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Islamic Finance, P2P sharing and their impact on the Banking and Micro Finance Industries in Pakistan

The conventional financial system of the modern world is facing many challenges. Following the recent credit crisis the model used by many investment and commercial banks is being questioned. Gold prices are surging and confidence and trust, two of the most precious commodities are at their record low. The crisis is said to be the worst since 1929. (islamicbanker.com) On the other hand the shariah-compliant banking seems to be flourishing. Shariah-compliant or Islamic banking stands on two pillars, the avoidance of interest (i.e. Riba) and risk sharing and it is these two fundamentals which help avoid liquidity risk and in turn overcome the underlying challenges in the conventional system. With growth rates of 20 -30% (islamicbanker.com) and over 300 institutions established we can safely say that that Islamic banking has gone global. It now accounts for 95% of banking assets in Saudi Arabia, 17 % in Qatar and 15% in Malaysia (islamicbanker.com). There are five basic Islamic financing contracts. 1. Murabaha:(Cost plus) A Murabaha transaction is basically a cost plus profit financing transaction in which a tangible asset is purchased by an Islamic bank at the request of its customer from a supplier. The Islamic bank sells this asset to its customer on a deferred sales basis with a markup that is banks profit. The mark up on the asset cannot be altered during the life of the contract. The Murabaha deals offer enough flexibility to be used in real estate and project financing. 2. Ijara and Ijara wa-Iqtina: (leasing and lease purchase) Ijara and Ijara wa-iqtina are Islamic leasing concepts similar to western operating and finance leases. Ijara is similar to conventional operating lease, where in an Islamic bank (lesser) leases the asset to the client (lessee) for agreed on lease payments for a specified period of time, but with no option of ownership for the lessee. The maintenance and insurance is the responsibility of the lesser. On the other hand, in ijara WA iqtina, lessee has the option of owing the asset at the termination of the lease. In both types of leasing, the lease payments must be agreed on in advance to avoid any speculation. 3. Istinsa: (leasing structured mode) Istinsa is a leasing mode which is used to finance long term or large scale facilities involving like construction of a sugar plant. In this mode, bank could either own the plant and charge the lessee a fee based on profits or sell the plant to the company on a deferred basis similarly like the Murabaha transaction.
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4. Mudaraba: (profit-sharing) Mudaraba is a trust based financing agreement in which an investor e.g. Islamic bank give capital to an agent for a project. Profits are based on prearranged and agreed ratio. In case of loss earn no return and the agent receives no compensation for his effort. 5. Musharaka: (equity participation) Musharaka is similar to a joint venture in which bank and agent jointly invest in some project. They agreed on some prearranged profits and losses. (Zaher and Hassan 2001) According to a report on Islamic Finance by the State Bank of Pakistan (SBP), during the last decade, the Islamic Financial Sector (IFS) has become one of the fastest growing segments of the overall global financial system. The market is becoming increasing diversified and is no longer focused on the basic modes of Islamic financing. Pakistan is no exception. Here, Islamic Finance emerged as a response to both religious and economic needs. Efforts for an interest free economy were started during the 1970s and by the end of 1980s Pakistan had one of the best Islamic finance models in the world. However, the system soon fell apart as it did not adequately address the needs of Shariah compliance. Hence, Islamic Banking was re-introduced in the year 2001 as a parallel system to the already existing conventional models. In 2007, Meezan Bank, a full fledge Islamic Bank with branches all over Pakistan opened its 100th branch in Karachi, marking the start of an era of accelerated growth of Islamic Finance in the banking sector of Pakistan. The top Islamic Banks in Pakistan include Meezan Bank, Albaraka Islamic Bank, Bank Islami Pakistan Limited, Dubai Islamic Bank, Dawood Islamic Bank Ltd. and Emirates Global Islamic Bank Limited. (Wikipedia contributors, 2011) Furthermore, the share of Islamic Banking Institutions Assets Deposits and Financing and Investment in the overall banking system increased to 4.6%, 4.2% and 4.4% respectively at the end of each quarter according to the Islamic Banking Bulletin of State Bank. SBP has played a key role in providing an enabling environment and a level playing field to the Islamic banking industry through the provision of a facilitative regulatory and supervisory framework. The Shariah compliance mechanism is the most comprehensive available in the world. Pakistan is the only country which has issued Guidelines on Islamic agriculture and microfinance. Similarly, SBP is the first central bank to have initiated Shariah-compliance inspection. As a result, the industry has experienced robust growth. SBPs recent achievement of being ranked as the second best central bank in promoting Islamic banking is a reflection of this effort.

SBPs next five years strategy for development of Islamic banking industry envisages rolling out of various international prudential standards developed by IFSB as an important pillar. They have accordingly seized the opportunity by capitalizing on IFSB's expertise through holding such workshops at this juncture. Banks in Pakistan have already adopted Basel II and adaptation of IFSB standards in Pakistan would enable Islamic banking institutions to perform on an equal footing with the conventional industry thereby achieving the ultimate objective of financial stability and soundness at the national level and smooth integration with the international financial infrastructure. New Initiatives for bringing in further Standardization in Shariah practices. 1. Adoption / Adaptation of Shariah Standards developed by Accounting and Auditing Organization for the Islamic Financial Institutions (AAOIFI). The introduction of international players in our Islamic banking industry has further necessitated the need to bring our industry at par with the global Shariah standards. Shariah Standards developed by Accounting and Auditing Organization for the Islamic Financial Institutions (AAOIFI) are an important and effective source available for bringing in the desired standardization in the Shariah practices. In order to bring our industry at par with the international standards and also achieve standardization of Shariah practices locally, a mechanism for adoption adaptation of these Shariah standards has been developed by SBP. According to this mechanism the meetings of Shariah Advisors Forum of are being held with a view to thoroughly study the AAOIFI Shariah Standards one by one, for their possible adoption / adaptation in our market. 2. Instructions & Guidelines for Shariah Compliance: Instructions & Guidelines for Shariah Compliance have been issued vide IBD Circular No. 02 of 2008. Instructions for Shariah Compliance cover regulations in areas related to appointment, duties/ responsibilities and report of Shariah Advisor; conflict resolution in Shariah rulings; permissible modes of financing and investment; essentials of Islamic modes of financing; use of charity fund; introduction of new products & services and schedule of service charges. Guidelines for Shariah Compliance cover areas like Internal Shariah compliance, Internal Shariah Audit; investment in shares; policy for profit distribution with PLS account holders and financial reporting & general disclosure requirements. 3. IFSB Risk Management Guidelines Islamic Financial Services Board (IFSB) promotes the development of a prudent and transparent Islamic financial services industry through introducing new or adapting existing international standards consistent with Islamic Shariah principles. It has issued standards/guidelines regarding Capital Adequacy, Risk Management and Corporate Governance for institutions offering Islamic financial services (other than Takaful). SBP has already adapted Risk Management
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Guidelines for Islamic Banking Institutions vide IBD Circular No. 01 of 2008. Some other Standards (Corporate Governance, Capital Adequacy, Transparency and Market Discipline and Supervisory Review process) are also in process of adaptations

Competition: Porters Five Forces (Tahir & Umer, 2008) Environment can be very big including social, economical and Political but the main environment of the firm is the industry in which firm is operating. For example, for an Islamic bank, banking industry is the main environment. Forces outside the industry are of significant importance in determining the overall efficiency of the industry. These forces effect all the firms in the industry but method of dealing with these forces vary from firm to firm. The state of competition for a company depends on the fives competing forces. The overall strength of these forces determines the success and progress of the company. (Porter 1980) The strength of these forces varies from company to company, it is very deep in the companies like paper and food where competition is very intense and it is very low in the companies like oil field equipment and car manufacturing. Competition in the Islamic Banking Industry can be judged by the following market forces within the Islamic Banking Industry. y Intensity of Rivalry: Islamic Banking is now available in more 16 big cities of Pakistan; however conventional banks have branches all over Pakistan including small and big cities. As far as product differentiation is concerned, even though commercial banks are mostly interested in the corporate sector, most of the new entrants are also opening Islamic branches. Also, the products developed by Islamic banking are most based on Ijarah and Murabah which are similar to leasing and cost plus sale of assets, respectively. Threat of new entrants: Despite the suspension order of issuance of new bank licences by the State Bank of Pakistan, foreign interest in Pakistans banking sectors seems to grow due to the untapped potential market of financial services present in the country. Weve seen many acquisitions in the conventional sector and the Islamic bank seems to be attracting a lot of interest from foreign Islamic banks, especially from Malaysia. On the other hand, a barrier to entry is the high distribution Costs and legal expenses of Islamic banking due to their dependence on the Shariah Board with lacks financial experts. In conclusion, threat to new entry in Islamic banking sector is moderate. Barriers are not too high to enter the market. Bargaining Power of Buyers: Islamic banking targets both individuals and institutions and its clients are usually categorized according to their religious motivations. Some are totally religiously motivated, some are partially profit orientated and a large majority which is mostly the corporate buyer, is totally profit oriented. Islamic Banks in Pakistan are mostly not able to offer higher profits which are why they mostly market themselves to the religiously motivated buyers. The totally religiously motivated buyer is profit
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inelastic whereas the partially motivated isnt and can easily shift to conventional banks services because switching costs are very low. Bargaining Power of Suppliers: The bargaining power of suppliers is highest in Islamic banking sector. As already mentioned above, there is a shortage of Shariah Scholars and trained Islamic finance professional in the country, and the ones that are available expect higher compensations as the conventional bankers. Moreover, due to lack of awareness there is also a shortage of investors in Islamic banking which results in higher cost of funds. Threat of Substitutes: Different microfinance banks are getting licenses in Pakistan and SBP is also encouraging them to come in. But the growth of other Islamic financial institutes is very low as compared to Islamic banks. (Tahir & Umer, 2008)

This trend has brought with it a race towards product development and creativity in the banking models and it goes hand in hand with an increasing trend of micro finance institutions both in the form of Strategic CSR activities and sustainable business subsidiaries of banks all over the world. Around the world millions of people are living without the financial services many take for granted. Without access to loans, savings accounts insurance and funds transfers the obstacles to overcoming poverty can be insurmountable. There is a movement underway to provide financial services to customers that financial institutions dont serve. This is called micro finance. One of the important facets of micro finance is micro credit. It may not be the only solution to poverty but sometimes this is all it takes to help a person become profitably self employed. Micro finance and micro credit which are often used interchangeably are both being subsidized as poverty alleviation tools in most developing countries. The model is based on the triple bottom line approach that focuses on people, profit and the planet and has the power to single-handedly defeat poverty. Industry Overview Pakistans microfinance industry is globally recognized for its legal, regulatory and strategic framework thanks to the efforts of the State Bank of Pakistan (SBP) since the year 2000. According to SBP, Eight Micro Finance Banks have been established and two of the worlds largest Microfinance Institutions have started their operations in Pakistan yet the current outreach is 2 million people which are only 7% of the potential market. According to the annual report of Pakistan Microfinance Connect, by December 2009, the combined assets of Pakistans microfinance industry were approximately PKR 35.4 billion (USD 0.42 billion). The gross loan portfolio (GLP) totaled PKR 20.2 billion (USD 0.24 billion), while outreach stood at approximately 1.73 million active borrowers, and 0.46 million active depositors.
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Pakistans micro finance industry as compared to India and Bangladesh is very small in terms of its balance sheet size and outreach. Indias Micro finance industry had an Asset base of approximately 5.1 billion USD, Bangladesh 3.5 billion USD whereas Pakistan has asset base of only 0.4 billion USD. However with more than 27 million potential customers the market opportunity is extremely high. The Competition The industry is characterized by three types of Micro finance Providers; Micro Finance Institutions (MFIs), Micro finance Banks (MFBs) and Rural Support Programs (RSPs). MFIs RSPs are basically non-banks non-government organizations (NGOs) providing micro finance service whereas MFBs are commercial banks licensed and regulated by the central bank of Pakistan to exclusively provide micro finance. The difference between MFIs and RSPs is that RSPs have a rural focus and are supervised by the securities and exchange commission of Pakistan. There are seven MFBs, fourteen MFIs and four RSPs currently operating in Pakistan out of which approximately 85% of industry assets are concentrated within seven organizations namely, Kushhali Bank Ltd.(KBL), The First Micro Finance Bank Ltd. (FMFB), National Rural Support Program (NRSP), Kashf Foundation (KF), Tameer Micro Finance Bank Limited (TMFB), Punjab Rural Support Program (PRSP) and Kashf Micro Finance Bank Ltd. (KMFB). The recent slowdown in microcredit growth is mainly attributable to the following constraints: (State Bank of Pakistan)

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Funding: MFIs are largely dependent upon subsidized funding from Pakistan Poverty Alleviation Fund (PPAF) to finance their lending operations which is limited. Similarly MFBs, owing to slow progress in deposit mobilization, have not yet become sustainable in generating internal funding. The sector faced difficulty in accessing commercial funds mainly from the risk averse commercial banks during 2009. However, the SBPs Microfinance Credit Guarantee Facility has been instrumental in mobilizing sizeable wholesale funds from the commercial banks to the microfinance sector recently. High operating costs: The sectors high operating cost to loans ratio (presently 22%) poses a key challenge to make microfinance a viable business model. A reliance on brick and mortar branches and extensive human resource base has been adding significantly to high operating costs. Credit Risk: Overall credit portfolio quality of the sector remains satisfactory. However, rapid growth in 2007 and 2008 led to multiple microfinance institutions
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lending to the same clients in a saturated market. Due to lack of appropriate internal controls, the phenomenon of over borrowing by clients has the potential to spread, and create spillover effects. In addition, high inflation is affecting the repayment capacity of micro borrowers and the increasing trend in pricing of microcredit may also create default risk. iv. Organizational Development: Sustainable growth and organizational development go hand in hand. By and large, the existing quality of governance, management teams, technology, and internal control systems of microfinance players are not conducive to the required level of growth. External factors: Challenging macroeconomic environment and the prevailing law and order situation in the country are also inhibiting the growth of microfinance sector. To address these challenges, the microfinance sector needs to be more innovative, more efficient, and more transparent.

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The following strategic framework laid down by the SBP provides a road map for sustainable growth of the sector for the next five years: i. Diversity: There exists a broad based government commitment to financial inclusion to promote inclusive economic growth. It will be important to continue implementation of policy approaches that provide the incentives for sustainable financial access and usage of a broad range of services (savings, credit, payments and transfers, insurance). The industry needs to shift away from the credit only approach and offer comprehensive financial services such as micro savings, remittances, and micro insurance. Innovation: Both the policy makers and microfinance players are keen to promote technological and institutional innovation as a means to expand financial system access and usage. SBP will soon launch a Financial Innovation Challenge Fund under the auspices of the UKAid sponsored Financial Inclusion Program (FIP), to support institutional and technological innovations in the industry. To reduce operating costs and attain rapid scale, microfinance players may leverage mobile phone technology and agents networks. Such platforms would also help them undertake specialized business proposals, for instance, financially inclusive Government to Persons (G2P) payments. SBP will encourage models that promote branchless banking. SBP will also establish and lead a formal consultative forum of key stakeholders on branchless banking. The consultative group will create synergies, facilitate sector innovations and market development, and develop collective understanding on critical issues.

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Funding: Deposit mobilization will be critical for the long term development of microfinance. However, in the short to medium term, SBP and PPAF, in collaboration with interested donors, will jointly develop funding plans for the sector. The funding base of the existing credit enhancement instruments will be further augmented. To expand deposit operations of MFBs, SBP will consider allowing access to banking payment systems and developing deposit protection schemes. Enterprise lending: Lending operations must extend to different economic and geographic segments. SBP will issue regulatory guidelines to MFBs for up scaling of loans, and develop a reporting structure to assess the geographic distribution of microfinance growth. Donor funding can support product development and market surveys. The envisaged growth in portfolio would also require the development of robust risk management systems within microfinance organizations. The pilot MFCIB in Lahore is expected to be extended to the rest of the country. This would minimize the incidence of clients over indebtedness. Organizational Development: Sustainable growth and organizational development go hand in hand. By and large, the existing quality of governance, management teams, technology, and internal control systems of microfinance players are not conducive to the required level of growth. External factors: Challenging macroeconomic environment and the prevailing law and order situation in the country are also inhibiting the growth of microfinance sector. Institutional development: Specific institutional strengthening and capacity development needs of individual players will be identified and assistance provided under the existing FIP Institutional Strengthening Fund. Consumer protection and empowerment: SBP will review and strengthen its regulatory and supervisory processes to ensure protection of microfinance clients rights. In addition, SBP in close collaboration with key stakeholders would launch a nation wide financial literacy program to create awareness amongst clients about banking products and services and their rights. Corporate Governance: The microfinance organizations will have to improve governance standards for better strategic direction, effective oversight, and strong internal controls.

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Minimum regulation of MFIs: The unregulated microfinance sector still constitutes a significant market share, and hence carries reputational risk owing to potential poor credit decisions and/or undesirable consumer protection practices. Therefore, a feasibility study will be conducted to bring the un regulated MFIs into a minimum regulatory framework. This will improve the sector wide discipline, transparency, and governance.

The Future of Micro Finance in Pakistan Islamic Micro Finance With the increasing trend of Islamic finance and micro finance in the banking sector of Pakistan the future of Banking seems to be a mixture of both. Conventional microfinance products have been very successful in Muslim majority countries. One of the earliest microfinance programs originated in Bangladesh with the experience of the Grameen Bank initiated by Nobel Prize winner Mohammed Yunus. Islamic countries, such as Indonesia and Pakistan, have a vibrant microfinance industry; approximately 44 percent of conventional microfinance clients worldwide reside in Muslim countries. Yet, conventional microfinance products do not fulfill the needs of many Muslim clients. Just as there are mainstream banking clients who demand Islamic financial products, there are also many poor people who insist on these products. Indeed, Sharia compliance in some societies may be less a religious principle than a cultural oneand even the less religiously observant may prefer Sharia compliant products. The Islamic Micro Finance Industry would be able to deliver greater value and probably alleviate poverty more efficiently and effectively because its interest-free, and the poor will not feel exploited at all. Moreover, Islamic finance is based on risk sharing and Islamic micro finance institutions could offer loans based on musharakah which is basically the securitization of investments and selling of ownership shares in the form of savings accounts. This type of a model does not restrict the clients rate of return and may be very attractive for the nonentrepreneurial poor. Also, Islamic micro finance itself is based on serving the economy and the value system is such that a micro finance institution based on Islamic micro finance wouldnt have to spend much on organizational development and in turn be able to cut costs. Lastly, Islamic micro finance institutions if deciding to fund through Sukuk certificates (which are like bonds in the conventional system) they will have to create SVPs (like investment houses in the conventional system). This type of a model provides low credit and low liquidity risk to the MFI. Hence, Islamic micro finance institutions with greater deposit mobilization, market outreach and interest free loans will attract foreign investment from Muslim banking all over the world and the market is likely to be characterized by healthy oligopolistic competition and can serve as the backbone of the economy by alleviating poverty. In short, MFIs can find Islamic finance a natural fit in their programs both debt and equity based.
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Peer to Peer Sharing and Micro Finance Recently, the trend of cloud computing and the formation of a global network that has triggered transformations in the music and publishing industry seems promising for the micro finance industry. Websites like Kiva.org, Prosper.com and Lendingclub.com have already taken the initiative of using peer to peer sharing models for micro financing and their models have positive implications for the micro finance sectors all over the world. Taking the example of Kiva.org, it is a non-profit organization with a mission to connect people through lending to alleviate poverty (Kiva). Kiva operates on a simple model of P2P sharing. By merely clicking on a button anybody can help a person listed with Kiva by lending through their Paypal accounts an amount as less as $25. This amount is transferred to the account of a micro finance institution (field partner) near the borrower. When a hundred people, all lend $25 it makes a large amount of money that can be used to fund larger loans. The repayment is made within no time and the payments are collected by the micro finance institutions, returned to you by Kiva and insured by Paypal. Since its creation in 2005, it now has 577,344 lenders and $210 million in loans with 132 field partners in 60 countries. If brought to Pakistan P2P Micro finance may offer solutions to the various problems faced by Pakistans Micro finance sector by leveraging the internet and a worldwide network to trigger changes in the industry structure. Traditionally micro finance institutions in Pakistan are being funded by donors but this form of funding is limited and unsustainable which is why the industry requires permanent sources of funding, the availability of which is restricted due to the following: a) Commercial Banks, which a major source of funding for the sector in many developing countries, lack experience and know-how of the micro finance sector and are highly risk averse due to inter alia, tight liquidity conditions. b) Even though Micro Finance Banks have the license to mobilize deposits they have been unable to do so at a large scale. c) The Pakistan Poverty Alleviation Fund (PPAF) is a funding body to the meet the needs of the sector but its funding is restricted to non regulated MFIs only and the body itself does not have sustainable sources of funds because it is being funded by the World Banks loans obtained by the Government of Pakistan. P2P sharing can very well resolve the problem of funding in the micro finance industry of Pakistan which may in turn encourage commercial banks to enter this industry. Commercial Banks with their large deposit bases will then dominate the micro finance industry. Once the industry is commercialized and not dominated by NGOs and RSPs more value will be created and the consumer being the sovereign due to lower switching costs of P2P micro finance banking will get to choose between different models.

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Technological developments in the industry like Easy Paisa by Telenor or a micro finance model that cashes on P2P sharing could decrease operational and organizational development costs of the industry players. Operational and organizational development costs of maintaining Brick and mortar branches of Micro finance institutions especially in the rural areas consists of a large proportion of the total costs of production of an MFP and if P2P sharing is able to decrease them, it could boost the deposit mobilization and outreach of micro finance industry. On the flip side we need to consider the fact that the target market of micro finance institutions in Pakistan is mostly concentrated in the rural areas where literacy levels are very low. Hence, P2P sharing if brought to Pakistan will be more of a funding source for Micro finance Providers and will hardly play a role in the cutting costs, yet if executed properly it could lower the cost of funds for micro finance institutions and in turn play a major role in poverty alleviation.

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Bibliography
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