With the global Islamic financial sector approaching close to $4 trillion in assets and having surpassed the Rs8 trillion assets milestone in Pakistan, a common question in Islamic finance revolves around the use of conventional benchmarks like Kibor or Libor when pricing an Islamic finance transaction or Sukuk. Considered one of the common myths is the belief that using a conventional benchmark rate to calculate rental for an asset or to determine the profit amount in a credit sale of goods in an Islamic financing contract makes the transaction impermissible.
This question gains significance in the context of the ongoing conversion in Pakistan’s banking sector. In light of the Federal Shariat court’s decision, the State Bank of Pakistan (SBP) aims to transition from an interest-based banking system to a more just and ethical Islamic banking system by the end of 2027. Additionally, concerns arise about what Islamic financial institutions will do when conventional benchmarks cease to exist after the conversion of the financial system in Pakistan. There is a strong desire among supporters of Islamic finance for the pricing mechanism to move away from benchmarks rooted in conventional banking, advocating for a more customised benchmark for Islamic finance that aligns with its unique requirements and values. Regulators also support the development of benchmarks that reflect the economy, create a positive economic impact, and are less prone to market manipulation, as seen in the case of Libor.
To understand the answers to these questions, we need to examine the issue in three dimensions: Shariah compliance, customer perception, and market competition.
From a Shariah compliance perspective, the majority of Shariah scholars, jurists, and Shariah standards issued by The Accounting and Auditing Organiaation for Islamic Financial Institutions (AAOIFI) Bahrain allow the use of conventional benchmark rates for pricing an Islamic transaction, provided that the transaction follows all the requirements of Islamic rules of contract. These rates are considered a measure or a number to calculate the return of a permissible transaction. Scholars clarify that the permissibility depends on the mode of finance, process, and steps followed. If all the required steps of a valid transaction are followed, it cannot be considered impermissible merely because the profit earned in the Islamic deal is similar to the interest earned in a loan transaction.
For instance, providing an interest-based loan at 10% to a customer is not permissible. However, earning a profit of 10% in a valid sale of raw material to a factory is allowed. Even if someone uses the Islamic rate of Zakat at 2.5% or the rate of Ushr at 10% to provide an interest-based loan, that act would remain impermissible as per Islamic rules.
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In addition, scholars strongly advise Islamic financial institutions that, while the use of conventional benchmarks is permissible, it is not preferable in Islamic finance to determine profit using conventional banking rates and benchmarks. They recommend exploring options for developing benchmarks based on Islamic banking markets or linked to some real economic parameter, aligning with the objectives of Shariah. In 2011, Thomson Reuters introduced the Islamic Interbank Benchmark Rate (IIBR) as a potential solution, addressing concerns related to interest-based benchmarks. The methodology involves contributions from a panel of Islamic banks, ensuring Shariah-compliant funding costs are reflected.
Secondly, customer perception related to the use of benchmarks is crucial. From a behavioural economics point of view, understanding the perception created by the use of an interest-based benchmark is essential. Many customers perceive it negatively when Islamic banks use conventional benchmarks, creating a hurdle in spreading the share of Islamic finance. Introducing a new benchmark is not just about rules; it could remove confusion for the common man and create a positive image for industry growth. A separate benchmark can enhance trust among stakeholders and help differentiate Islamic financial products. The SBP has acknowledged the need for a separate benchmark for the Islamic banking industry to boost public confidence.
The third dimension of the Islamic benchmark is market dynamics and competition. It will be interesting to observe how much the Islamic benchmark will differ from conventional benchmarks. The difference will depend on market dynamics, calculation methodology, and underlying factors such as linking to economic factors, market share of Islamic banks, and the activity of the Islamic inter-bank market. In markets allowing both conventional and Islamic banking, benchmarks may be closer, while in markets exclusively permitting Islamic banking, the benchmark may evolve differently.
Based on the above deliberations, developing an Islamic pricing benchmark merits serious efforts. For successful development and wider acceptability of such a benchmark, stakeholders need to ensure Sharia compliance, industry collaboration, transparent underlying methodology, wider dissemination, and close monitoring within the Islamic finance community. As the industry progresses, it is the right time for policymakers, regulators, industry players, and academics to sit together with the guidance of Shariah scholars to explore working models for Islamic pricing benchmarks. The development of an Islamic benchmark will not only foster confidence and trust in customers but also fuel the growth of Islamic finance in Pakistan.
AHMED ALI SIDDIQUI IS THE DIRECTOR OF IBA CENTRE FOR EXCELLENCE IN ISLAMIC FINANCE. AHMAR ALEEM IS LECTURER AT NED UNIVERSITY AND RESEARCH FELLOW AT MEEZAN BANK.
Published in The Express Tribune, February 5th, 2024.
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