OPINION: Pakistan: legal challenges to Islamic banking

Islamic banking has emerged as a significant segment of Pakistan’s financial system, serving both faith based and commercial objectives by mobilising substantial domestic capital.

Since its formal introduction in Pakistan in 1979, the industry has grown to claim a meaningful share of the banking sector, with assets and deposits running into trillions of rupees and a gradually expanding institutional footprint.

Despite this scale of evolution, it is yet in a struggling phase because of the structural, regulatory and specifically, the legal challenges, which require consideration of the legislation.

The said consideration is required for strengthening the subject legal framework as well as to address the transitioning of the conventional banking into Islamic banking, in accordance with the judgement of the Federal Shariat Court, passed in the year 2022, cited as PLD 2023 — Federal Shariat Court 47. The judgment has directed the government to transition Pakistan to a completely interest-free economic system within five years.

The judgment has reaffirmed that interest (Riba) in banking is prohibited (haram) under Islamic law (Sharia) and expressly directed the government to move towards an interest-free economy.

The review of the Pakistan legal framework shows that banking in Pakistan is governed mainly under the Banking Companies Ordinance, 1962 (the “Ordinance”), which serves as the principal law to regulate this sector, including defining the “banking” / “banking business” and the business that the banks can conduct. Interestingly, the Ordinance did not have a dedicated framework for Islamic banking until the enactment of the Banking Companies (Amendment) Act, 2024, through which Parliament introduced an exclusive Part (Part II-A) on Islamic banking, marking the first formal legislative basis for Islamic banking, although the State Bank is reportedly reviewing numerous existing laws to formalize this mandate.

Prior to the enactment of the Banking Companies (Amendment) Act, 2024, Islamic banking was regulated primarily through guidelines, circulars, and administrative directions issued by the State Bank of Pakistan.

The newly inserted Part II-A introduces a formal framework for Islamic banking; however, its scope remains limited, as it sets out only foundational principles and largely relies on earlier provisions of the Ordinance. For example, the newly introduced Part II-A has though provided that what could be the permissible business activities of Islamic banks; however, it did not provide a distinct and comprehensive statutory framework on the subject but simply provides that the businesses should be consistent with the Sharia Principles as specified by the State Bank and the Ordinance.

This deficient framework for Islamic banking is causing legal adaptability of the banking products offered by Islamic banks.

The legal framework provides minimal statutory definitions for Islamic banking products on both the deposit and financing sides. For example, in Diminishing Musharakah structures, Islamic banks are recognized as beneficial owners of the underlying assets for economic and risk purposes, whereas the legal ownership is retained by the customers. However, there is hardly any relevant legal definition of “beneficial ownership” available in any law, for this purpose.

SBP though once tried to include this definition in a draft law on foreclosures, during the Covid-19 period; however, the effort did not materialize. Similarly, there are rarely any legal provisions, which can define Islamic financing products such as Musawamah, Tawarruq, Bai Salam, Istisna, or Shirkat-ul-Milk/Shirkat-ul-Aqd. As a consequence, these gaps lead to low public awareness, conceptual ambiguity in masses, and legal complications in recovery cases instituted by the Islamic banks against defaulters.

These result in a fundamental disconnect between the advanced structures of Islamic finance and the understanding of banking courts in adjudicating default cases. The initial legal framework for recovery was based on a simplistic model, primarily addressing basic financing modes such as Murabaha (cost-plus financing) and Musharakah (partnership-based financing). Under Murabaha, banks purchased goods and sold them to customers at a deferred, marked-up price, acting as traders rather than lenders.

The documentation clearly recorded the purchase and sale prices, reflecting the transaction’s nature, but such simplicity differs sharply with the complexity of modern Islamic financing structures.

This straightforward model was easily comprehensible within the then existing legal framework, i.e. Banking Tribunals Ordinance, 1984. When defaults occurred, the recovery was based on the difference between the Purchase Price, the amount already paid by the customer and the outstanding Sale Price.

Eventually, the Banking Tribunals, while hearing & decreeing the cases were just relying on Purchase Price and Sale Price of underlying assets. This aspect remained so in the subsequent banking recover law, i.e., Banking Companies (Recovery of Loans, Advances, Credits and Finances), 1997 and even in the present law, i.e. Financial Institutions (Recovery of Finances) Ordinance, 2001.

However, the simplicity of this early model is not working now. As the market demanded more sophisticated financial products that could compete with conventional banking offerings, Islamic financial institutions began developing complex instruments, while maintaining Sharia compliance. Therefore, Islamic banks have evolved from the basic sale-based model to offer many other products, including, as an example, Diminishing Musharakah where the bank and customer jointly acquire an asset and the customer gradually buys out the bank’s share, a model increasingly used for home financing.

In this structure, the underlying asset is divided into units, which the customer purchases over time, shifting the financing framework from a simple sale of physical assets to the gradual transfer of unit ownership.

This unitization approach offered several advantages. It provided greater flexibility in structuring transactions, allowed for easier secondary market trading of Islamic financial instruments, and enabled the creation of investment vehicles that could pool various assets.

However, it also introduced a level of abstraction that moved significantly away from the original Purchase Price and Sale Price paradigm. Here came the Judicial Disconnect, i.e., when banking courts adjudicate default cases involving Islamic financing, they typically apply the same framework used for the original sale-based Islamic financing model. They look for the Purchase Price, Sale Price, and calculate the recovery amount based on this simple arithmetic.

The present recovery law (FIRO, 2001) simply refers vide Section 9 (3) to (a) the amount of finance availed by the defendant from the financial institution, (b) the amounts paid by the defendant to the financial institution and the dates of payment? and (c) the amount of finance and other amounts relating to the finance payable by the defendant to the financial institution up to the date of institution of the suit.

However, in unitized structures or complex Diminishing Musharakah arrangements, these concepts do not translate directly, since the said provisions don’t take into account the units & units’ price, which the delinquent customer was obliged to purchase and thus making payment to the bank. In this context, consider a scenario where a customer has defaulted on a Diminishing Musharakah home financing arrangement.

The bank and customer jointly owned the property and the customer had been making regular payments to acquire the bank’s share over time. Additionally, customer also paid rent for using the bank’s portion of the property.

However, when default occurs, calculating the outstanding amount requires considering multiple factors: the remaining bank ownership share, accrued rental payments, any early payment adjustments, and the current market value of the property.

Nevertheless, a court while attempting to adjudicate such a case through the lens of Purchase Price / Sale Price will inevitably struggle as the transaction was never a simple sale; it was a partnership arrangement with rental and ownership transfer components.

The present legal framework, therefore, does not provide adequate tools for such adjudication.

The example of Diminishing Musharaka is just an illustration. These issues frequently arise in the default cases of other Islamic financing products, more specifically in Sukuks cases and for certain other products where there are two stages (i) advance and (ii) finance. In the case of advance (for example in Istisna), Courts don’t recognize the transaction without financing agreements, which is a later stage as per sharia.

Therefore, this judicial disconnect has profound implications for the growth and stability of Islamic banking in Pakistan. Firstly, it creates legal uncertainty that discourages both banks and customers from engaging in Islamic financing.

Secondly, Banks find it difficult to recover their legal dues through legal channels, while the customers may face unfair treatment when courts misunderstand the nature of their obligations. Then it undermines the integrity of Islamic banking as a distinct financial system, as well. When the courts treat sophisticated Islamic instruments as simple sale transactions, they ignore the Sharia principles that distinguish these products from conventional financing.

Further, it creates asymmetric outcomes in the justice system. Conventional banking cases, well-understood within the established legal framework, receive more predictable and often more favourable treatment. This disparity disadvantages Islamic financial institutions in their efforts to compete with conventional banks.

Addressing this challenge requires a multi-pronged approach involving legislative reform, judicial education, and institutional development.

Legislative reforms should be the priority. Pakistan needs comprehensive legislation specifically designed for Islamic banking dispute resolution. This legislation should recognize the various modes of Islamic financing, provide clear guidelines for calculating recovery amounts in each mode, and establish procedures that respect the unique characteristics of Islamic financial instruments.

Additionally, judicial education represents another critical intervention. Banking Courts’ presiding officers should receive specialized training in Islamic finance principles and practices. This training should not be a one-time orientation but an ongoing professional development requirement, given the continuous evolution of Islamic financial products.

Furthermore, the State Bank of Pakistan, as the regulator of Islamic banking, should take a more active role in providing guidance to the judiciary. This could include issuing guidelines explaining new Islamic banking products, their structure, and the appropriate framework for understanding defaults and recovery in each product type.

Addressing these challenges is not merely a technical legal matter; it is essential for the credibility and growth of Islamic banking in Pakistan. Without proper legal infrastructure, Islamic banking will continue to operate under a cloud of uncertainty, unable to fulfil its potential as a genuine alternative to conventional finance.

The solution of these challenges lies in recognition of the problem by all stakeholders, followed by concerted action to reform legislation, educate the judiciary, and build institutions capable of supporting the continued evolution of Islamic finance. Only then can Islamic banking in Pakistan move beyond its prolonged infancy and mature into a robust financial system.

Copyright Business Recorder, 2025