Benchmarking Islamic Finance

A Framework for Evaluating Financial Products and Services

Mohd Ma'Sum Billah, Mohd Ma'Sum Billah

• Editorial: Routledge
• Año: 2021
• ISBN:
  9781000410365
• Edición: 1
• Categoría: Business
• Categoría: Islamic Banking & Finance

Pricing or benchmarking is a process of evaluating the performance of a financial company's products and services or systems, against other businesses, considered to be at the top of their field, by applying a measurement of "best in performance."

This book includes contributions from the leading global experts in the field who tackle topics such as whether the Islamic financial system has been dependent on the LIBOR / EURIBOR in its benchmarking exercises to date, and thus, whether it will be affected negatively by the predicted non-existence of the LIBOR / EURIBOR from 2021 onwards. They also address the question of whether the Islamic financial system requires benchmarking of its products and services and consider the emergence of Shar? ?ah-justified benchmarking in today's Islamic financial system. Additionally, they look at how benchmarking formulas should be adapted to ensure the satisfaction of customers within the principles of Maqasid al-Shar? ?ah.

It takes a legal and institutional approach to the subject, which readers will find particularly valuable, as there are various forms of Islamic finance institutions that do not conform to established models in the finance industry. Furthermore, there are emerging business models that will benefit from this line of investigation.

This book offers a timely analysis of these issues and redresses the existing misconceptions and misinterpretations pertaining to benchmarking, in an Islamic finance context, and, as such, provides guidance and strategies for future directions. It will appeal to researchers of Islamic banking, finance, and insurance, as well as, practitioners, particularly standard setting bodies, regulators, and policy makers.

Part I

Goodbye to the LIBOR?

The emergence of benchmarking in the Islamic financial system

1 Does Islamic finance need benchmarking?

Mustapha Abubakar, Suleiman Dalhatu Sani, and Isiaka Ahmed Halidu

Introduction

The fallout from the 2008 global financial crisis provided further credence to the operations of the Islamic finance services industry, as more investors became disenchanted with conventional finance. Islamic finance and banking, which operate as an interest-free system, are being viewed as an attractive alternative and a safe corridor against high volatility in interest rates experienced in the conventional financial markets. Evidently, the Islamic finance services industry (IFSI), though occupying a minute portion in comparison to the conventional counterpart, has positioned itself as a relevant player in the global financial system with assets value reaching USD 2.19 trillion in 2018 (IFSB, 2008). Within its framework of operations, the IFSI is anchored on asset-based financing transactions, thus leaning more towards financing the real economy. In the conventional landscape, however, charging interest on loans, which is forbidden in Islam, is the landmark feature in the operations of its various financial institutions. This clearly is contrary to the tenet of Islamic finance arrangement that recognizes the economic value of time and not the time value of money. The former underscores the principle of earning returns as being attainable mainly through a mutually agreed mechanism of sharing based on a rate of profit that is derived from real economic exchange activities, while the latter does not.

Generating sufficient returns to cover the cost of funds is a major consideration for an Islamic financial institution while granting financing. The smooth operations of the Islamic financial institutions (IFIs) with respect to credit financing have, however, incurred questions and doubts based on some perceived gaps that suggest its credibility is tainted. One of the recurring questions is how an Islamic finance institution determines its pricing of credit to customers in a way that truly reflects Islamic tenets. For a long time, the determination of the pricing of credit instruments has been based on conventional benchmarks such as the London Interbank Offered Rate (LIBOR), the Euro Interbank Offered Rate (EURIBOR), the Kuala Lumpur Interbank Offered Rate (KLIBOR), and many others that accommodate interest. For example, the LIBOR is only an estimation of the interest rates that prevail in the money market and thus an index measuring the cost of funds to banks. An aberration is thus seen in many quarters, suggesting that not much difference can be found between the existing Islamic credit prices and the conventional ones as real economic output and growth are not a factor in the determination of the pricing of Islamic credit instruments benchmarked against interest-based parameters. Indeed, the LIBOR benchmark rates are established to be fraught with scandals in their determination process, which necessitated the planned discontinuation of its use effective from the end of 2021.

Furthermore, rate of interest as the indicator for returns in the conventional arrangement differs from rate of profit, which the Islamic finance alternative recognizes in many respects. There are a number of dividing lines between the two. Firstly, in the case of Islamic rate of profit, its determination is guided by Sharī ͑ah principles, whereas for the conventional system, the interest rate is mainly determined through human effort. Secondly, in accounting for the interest income as in the conventional arrangement, earning is recognized upfront even before real economic activity that generates profit takes place as in the Islamic arrangement for profit rate. Again, the application of simple and/or compounded charges of interest as in the conventional arrangement derives its so-called legitimacy from the concept of time value of money.

There are a range of opinions on the potential of having an Islamic benchmark for pricing that decouples from the conventional one. One of the opinions revolves around the perception that it is highly improbable for the IFSI to introduce its unique benchmark due to the arbitrage activities in the financial cycle, and the minute portion the IFSI occupy (Azad et al., 2018). Another opinion suggests, however, that having a benchmark that is acceptable in Sharī ͑ah parlance has the potential of exercising price control that ensures transparency, justice, and fairness in financial and wealth circulation.

Given the foregoing issues as some of the factors that continue to generate thoughts among scholars, academic communities, and practitioners as well, this chapter seeks to argue for the need to come up with an alternative benchmark for pricing Islamic credit financial products that reflects Sharī ͑ah tenets. The chapter is organized into discussions on the LIBOR, EURIBOR, and their defects from an Islamic perspective, pricing mechanisms in Islamic financial products, current phenomena of IF products pricing, benchmarking in Islamic finance, future modeling directions and formulas for benchmarking in Islamic finance, including recommendations, and a conclusion.

LIBOR, EURIBOR, and their defects from an Islamic perspective

The LIBOR is an acronym for London Interbank Offered Rate. It is a benchmark interest rate derived from an average of hypothetical (not actual) interest rates at which the largest and most financially healthy banks operating in London are willing to borrow (not lend) money from one another. The LIBOR is based on unsecured wholesale transactions to the greatest extent possible, with a waterfall to ensure rate publication (Coyle, 2001; Federal Reserve Bank, 2014; ICE, 2019).

EURIBOR is the interbank offered rate at which large banks in the European Union borrow from each other. Though both the LIBOR and the EURIBOR perform similar roles, they are different in terms of the question asked of the panel banks. While the LIBOR asks each respondent the interest rate at which the bank itself can borrow, EURIBOR asks about the funding ability of the average panel bank. The benefit of the EURIBOR methodology is to better approximate the true rate of borrowing by dampening the psychological impact of overconfidence (Federal Reserve Bank, 2014).

The LIBOR and the EURIBOR both indicate the spread between bank credit and a risk-free interest rate, which means the estimate of interest rate submitted by one contributing bank reflects the credit risk (financial health) of that bank when borrowing, thus in aggregate the LIBOR is a pointer on the financial health of the banking system (Duffie and Stein, 2015).

These two benchmarks (particularly the LIBOR) are widely used by financial institutions globally to guide their loan pricing decisions (Financial Stability Board, 2019). Islamic banks also use the LIBOR as a benchmark when pricing certain Islamic financing products. Naturally, Islamic financing products are products whose profit is known and can be precisely calculated, fixed, and agreed upfront between the transacting parties. Common Islamic products include Murabaha, Ijarah, Salam, and Istisna (SHAPE and REDmoney, 2012; Trisiladi, 2019).

It means, for example, it is permissible in a murabahah for a bank to buy a car worth USD 100,000 and sell it to a client for a fixed profit of USD 20,000, totaling a sale price of USD 120,000, thus making the client indebted to the bank (with the profit amount). There are, however, other Islamic financing products that are naturally uncertain because their profit is unknown and cannot be precisely calculated, fixed, and agreed upfront because the profit (or loss or breakeven) can only be known after the outcome of the financed venture such as the common mushārakah and muḍārabah. It means, for example, that it is not permissible in a mushārakah for a bank to partner in a client’s business by injecting capital of USD 100,000 and require the client to pay a fixed profit of USD 20,000 totaling USD 120,000 because it cannot be guaranteed that the client business will make the USD 20,000 profit; as such it is uncertain. Islamic banks are permitted to use the LIBOR as a benchmark for pricing only the naturally certain Islamic financing products (AAOIFI, 2015).

There is a plethora of literature on the debate of Sharī ͑ah permissibility or non-permissibility of using the LIBOR/EURIBOR as a benchmark for pricing Islamic finance products (see ISRA, 2010). However, the majority of Sharī ͑ah opinions, based on fatwa (resolutions) from the industry’s Sharī ͑ah standard setters – Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), Organisation of Islamic Cooperation (OIC) International Islamic Fiqh Academy (IIFA), as well as Sharī ͑ah Boards of numerous Islamic Financial Institutions – have ruled its use as a permissible benchmark (AAOIFI, 2015; Ansari, 2019; JIBM, 2014; Kuwait Finance House Fatwa, 2019).

Nonetheless, the main defect associated with the LIBOR/EURIBOR is that they are intrinsically based on the interest (ribā) rate; as such, in the minority opinion of some scholars, it should be non-permissible. Therefore, based on this shade of opinion, the Islamic finance industry should have an Islamic benchmark rate...