Ever since their establishment, Islamic financial institutions (IFIs) have experienced huge growth and expansion as a niche market for Muslim society. They are also a feasible alternative to conventional financial Institutions. Islamic finance demonstrated resilience to financial shocks as evidenced in the aftermath the Great Financial Crisis (GFC) of 2007-2009.
Currently this financial segment experiences one of the fastest growths in the financial industry. Islamic finance insists on the elimination of any fixed or predetermined interest rate in financial transactions. It encourages equity participants and direct sharing of risk and reward by avoiding speculative transactions and unethical activities. Despite the prohibition of interest, Islamic financial instituitions still refer to the interest rate benchmark as rate of profit or rate of return for most financial products. However whether the practice is permissible from a Shariah point of view needs to be considered.
Benchmark from Conventional point of view
An Interest rate benchmark is a ‘reference rate’ or ‘base rate’. The base interest rate is set by national governments through central banks such as by the Federal Reserve in the Unites States of America. Examples of Interest rate benchmark are London Interbank Offered Rates (LIBOR), U.S.Treasury Security benchmark and Kuala Lumpur Interbank Offered Rates (KLIBOR). Usually, the financial institution will set up their financial benchmark profit rate by adding few basis points to the reference interest rate. For example, if the interest rate is 4%, and 50 basis points are added to it, the profit rate is calculated as 4.5%.
There are three main reasons why the interest rate benchmark is important in the conventional market. First, it is used by almost all financial institutions as a standardised reference to price the financial contracts; such as to set the profit rate of saving. Second, it is used to value the balance sheet items such as discount rate for financial valuations and accounting. Third, it is also used extensively in derivatives exchange such as swaps, future and options.
In a conventional system, it is deemed important for a central bank to set the correct rate of interest. For example, if a central bank sets the interest rate too low it can be problematic; in the case of the Federal Reserve in USA, setting too low interest rate since 2002 led to bubbles of real estate and GFC 2007-2009. Consumers were reluctant to save because the interest rate was too low, and this sequence of events rather inspired them to take high risk investing in risky assets such as real estate and stocks. Whereas, if the interest rate is set too high, there will be illiquid market and lower economic growth.
The Usage of Interest Rate in IFI; Permissible but not desired
The value of assets are emphasized more than the value of money in Islamic finance; this is because the investor cannot utilise money to earn more money. Islamic finance dissents with the idea of ‘money breeds money’. For each financial transaction, there should be underlying assets or any activity that will produce profit (which includes elements of risk and effort). Therefore, rather than making money by offering loans or mortgages and charging interest rate through financial products; a Shariah compliant bank is supposed to use depositors money to acquire assets and share any profits derived.
However, an issue arises on the usage of the interest rate as a benchmark for Shariah compliant contracts and instruments by IFIs. IFIs currently use conventional benchmarks, such as London Interbank Offered Rates (LIBOR), to ascertain the cost of funds and also rate of returns for Islamic financial products. In the present-day, the usage of interest rate, although discouraged, is still accepted as it is used merely as a benchmark in Islamic finance. Though the interest rate is used only as references, the usage should be possibly minimized or even abolished. Thereore, a suitable Islamic pricing benchmark for IFI is urgently needed, one that is based on real economic indicator such as CPI and GDP growth.
As a matter of fact, the first Islamic benchmark for Islamic finance existed and was launched in the year 2011, known as Islamic Interbank Benchmark rate (IIBR). The usage of IIBR is to measure expected profit for a numbers of Islamic Banks. However, this rate is not really based on real economic indicator. Many scholars pointed put that the calculation of IIBR is almost similar with conventional benchmarks such as LIBOR. Some scholars even emphasized that the calculation of benchmark that is not tied to the real economy (i.e. based on real productivity and profitability of assets) will not benefit the country’s economy.
For example, in a real scenario, take the product of Musharakah Mutanaqisah Partnership (MMP) which is used in Islamic Banking around the world. This financial instrument is also known as diminishing partnership between customer and banker. The customer will pay a monthly rental payment to the bank and will pay some amount for a certain period to redeem the bank’s share portion so that the customer can over time acquire the total ownership of a particular house or real estate. Theoretically, the MMP should be referring to the rental index or house price index. Compared to conventional mortgages, the period of financing and the cost of acquiring the property can be reduced through the MMP contract. However practically, most Islamic banks still continue to use interest rate and are reluctant to apply the rental rate index for the the calculation of MMP monthly payment.
Opinion of Shariah Scholars on the issues of interest as benchmark for IFI
The majority of current Shariah Scholars agree that the usage of interest rate as a benchmark in Islamic finance is not in conformity with Shariah. However, this benchmark is the only practically available benchmark in the market. The most important point however is the validity and bona fide of the contract of sale in Islamic finance. Therefore, some scholars argue that the usage of interest rate as a benchmark to figure out the profit rate does not cause the transaction to be invalid as long as it is free from the interest element. Thus, the usage of interest rate as benchmark can be used only as gauge or barometer of profit. Once an Islamic pricing benchmark index is available, the users must directly refer to it.
According to Taqi Usmani, Chairman of AAOIFI, the usage of interest rate as a benchmark for Islamic finance products will not invalidate the contract. This is because the rate of benchmark is nothing more than a number that is non-objectionable from Shariah perspective. Certain scholars argue that the the usage of interest rate in the market does not reflect real economic activity. Hence, the calculation of benchmark in Islamic finance should be based on real economy activity. Furthermore, the usage of conventional benchmarks such as KLIBOR or LIBOR is not appropriate in Islamic finance. This benchmark reflects the amount of money supply in the market but does not represent the real economy activity in the market.
However, there are a minority of scholars who insist the usage of interest rate as benchmark in Islamic Finance. Mohammed El-Gamal supports the usage of conventional interest rate benchmark in Islamic finance. He argues that the usage of Islamic Benchmark is “unnecessary, impractical and dangerous”. This is because Islamic finance is a new and immature market segment. There will be a high risk of liquidity in Islamic Finance.
Proposals of Islamic Benchmark
Some scholars have attempted to initiate an Islamic Benchmark. One of the best efforts was by a group of scholars of the Islamic Shariah Research Academy for Islamic Finance (ISRA). This group of researchers propose two models of benchmark calculation of Islamic benchmark. First, is the Capital Pricing Model (CAPM) that links the market risk of a project or business to its required rate of return- i.e. based on simple factors that are market risk and average rate of return of that particular business. But this model appears to have some shortcomings in that the result is unstable and impractical. Therefore, an extension model to CAPM, called Arbitrage Asset Pricing Model (APT) was proposed that includes several other factors such as inflation, industry production, exchange rates and changes in oil prices. Both models proposed were to be free of non-halal elements such as interest rate and non-real economic activity such as derivates market.
However, this proposal of the Islamic Pricing Benchmark by ISRA was rejected by practitioners, especially bankers. The implementation of different policy rates between conventional and Islamic banking it was held would lead to imbalance between Islamic banking and conventional banking system. For example, if the profit rate of Islamic banking is higher, customers would flock to invest in Islamic banking and vice versa- i.e. there is the risk of arbitrage by the customer. Furthermore, the proposed benchmark is quite costly to derive as there will be different benchmark pricing rates for different industries. This is because the Islamic Benchmark must be tied to real economic activity or productivity and profitability of the underlying assets.
There are other different types of benchmarks proposed by scholars:
Impact of Interest rate as benchmark in Islamic Finance
Even though most current Shariah scholars argue that the usage of interest rate as benchmark does not invalidate the legitimacy of Islamic finance products from a Shariah point of view, the usage still resembles conventional banking. Therefore, it is not surprising that some argue that “Islamic Banking allows riba from the back-door”. By using the interest rate as benchmark for the calculation of profit rate, the users especially consumers, will lose confidence in Islamic banking in the long run. This is because the user cannot comprehend the differentiation between Islamic and conventional products, as both are using the same rate of return.
In conclusion, the only available Islamic benchmark in Islamic Finance is IIBR. However, the IIBR can still be considered as a ‘camouflage’ of the interest rate as the figure is still based on the conventional benchmark. There are various proposals of Islamic benchmark based on real economic activity that can be applied in Islamic Finance proposed by Islamic finance researchers. In spite of this, the practitioners (for example bankers) and even government (example central bank) are quite reluctant to apply any of the models in the market. This is mainly due to liquidity risk as Islamic Finance can still be considered a new market segment and the possibility of arbitrage arising among consumers. However, once Islamic finance is ready to absorb the liquidity risk and all stakeholders are prepared to comprehend the objective of applying the Islamic benchmark, the idea can certainly be put into action.
This material is for informational purposes only. The information is not intended to be used as the only basis for investment decisions, nor should it be construed as advice designed to meet your particular needs. You are advised to seek the advice of your financial adviser, legal or tax professional, prior to making any decision based on any specific information contained herein.