Islamic banking – Pakistan – legal framework challenges

The Islamic banking sector has emerged as one of the fastest growing segment of modern finance, built on Sharia principles that prohibit interest and prioritize asset backed, risk sharing financial structures. The global Islamic finance industry exceeded US$5.5 trillion in total assets in 2024, with Islamic banking constituting the dominant share of this market. The industry data from the Islamic Finance Development Indicator, published by LSEG in collaboration with the Islamic Corporation for the Development of the Private Sector, confirms that Islamic banking represents approximately 72 percent of total Islamic finance assets and is now present in 84 markets worldwide. The largest Islamic finance jurisdictions by asset size are led by Iran, Saudi Arabia, and Malaysia, which together account for around US$4.3 trillion of global Islamic finance assets. Islamic banking is therefore most systemically significant in jurisdictions where it is embedded directly within national banking law and central bank supervision frameworks, including Iran under the Law for Usury Free Banking (1983), Malaysia under the Islamic Financial Services Act 2013, Saudi Arabia under the Banking Control Law (Royal Decree No. M/5) together with the Saudi Central Bank’s Shariah Governance Framework, the United Arab Emirates under federal central bank legislation establishing Sharia governance oversight, Kuwait through amendments integrating Islamic banks into Law No. 32 of 1968 and Central Bank of Kuwait instructions, Qatar under Law No. 13 of 2012, Bahrain under the Central Bank of Bahrain Rulebook Volume 2 for Islamic Banks, Turkey under Banking Law No. 5411 governing participation banks, Indonesia under Act No. 21 of 2008 on Sharia Banking, and Pakistan within the broader banking law framework under the Banking Companies Ordinance, 1962, supported by State Bank of Pakistan regulation and supervision.

At a structural level, the global financial system operates through two banking models that may appear institutionally similar but diverge fundamentally in philosophy, ethics, and economic purpose. The conventional banking is organized around interest-based lending, risk transfer mechanisms, and profit maximization, treating money as a commodity capable of generating returns independent of productive economic activity. On the contrary, Islamic banking challenges these assumptions by prohibiting interest, emphasizing shared risk, and linking financial transactions to tangible assets and productive enterprise. This distinction creates not only contractual differences but a deeper conceptual divide in how finance is expected to function within society. Where conventional finance prioritizes efficiency, scale, and capital accumulation, Islamic banking places ethical controls, social responsibility, and distributive fairness at the center of financial decision making. This divergence reflects competing views on how risk should be allocated, how capital should be rewarded, and how financial systems should serve the broader economy rather than operate in isolation from it.

Despite these philosophical differences, both systems operate within a shared legal architecture that defines the institutional meaning of banking in surprisingly consistent terms across jurisdictions. Banking law is almost universally structured in two core functions: the acceptance of deposits and the lending or advancing of money. Pakistan’s Banking Companies Ordinance, 1962 defines banking as “the accepting, for the purpose of lending or investment, of deposits of money from the public,” a definition mirrored almost verbatim in India’s Banking Regulation Act, 1949. These formulations establish deposit taking and credit extension as the legal foundation of banking activity, regardless of the financial model governing the structure of transactions.

This legal structure is equally visible across advanced financial systems. In the United States, Title 12 of the United States Code defines a bank as an institution that both accepts demand deposits or deposits withdrawable through payment instruments and engages in the business of making commercial loans. In the United Kingdom, although the Banking Act 2009 does not offer a single statutory definition of banking, regulatory treatment facilities deposit taking as the defining feature, reinforced by the Financial Services and Markets Act 2000 framework linking deposits to lending and investment activity. In Australia, the Banking Act 1959 explicitly defines banking business as the taking of money on deposit and the making of advances. Comparable formulations appear in the banking laws of Germany, France, Japan, and other major jurisdictions, reflecting a shared global legal understanding of banking’s core functions.

This consensus is further reinforced by international regulatory standards. The Basel framework is premised on the assumption that banks are institutions that accept deposits and extend credit, while the Basel Core Principles for Effective Banking Supervision embed this model into licensing, governance, and supervisory requirements. Across jurisdictions and regulatory systems, banking is therefore consistently understood as comprising two foundational functions: deposit acceptance and credit extension. Islamic banking operates within this same institutional structure but applies a distinct ethical and contractual logic to how these functions are performed, demonstrating that the distinction between conventional and Islamic finance lies not in the legal architecture of banking itself, but in the principles governing the use of capital, the distribution of risk, and the social purpose of financial intermediation.

However, this definition, rooted in conventional interest-based financial systems, poses significant conceptual and regulatory challenges for Islamic banking, which operates on Shariah-compliant principles that prohibit interest (riba) and emphasize profit-and-loss sharing through investment partnerships rather than lending. Hence, this definition of “banking” becomes challenging, especially on the “lending” side, when it comes to the field of Islamic banking. The issue here is that Islamic banking does not recognize or acknowledge “lending” in any manner, which creates difficulties in practical scenarios, while establishing Islamic banking in the world. This problem though does not arise on the deposits side, which is acknowledged by islamic law under the concept of Mudarabah, where the depositors is “Rab-ul-mall” (capital owner) and the bank is Mudarib (fund manager).

“Lending” is not allowed in Islam, firstly for the issue of “Riba” and secondly, there is no concept of lending or Qarz in Islam, except “Qarz-e-Hasna”, which is an Islamic concept meaning a “benevolent loan”, essentially an interest free loan given to help someone in need, with repayment based on the borrower’s ability or willingness. This does not suit, obviously, for commercial businesses like banking. The concept behind impermissibility of lending or loan is the Islamic financial view, emphasizing social welfare and compassion over profit and it is a cornerstone of Islamic finance, promoting mutual aid and community support without the burden of riba (interest).

To overcome this conceptual contradiction, Islamic banks have restructured “lending” into trade-based products. By leveraging concepts like Murabaha (cost-plus financing), Musawwamah, Tawarruq, and Istisna, banks frame the provision of funds as a sale or trade transaction. However, this approach has though provided a firm foundation for the industry’s growth, however, it faces persistent criticism. Skeptics argue that these products are merely “lending in disguise” portraying financing as trade to meet legal requirements while maintaining the economic substance of a loan.

This is probably the high time for Islamic bankers and sharia scholars in Pakistan to deliberate on the subject matter and consider some other ways, so that the conceptual confusions and contradictions be cleared for future. It is suggestable in this regard that the Islamic bankers and sharia scholars should consider that whether the “lending” side of “banking” can be defined in some different way. One such example is that of Malaysia.

Interestingly, Malaysia is leading “islamic banking” in the world has a different legal definition of banking. Malaysia though operates on a dual banking system regulated by separate statutes, however, the Malaysian laws provides a separate definition of Islamic banking i.e. Section 2 of IFSA which defines “Islamic banking business” as – “Accepting Islamic deposits on current account, deposit account, savings account or other similar accounts, with or without the business of paying or collecting cheques drawn by or paid in by customers, and the conduct of any other business, the aims and operations of which are based on Shariah principles”. Particularly, this definition does not include “lending” as an element. Instead, it focuses on accepting Islamic deposits and conducting business based on Shariah principles, although its Section 28 further elaborates that Islamic banks may carry out various Shariah-compliant activities including: Murabaha, bai bithaman ajil (deferred payment sale), and other sale-based contracts.

This example can be looked into by Islamic bankers and sharia scholars in Pakistan for considering that whether the term “lending” can be replaced with some other “term”, like “investment” or “trading” in context of Islamic banking. Or, in the alternative, it can replaced with similar wording as adopted by Malaysia. The idea is that the definition of Islamic banking be amended (for example) as “accepting deposits from the public for the purpose of investment / trading or doing any business as per sharia principles”. This will align the legal perspective of banking with the Islamic banking in actual, on both sides, i.e. deposits and trading.

It is notable in this regard that although the State Bank of Pakistan has recently introduced a new definition of “Business” for Islamic Banking, vide Section 39C (c) of the Banking Companies Amendment Act, 2024, however, it again falls back on Section 7 of the BCO, i.e. “Forms of business in which banking companies may engage”. The new definition refers it “Doing such businesses as are prescribed in Section 7 of this Ordinance subject to conformity with the Principles of Shariah, as specified by the State Bank”. This again is creating confusion and it needs further deliberations.

Pakistan has an opportunity to shift Islamic banking as a strategic pillar of national economic policy by aligning its regulatory approach with developed global practice followed in the leading jurisdictions such as Malaysia and Saudi Arabia including other countries. The Islamic banking becomes systemically strong when it is supported by rational legal definitions, dedicated statutes, strong central bank supervision, and integrated Sharia governance frameworks. Malaysia’s model shows how clear statutory recognition and regulatory structuring can create institutional depth, innovation capacity, and market confidence, whereas Saudi Arabia’s experience demonstrates the importance of embedding Sharia governance within the core financial regulatory structure rather than treating Islamic finance as a peripheral segment. Therefore, for Pakistan, the priority is regulatory reforms rather than expansion in scale alone. The regulators must strengthen legal clarity, improve product authenticity, enhance Sharia governance, and modernize supervisory standards to ensure consistency, transparency, and credibility. The institutional coordination between the State Bank of Pakistan, SECP, and other regulatory bodies must be deepened to eliminate division and ambiguity in regulatory framework. Islamic banking in Pakistan can move beyond form based compliance toward genuine risk sharing, productive investment, and development finance with the right regulatory architecture. In doing so, Pakistan can transform Islamic banking from a parallel system into an integrated engine of financial inclusion, capital formation, economic resilience, and sustainable growth, aligning ethical finance with national development objectives and placing the country within the evolving global architecture of Islamic finance.