Over the past decade, a not-so-silent revolution has been brewing in Pakistan’s banking sector, one that’s reshaping the financial landscape faster than you can say “Riba-free”. Once a niche player, Shariah-compliant has now come on its own and outpaced the conventional industry in both growth and profitability.

By June, the Islamic banking (IB) asset base had swelled to Rs9.7 trillion, making up 18.7 per cent of the overall industry. Of this, full-fledged institutions had a share of 12.3pc, or Rs6.4tr, while another 6.4pc, or Rs3.2tr, came from the branches.

A decade ago, its proportion used to be 10.4pc. Put another way, both IB and Islamic banking branches (IBB) have outperformed the sector, increasing at a 10-year compound annual growth rate of 24.8pc and 23.8pc, respectively, compared to conventional’s 15.4pc.

After the 2008 financial crisis, Pakistani banking has heavily prioritised investments, ie lending to the sovereign, over advances to consumers and businesses. This trend has especially accelerated over the last few years due to the government’s fiscal needs. On the other hand, advances have lagged behind, making up less than a quarter of the overall asset base as of June.

While the investments-to-deposits of the industry are extremely high at 95.2pc, there are noticeable differences. Now, you have conventional banks with investments-to-deposits of 105.2pc as of June — meaning that they are now borrowing from other financial institutions (including the State Bank) to lend to the government. In contrast, IBB operates at 58.5pc while IB operates slightly higher at 62.3pc.

As of March, Shariah-compliant accounts made up a healthy 30.5pc of all banking branches, compared to 12.1pc back in June 2014

Expectedly, it’s coming at the expense of financing. Back in June 2014, conventional banking’s advances-to-deposits (ADR) used to be 49.3pc, which has now fallen to 34.3pc in the latest period. On the Islamic side, there’s been more movement, with the ADR for IB peaking at 71.8pc in March 2019 and IBB at 69.8pc in March 2022.

Since then, there’s been a marked decline to just 48.1pc for the former and 44.4pc in the case of the latter. Due to the policy rate environment, there was virtually no incentive for anyone to issue credit, but with the start of monetary easing now, perhaps things will improve a little.

An identical trend plays out on the liabilities side, where deposits and other accounts for IB have risen at a 10-year compound annual growth rate of 23.1pc and IBB at 22.7pc — almost twice as fast as the 12.4pc of conventional banking. As of June, the sector’s total deposits stood at Rs32.5tr, of which the Islamic share was 22.6pc, up from 10.6pc in the same period of 2014.

This essentially means that an ever-growing number of people are now moving towards Islamic institutions — both full-fledged and branches. Is it because they have higher trust or comfort in placing funds with Shariah-compliant instruments? However, there could be another explanation: the reason behind this shift lies in how the industry has expanded its branch network.

As of March, IB and IBBs accounted for a healthy 30.5pc of all banking branches, compared to just 12.1pc back in June 2014. The former’s network tripled from 868 to 2,806, while the latter surged by 391pc from 467 to 2,295 during the period under review. Contrast this with conventional, where the number of branches rose by a more modest 19.9pc from 9,649 to 11,577 over almost a decade.

Are financial institutions expanding their Islamic network because people want to put their money in Shariah-compliant instruments, or is it because branches, especially newer ones, are increasingly becoming Islamic because of the push by the State Bank? You can decide if the chicken came first or the egg.

So far, everything points to how the Shariah-compliant segment has outperformed the overall industry. However, one area where conventional does better is efficiently mobilising funds from customers, boasting average deposits per branch of Rs1.96 billion as of March. This is higher than both IB’s Rs1.6bn and IBB’s 1.1bn, with the gap only widening over the last decade.

Regardless of this operational efficiency at the branch level, Islamic banks now occupy an increasingly higher share of the overall banking profits. During 6MFY24, IB accounted for 27.8pc of the industry’s total net income, while IBB made up another 20.8pc. Note that their cumulative share in most major balance sheet items or even branch networks doesn’t exceed 30pc.

But it’s not because they are doing something exceptional that others can’t seem to imitate. Traditionally, the reason behind Islamic banking’s performance in terms of profitability lies in a regulatory advantage, where there was no minimum deposit rate levied. This lent them significant cost savings, one that was borne at the expense of customers. Unfortunately, all the noise and complaints have fallen on the regulator’s deaf ears.

Mutaher Khan is the co-founder and AbdulAziz Malik is an intern at Data Darbar

Published in Dawn, The Business and Finance Weekly, September 23rd, 2024