official capacities. It happened only once in the second meeting that a
full bench of 12 members was present. The CIE concluded its work in seven meetings
only. There were political considerations behind the CIE report. The ruling party
constituted a coalition government with the support of religio-political parties that
were demanding for the Islamization of the economy. The FSC judgement on Riba put
the government under tremendous pressure to do something about eliminating interest
from the economy of Pakistan. The CIE report served as an eye wash only and
government did not take any action on it (Khan, 2003).
The riba case remained frozen for several years at the SC due to lack of a full
quorum of judges. There was a standstill position on the issue of Islamization of the
economy of Pakistan from mid 1992 to early 1997. However, the CIE made another
MF attempt to resolve the deadlock when in May 1997 it invited the International Institute
of Islamic Economics (IIIE) to offer its recommendations to revamp the financial sector
34,9 of Pakistan on Islamic lines. In July 1998, the IIIE submitted its findings to the CIE,
titled, ‘‘International Institute of Islamic Economics (IIIE)’s Blueprint of Islamic
Financial System, Including Strategy for Elimination of Riba’’. The IIIE report was
composed of nine chapters, covering the areas of modern commercial banking,
government transactions, international transactions, central banking, strategy of
668 phasing out interest from the economy of Pakistan and legal cover for the Islamic
financial system.
The IIIE’s banking model was primarily based on bai muajjal, bai salam, Ijarah
mudarabah and musharakah. The IIIE described the main characteristics of these
instruments as provided in the CII report, the CIE report and the literature on Islamic
economics and finance. In the system of bai muajjal, the IIIE made a controversial
recommendation that clients should bear all losses arising out of their refusal to buy
bai muajjal goods (International Institute of Islamic Economics (IIIE), 1998, p. 50). The
IIIE contended that bai salam can be used at banks without bringing any radical
changes in the existing conventional banking structure (International Institute of
Islamic Economics (IIIE), 1998, p. 52). However, Islamic scholars believe that the true
adoption of bai salam requires banks to become very active agents in the commodity
market. The IIIE argued that the bank can sell the leased asset to the lessee before the
expiry of a lease contract. It did not remain mindful to the fact that such a sale is not
permissible under the Islamic Shariah (International Institute of Islamic Economics
(IIIE), 1998, p. 53; Supreme Court of Pakistan Judgement on Riba, 1999, para 478). The
IIIE argued that banks are not charity houses, and so they should not provide qard-e-
hasanah (goodly loans) to the destitute members of society (International Institute of
Islamic Economics (IIIE), 1998, p. 57). Furthermore, the IIIE disallowed the service
charge system calling it as an interest-based activity (International Institute of Islamic
Economics (IIIE), 1998, p. 58).
The IIIE contended that the SBP should control the Islamic financial market
through an effective regulatory environment but not through dictating terms to banks
in their dealings with clients (International Institute of Islamic Economics (IIIE), 1998,
chapters 5 and 6). It strongly proposed for the establishment of an Islamic inter-bank
money market. It proposed a large number of the interest-free securities such as ‘‘bai
muajjal-based tradable securities’’, ‘‘salam certificates’’, ‘‘asset Ijarah securities’’,
‘‘transferable Ijarah warrants’’, ‘‘general musharakah certificates’’, ‘‘special musharakah
certificates’’ and ‘‘decreasing-participation/redeemable musharakah certificates’’. These
securities should be traded in the Islamic money market to serve short and long-term
financial needs of economic agents (International Institute of Islamic Economics (IIIE),
1998, chapter 5). Furthermore, the SBP should trade in these securities to regulate
money supply and provide financial assistance to government (International Institute
of Islamic Economics (IIIE), 1998, p. 114). However, problems of budget deficit, foreign
debt and other inherited structural imbalances of the economy of Pakistan may not
allow the replacement of interest-based government securities with interest-free
securities as well as the establishment of an Islamic money market on a risk-sharing
basis (Ministry of Finance of Pakistan, 2002).
Some of the IIIE’s recommendations were repetitive and others were unfeasible due
to practical difficulties and socio-economic hurdles. For example, the proposals for
financing the purchase of consumer goods, financing micro-enterprises and
agricultural financing have already been mentioned in the literature on Islamic finance.
The proposal of financing working capital needs of business enterprises under the PLS Banking
system already failed due to practical difficulties. The IIIE’s approach for eliminating
interest from the financial system of Pakistan was very narrow. Simply it aimed at
movement in
replacing interest-based instruments with interest-free instruments by requiring a Pakistan
minimum departure from the existing conventional banking framework. It showed
little reliance upon moral and motivational reinforcements and greater dependence on
strict legal and regulatory measures to ensure the compliance of people with the
proposed interest-free banking system. The IIIE prepared its report without consulting
669
bankers, experts in the Islamic Shariah and other related disciplines. Like other past
theoretical attempts, the IIIE’s model also failed to bear any cognizable impact on the
interest-free banking movement in Pakistan (Khan, 2003).

6. SC judgements on Riba (interest) in 1999 and 2002

In February 1999, the SC commenced its hearing on appeals lodged by the government
of Pakistan and financial institutions against the 1991 FSC Judgement on Riba. On 23
December 1999, the SC gave its verdict to uphold the FSC Judgement confirming the
rejection of the interest-based economy of Pakistan. The SC resolved that the prevalent
bai muajjal (mark-up) practice under a buy-back agreement is an interest-based
activity, because it involves pure lending on the basis of mark-up or fixed rent on the
loaned capital (Supreme Court of Pakistan Judgement on Riba, 1999, paragraphs 219
and 501). The SC observed that banks and leasing companies are practising the finance
lease, another form of interest (Supreme Court of Pakistan Judgement on Riba, 1999,
para 28). The SC observed that Section 79 of the 1,881 Contract Act that allows interest
on the ‘‘service charge’’ in case of default is repugnant to the injunctions of Islam
(Supreme Court of Pakistan Judgement on Riba, 1999, para 537 and 480). The SC
resolved that the prevalent PLS investment and financing arrangements in the banking
and financial system of Pakistan are based on interest (Supreme Court of Pakistan
Judgement on Riba, 1999, paragraphs 36-8). The SC affirmed the FSC’s verdict that
bills, debentures, bonds and other commercial instruments should be banned under
Islamic Shariah (Supreme Court of Pakistan Judgement on Riba, 1999, para 500). The
SC held that defence saving certificates, treasury bills, federal investment bonds,
foreign exchange bearer certificates and prize bonds are interest-based securities.
Therefore, a return over them in the name of mark-up or profit is nothing but interest
(Supreme Court of Pakistan Judgement on Riba, 1999, para 39).
The SC ordered to develop legal, regulatory and tax systems truly compatible with
the Islamic financial system. It set out guidelines for abolishing interest from the
economy of Pakistan by 30 June 2001. The government set up a ‘‘Commission for
Transformation’’ in the SBP to devise measures for ensuring the compliance of the
financial sector with Shariah. A task force was formulated in the Ministry of Law and
Parliamentary Affairs of Pakistan to devise legal and regulatory frameworks for the
Islamic economy. Another task force was set up in the Ministry of Finance of Pakistan
to direct and facilitate the transformation of existing interest-based government
securities into Islamic modes of financing. The government, however, failed to make
satisfactory progress over the transformation work and therefore, it sought an
extension from the SC till 30 June 2002. Afterwards, it changed its mind to implement
the SC orders on riba. On 1 December 2001 the SBP issued detailed criteria for setting
up an Islamic commercial bank in the private sector of Pakistan. The government
contended that the establishment of the first Islamic bank in the country would be a
partial implementation of the SC orders and other plans, which are in the pipeline,
MF would be shortly implemented in order to fully comply with the SC orders. On the other
34,9 hand, it extended full surety to international parties that it would be able to seek the
approval of the SC for adopting a dual approach whereby Islamic financial institutions
and conventional financial institutions will co-exist in the market. Therefore, Islamic
banking should be viewed as an opportunity to diversify financial instruments and
deepen the financial intermediation in Pakistan (Khan, 2003).
670 In the beginning of June 2002, the government moved a petition at the SC to review
its judgement of 1999 on riba. It contented that the SC’s prescribed parameters for
devising the Islamic economic system were unrealistic and harmful to the economy of
Pakistan and thereby the SBP has devised regulations to promote Islamic banking
under a dual system. The first Islamic bank – Meezan Bank Limited – has been
functioning successfully since May 2002. The government pleaded to the SC to
suspend its earlier judgement on riba and instead approve the adoption of Islamic
banking under a dual banking system. Two major religious parties, namely ‘‘Jamaat-e-
Islami’’ and ‘‘Jamiat-e-Ulema-e-Pakistan’’ who were opposing the reopening of riba case
put blame on government for delaying the matter of abolishing interest from the
economy of Pakistan for the last 54 years. They pleaded with the SC to take firm action
for completing the transformation of the economy along Islamic lines. However, on 24
June 2002 the SC set aside its previous judgement on riba and asked the FSC to
re-examine the riba case for giving ‘‘definite findings’’ to the points raised by the parties
during the review hearing (Khan, 2003).
There were some grey areas in the SC decision on Riba review case, 2002 which
suggested that its outcome was predetermined. Before the commencement of the Riba
review case, the government of Pakistan imposed a premature retirement on Justice
Muhammad Taqi Usmani who was very strict about implementing the 1999 SC orders
on riba. The appointment of two Islamic scholars on the SC bench for hearing was also
highly controversial. Both judges were publicly known for holding a personal opinion
that bank interest does not fall within the ambit of riba that is prohibited by the holy
Quran and Sunnah. The SC restricted the hearing on riba case review to a few
individuals. The government’s opponents did not get a fair chance to present their
viewpoints before the court. The SC decision on riba case review was delivered hastily
because the government was given the final deadline to implement the 1999 SC orders
by 30 June 2002 (Khan, 2003).
There are convincing reasons to doubt the government’s sincerity in implementing
the 1999 SC orders on riba. The government’s achievements in implementing the SC
orders comprised of some paper work, half-baked plans and ‘‘early drafts’’. The
government wasted a lot of time due to indecision and lack of commitment over the
transformation work. It did not devise any viable strategies and timetable for
completing the task of Islamization. It even thought of declaring a financial emergency
in Pakistan to make the SC orders on riba ineffective. Policy makers and experts had no
clue as to how to find the Islamic alternatives to domestic and foreign debt which were
more than US$60 billion in the budget year 2000-2001. The task force in the Ministry of
Finance warned that any departure from the conventional based modalities of
government borrowings from the SBP might distort the market and cause major
problems in pursuing an effective monetary policy. It further resolved that government
debt schemes such as prize bonds, defence saving certificates and investment bonds
should be made permissible under the Islamic Shariah because such contracts are
executed by a mutual consent of the parties concerned. In the given context, it may be
stated that the government and its agencies set up a good stage to knock down the case Banking
of implementing interest-free banking system in Pakistan once and for all (Khan, 2003).
movement in
7. Future of interest-free banking in Pakistan under dual system Pakistan
During the hearing of the Riba review case, the government claimed before the SC that
the SBP would ensure the parallel development of the interest-free banking within the
existing interest-based financial system of Pakistan. It further claimed that the
adoption of a dual banking system would eliminate the risk of any major cost or
671
damage to the economy. However, Islamic banks might face serious difficulties while
performing their borrowing and lending functions in the fold of conventional
regulations. The SBP itself maintained that in the risk-averse market environment of
Pakistan, fund mobilization schemes based on risk-sharing mechanisms could not
succeed. In this situation, Islamic banks may be obliged to offer higher profit than the
market rate of interest to attract deposits, as had previously happened in the so-called
interest-free banking practice in Pakistan from 1981 to 1985. In the context of risk and
return trade-off, the quest for earning higher profit margins would require Islamic
banks to invest in more diversified and innovative projects thereby further shrinking
their deposit base of risk-averse depositors. Islamic banks would generally attract
risky and bad projects, leaving hardly any diversification benefits. They would become
highly exposed to the risk of non-payment, default and loss on their investments, which
would expose them to high liquidity risk leading to bankruptcy and a roll back
(Meenai, 1998; Nienhaus, 1983). In the given circumstances, they might follow a highly
conservative lending policy implicitly based on market interest rates. In other words,
market realities might oblige them to do conventional banking in other garbs. The
Islamic Shariah experts, the economist and bankers who prepared the 1980 CII report
unanimously agreed that true interest-free banking practice could not succeed in
Pakistan under the dual system and in the ambit of a conventional financial system
(Council of Islamic Ideology (CII), 1980, chapters 4 and 5).
Despite all, there are at the present six so-called Islamic banks in Pakistan which
have established 46 branches across the country. They include Al Baraka Islamic Bank,
BankIslami Pakistan, Dubai Islamic Bank Pakistan, Emirates Global Islamic Bank,
First Dawood Islamic Bank and Meezan Bank. In addition there are nine conventional
banks which have set up more than 62 fully committed Islamic banking branches
across the country. Islamic banking operations are now spread across 16 major cities of
Pakistan, comprising 2.2 per cent of the total banking industry with assets amounting
to US$1.3 billion (Al-Refai, 2006).

8. Factors causing failure to the interest-free banking movement

in Pakistan
The interest-free banking movement failed in Pakistan due to following reasons. There
was a lack of genuine political will for implementing the interest-free banking system
in Pakistan. The President of Pakistan Mohammad Ziaul Haq initiated the interest-free
banking project just to meet its vested interest. Other governments also used interest-
free banking as a political tool to reap their vested interests. The bureaucrats sitting in
the Ministry of Finance of Pakistan also shunned interest-free banking because it was
posing a threat to their status quo position and power in the financial sector of
Pakistan. Similarly the SBP did not find itself under any incentive or compulsion to
provide proper training, documentation and technical assistance to banks for truly
adopting interest-free banking systems. The banking culture of Pakistan is geared
MF against the spirit of interest-free banking. The banking personnel do not possess any
34,9 skill and vision to perform their duties on Islamic lines. The non-performing loans,
write-offs and cooperative scandals are the part and parcel of the financial sector of
Pakistan. The political misuse of the financial sector is too rampant in Pakistan. The
few social elites of Pakistan hold exclusive rights over bank credit, concessionary
borrowings, subsidies and other benevolent schemes and are also frequently involved
672 in loan defaults. The banking services in Pakistan are very expensive and unpopular in
general public and they are of little help to small investors and business people.
General depositors, comprising more than 60 per cent of the total deposits in the
banking sector of Pakistan, are risk-averse and they do not want to commit their funds
under the interest-free banking system (Yaqoob, 1998). The majority of the business
people do not want to share their true profitability and business privacy with banks
because of the rigid and corrupt tax system of Pakistan. The overall socio-economic
set-up of Pakistan is exploitative and the many malpractices are eating the moral fabric
of the country. Apart from interest, there are other deeply interlinked forces and agents
in the systems of production and distribution of wealth and economic resources in
Pakistan which promote the welfare of a few social superiors. Thus, it was hardly
possible to enforce the interest-free banking system in the prevalent exploitative socio-
economic and political climate of Pakistan. The increasing effects of globalization and
privatization of the economy of Pakistan also undermined the chances of success of the
interest-free banking practice in Pakistan (Khan and Bhatti, 2006; Prime Minister’s
Committer Report on Self-Reliance, 1991).

9. Summary and conclusion

The government of Pakistan embarked upon eliminating interest from its financial
economy and financial sector in early 1980s. Over two decades it spent huge resources
on implementing the Islamization project but the success was always only illusory. In
2002 it made a U-turn and started to promote the Islamic baking practice within the
existing conventional financial system of Pakistan. This paper explores the 26-year old
interest-free banking movement in Pakistan and explains the causes of its failure. The
interest-free banking system was tried in Pakistan under a piecemeal approach, with
little professional integrity. The government of Pakistan was not sincere in eliminating
interest from its economy and banking system and always used the issue to achieve
some political ends. The SBP made only half-hearted efforts to implement the
conceptual frameworks of Islamic banking developed by experts from time to time.
The judicial courts of Pakistan took the matter of implementing the interest-free
banking system in Pakistan in their hands but all such efforts ended in a sheer despair.
The polity of Pakistan was widely divided over the issue of Islamization. Apart from
government, financial institutions, depositors and business people of Pakistan did not
approve the cause of interest-free banking because it was going to hit hard their
material benefits. There was a need to eradicate other exploitative elements from the
socio-economic life of Pakistan along with interest. There was also a need to sort out
serious micro and macro economic problems of Pakistani economy so as to create
favourable environment for the growth and development of interest-free banking
institutions to grow in the country. The few private Islamic banks, however, have
recently emerged to operate on a limited scale in the financial sector of Pakistan, which
is not an appreciative situation for the country overwhelmed by the Muslim
population.
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Further reading
State of Banks of Pakistan (2005), Annual Report 2002, Karachi.
674
Appendix. Glossary of Arabic words and terms
Bai salam A sale in which the buyer pays the price of goods (generally farm goods) in
advance
Qard-e-hasanah Goodly loans or free of charge loans for helping the poor
Mudarabah A joint venture between the fund manager and the fund provider
Musharakah Equity participation under Islamic principles
Quran The divine message revealed by God on holy Prophet Mohammad (pbuh)
Riba Interest in simple or compound form
Riba al-nashiáh Interest in loan or financial transactions
Shariah The Islamic canonical law based upon the teachings of the holy Quran and
Sunnah of the holy Prophet Mohammad (pbuh)
Ijarah Leasing

Corresponding author
M. Mansoor Khan can be contacted at: mansoor.khan@unisa.edu.au

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