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Need for Islamic Interbank0ffered Rate

By Muhammad Munir Ahmed 2015-11-30
BOTH conventional and > lslamic banks use the Karachi Interbank Offered Rate to price their products and services.

Since Kibor is essentially an interest-based benchmark, it attracts a great deal of criticism about its compatibility with Islamic economic thought, which is primarily based on a profit-and-loss sharing system.

The need for an Islamic Interbank Offered Rate (Ibor) is frequently raised by the concerned quarters.

This article will examine the rationale for the using of Kibor by Islamic banks, as well as the preparatory work and the parameters of a profitbased benchmark that can be used by Islamic banks (IBs).

In pursuant to the Supreme Court`s decision calling for the Islamisation of the economy in 2002, Shariah scholars allowed IBs to use prevailing interest rates as benchmark to price their products, as no other alternative was available.

While no timeline was provided, it was generally believed that after mainstreaming of the Islamic banking sentiment, a profit-based yield curve would become available, prompting IBs to switch to an Islamic reference rate. However, after 14 years, no serious effort has been made.

However, in November 2011, Thomson Reuters had launched the first Islamic finance benchmark rate the Islamic Interbank Benchmark Rate (IIBR) to provide an indicator for the average expected return on Shariah-compliant short-term interbank funding.

The llBR is based on rates quoted by 18 Islamic banks and Islamic windows of conventional banks and approved by leading Shariah scholars. But it is not used widely, expect for a few in the Islamic finance industry.

The main reason is that the llBR is arrived at by taking an average ofrates of Islamic financial institutions, which are based on conventional interest benchmarks.

Until the 12th century, surplus units (savers) and deficit units (borrowers) of an economy used to interact directly, as no financial intermediaries (like banks) were in place at that time. In other words, it was `peer to peer finance` (nowadays called P2P Finance), under which savers used to get a better return on their savings because the pricing of loans or investments was made in line with the market profit rate.

In the Golden Age of Islam (from 7th-11th century), the profit rate was the reference rate for determining the return on investment/partnership in business etc. The annual profit rate was announced by the Ottoman Empire as a benchmark for settlingdeals under a Murabaha mark-up on the purchase price.

With the advent of Islamic banking, it was expected that the new incumbents would use profit rates for calculating the return on savings and investments, thereby providing better rates to depositors. This was the only way to make Islamic banking different and better than its conventional counterpart.

Unfortunately, this could not be done, mainly due to the Islamic banks following the footprints of interest-based banks. Critics say there is little difference in the interest rates and the profit rates offered by both type of banks.

A great deal of research and analysis will be required to calculate the profit rates for various business clusters, with the help of time series dataof real sector businesses, which is easily available now. It is very encouraging that universities and leading educational institutions are now moving towards Islamic finance.

Last year, the Journal of Islamic Business and Management (JIBM) of Riphah University, Islamabad, had initiated a discussion over the theoretical aspects of Ibor. Now, IBA Karachi has established a centre of excellence for the promotion of Islamic finance.

In order to promote Shariahcompliant banking, it is important to create a visible difference in the working of IBs and their conventional counterparts and to also highlight the advantages of Islamic banking. This can only be done by working under Ibor, which is likely to provide higher rates for savers (depositors).

Conventional banks offer very poor rates to their depositors and are thriving on the strength of their current accounts on which no return is paid.

IBs are also faithfully following their conventional counterparts in this regard. Their rate of profit on savings accounts is almost similar to the interest rate offered by conventional banks on their saving deposits, and the IBs also offer no return on current/business accounts. By offering higher rates than conventional banks, they can attract a number of the latter`s depositors.

On the asset side, Ibor is also likely to be higher than Kibor. For this, IBs will have to enter hitherto un-served areas like agriculture, small and medium enterprises and microfinance. These credit-starved sectors surviving on costly loans from informal sources will become wholesale borrowers of Islamic banks.• The writer is President, institute of Banking and Business Learning.