Federal Sharia Court in Pakistan: Towards an interest-free economy

The legality of riba pricing mechanisms in business transactions has been the subject of extensive debate in Pakistan and in schools of Islamic jurisprudence. Riba broadly refers to the concept of interest earned on loans or deposits, or gains made in usury-like business or commerce.

In a recent development (April 28, 2022), the Federal Shariah Court of Pakistan declared the imposition of riba in all business transactions as illegal and contrary to the injunctions of Islam. The Court ordered that all references to interest under local law be repealed or amended and that further steps be taken by government authorities to ensure an absolutely riba-free economy. As a result, banking/financial institutions, investors and individuals can only undertake Islamic/Sharia compliant financing. The decision has prospective effect, fully preserving all existing obligations, including the State’s international obligations.

A number of concerns emerge for investments in Pakistan, which largely relate to the practical application of the different modes of Islamic financing; particularly in view of the five-year deadline set by the Court for a complete overhaul of the system. A key feature of Islamic finance is that it requires investors to participate directly in the underlying risk of the transaction, so there is a direct link between investors and the assets that support the transactions. This translates to investors needing to bring in their personal income to cover any losses. Sales of underlying assets could therefore be viewed as unsecured loans in bankruptcy proceedings, potentially nullifying the sale itself; thereby compromising investor confidence and protection.

Consistent and globally consistent guidance is therefore needed to reduce the implications that can weigh on investors and financial institutions, in particular to preserve both the substance and the low risk appetite that characterize traditional business transactions. . Although in principle it could be argued that the legal enforceability of investors’ claims would remain unaffected if Sharia views on Islamic business transactions were read collectively with traditional commercial law practices and existing precedents, the decisions of Islamic courts could progressively cancel current practices and requalify the nature of these operations.

Nonetheless, Islamic securitization complements the universe of conventional asset-backed securities as an alternative and more diversified financing option that broadens the price spectrum and the supply of assets. Currently, the International Monetary Fund, World Bank, and Asian Development Bank all offer Shariah-compliant financing solutions. China has also accepted funding for projects under the China-Pakistan Economic Corridor (CPEC) under Sharia principles. The sukuk has also become an internationally accepted alternative to sovereign borrowing, especially for infrastructure financing. Therefore, Islamic finance can even benefit small and medium enterprises and investments in public infrastructure projects; meet a critical need in the Pakistani market.

The Central Bank of Pakistan has also steadily used extensive measures to align its progress towards a purely compliant system, adopting the Shariah standards set by the Auditing and Accounting Organization of Islamic Financial Institutions (AAOIFI). Yet there is an urgent need to develop national policies and establish progressive implementation, using concrete standards of regulation and enforcement at each stage. Increased efforts will therefore need to be made to replace the traditional features of transaction structures, to enable credit enhancement and improve liquidity support.

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