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Islamic Finance, P2P sharing and their impact on the Banking and Micro
Finance Industries in Pakistan
The conventional financial system of the modern world is facing many challenges. Following the
recent credit crisis the model used by many investment and commercial banks is being
questioned. Gold prices are surging and confidence and trust, two of the most precious
commodities are at their record low. The crisis is said to be the worst since 1929.
(islamicbanker.com)
On the other hand the shariah-compliant banking seems to be flourishing. Shariah-compliant or
Islamic banking stands on two pillars, the avoidance of interest (i.e. Riba) and risk sharing and
it is these two fundamentals which help avoid liquidity risk and in turn overcome the underlying
challenges in the conventional system. With growth rates of 20 -30% (islamicbanker.com) and
over 300 institutions established we can safely say that that Islamic banking has gone global. It
now accounts for 95% of banking assets in Saudi Arabia, 17 % in Qatar and 15% in Malaysia
(islamicbanker.com).
There are five basic Islamic financing contracts.
1. Murabaha:(Cost plus)A Murabaha transaction is basically a cost plus profit financing transaction in which a
tangible asset is purchased by an Islamic bank at the request of its customer from a
supplier. The Islamic bank sells this asset to its customer on a deferred sales basis with a
markup that is banks profit. The mark up on the asset cannot be altered during the life of
the contract. The Murabaha deals offer enough flexibility to be used in real estate and
project financing.
2. Ijara and Ijara wa-Iqtina: (leasing and lease purchase)Ijara and Ijara wa-iqtina are Islamic leasing concepts similar to western operating and
finance leases. Ijara is similar to conventional operating lease, where in an Islamic bank
(lesser) leases the asset to the client (lessee) for agreed on lease payments for a specified
period of time, but with no option of ownership for the lessee. The maintenance and
insurance is the responsibility of the lesser. On the other hand, in ijara WA iqtina, lessee
has the option of owing the asset at the termination of the lease. In both types of leasing,
the lease payments must be agreed on in advance to avoid any speculation.
3. Istinsa: (leasing structured mode)Istinsa is a leasing mode which is used to finance long term or large scale facilities
involving like construction of a sugar plant. In this mode, bank could either own the plant
and charge the lessee a fee based on profits or sell the plant to the company on a deferred
basis similarly like the Murabaha transaction.
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4. Mudaraba: (profit-sharing)Mudaraba is a trust based financing agreement in which an investor e.g. Islamic bank
give capital to an agent for a project. Profits are based on prearranged and agreed ratio. In
case of loss earn no return and the agent receives no compensation for his effort.
5. Musharaka: (equity participation)Musharaka is similar to a joint venture in which bank and agent jointly invest in some
project. They agreed on some prearranged profits and losses.
(Zaher and Hassan 2001)
According to a report on Islamic Finance by the State Bank of Pakistan (SBP), during the last
decade, the Islamic Financial Sector (IFS) has become one of the fastest growing segments of the
overall global financial system. The market is becoming increasing diversified and is no longer
focused on the basic modes of Islamic financing.
Pakistan is no exception. Here, Islamic Finance emerged as a response to both religious andeconomic needs. Efforts for an interest free economy were started during the 1970s and by the
end of 1980s Pakistan had one of the best Islamic finance models in the world. However, the
system soon fell apart as it did not adequately address the needs of Shariah compliance. Hence,
Islamic Banking was re-introduced in the year 2001 as a parallel system to the already existing
conventional models. In 2007, Meezan Bank, a full fledge Islamic Bank with branches all over
Pakistan opened its 100th branch in Karachi, marking the start of an era of accelerated growth of
Islamic Finance in the banking sector of Pakistan.
The top Islamic Banks in Pakistan include Meezan Bank, Albaraka Islamic Bank, Bank Islami
Pakistan Limited, Dubai Islamic Bank, Dawood Islamic Bank Ltd. and Emirates Global IslamicBank Limited. (Wikipedia contributors, 2011)
Furthermore, the share of Islamic Banking Institutions Assets Deposits and Financing and
Investment in the overall banking system increased to 4.6%, 4.2% and 4.4% respectively at the
end of each quarter according to the Islamic Banking Bulletin of State Bank.
SBP has played a key role in providing an enabling environment and a level playing field to the
Islamic banking industry through the provision of a facilitative regulatory and supervisory
framework. The Shariah compliance mechanism is the most comprehensive available in the
world. Pakistan is the only country which has issued Guidelines on Islamic agriculture andmicrofinance. Similarly, SBP is the first central bank to have initiated Shariah-compliance
inspection. As a result, the industry has experienced robust growth. SBPs recent achievement of
being ranked as the second best central bank in promoting Islamic banking is a reflection of this
effort.
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SBPs next five years strategy for development of Islamic banking industry envisages rolling out
of various international prudential standards developed by IFSB as an important pillar. They
have accordingly seized the opportunity by capitalizing on IFSB's expertise through holding such
workshops at this juncture. Banks in Pakistan have already adopted Basel II and adaptation of
IFSB standards in Pakistan would enable Islamic banking institutions to perform on an equal
footing with the conventional industry thereby achieving the ultimate objective of financial
stability and soundness at the national level and smooth integration with the international
financial infrastructure.
New Initiatives for bringing in further Standardization in Shariah practices.
1. Adoption / Adaptation of Shariah Standards developed by Accounting and AuditingOrganization for the Islamic Financial Institutions (AAOIFI). The introduction of
international players in our Islamic banking industry has further necessitated the need to
bring our industry at par with the global Shariah standards. Shariah Standards developedby Accounting and Auditing Organization for the Islamic Financial Institutions (AAOIFI)
are an important and effective source available for bringing in the desired standardization
in the Shariah practices. In order to bring our industry at par with the international
standards and also achieve standardization of Shariah practices locally, a mechanism for
adoption adaptation of these Shariah standards has been developed by SBP. According to
this mechanism the meetings of Shariah Advisors Forum of are being held with a view to
thoroughly study the AAOIFI Shariah Standards one by one, for their possible adoption /
adaptation in our market.
2. Instructions & Guidelines for Shariah Compliance: Instructions & Guidelines forShariah Compliance have been issued vide IBD Circular No. 02 of 2008. Instructions for
Shariah Compliance cover regulations in areas related to appointment, duties/
responsibilities and report of Shariah Advisor; conflict resolution in Shariah rulings;
permissible modes of financing and investment; essentials of Islamic modes of financing;
use of charity fund; introduction of new products & services and schedule of service
charges. Guidelines for Shariah Compliance cover areas like Internal Shariah compliance,
Internal Shariah Audit; investment in shares; policy for profit distribution with PLS
account holders and financial reporting & general disclosure requirements.
3. IFSB Risk Management Guidelines Islamic Financial Services Board (IFSB) promotes the development of a prudent and transparent Islamic financial services
industry through introducing new or adapting existing international standards consistent
with Islamic Shariah principles. It has issued standards/guidelines regarding Capital
Adequacy, Risk Management and Corporate Governance for institutions offering Islamic
financial services (other than Takaful). SBP has already adapted Risk Management
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Guidelines for Islamic Banking Institutions vide IBD Circular No. 01 of 2008. Some
other Standards (Corporate Governance, Capital Adequacy, Transparency and Market
Discipline and Supervisory Review process) are also in process of adaptations
Competition: Porters Five Forces (Tahir & Umer, 2008)
Environment can be very big including social, economical and Political but the main
environment of the firm is the industry in which firm is operating. For example, for an Islamic
bank, banking industry is the main environment. Forces outside the industry are of significant
importance in determining the overall efficiency of the industry. These forces effect all the firms
in the industry but method of dealing with these forces vary from firm to firm.
The state of competition for a company depends on the fives competing forces. The overall
strength of these forces determines the success and progress of the company. (Porter 1980)
The strength of these forces varies from company to company, it is very deep in the companies
like paper and food where competition is very intense and it is very low in the companies like oilfield equipment and car manufacturing.
Competition in the Islamic Banking Industry can be judged by the following market forces
within the Islamic Banking Industry.
y Intensity ofRivalry: Islamic Banking is now available in more 16 big cities of Pakistan;however conventional banks have branches all over Pakistan including small and big
cities. As far as product differentiation is concerned, even though commercial banks are
mostly interested in the corporate sector, most of the new entrants are also opening
Islamic branches. Also, the products developed by Islamic banking are most based onIjarah and Murabah which are similar to leasing and cost plus sale of assets, respectively.
y Threat of new entrants: Despite the suspension order of issuance of new bank licences by the State Bank of Pakistan, foreign interest in Pakistans banking sectors seems to
grow due to the untapped potential market of financial services present in the country.
Weve seen many acquisitions in the conventional sector and the Islamic bank seems to
be attracting a lot of interest from foreign Islamic banks, especially from Malaysia. On
the other hand, a barrier to entry is the high distribution Costs and legal expenses of
Islamic banking due to their dependence on the Shariah Board with lacks financial
experts. In conclusion, threat to new entry in Islamic banking sector is moderate. Barriers
are not too high to enter the market.y Bargaining Power of Buyers: Islamic banking targets both individuals and institutions
and its clients are usually categorized according to their religious motivations. Some are
totally religiously motivated, some are partially profit orientated and a large majority
which is mostly the corporate buyer, is totally profit oriented. Islamic Banks in Pakistan
are mostly not able to offer higher profits which are why they mostly market themselves
to the religiously motivated buyers. The totally religiously motivated buyer is profit
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inelastic whereas the partially motivated isnt and can easily shift to conventional banks
services because switching costs are very low.
y Bargaining Power of Suppliers: The bargaining power of suppliers is highest in Islamicbanking sector. As already mentioned above, there is a shortage of Shariah Scholars and
trained Islamic finance professional in the country, and the ones that are available expect
higher compensations as the conventional bankers. Moreover, due to lack of awareness
there is also a shortage of investors in Islamic banking which results in higher cost of
funds.
y Threat of Substitutes: Different microfinance banks are getting licenses in Pakistan andSBP is also encouraging them to come in. But the growth of other Islamic financial
institutes is very low as compared to Islamic banks. (Tahir & Umer, 2008)
This trend has brought with it a race towards product development and creativity in the banking
models and it goes hand in hand with an increasing trend of micro finance institutions both in the
form of Strategic CSR activities and sustainable business subsidiaries of banks all over the
world. Around the world millions of people are living without the financial services many take
for granted.
Without access to loans, savings accounts insurance and funds transfers the obstacles to
overcoming poverty can be insurmountable. There is a movement underway to provide financial
services to customers that financial institutions dont serve. This is called micro finance. One of
the important facets of micro finance is micro credit. It may not be the only solution to poverty
but sometimes this is all it takes to help a person become profitably self employed. Micro
finance and micro credit which are often used interchangeably are both being subsidized as
poverty alleviation tools in most developing countries. The model is based on the triple bottom
line approach that focuses on people, profit and the planet and has the power to single-handedly
defeat poverty.
Industry Overview
Pakistans microfinance industry is globally recognized for its legal, regulatory and strategic
framework thanks to the efforts of the State Bank of Pakistan (SBP) since the year 2000.
According to SBP, Eight Micro Finance Banks have been established and two of the worlds
largest Microfinance Institutions have started their operations in Pakistan yet the current outreach
is 2 million people which are only 7% of the potential market.
According to the annual report of Pakistan Microfinance Connect, by December 2009, the
combined assets of Pakistans microfinance industry were approximately PKR 35.4 billion (USD
0.42 billion). The gross loan portfolio (GLP) totaled PKR 20.2 billion (USD 0.24 billion), while
outreach stood at approximately 1.73 million active borrowers, and 0.46 million active
depositors.
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Pakistans micro finance industry as compared to India and Bangladesh is very small in terms of
its balance sheet size and outreach. Indias Micro finance industry had an Asset base of
approximately 5.1 billion USD, Bangladesh 3.5 billion USD whereas Pakistan has asset base of
only 0.4 billion USD. However with more than 27 million potential customers the market
opportunity is extremely high.
The Competition
The industry is characterized by three types of Micro finance Providers; Micro Finance
Institutions (MFIs), Micro finance Banks (MFBs) and Rural Support Programs (RSPs). MFIs
RSPs are basically non-banks non-government organizations (NGOs) providing micro finance
service whereas MFBs are commercial banks licensed and regulated by the central bank of
Pakistan to exclusively provide micro finance. The difference between MFIs and RSPs is that
RSPs have a rural focus and are supervised by the securities and exchange commission of
Pakistan.
There are seven MFBs, fourteen MFIs and four RSPs currently operating in Pakistan out of
which approximately 85% of industry assets are concentrated within seven organizations namely,
Kushhali Bank Ltd.(KBL), The First Micro Finance Bank Ltd. (FMFB), National Rural Support
Program (NRSP), Kashf Foundation (KF), Tameer Micro Finance Bank Limited (TMFB),
Punjab Rural Support Program (PRSP) and Kashf Micro Finance Bank Ltd. (KMFB).
The recent slowdown in microcredit growth is mainly attributable to the following constraints:
(State Bank of Pakistan)
i. Funding: MFIs are largely dependent upon subsidized funding from Pakistan PovertyAlleviation Fund (PPAF) to finance their lending operations which is limited.
Similarly MFBs, owing to slow progress in deposit mobilization, have not yet become
sustainable in generating internal funding. The sector faced difficulty in accessing
commercial funds mainly from the risk averse commercial banks during 2009.
However, the SBPs Microfinance Credit Guarantee Facility has been instrumental in
mobilizing sizeable wholesale funds from the commercial banks to the microfinance
sector recently.
ii. High operating costs: The sectors high operating cost to loans ratio (presently 22%)poses a key challenge to make microfinance a viable business model. A reliance on
brick and mortar branches and extensive human resource base has been adding
significantly to high operating costs.
iii. Credit Risk: Overall credit portfolio quality of the sector remains satisfactory.However, rapid growth in 2007 and 2008 led to multiple microfinance institutions
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lending to the same clients in a saturated market. Due to lack of appropriate internal
controls, the phenomenon of over borrowing by clients has the potential to spread,
and create spillover effects. In addition, high inflation is affecting the repayment
capacity of micro borrowers and the increasing trend in pricing of microcredit may
also create default risk.
iv. Organizational Development: Sustainable growth and organizational developmentgo hand in hand. By and large, the existing quality of governance, management
teams, technology, and internal control systems of microfinance players are not
conducive to the required level of growth.
v. External factors: Challenging macroeconomic environment and the prevailing lawand order situation in the country are also inhibiting the growth of microfinance
sector. To address these challenges, the microfinance sector needs to be more
innovative, more efficient, and more transparent.
The following strategic framework laid down by the SBP provides a road map for sustainable
growth of the sector for the next five years:
i. Diversity: There exists a broad based government commitment to financial inclusionto promote inclusive economic growth. It will be important to continue
implementation of policy approaches that provide the incentives for sustainable
financial access and usage of a broad range of services (savings, credit, payments and
transfers, insurance). The industry needs to shift away from the credit only approach
and offer comprehensive financial services such as micro savings, remittances, and
micro insurance.
ii. Innovation: Both the policy makers and microfinance players are keen to promotetechnological and institutional innovation as a means to expand financial system
access and usage. SBP will soon launch a Financial Innovation Challenge Fund under
the auspices of the UKAid sponsored Financial Inclusion Program (FIP), to support
institutional and technological innovations in the industry. To reduce operating costs
and attain rapid scale, microfinance players may leverage mobile phone
technology and agents networks. Such platforms would also help them undertake
specialized business proposals, for instance, financially inclusive Government toPersons (G2P) payments. SBP will encourage models that promote branchless
banking. SBP will also establish and lead a formal consultative forum of key
stakeholders on branchless banking. The consultative group will create synergies,
facilitate sector innovations and market development, and develop collective
understanding on critical issues.
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iii. Funding: Deposit mobilization will be critical for the long term development ofmicrofinance. However, in the short to medium term, SBP and PPAF, in
collaboration with interested donors, will jointly develop funding plans for the
sector. The funding base of the existing credit enhancement instruments will be
further augmented. To expand deposit operations of MFBs, SBP will consider
allowing access to banking payment systems and developing deposit protection
schemes.
iv. Enterprise lending: Lending operations must extend to different economic andgeographic segments. SBP will issue regulatory guidelines to MFBs for upscaling of
loans, and develop a reporting structure to assess the geographic distribution of
microfinance growth. Donor funding can support product development and market
surveys. The envisaged growth in portfolio would also require the development of
robust risk management systems within microfinance organizations. The pilot MFCIB
in Lahore is expected to be extended to the rest of the country. This wouldminimize the incidence of clients over indebtedness.
v. Organizational Development: Sustainable growth and organizationaldevelopment go handinhand. By and large, the existing quality of governance,
management teams, technology, and internal control systems of microfinance
players are not conducive to the required level of growth.
vi. External factors: Challenging macroeconomic environment and the prevailing lawand order situation in the country are also inhibiting the growth of microfinance
sector.
vii. Institutional development: Specific institutional strengthening and capacitydevelopment needs of individual players will be identified and assistance provided
under the existing FIP Institutional Strengthening Fund.
viii. Consumer protection and empowerment: SBP will review and strengthen itsregulatory and supervisory processes to ensure protection of microfinance clients
rights. In addition, SBP in close collaboration with key stakeholders would launch a
nationwide financial literacy program to create awareness amongst clients about
banking products and services and their rights.
ix. Corporate Governance: The microfinance organizations will have to improvegovernance standards for better strategic direction, effective oversight, and strong
internal controls.
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x. Minimum regulation of MFIs: The unregulated microfinance sector stillconstitutes a significant market share, and hence carries reputational risk owing to
potential poor credit decisions and/or undesirable consumer protection practices.
Therefore, a feasibility study will be conducted to bring the un regulated MFIs into a
minimum regulatory framework. This will improve the sector wide discipline,
transparency, and governance.
The Future of Micro Finance in Pakistan Islamic Micro Finance
With the increasing trend of Islamic finance and micro finance in the banking sector of Pakistan
the future of Banking seems to be a mixture of both.
Conventional microfinance products have been very successful in Muslim majority countries.
One of the earliest microfinance programs originated in Bangladesh with the experience of the
Grameen Bank initiated by Nobel Prize winner Mohammed Yunus. Islamic countries, such asIndonesia and Pakistan, have a vibrant microfinance industry; approximately 44 percent of
conventional microfinance clients worldwide reside in Muslim countries. Yet, conventional
microfinance products do not fulfill the needs of many Muslim clients. Just as there are
mainstream banking clients who demand Islamic financial products, there are also many poor
people who insist on these products. Indeed, Sharia compliance in some societies may be less a
religious principle than a cultural oneand even the less religiously observant may prefer Sharia
compliant products.
The Islamic Micro Finance Industry would be able to deliver greater value and probably alleviate
poverty more efficiently and effectively because its interest-free, and the poor will not feelexploited at all. Moreover, Islamic finance is based on risk sharing and Islamic micro finance
institutions could offer loans based on musharakah which is basically the securitization of
investments and selling of ownership shares in the form of savings accounts. This type of a
model does not restrict the clients rate of return and may be very attractive for the non-
entrepreneurial poor. Also, Islamic micro finance itself is based on serving the economy and the
value system is such that a micro finance institution based on Islamic micro finance wouldnt
have to spend much on organizational development and in turn be able to cut costs.
Lastly, Islamic micro finance institutions if deciding to fund through Sukuk certificates
(which are like bonds in the conventional system) they will have to create SVPs (like investmenthouses in the conventional system). This type of a model provides low credit and low liquidity
risk to the MFI. Hence, Islamic micro finance institutions with greater deposit mobilization,
market outreach and interest free loans will attract foreign investment from Muslim banking all
over the world and the market is likely to be characterized by healthy oligopolistic competition
and can serve as the backbone of the economy by alleviating poverty. In short, MFIs can find
Islamic finance a natural fit in their programs both debt and equity based.
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Peer to Peer Sharing and Micro Finance
Recently, the trend of cloud computing and the formation of a global network that has triggered
transformations in the music and publishing industry seems promising for the micro finance
industry. Websites like Kiva.org, Prosper.com and Lendingclub.com have already taken the
initiative of using peer to peer sharing models for micro financing and their models have positiveimplications for the micro finance sectors all over the world.
Taking the example of Kiva.org, it is a non-profit organization with a mission to connect people
through lending to alleviate poverty (Kiva). Kiva operates on a simple model of P2P sharing.
By merely clicking on a button anybody can help a person listed with Kiva by lending through
their Paypal accounts an amount as less as $25. This amount is transferred to the account of a
micro finance institution (field partner) near the borrower. When a hundred people, all lend $25
it makes a large amount of money that can be used to fund larger loans. The repayment is made
within no time and the payments are collected by the micro finance institutions, returned to you
by Kiva and insured by Paypal. Since its creation in 2005, it now has 577,344 lenders and $210million in loans with 132 field partners in 60 countries.
If brought to Pakistan P2P Micro finance may offer solutions to the various problems faced by
Pakistans Micro finance sector by leveraging the internet and a worldwide network to trigger
changes in the industry structure.
Traditionally micro finance institutions in Pakistan are being funded by donors but this form of
funding is limited and unsustainable which is why the industry requires permanent sources of
funding, the availability of which is restricted due to the following:
a) Commercial Banks, which a major source of funding for the sector in many developingcountries, lack experience and know-how of the micro finance sector and are highly risk
averse due to inter alia, tight liquidity conditions.
b) Even though Micro Finance Banks have the license to mobilize deposits they have beenunable to do so at a large scale.
c) The Pakistan Poverty Alleviation Fund (PPAF) is a funding body to the meet the needs ofthe sector but its funding is restricted to non regulated MFIs only and the body itself does
not have sustainable sources of funds because it is being funded by the World Banks
loans obtained by the Government of Pakistan.
P2P sharing can very well resolve the problem of funding in the micro finance industry of
Pakistan which may in turn encourage commercial banks to enter this industry. Commercial
Banks with their large deposit bases will then dominate the micro finance industry. Once the
industry is commercialized and not dominated by NGOs and RSPs more value will be created
and the consumer being the sovereign due to lower switching costs of P2P micro finance banking
will get to choose between different models.
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Technological developments in the industry like Easy Paisa by Telenor or a micro finance
model that cashes on P2P sharing could decrease operational and organizational development
costs of the industry players. Operational and organizational development costs of maintaining
Brick and mortar branches of Micro finance institutions especially in the rural areas consists of a
large proportion of the total costs of production of an MFP and if P2P sharing is able to decrease
them, it could boost the deposit mobilization and outreach of micro finance industry.
On the flip side we need to consider the fact that the target market of micro finance institutions in
Pakistan is mostly concentrated in the rural areas where literacy levels are very low. Hence, P2P
sharing if brought to Pakistan will be more of a funding source for Micro finance Providers and
will hardly play a role in the cutting costs, yet if executed properly it could lower the cost of
funds for micro finance institutions and in turn play a major role in poverty alleviation.
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