One of the drawbacks of the modern economic system is how it rewards certain professions over others, completely detached from the underlying utility; for example, school teachers earn a fraction of what treasury bankers do.

One of them commits their entire lives to building the future of coming generations while the other sits at a desk all day putting public money in ‘risk-free’ government securities and pretends to be part of the high-finance community.

On a completely unrelated note, the advances-to-deposits of full-fledged Islamic banks in Pakistan fell to just 48.7 per cent by the end of 2023, while that for window operations reached 50.9pc. Though still slightly better, the ratios are converging with the conventional industry, which stood at 44.4pc.

This has been the most prominent theme in Pakistan’s Islamic banking, which was nascent until a few years ago. Locked out of government securities for the most part, it made money by lending to individuals and businesses.

Perhaps seeing their conventional counterparts make a killing without too much effort motivated Islamic banks to join the bandwagon. With high interest rates and the ever-growing fiscal needs of a cash-strapped government, the choice was quite clear: double down on risk-free securities and cut back on lending.

Over the last five years, more than 30pc, or Rs 4.5tr, of all new deposits have been Islamic, as some big names in the conventional banking sector have aggressively shifted towards Shariah-compliant finance

Unlike conventional banks, Islamic banks had a big advantage: there was no minimum deposit rate (MDR), so they could pay a much lower return (or whatever they want to call it) to customers. In Q4FY23, almost a quarter, or Rs6.7 trillion, of all banking deposits were Islamic. Out of this, around two-fifths of the customer money was in the current accounts anyway — ie at zero cost. Another Rs2.4tr was in savings accounts where the prevailing remuneration was lower than the rest of the industry.

This gave Islamic banking an edge over the rest, so much so that everyone has started following suit. Over the last five years, more than 30pc, or Rs 4.5tr, of all new deposits have been Islamic, as some big names in the conventional banking sector have aggressively shifted towards Shariah-compliant banking.

Similarly, the Shariah factor in terms of new branches is even stronger. Between 2019 and 2023, Pakistani banks opened 2,714 net branches, of which 2,104 were Islamic. That’s more than three-fourths of all new branches and does not incorporate the 634 additional windows.

An ever-growing part of this network is simply being used to collect cheaper deposits and then use them to fund the government’s fiscal misadventures. In the last five years, full-fledged Islamic banks have increased net investments by Rs2.6tr, or twice as much as their financing. As a result, the investments-to-deposits (IDR) ratio has tripled to 63.5pc by 2023 from 21.4pc. This is an improvement compared to the overall industry’s IDR of over 90pc.

Between 2019 and 2023, Pakistani banks opened 2,714 net branches, of which 2,104 were Islamic

Plus, the reason this IDR is lower is not because Islamic banks don’t want to put more money in sovereign papers but that there aren’t enough Shariah-compliant avenues available. With the government planning to make the financial system completely Islamic by 2027, that will obviously change, and the hedge fund managers will double down on capital deployment.

The challenge with banking, whether Islamic or conventional, lies in the dominance of the opportunity cost of treasury. The Shariah-compliant segment often faces more scrutiny, possibly due to concerns about the treatment of depositors. However, it’s encouraging to see that the government has recognised this issue and has suggested the possibility of removing the minimum deposit rate exemption for these banks.

However, this adjustment will primarily help reduce the profitability gap between conventional and Islamic branches. The more significant challenge lies in the overall approach to banking. Beyond credit concerns, which can be influenced by interest rates and macroeconomic factors, there’s a notable reluctance among institutions to facilitate the opening of basic accounts.

Just consider the fact that scheduled banks opened only a little over 134,000 net accounts during FY23. Consider that it is most likely that executives of the same institutions spoke at many conferences about the importance of financial inclusion. Transitioning Pakistan towards Shariah-compliant finance wouldn’t change the industry’s DNA.

Published in Dawn, The Business and Finance Weekly, May 27th, 2024