KARACHI - The financial soundness and solvency of the domestic Islamic banks remained strong despite constraints and global financial crisis as the total assets of the industry increased to Rs 235.3 billion during the first half of CY08. From 01 January to June 2008, the deposits of the Islamic banks surged to Rs 168.9 billion, financing and investments mounted to Rs 166.4 respectively while the number of full-fledged Islamic bank branches including stand-alone branches of conventional banks extended to 331 as of end-Aug CY08. A detailed performance review on Islamic banking in Pakistan during H1-CY08 ended on June 2008 revealed that Islamic banking in Pakistan has grown rapidly in the last few years. Keeping in view the small size of the industry and its evolutionary nature, the growth achieved so far has been impressive and has persistently outpaced its conventional counterparts. The consistently high average growth rate is attributed to the entry of four new players in the market in CY06 and CY07. At present there are six Islamic Banks (IBs) operating in Pakistan with 228 branches. Though the performance in terms of growth of assets is impressive, it has not translated into a proportionate increase in profitability as reflected in the ROA and ROE for Islamic banks. At 0.6 and 3.3 percent for CY07 respectively, these ratios for Islamic banks are below the overall banking sector average. Notably, these indicators do not portray the actual picture due to the entry of four new banks in the market which started operations as recently as CY06 and 156 CY07, and are still in the process of establishing their business, expanding their deposit base and enhancing the scope of their operations. It would normally take a new bank 3-4 years to become profitable and start operating efficiently, i.e. once the start-up costs and the expenditure on the development of management systems and related infrastructure, start to yield results. This shows a higher ROA (2.6 percent) and ROE (16.3 percent) in CY05, when there were only 2 dedicated Islamic banks operating in the industry. Both indicators declined sharply in the subsequent year (with a marginal improvement in CY07) simply due to the enhanced capital and asset base effect: the new banks contributed a significant amount to the total capital and asset base of the Islamic banking industry, but the earnings are still largely concentrated in the two previously established banks in the sector. Both ROA and ROE for the industry are expected to increase in coming years, as the new banks establish themselves on a sound footing. That said the current strains on the macroeconomic environment might exacerbate this process. The composition of a bank's balance sheet is one of the key determinants of the nature of risks it faces in its operating environment gives a comparative position of the balance sheet components of the conventional banking industry and Islamic banks for CY07. On the face of it, the two columns reflect an almost similar distribution of assets and liabilities, however there are some embedded issues which make the composition of the asset-liability structure of Islamic banks relatively more peculiar, as discussed below. The most significant issue faced by Islamic banks is that of liquidity management. The composition of their asset base reveals a dearth of Shariah-compliant investment options, as evidenced by the relatively small size of the investment portfolio in comparison with conventional banks. As the weakening macroeconomic environment manifested itself in the form of a more moderate economic growth rate and credit demand in the economy in CY07, conventional banks showed an inclination for expanding their investment portfolio, which increased by 53.0 percent during the year, compared with a growth of only 10.8 percent in loans and advances. This resulted in increasing their share of investments to 24.7 percent of total assets. While Islamic banks' investments portfolio has also increased substantially in CY07, it constitutes only 15.0 percent of the asset portfolio. Moreover, a large chunk of such investments consists of private sector Sukuk, which have relatively illiquid secondary market, and is generally held to maturity. Most of these instruments are not SLR eligible and Islamic banks are generally required to maintain relatively larger cash balances in order to meet the 9.0pc SLR requirement,9 which carries a high opportunity cost in an environment of rising interest rates. This situation is deemed to improve to some extent given the recent launch of the Government of Pakistan Ijara Sukuk .