How will a transition to interest-free banking work?

The easy part is over. The banking regulator is withdrawing its legal challenge to the decision of the Federal Shariat Court (FSC) to do away with interest-based banking by the end of 2027. Now begins the hard part. Making banking interest-free in five years seems like a task of Herculean proportions. So let's break it down into three specific questions.

One, the very idea of interest-free banking. For the uninitiated, it may sound like an oxymoron: after all, why would a bank lend money to a customer if it's going to receive zero interest on the principal?

Two, how will banking become 100 per cent Islamic in just five years, given that the share of Sharia-compliant banking assets is currently less than 20pc, even after more than two decades of government support?

Interest-free banking doesn't mean the bank operates on a no-profit, no-loss basis. Unlike a conventional bank, which acts purely as a creditor and makes a gain on a loan (read: interest), the bank-customer relationship in Islamic banking changes according to the mode of finance and the nature of the facility.

Islamic banking is essentially asset-backed. Instead of giving cash to a customer to buy a car, an Islamic bank buys the car itself and rents it out to the customer and gradually transfers the asset's ownership over a period of time. In other words, the bank becomes the "lessor" and the customer becomes the "lessee".

The way the transaction is structured may possibly generate the exact same return to both conventional and Islamic banks. But the roundabout way of letting a customer own a car makes the whole process Islamic, experts say.

"Islam prohibits interest, not trade. The banking process matters. Islamic banks aren't money lenders. They operate as trading and investment houses," Meezan Bank Ltd Senior Executive Vice President Ahmed Ali Siddiqui told.

State Bank of Pakistan's former governor Dr Ishrat Husain publicly expressed his disappointment with the Islamic banking industry last year, saying it had fallen "short of expectations".

In a phone interview on Thursday, Dr Husain reiterated his view that the banking industry should have achieved "30-40pc conversion" in the 21 years since he awarded the first Sharia banking licence to Meezan Bank Ltd in 2001.

"With the latest development, I think the pace of conversion will accelerate. Conventional banks have only five years. Faysal Bank Ltd has already converted and other banks will now be under pressure to make the transition," he said.

Faysal Bank will become a full-fledged Islamic lender by the end of 2022 after ringfencing its residual conventional loan portfolio. It is in the process of surrendering its conventional banking mandate and becoming the country's sixth Islamic bank. In addition to the existing five players, as many as 17 conventional banks currently operate their Islamic banking branches in Pakistan.

According to Faysal Bank Chief Financial Officer Syed Majid Ali, there's never been a conversion of a conventional bank to an Islamic bank at such a "massive scale". The size of Faysal Bank's balance sheet was Rs997 billion at the end of June. The conventional lender took five years to fully make its business 100pc Sharia compliant. The first step the government is expected to take to make the banking sector conform to Islamic principles is the transition of its own ministries and institutions to Islamic banking.

"The government should announce the plan for converting National Bank of Pakistan into a Sharia-compliant entity," Mr Siddiqui said, referring to the state-owned bank that had, until recently, opposed the transition by mounting a legal challenge to the FSC decision.