Islamic Banking in Pakistan To Outpace Conventional Peers by 2026

With a continued strong growth trajectory, Pakistan’s Islamic banking industry is estimated to materially outpace conventional banking by 2026, according to Moody’s Investors Service.

This may come true during the timeframe given by Moody. But, the bigger issue that the report fails to mention is whether Islamic finance will be able to help reduce poverty in the country.  We strongly believe that reducing poverty in a society should be one of the primary goals of Islamic finance.

So far, Islamic finance policymakers have failed to deliver on this promise.

“Huge growth over the past decade shows no signs of slowing. The Islamic banking industry in Pakistan has grown by 24 percent a year on average over the last decade, expanding by 30.6pc in 2021 alone,” said Moody’s in its latest report on Tuesday.

“We expect growth in Islamic banking to continue to materially outpace conventional banking, reaching a market share of total assets and deposits of around 30pc by end 2026, with net financings market share at around 33pc,” it said attributing this growth to a combination of a predominantly Muslim population, still modest financial inclusion, and the commitment of the government and regulators as the key driving forces.

It said Islamic banking assets grew by an average of 24pc per annum over the past decade to Rs5.577 trillion ($31.2bn), accounting for around 19pc of total banking assets, up from 8pc (Rs641bn) in 2011. It forecast annual growth of over 25pc over the next five years, pushing up the sector’s market share to around 30pc.

Moreover, financial inclusion in the country is still modest, despite recent progress; according to the State Bank of Pakistan (SBP), approximately 62pc of the country’s adult population have an account with a formal financial institution, against an average of 95pc in high-income countries.

The combination of these factors provides the bedrock for the industry’s development. Past studies have also identified an overwhelming demand for Islamic banking products, with religious considerations an integral part of the decision process.

Deposits of the Islamic banking industry also stood at Rs4.211tr, holding a 19.4pc market share, with an average annual growth of 23pc over the period. Net financings amount to Rs2.597tr, or a 25.7pc of market share, and have grown even faster than deposits, reaching an average expansion of 29pc over the past decade.

Moody’s noted that the outperformance of financings was likely driven by the more limited availability of Shariah-compliant liquidity products as well as strong demand for financing products.“We estimate average growth over 2021-2026 to range between 25pc-28pc for total assets and deposits, and over 20pc for net financings. The Islamic banking industry’s growth will continue to outpace system growth, and its market share will grow further.

The Islamic banking industry in Pakistan comprises 22 Islamic banking institutions, consisting of five fully-fledged Islamic banks and 17 conventional banks that have Islamic banking branches. A total of 3,956 branches were in operation as of December 2021, with an additional 1,442 Islamic banking windows (dedicated counters at conventional branches). In 2021, 500 branches were added. Moody’s expected at least a similar number of new branches to be added yearly over the next five years.

Increasing the use of digital and electronic channels will also support the industry’s growth. Given the industry’s growth potential and strong financial performance, “we expect more banks to apply for Islamic banking licenses and for conventional banks to convert to fully Islamic banks” as recently Faysal Bank Ltd, a mid-sized bank with around 3pc market share, started the process of converting conventional banking to Islamic.

Not only the solid financial performance, but Islamic banking institutions in Pakistan are also more profitable than their conventional counterparts and their loan performance is better. For 2021, they reported a return on assets of 1.3pc and a return on equity of 21.4pc, compared to 1pc and 14.1pc for conventional banks.

The difference in profitability was due to lower loan-loss provisioning needs at the Islamic banks, given their better loan quality and their lower funding costs. Similarly, non-performing finances (NPFs), the equivalent to non-performing loans in conventional banking, stand around 2.7pc of gross financings, well below the market average of 7.9pc.

Superior loan performance reflects both a lack of legacy problem loans and financings and the banks’ recent aggressive growth, which has increased the denominator of the ratio and indicates their financings have still to be tested in a downturn. Islamic banking institutions do, however, maintain slightly lower capital and liquidity buffers.

Lower liquidity reflects Islamic banks’ higher proportion of financing-to-deposits (at 62pc, against 47pc for conventional banks), but also the historically more limited availability of Shariah-compliant liquidity products, although this has been gradually improving.

At the same time, the report highlighted that Islamic banking institutions perform better in terms of asset quality and profitability, but have lower capital and liquidity levels.