Islamic banking industry (IBI) continued to grow and it posted 17.5 percent growth in total assets during the first half of current calendar year 2011 (CY11).

Earning indicators of Islamic banks also outperformed those of the overall banking sector for the first time, as Return On Assets (ROA) for the period under review increased from 0.8 percent to 1.6 percent. Similarly, Return On Equity (ROE) surged to a healthy 16.5 percent from 5.2 percent as of Dec 10.

According to State Bank of Pakistan data, Islamic banking registered double digit annual growth over the last decade and with current increase the total assets of Islamic banking insinuations (IBIs) surged to Rs 560 billion by June 2011, compared with Rs 477 billion in December 2010, depicting an increase of Rs 83 billion in first half of CY11.

Besides that, growing share of IBIs in Pakistan's banking system was indicative of their increasing significance in the overall banking industry and end of first half IBIs had 7.3 percent share in total assets of the banking sector, which is more than total assets of the 5th largest bank in Pakistan and over four times of the total assets managed by all DFIs in the country.

IBIs also registered a healthy increase in earning indicators during the Jan-June of CY11 as return earned on financing increased by Rs 3.5 billion or 30 percent over the corresponding period of CY10. During the period under review, with an increase of 16 percent, deposits of IBIs mounted to Rs 452.1 billion from Rs 390.1 billion. Investment surged to Rs 231.3 billon and financing Rs 188.6 billion after an increase of 46.6 and 4.6 percent.

A strong growth of 46.6 percent was registered in total investments (net) during first half of current calendar year and investment surged to Rs 231.3 billon in June 2011 from Rs 157.8 billion in December 2011. The unprecedented growth in investments also caused a significant shift in IBIs' assets mix from financing to investments.

IBIs also adopted the trend of investment in government papers, which was quite similar to that of conventional banks in Pakistan and issuance of GoP Ijarah Sukuk of over Rs 182 billion between October 2010 and June 2011 facilitated this shift from financing to high quality sovereign investments enabling IBIs to invest as much as 83.7 percent of their incremental assets in government securities during first half of CY11.

Nevertheless, the most significant improvement was witnessed in return earned on investments as the shift in asset mix from low yielding placements in interbank market through commodity murabaha like instruments to higher yielding investments in Ijarah Sukuk started to payoff in the form of better earnings.

The return earned on investments during the period under review shot up by 7.4 billion rupees (rise of 175 percent) from the corresponding period of 2010. The efficiency of IBIs' use of resources also improved with operating expenses to gross income ratio decreasing to 62.3 percent during the first half of 2011 as compared to 71.8 percent during the same period of 2010. This improvement was primarily due to increase in return earned on financing and investment rather than reduced operating expenses.

In the wake of deteriorating asset quality and continued government borrowings through Ijarah Sukuk offering attractive returns, IBIs remained shy of lending to the private sector despite sufficient availability of loanable funds. With growing supply of Shariah-compliant low-risk sovereign sukuks, IBIs increased their exposure towards investments, thus registering a further drop in their Financing-to-Deposit ratio (FDR) to 40.8 percent, compared to 55.4 percent for the entire banking sector.

In terms of credit allocation, around half of the total credit extended by IBIs was directed towards four key areas--textile, energy, chemical and individuals.

Going forward, the 200 basis points cut in the policy rates, coupled with lack of immediate availability of new sovereign Sukuk, might redirect some funds to private sector, though energy crises, poor law and order situation and slack economic performance would continue to hamper any major reallocation of credit to private sector in the short run.