Friday, May 7, 2010

State of Modaraba Industry in Pakistan


The efforts for Islamisation of the banking system started way back in the 1960s but, it only gained momentum during the period of General Zia-ul-Haq who, in fact, tried to islamise every sphere of life. General Zia amended the legal framework of Pakistan’s financial and corporate system on June 26, 1980, to permit the issuance of a new interest-free instrument of corporate financing named the Participation Term Certificate (PTC). An Ordinance was promulgated to allow the establishment of Modaraba companies and the floatation of Modaraba certificates for raising risk-based capital. Subsequently amendments were also made in the Banking Companies Ordinance, 1962, and related laws to include the provision of bank financing through profit and loss sharing, mark-up in prices, leasing and hire purchase.

As a result of that amendment, all the nationalized commercial banks started separate counters from January 1, 1981, to mobilize deposits on a profit-and-loss sharing basis. And from July 1, 1982, banks were allowed to provide financing to meet the working capital needs of trade and industry on a selective basis under the technique of Musharakah, an agreement under which the Islamic bank provides funds, that are mixed with the funds of the business enterprise and others, and profit is distributed among the partners in predetermined ratios, while any loss is borne by each partner strictly in proportion to respective capital contributions.

From July 1, 1985, no bank in Pakistan was allowed to accept any interest-bearing deposits and all existing deposits in a bank were treated on the basis of profit and loss sharing. However, deposits in current accounts remained unaffected, under which neither interest nor a share in profit or loss was allowed. But foreign currency deposits in Pakistan and lending of foreign loans continued on interest as before. However, these procedures adopted by banks in July 1985, based largely on a ‘mark-up’ technique with or without ‘buy-back arrangement,’ were eventually declared un-Islamic by the Federal Shariat Court (FSC) in a judgment in November 1991.

Many further developments were made by the central bank, Government and the judiciary. However, further improvements towards the development of the Islamic financial industry are being made by them and Islamic financial institutions are growing in number and size year by year.

Besides Islamic banks, there is another type of Islamic financial institution which is called a Modaraba Company. The Modaraba companies were formed under the Modaraba companies and Modaraba (Floatation and Control) Ordinance promulgated on June 26, 1980, which was in continuation to the policies of the then President of Pakistan; Gen. Zia – Ul – Haq to islamise every sphere of life in Pakistan.

Modaraba Concept:

The term Modaraba is an Arabic term and implies a contract between two parties, whereby one party, the Rab-ul-mal entrusts money to the other party called the Mudarib, to put in his management expertise and utilize it in agreed manner. Profits of the Modaraba are shared in a pre agreed ratio and losses in the proportion of the capital invested.

Modarabas – The Pakistani Experience

Majority of the Modarabas in Pakistan are in the financial sector, although there is no restriction on the nature of business except that it should be according to the injunctions of Islam. The business / financing activities currently undertaken by modarabas in Pakistan are Ijarah, Morabaha, Musharika, Trading, Equity/Portfolio financing and manufacturing.

Modarabas have a dynamic and progressive role to play in the Islamisation of the financial system of the country. Modarabas provide a good transit point as they have an appropriate infrastructure in place with more than 20 years of practical experience.

In the organized sector of Pakistan the concept of Modarabas emerged in 1979 as a result of the Government's initiatives towards Islamisation of the economy. For this purpose a Council named the Council of Islamic Ideology was set-up. This Council was given the task of devising a blueprint for the Islamisation of the economic and financial sectors. The promotion of Modarabas was an important component of this blueprint.


The current state of Modarabas in Pakistan is very poor and except some good players, majority of the Modarabas are in trouble. Major factors which have contributed towards these conditions are;

Divergent Shariah interpretations

Different Islamic scholars interpret Shariah according to their own school of thought. There are four school of thoughts namely; hanafi, hanbali, shafai, maliki in one sect of Muslims whereas another sect follows twelve imams. So there are two universally accepted school of thoughts; the Sunnis and the shias, and within them there are variations which create confusion among the scholars to arrive at a universally accepted solution. Another disadvantage of this variation among the scholars is that those scholars who are well known among others try to force their point of views and it has become a general practice that nowadays Islamic scholars are imitating the products of conventional banking by justifying it by the help of ayats or hadis regardless of their context.

Musharika and Murabaha modes being used as alternative to Riba

It is a general practice in Pakistan that Modarabas use murabaha and musharika as alternative to Riba which means the actual spirit of prohibition of Riba is not observed. For instance in almost all the Modarabas all the transactions are made in cash and there is no concept of trading or leasing on deferred payment basis.

Corporate governance - lack of independent & competent directors on the boards of various Modarabas

Due to inherent faults in the structure of the Modarabas, low profitability and less popularity in the corporate sector the Modaraba companies failed to attract competent directors from the industry. In addition to that low remuneration structure across the board is a main disadvantage to the Modaraba sector as it failed to attract high class professionals both for its top and middle management.

Favoritism towards the sponsors/major shareholders

Majority of the directors are appointed by major shareholders and even the (so called) independent directors are also elected by the major shareholders. In fact there is no representation of minority shareholders of the management company. Hence there are only two classes of directors on the boards of Modarabas i.e. those who are elected by the sponsors and those who have been nominated by the major investors.

Misappropriation of funds by the sponsors/management company

Weak regulatory supervision and least controls by the authorities coupled with dishonest and incompetent management of the Modarabas resulted in huge volumes of nonperforming loans which upon investigations revealed that the sponsors and even the middle management were involved in the misappropriation of assets of the Modaraba and in most of the cases the employees of the management company were found directly involved in misappropriation of funds of the Modaraba.

Benami facilities to drain funds out of the certificate holders’ money

In continuation of the above, many investigations revealed that the sponsors themselves were involved in creating Benami facilities, hence they drained millions of rupees by these methods and the Modaraba industry started suffering huge losses which continued over two decades and interestingly there was no authority during these years to probe against these crimes.

Investment in non Shariah compliant stock market securities

In addition to the above non Shariah compliant activities in which the Modarabas actively participate; large investments are also made in non Shariah compliant stock market securities such as shares of commercial banks, investment banks, brokerage house and other companies whose businesses are not in line with the conjunction of Islam.

Poor regulatory supervision

Since the promulgation of Modaraba Ordinance till the year 2000 there was virtually no authority to continually check the affairs of the Modarabas as many of the Modarabas were pushed to winding up by the then regulator; State bank of Pakistan and the current regulator Securities and Exchange Commission of Pakistan. All these Modarabas could have been saved from winding up and defaults if proper and continuous onsite and offsite monitoring process were in place

Weak Shariah compliance process in place

Although there is a reference of Shariah board given in the Ordinance and conformity with injunction of Islam in the Modaraba rules but in fact this is a debatable and subjective issue and there is a need to prepare a proper framework for Modarabas to streamline their operations in line with the teachings of Islam, otherwise this will lead to collapse of the Modaraba sector which is already in the state of collapse