Pakistan’s push for interest-free banking faces challenges

Pakistan is aiming to implement an interest-free Shariah-compliant banking system by January 2028. While the ambition reflects a momentous shift toward an Islamic values-based financial system, practitioners caution that unresolved challenges could undermine the transition.

Renewed political will
In April 2022, the Federal Shariat Court (FSC), the country’s constitutional Islamic religious court, ruled that the entire banking system must be completely free of riba – more commonly known as interest - by the end of 2027. The court instructed federal and provincial governments to amend relevant banking laws to comply with the Shariah legislation. 

The directive, however, wasn’t the FSC’s first attempt to push for a fully Islamic banking system. The religious court made an initial declaration in 1999, notes Dr Sanaullah Ansari, CEO of Al-Iqtisad Consulting, only for it to be delayed by later governments through appeals and legal reviews. 

“This process continued and finally, in April 2022, FSC ordered the government to convert the current conventional banking system by December 31, 2027,” he says. 

However, this time there is adequate political will to introduce Islamic banking, complemented by a clear roadmap accorded by the State Bank of Pakistan (SBP), the country’s central bank. Following the FSC’s decision, the SBP released its five-year plan (2023–2028), setting ambitious goals to transform the conventional banking sector. 

There are currently 22 banks operating in Pakistan, including six fully-fledged Islamic lenders. Many of the remaining conventional banks either operate Islamic windows or have started planning for a full conversion. United Bank Limited (UBL) and Faysal Bank have transitioned, while Bank of Khyber and National Bank of Pakistan are en route. Others like Bank of Punjab are also exploring the shift.

In parallel, the Securities and Exchange Commission of Pakistan (SECP) - the country’s financial regulatory agency - introduced the Shariah governance guidelines in January 2023.

These apply to non-banking financial companies, Takaful operators, and private pension funds, with the aim of deepening Islamic capital markets.

Sovereign debt, coordination mar outlook 
Pakistan is the second-largest Muslim-majority country in the world. However, despite strong numbers, financial inclusivity across the country is fairly tepid. The country’s sovereign debt profile is another critical factor; the IMF notes that government debt stands at 71.4% of the Southeast Asian nation’s GDP, much of which is denominated in conventional, interest-bearing instruments.

“Most of the government’s liabilities are in conventional form,” says Mohamed Damak, head of Islamic Finance at S&P Global Ratings. “The government could choose to issue only sukuks going forward to refinance all commercial debt and net new borrowings, assuming that the market appetite for these instruments will be there.”

Damak adds that a significant portion of the debt is in the form of multilateral loans, bilateral loans, and central bank swap lines, with some of the multilateral loans having very long-term tenors. “It remains to be seen if and how these can be converted or structured in a Shariah-compliant format,” he adds.

Farrukh Raza, CEO of Islamic Finance Advisory & Assurance Services (IFAAS), believes that renegotiation is likely to take time due to legal and risk concerns from creditors, as well as the complexity of restructuring existing debt. “Stakeholders need to stay focused and resolve these matters as soon as possible.” 

Despite steps taken by the SBP and SECP, several market practitioners highlight a lack of coordination between key institutions and an absence of clear, realistic timelines.

“There needs to be a more well-thought-out process with a realistic plan and determined goals,” says Raza. “There needs to be better coordination with policies and implementation among the different entities in the country.”

He outlines three critical requirements for a successful transition.

“There needs to be a political will to genuinely support this transition and all stakeholders to be aligned on making it happen,” he says. 

“Secondly, you need a well-structured roadmap with clear targets and timelines for everyone to understand and work towards. Thirdly, you need to create a national champion among state institutions to own, lead and deliver this transition.”

This lack of coordination is closely tied to insufficient communication. Public engagement has been limited, with few workshops, conferences, or awareness campaigns to educate stakeholders about what this transition entails, according to Ansari.

“While the SBP and SECP have done valuable work, the broader market is still unclear about how this transition will play out,” he says. “Without consistent messaging and cooperation between players, implementation by 2027 will be difficult.”

Changing perceptions
A significant challenge lies in public perception. Many consumers raise doubts on the veracity of the Islamic banking system, considering it a repackaged version of the conventional banking system. This lack of trust dents its uptake as well as its credibility. 

Ansari notes that many banking customers question whether there is a meaningful distinction between Islamic and conventional products. “Whilst a lot of work has been done to facilitate Islamic banking, there is still a perception that it is merely a replication of conventional banking,” he says.

Sceptics also point to challenges in countries that have adopted Islamic financial systems, including Iran, Sudan and Afghanistan, though Raza believes comparisons with those countries to be unfair. 

“It’s not fair to compare Pakistan’s transition with these countries because all of them remain challenged on the international stage,” he says. “The issues they face are political in nature and not due to their financial systems being Shariah-compliant.”

Creating goodwill through education and awareness in addition to a clear timeline and roadmap to assimilate these changes thus remains key.