The Islamic banking industry is growing but it also faces structural problems. The industry holds approximately 15 per cent of total banking deposits. But when it comes to investments, Islamic banks have a share of only 5pc in the form of liquidity instruments. Currently, conventional banks have two kinds of liquidity instruments: treasury bills and Pakistan Investment Bonds ( PIBs). The tenors of treasury bills are three, six and 12- months while those of PIBs range from three to 30 years. Islamic banks, however, have only one liquidity instrument to invest in: government Ijara Sukuk ( GIS), the last auction of which was held in June 2017.
The difference between conventional instruments and GIS is that the former are pure debt securities while the latter has an underlying asset to back it. As of June, the total amount of PIBs and treasury bills held by conventional banks was Rs2.2 trillion and Rs4.8tr, respectively. Islamic banks held GIS worth only Rs368 billion. Banks keep these liquidity instruments to meet their Statutory Liquidity Requirement ( SLR), which is aimed at protecting the institution in the case of a panic run on the bank. Previously, both conventional and Islamic banks were supposed to keep 19pc of their demand and time liabilities in the form of SLR- eligible instruments. But the inventory of Islamic liquidity instruments was depleting. So instead of issuing new instruments, the State Bank of Pakistan ( SBP) revised the SLR requirement downward to 14pc for Islamic banks in November 2016. This has actually sent the wrong signals about the industry. Technically, Islamic banks are now riskier than conventional banks as the former keep a smaller percentage of their deposits in SLR- eligible instruments.
Instead of allocating new assets for the Islamic banking industry, the PML- N took the largest motorway asset out of the domestic market and floated international sukuk against it. Its priorities were clear: foreign exchange reserves were the country's main need while domestic funding could be raised through treasury bills and PIBs. Hence, consideration for the Islamic banking capital market went on the backburner. However, to avert a liquidity deployment crisis at that time, the SBP issued a circular in October 2015 that allowed the Ministry of Finance to buy the sukuk that were maturing in a month's time on deferred payment for one year. This deferred payment purchase by the government - also known as bai muajjal - took out the tradability component from the instrument. Nevertheless, it was SLR- eligible.
In Islamic banking, assets have to be created before liabilities unlike the conventional model. Due to a lack of government-guaranteed SLR-eligible papers, Islamic banks have been forced to finance PSEs at fine rates, raising the risk of non-performing loans. Due to smaller returns on their assets, Islamic banks are finding it difficult to raise deposits at higher rates, resulting in deposit attrition. Also, these institutions don't have the luxury of an interest rate corridor (available to conventional banks) where banks can place funds at a minimum rate or borrow at a maximum rate from the SBP in dire need. Hence, the axiom that the central bank is the lender of last resort to all banks doesn't exist for Islamic banks.
Following measures should be taken to address these problems: the finance ministry should buy sukuk on deferred payment from Islamic banks before maturity and sell them back in the market and then repeat the whole process. Through multiple iterations, Islamic banks will be able to get rid of their excess liquidity. The ministry should also allocate more assets for sukuk. The government should come up with a short- term alternative to treasury bills for Islamic banks. A possible solution can be a product that allows the government to fund its quarterly purchases of crude oil/ furnace oil through the Islamic banking industry by issuing SLR- eligible short- term paper.