Benchmarking for Islamic banks

Updated September 02, 2019

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The State Bank of Pakistan (SBP) recently issued guidelines for the Modaraba-based Islamic refinance scheme for the working capital financing of small and low-end medium enterprises. The subsidised rate will be six per cent as opposed to the regular rate of approximately 18pc.

In a market with a steeply upward sloping yield curve, financial institutions are facing the risk of higher defaults. Islamic banks may be faced with even more difficulties. They have large housing finance and car finance portfolios.

Islamic banks are not required to maintain a minimum deposit rate. Mostly, average bank customers’ move to other banks for better rates is inelastic (barring large corporate clients). One can argue that Islamic banks should develop their own benchmarks in the wake of excess liquidity.

Critics of Islamic banking argue that the benchmarking of returns to conventional interest rates makes it synonymous with Riba. Islamic banks insist that the similar pricing of products doesn’t make them noncompliant with Sharia.

After 60 years, the London Interbank Offered Rate (Libor) is going to be phased out by 2021. Libor has been criticised for being subjective and manipulated by banks. According to the Financial Times, deals worth $300 trillion are linked to Libor. Of course, it is not easy to replace it. But the watchdogs are serious about the exit strategy. Other jurisdictions are also shedding their attachment to the equivalent benchmark rates like Euribor.

Islamic banks must have a significant share before they can experiment with influencing the financial system

To fill this vacuum, alternative benchmark rates, like the Secured Overnight Funding Rate (Sofr), are being experimented with. Sofr is a based on transactions in the US treasury repurchase market where banks and investors borrow or loan treasuries overnight. British Sonia and Swiss Saron are other similar examples.

In this backdrop, a discussion on benchmarking for Islamic financial institutions is timely. Internationally, Islamic financial institutions have a dollar-based benchmark of their own.

Thomson Reuters launched Islamic Interbank Benchmark Rate (IIBR) in 2011 in cooperation with Islamic Development Bank (IDB), Accounting and Auditing Organisation of Islamic Financial Institutions (AAOIFI) and Bahrain Association of Banks (BAB). The rate is not very popular and faces one of the lacunae that Libor also faces: subjectivity.

Research suggests the development of a real estate index as a benchmark for Islamic banks with housing portfolios. The margin for risk will be added to compensate for the residential-versus-commercial risk as well as the high-end locality-versus-suburban locality risk.

This will also strengthen their credibility with sceptics – a major impediment to its widespread adoption. The current Islamic banking portfolio is 15pc of total banking-sector assets. The SBP wants to grow it to 25pc by 2023.

The availability of credible data for the development of a real estate index is indeed a challenge. However, one of our neighbouring countries has developed such an index in consultation with global experts. The index is able to weed out externalities and can result in a best-fitting model with limited data points. We need to perhaps find our own solutions.

Real estate investment trusts (Reits), companies that own and sometimes operate income-producing real estate, are another instrument that can benefit from such research and development.

Critics of Islamic banking argue that the benchmarking of returns to conventional interest rates makes it synonymous with Riba. Islamic banks insist that the similar pricing of products doesn’t make them noncompliant with Sharia

Benchmarking the performance of Reits to a real estate index will give it a realistic picture. The off-take of Reits in Pakistan and their tax structure are a subject of another discussion.

Similarly, car Ijarah or rentals can also be benchmarked to alternate service providers. The engagement with customers is evolving and technology is democratising access to finance. Rental agreements related to commercial cars and vehicles may be benchmarked to Careems and Ubers of the world.

The arguments against benchmarking to other-than-interest rates have their merits too.

“Differences in the rates on particular products may lead to arbitrage if the central bank allows it,” said Dr Akram Laldin, a renowned Malaysia-based scholar of Islamic finance. Moreover, banks are connected with the international financial markets as well as local counterparts, which may lead to significantly different rates, making it difficult to do uniform transactions. Islamic banks must have a significant share before they can experiment with influencing the financial system.

The most practical solution, according to a senior banker, is that Islamic banks should develop their own rates based on Musharaka/Mudaraba agreements in the interbank markets. Recently, fixed-rate Sukuk were auctioned by the government of Pakistan. Similar, more frequent sovereign issues can be used as benchmarks for long-term financing by financial institutions. Benchmarking to gold has had its own space in the academic circles.

In the light of changing dynamics in the financial sector, the discussion warrants some focused coordination among the academia, practitioners, regulators and digitisation experts to develop more innovative solutions.

The writer works as senior manager at the Centre for Excellence in Islamic Finance at IBA, Karachi

sahson@iba.edu.pk

Published in Dawn, The Business and Finance Weekly, September 2nd, 2019