KARACHI: The modaraba sector has become uncompetitive owing to its overreliance on archaic models of business with little focus on fin-tech and modern distribution channels, according to the regulator of the corporate sector.

In its detailed diagnostic review of Islamic finance in the country’s non-banking financial sector released a few days ago, the Securities and Exchange Commission of Pakistan (SECP) said modarabas should “rethink” their business plans and look for new opportunities following the recent removal of tax exemptions.

Like mutual funds, Modarabas are also collective investment schemes. Investors give funds to modaraba management companies against certificates (or shares) and earn proportionate returns.

But unlike mutual funds that invest mainly in stocks and debt instruments, modarabas are supposed to invest directly in small and medium-size businesses that are unlikely to receive bank financing for various reasons.

Speaking to Dawn on Saturday, Modaraba Al-Mali Managing Shareholder Aftab Ahmad Chaudhry said the country needs business-running modarabas instead of lending-oriented ones.

“Most Modarabas acted like banks and went into lending. They lost money because of a high rate of loan defaults. The industry should’ve focused on commercial enterprises instead,” he said, adding that most entities failed to pay good returns to their investors.

At the end of 2021-22, equity and total assets of the Modaraba sector were Rs25.4 billion and Rs61.4bn, respectively. There’re 28 Modarabas listed on the Pakistan Stock Exchange. But only 11 of the 22 profit-making entities declared a cash dividend for 2021-22, according to SECP data.

The regulator wants the sector to be “flexible enough” to venture into all sorts of Sharia-compliant businesses, including pure financial services, leasing, real-estate development and project-based financing.

But large-scale scams as well as misselling have eroded public trust in Islamic financial services, according to the diagnostic review. “The fraud committed in the name of Modaraba… shattered public trust,” it said while calling for remedial measures from all stakeholders, including law enforcement agencies.

Mr Chaudhry said one of the main reasons for a lack of interest from investors is that the structure of modarabas doesn’t grant voting rights to certificate holders. The non-voting status of certificate holders discourages people from taking exposure to this sector. “The regulators should amend the rules to fix this problem,” he said.

Secondly, Mr Chaudhry said the regulators should steer the Modarabas away from the lending business while nudging them towards commercial activity.

“Distressed modarabas should be merged with successful ones. After consolidation, they should be asked to declare dividends to generate interest among investors,” he added.

Published in Dawn, February 26th, 2023