“Islamic Capital Markets and New Product Development - Establishing alternative pricing
and valuation benchmarks and delinking from conventional benchmarks.”
‘Issues and Challenges for developing an Islamic Inter-bank
Benchmark in Pakistan’
Author’s Name: Suleman Muhammad Ali
Author’s current affiliation & position: Manager Product Structuring and Research; Product
Development & Shariah Compliance – Meezan Bank Limited.1
Email addresses of the author: sulemanmuhammadali@gmail.com
Telephone number: +92 3002762632
About the Author:
Mr. Suleman Muhammad Ali holds an MBA (Finance) degree from Institute of Business
Administration, Karachi and is a Chartered Islamic Finance Professional (CIFP) from INCEIF,
Kuala Lumpur. Currently he is the Manager- Product Structuring & Research at Meezan Bank
Limited leading the product structuring and Shariah compliance function related to Islamic
Structured finance, Sukuk Issues, Treasury and Corporate Finance. Mr. Ali is also a reputed
Islamic banking trainer, has conducted various corporate workshops/seminars across Pakistan
and is a regular speaker on the subject at NIBAF - a training arm of State Bank of Pakistan
(SBP). He was involved in the structuring of Pakistan’s first ever short term KAPCO Sukuk and
the development/presentation of proposal regarding the launch of Islamic Interbank Offered Rate
- Karachi (IIBOR - K) in Pakistan to SBP.
1
Competing Interest: Author’s employment with Meezan Bank.Limited.
Page 1 of 40
Abstract
Purpose: The purpose of this paper is to identify and discuss the issues and challenges involved
in developing an Islamic interbank benchmark in Pakistan.
Design/approach: To achieve this objective the paper initially evaluates the need and the
purpose for having a separate Islamic benchmark. Subsequently the paper compares the
mechanisms of interest based benchmark prevailing in Pakistan and the Islamic interbank
benchmark rate launched recently in the international market with the proposed mechanism of
Islamic benchmark in Pakistan. This proposed mechanism is further critically evaluated
regarding its practicality and the challenges involved in making the benchmark a reliable
representative of the Islamic interbank market are discussed at length. The crucial question
whether this Islamic benchmark will be independent from the prevailing conventional
benchmark is analyzed along with suggested scenarios under which the Islamic benchmark shall
be de-linked from the conventional benchmark.
Methodology: The study is based on the review of various scholarly writings on the importance
and requirement of Islamic benchmark rate, review of industry statistics, review of relevant data
on prevailing benchmarks, direct observation of behavior of industry participants, author’s
personal experience and association with the industry including involvement in the development
of the proposed mechanism for Islamic benchmark in Pakistan and various minutes of the
meetings held for implementation and launch of the proposed benchmark.
Findings & Practical implications: The study identifies the issues hampering the development
of a reliable Islamic benchmark in Pakistan and concludes that in the prevailing circumstances
the benchmark if launched will not be independent from the conventional benchmark unless
certain regulatory and other measures are taken. The analysis conducted provides avenues for
further research and will facilitate regulators and industry players in formulating strategies and
policies in pursuit of developing the Islamic benchmark in Pakistan.
Keywords: Karachi Inter-bank Offered Rate (KIBOR); standardization; benchmark, market
forces; independence; Islamic Interbank Offered Rate – Karachi (IIBOR-K)
Page 2 of 40
1.0
Introduction
After the debacle in the attempts to introduce Islamic Banking in the 1980s the industry saw a
renaissance in Pakistan when in 2002 Meezan Bank Limited (MBL) was given the first full
fledged Islamic Banking license in Pakistan (MBL Annual Report 2010). The progress during
the past 10 years has been phenomenal. From a meager Rs. 8 Bn Deposits in 2003 the industry
has grown to a level of Rs.706Bn as on December 2012 (Islamic Banking Bulleting-State Bank
of Pakistan [IBB-SBP] December 2012). Similarly the Total Assets of the industry have grown
from Rs.13Bn in 2003 to Rs. 837 Bn during this period (IBB-SBP December 2012). Aided with
these figures the Islamic Banking industry has now captured around 9.7% share of the overall
banking market in terms of deposits (IBB-SBP December 2012). These figures seem all the more
impressive given the fact that the Islamic Banks operate in an environment which is fiercely
dominated by conventional banks operating in the country for the last 65 years. However despite
these achievements the dominant conventional climate has led Islamic banks to follow the
footsteps of conventional banks in matters ranging from product design, packaging, pricing,
marketing, customer service, costing, profit rates and other areas. This imitation of conventional
products in form although does not necessarily result in Shariah non compliance of the Islamic
financial products if the substance structure and operational execution of the transaction is based
on Shariah principles rather than the riba based Qard structures of the conventional banks; the
imitation in form has become a bone of contention in convincing the masses regarding the
Shariah compatibility of the current Islamic banking system and products in Pakistan. Hence this
reputational road block; despite the growth in recent years; has hindered Islamic banks to make
any significant inroads in areas untouched by conventional banks so much so that with only 10%
of the country’s population having a formal bank account (World Bank 2011, ‘World Bank
Page 3 of 40
Financial Inclusion Data’) the unbanked section of the country’s population still stands at a
massive 90%. The Shariah Reputation Risk is a unique feature faced by an Islamic financial
institution in addition to the reputational risk related to the solvency of the financial institution.
While Islamic financial institutions may sustain the confidence in the public regarding their
ability to pay their debts as they fall due at the same time any dent in confidence regarding the
level of Shariah compliance adhered to by these institution can also have disastrous effects
causing a bank run on deposits or drying up of credit disbursements causing a liquidity crises
which can in turn ultimately lead to the insolvency and default of the institution.
While the issue of imitation of conventional products in form is a common phenomenon through
out the global Islamic financial markets; the issue is a serious threat in the context of Pakistan
given the chequered experience of the public with the Islamic banking experiment of the 1980s
The experiment was declared un-Islamic by Federal Shariat Court (FSC) of Pakistan in 1991 and
by Shariah Appellate Bench (SAB) of the Supreme Court of Pakistan in 1999 (Usmani 2007).
Similar apprehensions exist among the general public regarding the Shariah compatibility of the
current Islamic financial system.
2.0
The use of KIBOR as a benchmark:
In Pakistan the representative benchmark used by commercial banks to price their financing
products is the Karachi Interbank Offered Rate (KIBOR). The mechanism for calculating
KIBOR will be discussed in the later section; however the KIBOR was launched in January 2004
and all the commercial banks were required; upon the instructions of SBP (BPD CircularNo.1,
21 January 2004); to price their corporate lending based on KIBOR. Before the launch of
KIBOR the commercial banks either used the prevailing rates of various tenors of the sovereign
Treasury Bills issued by SBP or the SBP discount window rates as the base rates for pricing their
Page 4 of 40
lending products. With the establishment of Meezan Bank Limited (MBL) as the first
commercial Islamic bank in 2002; the bank also started to use the Treasury Bill rates as the base
rate for pricing its products. Subsequently with the incorporation of KIBOR the bank started to
price its products based on this benchmark. The use of interest based benchmarks is prevalent in
all the Islamic financial market and is widely being used by Islamic banks for financing their
products; the main reason for this is the absence of any worthwhile market representative Islamic
financial benchmark. The use of these benchmarks has been allowed by Islamic scholars based
on the fact that if the underlying transaction is based on the compensatory contracts, procedures
and principles allowed by Shariah rather than the contract of Qard (as is the case with
conventional banks) the mere usage of a conventional benchmark for calculating the price or the
profit amount does not render the transaction haram or impermissible. Usmani (1998, p.119)
states:
If a Murabaha transaction fulfills all the conditions enumerated in this chapter, merely using
the interest rate as a benchmark for determining the profit of murabaha does not render the
transaction as invalid, haram or prohibited because the deal itself does not contain interest.
Similarly the juristic pronouncement given by the Shariah board of the Islamic Interbank
Benchmark Rate (IIBR) (2011, p.1) states that:
in the absence of benchmarks that have evolved from Shari`a precepts for transacting,
Islamic financial institutions have been making regular use of LIBOR (the London Interbank
Overnight Rate) which is based on interest and is therefore in no way reflective of Islamic
values and principles. It is for this reason that such a benchmark is ill-suited as an accurate
indicator of value within Islamic markets even though fiqh councils and committees have
ruled that it is lawful to use such benchmarks as references in the absence of anything else.”
Hence from these quotes it is clear that while the scholars have given the approval for the usage
of the conventional interest based benchmarks the usage is considered undesirable and only on
the condition that the representative Islamic benchmarks are not available. Commenting on the
use of conventional benchmarks Usmani (1998, p.119-120) further states:
Page 5 of 40
It is, however true that the Islamic banks and financial institutions should get rid of this
practice as soon as possible, because, firstly, it takes the rate of interest as an ideal for a halal
business which is not desirable, and secondly because it does not advance the basic
philosophy of Islamic economy having no impact on the system of distribution. Therefore the
Islamic banks and financial institutions should strive for developing their own benchmark.
The development of indigenous Islamic financial benchmark in Pakistan is not only the desire of
the country’s Islamic finance scholars but is also the requirement for the industry to make further
inroads into the country’s financial landscape and even more so to bring the 90% unbanked
population in to financial inclusion which has largely been untouched by the conventional
system for the last 66 years.
3.0
The ingredients of an Islamic benchmark:
While commenting on the need for an Islamic benchmark the fatwa of the Shariah board of the
IIBR (2011) states:
Since the Shari`a of Islam insists on transacting with justice and the doing of good, it requires
the development of instruments that measure what occurs in the markets in accordance with
values and principles that correspond with the Shari`a of Islam. Unless a benchmark is
derived from within the value system on which the Islamic financial services industry is
based, that benchmark can never serve as a true and accurate point of reference for the
industry. This is why there is such a pressing need today for benchmarks that describe
Islamic markets with precision while also according with authentic Islamic modes of
transacting.
In the previous section we have looked at the requirement of an indigenous Islamic financial
benchmark both from the Shariah as well as the commercial perspective. Before discussing the
possibilities, issues and options for launching such a benchmark it is important to extract and
outline the broad objectives and goals that such a benchmark must fulfill from both the
perspectives:

The benchmark must be a reliable standard representative of the Islamic financial markets’
liquidity situation for unsecured risk, placements and acceptances.
Page 6 of 40

It must be derived from the value system and contracts based on the principles of Shariah and
Islamic modes of financing.

The benchmark must be acceptable to the industry participants to the extent that it used for
their internal pricing and for pricing their wholesale, retail and interbank financing
transactions.

The benchmark must be a means of achieving the distributive justice as outlined by the
principles of Islamic economics.
4.0
Mechanism of KIBOR
Karachi Inter-bank Offered Rate (KIBOR) uses the Reuters infrastructure for its daily quotations.
The contributors of KIBOR are around 20 conventional commercial banks (as selected by
Financial Markets Association of Pakistan (FMA)) operating in Pakistan. As per the FMA
(Master Communique’ on Kibor 2009) the contributing banks contribute their two way Bid and
Ask rates daily by 11:20 am (Pakistan Standard Time) to the Reuters for the tenors ranging from
overnight to 3 years. The Reuters cancels out the highest and lowest rates as outliers and
calculates the arithmetic mean of the remaining rates. The FMA also acts as the guardian of the
KIBOR setting process. Initially rates of only 1-month, 3-month and 6-month tenors were
quoted; the quoted rates for various tenors have been extended over the years. The 6-month and
the 1-year KIBOR are the most widely used rates for pricing long term and short term financial
transactions.
Rules and Mechanism of KIBOR as per FMA (Master Communiqué on Kibor 2009):
 All KIBOR contributor banks are required to quote their two way prices for minimum
amount of PKR100mn, within the allowable maximum bid/offer spreads for the relevant
tenor as indicated below:
Page 7 of 40
- Overnight – 1month
- 3 and 6 months
- 9 months, 12 months, 2 & 3 years
50basis points
25 basis points
50 basis points
 The quoted prices would remain valid between 11:30 am – 11:50 am for all KIBOR tenors.
 KIBOR contributing banks should have unsecured contributing limits for at least 25% of
other KIBOR contributing banks. In cases where unsecured lending limits for any particular
KIBOR contributing bank do not exist or are temporarily full, the quoting bank is required to
honor its KIBOR quoted bid price.
 Banks which fail to submit KIBOR rates to Reuters for 4 Business Days during any calendar
month would be suspended for the next 1 month from the list of KIBOR contributors. SBP
will monitor this regularly and instruct the Reuters to comply with the said instructions under
advice to FMA
5.0
Proposed Mechanism of Islamic Interbank Offered Rate – Karachi (IIBOR-K)
In this section we look at the proposed mechanism of IIBOR – K developed by Meezan Bank
Limited and presented to the State Bank of Pakistan on 4th June 2010. As far as the structure of
the mechanism is concerned it is similar to the way other benchmarks like LIBOR and KIBOR
are derived; with Islamic Banks and Islamic Banking Windows of conventional banks
contributing rates each day for various tenors based on their liquidity position and their forecasts
for the future trend of the market. The following mechanism and specific rules were outlined for
the IIBOR – K in the proposal put forward before the SBP:
1) Banks that can contribute shall be Islamic Banks (IBs) and Islamic Windows (IWs). However
initially only the six full-fledged Islamic banks shall be the contributors. Islamic windows
shall join in at a later stage
Page 8 of 40
2) All contributor banks shall be required to quote their two way expected profit rates on
Interbank Mudarabah/Musharakah/Wakala Placements for the amount of PKR 25 million,
within the allowable maximum bid/offer spreads for the relevant tenor as indicated in Table 1
below. The quoted prices would remain valid between 11:45am-12:00 pm Pakistan Standard
Time (PST) for all IIBOR-Karachi tenors. Initially only rates for 1-week to 6-months tenor
shall be quoted.
3) If the bank is hit on its IIBOR-Karachi price once in any tenor, it can then change the price
for any IIBOR-Karachi tenor in a subsequent quote. However, the bid/offer spread in case of
any subsequent price must not be more than the allowable bid/offer spread as per Table 1.
Table 1
1 week, 2 weeks and 1 month
3 and 6 months
100 basis points
50 asis points
4) IIBOR-Karachi contributor banks should have unsecured placement limits in place for at
least 25% of other IIBOR-Karachi contributing banks. In cases where unsecured placement
limits for any particular IIBOR-Karachi contributing bank do not exist or are temporarily
full, the quoting bank is required to honor its IIBOR-Karachi quoted bid price. Banks which
fail to submit IIBOR-Karachi rates to Reuters for 7 Business Days during any calendar
month would be suspended for the next 1 month from the list of IIBOR-Karachi contributors.
5) Other Miscellaneous Guidelines
a) All IIBOR-Karachi Contributors to submit their rates to Reuters latest by 11:35 am PST.
b) To calculate IIBOR-Karachi Fixings, Reuters will exclude highest and lowest prices as
per Table 2 and calculate the arithmetic mean for the remaining values.
c) All IIBOR-Karachi interbank related deals should be mentioned properly in reporting
through money market Central Reporting System (CRS) to SBP.
Page 9 of 40
Table 2
Number of Contributing
Banks
Less than or Equal to 4
Between 5 & 8
More than 8
6.0
Outlier Prices to
Removed
None
1 highest & 1 lowest
2 highest & 2 lowest
be
Analysis and comparison of proposed IIBOR-K mechanism with other benchmarks
The mechanism for deriving IIBOR - K is quite similar to the mechanism of other conventional
benchmarks and the Islamic Interbank Benchmark Rate (IIBR); the only Islamic banking
benchmark launched in November 2011 jointly by Thomson Reuters (TR) and AAOIFI.
However compared to the IIBR which does not relate to any specific region, country or
jurisdiction (TR 2011, ‘IIBR Fact Sheet’) the proposed IIBOR-K is related to the city of Karachi
and the rate shall be the benchmark for the financings provided through out the jurisdiction of
Pakistan. Secondly the IIBR is the benchmark rate for the financings to be provided in the
currency of United States Dollars and not in any particular currency of the countries to which the
contributor banks relate to; hence it is supposed to be the global benchmark for Islamic
banks(TR 2011, ‘IIBR Fact Sheet’). With the major contributors of IIBR being banks from the
GCC the IIBR may represent the ground realities of liquidity situation in the GCC but surely
may be in stark contrast to ground realities in other Islamic financial markets like Malaysia,
Indonesia, Pakistan, Africa, etc. For this reason the use of IIBR in USD denominated financing is
non existent in the markets outside the GCC. Based on observation and discussion with industry
participants even in GCC the major banks; both the contributors and non contributors to the
IIBR; do not use IIBR as the preferred benchmark for providing USD based financings. This
shows that there is a lack of confidence in IIBR being the true representative of the industry.
Another major difference between IIBR and IIBOR-K is that while the IIBR is based on the
Page 10 of 40
quotes of the Bid rates (TR 2011, ‘IIBR Fact Sheet’), IIBOR-K is proposed to be a two way rate
based on both Bid and Ask quotes of the contributing banks for various tenors. Hence the
IIBOR-K shall be quoted in form of a range rather than a single rate. To ensure that the range is
not expansive the proposed mechanism has restricted the maximum spread allowed when the
quote is made. Both the benchmarks are not based on fixed returns as is the case with
conventional interest based benchmarks but are rather based on expected rates; i.e. the
contributors are asked to submit the expected rates that they would be willing to provide/demand
for certain amount of funding. The reason for this is that while conventional rates are guaranteed
as an obligation on the obligor in a contract of qard or loan the underlying Islamic interbank
transactions are based on Musharakah, Mudarabah, Wakalah or Commodity Murabaha under
which the returns are not guaranteed but are to be earned based on the actual underlying
performance of investment or trade transaction. The mechanism of IIBOR-K also defines the
minimum amount of acceptance / placement for which the rates are to be quoted which is PKR
25million compared to the lot size required under the rules of KIBOR; which is PKR 100million;
this amount seems paltry however the same has been kept due to the industry dynamics as will
be discussed in the later sections. In contrast the mechanism of IIBR does not outline any such
minimum lot size amount for making the quote but refers to the market amount of USD in the
question asked to the contributors (TR 2011, ‘IIBR Fact Sheet’). This can be a problem since the
contributing banks to the IIBR currently range from GCC region to Malaysia while there are
plans to include more Islamic banks from other regions; with each region having different
standards and levels for market amount of USD this mechanism is bound to discourage actual
cross border interbank transactions based on the benchmark making it at best a quoted
benchmark rather than a traded one. To make the IIBOR-K a practical industry representative
Page 11 of 40
benchmark and to avoid artificial quotes by the contributor banks certain provisions have been
built in its mechanism including the rule that the contributed rates shall remain valid for 15
minutes between 11:45am till 12:00pm and any bank which is approached for its expected ask
rate during this time period by any other contributing bank will be required to honor its
commitment and place funds with that investee bank provided the investor bank has sufficient
room in its interbank placement limits for that investee bank. Likewise to ensure that there is
sufficient interbank flow of funds among IIBOR-K contributors the rules also require that each
contributor bank must have unsecured placement limits in place for at least 25% of other IIBORK contributing banks. At the same time the rules make it mandatory for the quoting banks to
accept funds at the quoted expected bid rate if it is approached during the defined time period by
any other contributing bank. Similarly to keep track of the deals at the quoted rates the proposed
rules also require the contributing banks to specifically mention such interbank deals as IIBORK related in the SBP reporting system. No such measures seem to have been incorporated in the
IIBR mechanism which would ensure that the IIBR contributed rates are genuine and the rate
actually becomes an industry representative practical benchmark. However under the IIBR
mechanism TR is required to carry out the audit and review of the contributed rates before
calculating the average IIBR rate for the day. Along with this audit requirement the IIBR is also
supervised by a supervisory and technical advisory committee known as the Islamic Benchmark
Committee (IBC) comprising of representatives of all the contributing banks, AAOIFI, Thomson
Reuters, Islamic Development Bank, etc. At best the IBC based on the recommendations of TR
can include or exclude any contributor bank in case of persistent out of the market non genuine
quotes or any other breach of the agreement between the contributing banks (TR 2011, ‘IIBR
Fact Sheet’). However as far as measures required to make the benchmark practical and tradable
Page 12 of 40
is concerned the IIBR seems to be deficient in this regard when compared to the proposed
IIBOR-K mechanism. At the same time it is important to note that there is no provision of any
supervisory body for the IIBOR-K to judge the matter in case of conflict or to implement the
rulings like inclusion or exclusion of contributors as an independent impartial party. SBP can
play this role as it is doing in case of KIBOR.
7.0
Issues and challenges in developing and launching IIBOR - K
The purpose of having benchmarks is to have a reliable barometer available for the users to judge
the status of the liquidity position of the industry which would help them in making an informed
financial decision. Hence the benchmark must be reflective of the industry status and market
dynamics. There is no point in having a benchmark which is not reflective of the industry
position of liquidity. Such benchmarks would lead users to make decisions which have not
optimally taken in to account the liquidity position of the market and the level at which the
interbank market prices the risk given the tenor of financing for clean unsecured financing. The
same was the concern of the SBP representatives on the proposal presented before them. While
appreciating the efforts of Meezan Bank’s team and the viability of the mechanism of the
IIBOR-K the SBP reiterated the need for making it a true representative of the Islamic banking
industry and stressed that for this purpose ‘all Islamic banks must not only be in consensus but
also be the contributors to the daily rates for deriving the IIBOR –K rates’. Despite these
promising developments in 2010 the launch of IIBOR – K has been stalled to date due to
impeding issues and challenges which need to be conquered for developing a truly reliable and
representative Islamic benchmark rate for the Islamic banking industry in Pakistan. These issues
and challenges are discussed at length in the following sections.
7.1
Size of the industry
Page 13 of 40
Why did the SBP stress the need for including at least all the Islamic banks as contributors to the
rate before the final launch? The answer lies in the small size of the industry. Despite attaining
around 10% market share the Islamic banking industry in Pakistan is still dwarfed by the
conventional banking system of the country. As per the current figures (2012 year end) there are
5 fulfledged Islamic Banks and 13 Islamic Banking windows (IBB-SBP December 2012). This is
in stark contrast to the size of the conventional banking market which has around 32 commercial
banks. Out of these 30 banks; up to 20 are contributors to KIBOR for various tenors. These
include top 5 commercial banks known as the Big 5 controlling 52% market share of the banking
industry namely MCB Bank, United Bank Limited, National Bank of Pakistan, Allied Bank
Limited and Habib Bank Limited (Annual Reports 2011). Hence the KIBOR is determined based
on contributions from a major portion of the banking industry and thereby representing the real
market sentiment. Absence of one or two contributor banks on any single day would not affect
the status of KIBOR not reflecting the industry status. However since Islamic banking is
relatively a small industry with only five participants the absence of one or two participants or
disqualification of one or two participating banks will render the IIBOR-K as meaningless and
not reflecting the industry ground realities.
7.2
Industry Dynamics
The current Islamic banking industry landscape is largely dominated by one large Islamic bank.
Meezan Bank Limited (MBL) is the first and largest Islamic Bank of Pakistan controlling a
market share of 32.5 % in terms of deposits and 33% in terms of assets as of December 2012
(MBL Annual Report 2012). The remaining numbers are shared by 4 Islamic banks and 13
Islamic banking windows. In terms of profitability MBL ranked 9th in the whole banking
industry as per the results for the year ended December 2011 with a bottom line profit after tax of
Page 14 of 40
PKR 3.392 billion. Compared to this the rest of the full-fledged Islamic banks in the industry
managed to secure a combined bottom line of PKR 1.11 billion; with Bank Islami Limited (BIL)
and Al Baraka Bank Pakistan Limited (ABBPL) showing earnings of PKR 410 million each
Dubai Islamic Bank (DIB) making an earning of PKR191million while Burj Bank Limited
(BBL) made a net loss of PKR 288 million. With this controlling stake in the market other
market participants are anxious of being a partner contributor to an average industry benchmark.
The relative strength of MBL in terms of profitability has enabled the bank to invest heavily in
its branch network over the years. With 310 branches MBL has the 8th largest bank network in
the industry (MBL Annual Report 2012), the closest to MBL among Islamic banks is BIL with a
branch network of 102 (BIL Annual Report 2012). The total number of Islamic banking branches
in the country as of year ending December 2012 was 1097 branches (IBB-SBP December 2012).
This widespread branch network provides MBL with an extensive outreach and higher sources of
generating low cost retail liquidity. This has resulted in MBL having the lowest average cost of
deposit rate of 5.3% in the Islamic banking industry (MBL Annual Report 2011). In fact when
looking in terms of the whole banking industry MBL has the 7th lowest cost of deposits among
32 commercial banks. As per the year ended 2011 the rest of the Islamic banks experienced the
following costs of deposits (according to 2011 annual reports).
Name of Bank
Cost of Deposits
Bank Islami Limited
6.3%
Dubai Islamic Bank
6.4%
Burj Bank Limited
8.4%
Al Baraka Bank Pakistan Limited
8.7%
The proportion of low cost Current Account and Saving Account (CASA) deposits; an important
statistical performance benchmark in the industry; of MBL as of December 2011 was 65%.
Comparatively other Islamic banks fared as per the following table (according to 2011 annual
reports).
Page 15 of 40
Name of Bank
Proportion of CASA
Bank Islami Limited
48.5%
Dubai Islamic Bank
53.8%
Burj Bank Limited
44.6%
Al Baraka Bank Pakistan Limited
45.9%
In terms of wholesale sources to funding MBL due to its better credit rating; as mentioned in the
following section; and strength of its balance sheet is able to have diverse lines with other
conventional financial institutions to accept and place funding through the modes of Tawarruq
and commodity murabaha. These entire factors place MBL into a very strong position by a huge
margin compared to its Islamic banking counterparts creating a perception that MBL will be able
to control the benchmark rates to its benefit and to the detriment of other banks. Such
perceptions may seem unreal given the mechanism of IIBOR-K as stated above which requires:
i) the rates quoted by each bank to be executable to control the rigging of the benchmark and;
ii) the average will be a trimmed average by discarding the highest and the lowest prices.
However given the fact that the rates of offer/bid will only be given for a meager PKR 25 million
which will not have a huge impact on MBL given the sheer size of its balance sheet and the fact
that if the contributor banks on any given day fall below the number of five the trimmed average
formula will not be implemented making the controlling of the benchmark by the industry’s
largest bank a certain possibility. The IIBOR-K derived from such a situation may be to low to
be acceptable to other Islamic banks in the industry; who will have to charge a higher premium
over and above the benchmark rate making it difficult for them to market their financing
products to their corporate and retail customers.
The low cost of deposits will certainly enable MBL to quote rates which are very much lower
than the rest of the market. Hence even if we consider that the number of contributors does not
fall below five contributors the rates quoted by MBL shall be sidelined as outliers. The IIBOR-K
in such cases will then be based on the remaining values. These values may be contributed by a
Page 16 of 40
large number of Islamic banks and Islamic banking windows but the resulting IIBOR-K rates
may not reflect the true industry position nor be based on the lowest cost and risk levels of the
industry since after all MBL does represent 33% share of the industry.
7.3
Ratings
The contributing banks for LIBOR and KIBOR have similar ratings and financial strength which
allows for each of the contributing banks to freely trade funds between them at the contributed
rates. The ratings of the big 5 group of banks; the major contributor to the KIBOR and the other
second tier contributor banks as at September 2012 is as follows (SBP 2012):
Name of Bank
Rating Agency
Short
Rating
National Bank of Pakistan
Allied Bank Limited
United Bank Limited
MCB Bank Limited
Habib Bank Limited
Bank Alafalah Limited
Askari Bank Limited
Faysal Bank Limited
Bank Al Habib Limited
Habib Metropolitan Bank
JCR-VIS
PACRA
JCR-VIS
PACRA
JCR-VIS
PACRA
PACRA
PACRA
PACRA
PACRA
A-1+
A1+
A-1+
A1+
A-1+
A1+
A1+
A1+
A1+
A1+
Term Long
Rating
term
AAA
AA+
AA+
AA+
AA+
AA
AA
AA
AA+
AA+
As can be observed the short term ratings of all the major banks contributing to the KIBOR are
same. This ensures that each bank has sufficient lending limits approved with other banks for
short term interbank placements. The following is the ratings of Islamic banks operating in
Pakistan (SBP 2012):
Name of Bank
Rating Agency
Short
Rating
Meezan Bank Limited
Bank Islami Limited
Dubai Islamic Bank
Burj Bank Limited
Al Baraka Bank Pakistan Limited
JCR-VIS
PACRA
JCR-VIS
JCR-VIS
JCR-VIS
A-1+
A1
A-1
A-1
A-1
Term Long
Rating
term
AAA
A
A
A
Page 17 of 40
Due to MBL’s relative strength as mentioned earlier the bank has both long term and short term
ratings higher than its peers. In fact MBL’s short term ratings are equal to the top tier
commercial banks in the industry. As far as other players in the Islamic banking industry are
concerned all of them have a one level lower short term credit rating of A-1.
Due to this difference in credit ratings all Islamic banks do not have sufficient interbank credit
lines with each other; thereby reducing the volume of transactions between them. Instead Islamic
banks are more satisfied with having interbank short term credit lines with the Islamic banking
windows of conventional banks which have the same credit rating as their conventional parent
companies since ratings are issued for the institution as a whole and not independently for the
window operations. Almost all of the conventional banks mentioned in the ratings grid have
conventional windows except Allied Bank Limited. Secondly the development of product
structure of local commodity murabaha in 2007 in Pakistan has allowed Islamic banks to use this
vehicle of Tawarruq for parking their excess liquidity even with conventional banks. Such
measures have raised eyebrows of various observers including the regulator; however the Islamic
banks and their Shariah advisors have justified these measures in the past on the basis of non
availability of sufficient Shariah compliant avenues for deployment of excess liquidity by
Islamic banks and the fact that the commodity murabaha transaction structurally involves sale of
goods rather than lending of funds to conventional banks. Hence the Islamic banks have other
alternatives with better risk profiles to invest their excess liquidity with rather than rely on other
Islamic banks.
The unavailability of sufficient lines was also raised as one of the stumbling road block
restricting the development of Islamic interbank market and practical viability of IIBOR-K
during the meetings between Islamic banks for the launch of IIBOR-K. Since rates quoted for
Page 18 of 40
IIBOR-K need to be executable as mentioned in the mechanism above so as to avoid rigging of
rates and make the benchmark a real representative of the industry; the unavailability of
sufficient lines would effectively make the contributed quotes non-executable hence increasing
the chances of the IIBOR-K rates being rigged.
7.4
Standardization
Another important factor inhibiting interbank flow of funds between Islamic banks is the fact
that different Islamic banks and windows use products based on different modes for acceptance
and placement of funds in the interbank market. This was also the main factor highlighted by
Treasurers and Shariah advisors in the various meetings held between Islamic Banks to build a
consensus for the launch of IIBOR-K. MBL, ABBPL and BBL use the Musharakah structure for
accepting and placing liquidity. On the other hand DIB uses the Wakalah based structure for
placement of liquidity. The second largest Islamic bank BIL initially had its interbank product
structure based on Wakalah but later discarded it citing Shariah compliance issues; the bank also
was not in favor of using Musharakah based structure earlier but now seems to be settled with
the same structure. As far as Islamic windows of conventional banks are concerned Bank Alfalah
Islamic, MCB Islamic, Habib Metropolitan Islamic and Habib Bank Islamic use the Musharakah
based structure for interbank activity. Faysal Bank Islamic, Standard Chartered Saadiq and
Soneri Bank Islamic use the Mudarabah Structure. Similarly the use of Commodity Murabaha or
Tawarruq has been a major bone of contention among Islamic banks in terms of its compliance
to Shariah. Disapproval of the product gained its momentum after the issuance of ruling
regarding impermissibility of organized Tawarruq by Islamic Fiqh Academy. While MBL, BIL
and DIB use it sparingly other Islamic banks have not allowed the use of this product.
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Hence it is clear that unlike conventional banking system where there is only one product
structure; based on lending; Islamic banks in Pakistan use various different structures for
acceptance and placement of funds in the interbank market. To resolve this matter and to bring a
certain level of standardization Musharakah and Wakalah structures were selected by Shariah
Advisors and Treasurers for the purpose of standardization during meetings for the launch of
IIBOR-K based on SBP directives. In the initial round of circulation for final approval the
Musharakah based structure and the Interbank Master Musharakah Agreement were approved
and finalized by MBL, Dawood Islamic Bank (now BBL), ABBPL and Emirates Global Islamic
Bank (now merged with ABBPL). The product was disapproved by DIB and BIL citing Shariah
concerns. The Wakalah based structure and the Master Wakalah Agreement were approved and
finalized by MBL, ABBPL and DIB. However Dawood Islamic Bank and BIL disapproved the
structure based on Shariah reasons. Without divulging these Shariah reasons it is imperative to
mention the nature of reasons for disapproval raised by each bank:

Dawood Islamic Bank cited Fiqhi concerns and questioned the permissibility of Wakalah for
istithmar (investment) purposes.

BIL’s concerns regarding Musharakah where more related to operational aspects for instance
use of hiba, waad and the ability of all Islamic banks to segregate and manage special
investment pools from its general pools.

Regarding Wakalah; BIL cited Fiqhi concerns in using Wakalah and giving a fixed fee to the
wakil in a special investment pool where the Wakeel is also participating as a partner along
with the Muwakkil.

Regarding its non approval of Musharakah; DIB advised that ‘its global Shariah board is not
convinced regarding the Shariah compliance of the Interbank Musharakah product and hence
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it is not possible for them to secede from them’; hence the reason was more of an internal
policy matter rather than a purely Shariah issue.
While the Fiqhi issues are not the subject of discussion of this paper it is pertinent to mention
over here that hiba and waad are only applied by Islamic banks in Pakistan when calculating and
distributing monthly Mudarabah profits to general pool of depositors; the same are not employed
by Islamic banks in interbank Musharakah transactions involving special investment pools as has
been observed over the years by the author; hence BIL’s concerns regarding this seem to be
unreal.
Hence despite these efforts the six Islamic Banks in 2010 failed to agree on any single product
structure and legal documentation to be used in the Islamic interbank market. However despite
these setbacks since the Musharakah based structure was still largely acceptable by a large
number of Islamic windows along with four full-fledged Islamic banks; MBL initiated a second
level of consensus exercise in which Islamic Windows of conventional banks were asked to give
their consent and approval for this products structure and its legal documentation. This received
an overwhelming response and the following windows gave their consent for the Interbank
Musharakah product: Faysal Bank Islamic Banking, Askari Bank Islamic Banking, Habib
Metropolitan Islamic, Bank Alfalah Islamic Banking, National Bank Islamic, MCB Islamic and
Habib Bank Islamic. Despite this consensus the launch of IIBOR-K could not be achieved in
2010 due to the absence of two key players in the industry i.e. BIL and DIB.
The current situation in 2013 is more or less the same with seven Islamic windows and three
fulfledged Islamic banks being in consensus on the Interbank Musharakah Structure; while three
fulfledged Islamic banks are in consensus for the Wakalah structure. With this divided mandate
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the development of an efficient Islamic interbank market and hence a viable benchmark remains
a distant possibility.
7.5
Low confidence regarding Shariah compliance:
Due to different schools of Fiqh; scholars from Malaysia, Pakistan and Gulf Region have
different opinion on different issues which result in different product structures prevailing in
different regions. This has hindered the process of standardization and integration of global
Islamic financial markets; restricting the flow of funds between jurisdictions; since Islamic
investment opportunities like sukuk issues in Malaysia may not be acceptable to scholars from
Pakistan or GCC and vice versa due to underlying Shariah non compliance issues. Unrestricted
flow of funds; as is the case with conventional financial markets; is crucial for the development
of a well integrated and efficient global Islamic financial market.
While inter regional differences are understandable intra regional differences are a real cause of
concern within the nascent Islamic financial market in Pakistan. The issue of standardization in
Pakistan is not related merely to the transaction structures in the interbank market (as discussed
above) but extend to the general banking products that each Islamic bank offers. In fact this
problem is an extension of the issue of standardization in the global Islamic financial markets
due to different Shariah opinions in each jurisdiction. While there is sufficient level of
understanding among Islamic banks having local Pakistani scholars on their Shariah boards or as
Shariah advisors; products of Islamic banks with foreign Shariah boards are seen with
skepticism. The local religious schools and their fatwa issuing bodies have only certified
products of Islamic banks with local Shariah scholars. While the position of these institutions
regarding Islamic banks with foreign scholars is that of anonymity; that is neither approving nor
disapproving these institutions. This is also the position of the country’s two biggest religious
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institutions Jamia Darul Uloom and Jamia Al Rashid; both the institutions hold heavy influence
among the general public. Again the major reason underlying this issue seems to be the
difference of opinion between the different schools of thought since the Hanafi fiqh is the major
school of thought prevailing in Pakistan while scholars of Arab origin in other Islamic banks
follow other schools of thought.
Hence while MBL has approved the Wakalah based interbank product structure of DIB the bank
does not have any interbank placement lines with DIB. Similarly MBL also does not have any
placement lines with Standard Chartered (SCB) Saadiq (Pakistan). Similar is the position of BIL
and BBL regarding these two institutions. The reason in both these cases is the lack of
confidence that prevails in the market regarding the Shariah compliance level of the financing
products of these two institutions and the level of systems in place to ensure Shariah compliant
execution of approved products which in turn leads to confidence deficit regarding the
permissibility of income earned by these institutions. It is important to note however that similar
lack of confidence among local Islamic Banks does not exist regarding ABBPL even though the
bank is a subsidiary of Al Baraka Banking Group (ABG), a Bahraini joint stock company. Even
the religious schools of the country also have a positive opinion regarding the bank. This seems
to be due to the fact that the bank’s management has devised its Shariah governance structure
according to the sentiments of the market by incorporating a local panel of well reputed and
qualified Shariah scholars. There are three local Shariah scholars on its panel for managing
Shariah matters of the subsidiary along with the high profile global Shariah board of the ABG.
The bank used to operate with one Shariah scholar previously but reconstituted its local panel in
2010 when the bank acquired Emirates Global Islamic Bank. In contrast DIB and SCB Saadiq
both employ one local Shariah scholar who works under their global Shariah boards.
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This issue has also hampered the development of clean interbank lines between Islamic banking
institutions restricting the free and efficient flow of funds between them. Resolution of this issue
is crucial for the development of the Islamic banking industry and the launch of an Islamic
benchmark rate in the country. Various measures need to be taken to resolve this issue.
Institutions facing the problem of market perception and Shariah acceptability need to rethink on
their Shariah governance structures and probably follow in the footsteps of ABBPL: keeping
intact their high profile global Shariah boards as well as creating a local committee of local
Shariah scholars catering to the local demands and sentiments of the market. This may result in
different Shariah positions being taken by these banks for the same product being offered in
different markets; for instance rebate on early payments in Murabaha transactions which may be
allowed in the GCC markets but prohibited in the Pakistani market; or different products being
offered for different markets. However this is the strategy employed by successful multinational
organizations worldwide; take for instance the example of Pizza Hut and KFC offering different
menus for different markets catering to the local tastes.
Such differences of opinion can also be weeded out through Shariah advisor level negotiations
between Islamic banks. Alternatively the Islamic banks (especially those with foreign Shariah
scholars) can approach the local religious and fatwa institutions to resolve the issues and
misunderstandings regarding their products. This will not only help in bringing standardization
but also result in more marketability and acceptability of their brand name.
7.6
Role of Central Bank Shariah Board
Role of the central Shariah Board is crucial for the development and standardization of Islamic
banking products in any jurisdiction. The State Bank of Pakistan (SBP) incorporated its Shariah
Board in the year 2004; two years after issuing the first license for establishing a full-fledged
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Islamic bank in the country. Over the past nine years SBP Shariah Board has been instrumental
in achieving several crucial landmarks for instance approval of Essentials and Model
Agreements for Islamic Modes of Financing; Structuring and launch of WAPDA Sukuk and a
series of Sovereign Ijarah Sukuk; adoption and adaptation of four AAOIFI Shariah standards in
Pakistan; issuance of instructions and guidelines for Islamic Banking Institutions; etc. Despite
these achievements the SBP Shariah Board has not been able to make any impact regarding the
following:
(1) Achieving standardization/harmonization of Shariah interpretations among Islamic banks: To
date the SBP Shariah Board has not taken any measures in resolving the differences of opinion
prevailing in the market as discussed in the previous section. One reason for this is evident from
the roles of the SBP Shariah Board (SBP 2008, Strategic Plan for the Islamic Banking Industry
in Pakistan [SPIBIP]) which does not require individual Islamic banks to acquire approval of
SBP Shariah Board before launch of new products in the market. This is unlike the role of
Syariah Advisory Council (SAC) of Bank Negara Malaysia (BNM) which requires the individual
banks to take the approval of SAC (SBP 2008, SPIBIP); this ensures an in built mechanism for
achieving standardization across the industry within BNM’s jurisdiction. While recognizing its
benefits the strategy adopted by BNM can also result in inertia, lack of innovation and creativity
in the industry by slowing down the process of new product development and launch by erecting
stumbling blocks of procedures, policies and approvals of the regulator. Due to these reasons
SBP has adopted the current approach which has resulted in the development of diverse menu of
products and solutions available for Islamic banking customers. However despite this policy,
standardization of the industry can be achieved in a harmonious manner if the regulatory Shariah
Board makes a pro-active intervention by requiring the Islamic banks and their Shariah advisors
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to sit together and weed out the outstanding differences through a series of constructive
discussions with the SBP Shariah Board acting as a moderator.
(2) Resolution of long outstanding structural issues necessary for the development of the Islamic
banking industry: Availability of Central Bank’s Lender of Last Resort Facility for Financial
institutions (which we will discuss in detail in the next section) and sovereign short term money
market instruments for managing liquidity; are necessary ingredients for building a strong
infrastructure for an effective financial system. Despite several proposals from Islamic banks in
this regard; the past nine years have not seen any worthwhile development in this area.
(3) Providing Shariah compliant alternates to SBP’s preferential conventional financing schemes:
Similarly Islamic banks have developed appropriate solutions for other major problems facing
the industry and submitted the proposals to the SBP Shariah Board. These proposals include the
development of Shariah compliant alternates to Long Term Finance Facility for export oriented
projects – a facility under which SBP provides liquidity at subsidized rates to conventional banks
for providing subsidized funding to exporters, solutions enabling Islamic banks to execute
forward foreign currency transactions with SBP and proposed Shariah compliant structure for
collateralized Islamic interbank placement product an alternative to conventional repo and
reverse repo transactions. These issues are of vital importance for the development of Islamic
money market but no significant progress or intent at the regulatory level can be seen.
A major reason for this inertia and the dormant role played by SBP’s Shariah Board lies in the
governance structure of its Shariah board; explained one Islamic banking executive during
discussion with the author. The composition of the SBP’s Shariah board (SBP 2008, SPIBIP)
shall involve two Shariah scholars, one accountant, one lawyer and director of the Islamic
Banking Department (IBD) of SBP who shall also act as secretary to the Shariah Board. The role
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of the accountant and the lawyer shall only be to provide technical help to the Shariah scholars.
The authority to make final decisions shall rest with the chairman of the board who shall be from
among the two Shariah scholars. The problem lies in the fact that since its incorporation either
one or both of the scholars appointed on the SBP Shariah board has at the same time served as
Shariah advisor of a particular Islamic bank. Currently one of the scholars on SBP Shariah Board
is also the Shariah advisor of DIB while the other scholar is the Shariah advisor of MCB Islamic.
This is not the case in other jurisdictions for instance in Malaysia the BNM SAC members are
not allowed to work in the Shariah committee of any financial institution. The executive
explained that this does not ensure independence of the Shariah board with the focus of the board
being diverted to matters which are of more significance to the banks’ the Shariah scholars are
associated with rather than resolving the pressing matters of the overall industry.
7.7
Non availability of Shariah compliant Financier of Last Resort Facility (FOLRF)
One major role that Central Bank needs to play is that of being the financier of last resort to all
the banks in the industry. Currently SBP provides this facility to conventional banks in Pakistan
through its 3 Day discount window facility known as reverse repo facility at the prevailing
discount rates (SBP 2009, DMMD Circular No.1). The conventional banks can avail this facility
by placing government papers as securities to the SBP. In contrast there is no such facility
available for Islamic banks. A Shariah compliant structure for this facility based on the concept
of Mudarabah was developed in consensus by Islamic banks and submitted to SBP on 12th
September 2011. Subsequently the members of the development committee of the proposal also
gave their presentation to SBP.
Under the structure whenever any Islamic bank is short of funds it can approach the SBP for
requirement of funds. SBP after the usual scrutiny can provide funds as Rabul Maal by investing
Page 27 of 40
in the general asset pool of the investee Islamic bank; which is managed by the Islamic bank as
Mudarib. SBP’s investment will be given a profit sharing weightage. The tenor of SBP
investment can be from 1 – 3 days; to be decided at the time of application by the Islamic bank.
Upon maturity of the investment period; profit of the pool will be calculated from which the
profit share of SBP will be calculated as per the pre agreed profit sharing weightage and
distributed to SBP along with the initial investment value.
The structure is similar to that followed by the central bank of Indonesia. However despite the
efforts the Islamic banks are still devoid of this facility. Without this facility Islamic banks are
devoid of a source of liquidity supply which can act as a cushion in times of liquidity crunch.
Currently in times of liquidity crunch Islamic banks have to rely on the interbank market to avail
liquidity. Due to under development of Islamic liquidity market as discussed in previous sections
arranging liquidity from the interbank market becomes an uphill task. Consequentially liquidity
can only be arranged at higher costs, and more often the overnight rates offered for the liquidity
are even higher than the SBP window rates available for conventional banks. Apart from this the
non availability of the Islamic Discount Window causes Islamic banks to take a cautious
approach in managing their funds. This impacts their daily and weekly liquidity management
approach since Islamic banks have to fulfill daily and weekly statutory Cash Reserve
Requirements (CRR) of the regulator. This has resulted in a situation where the Islamic financial
market and the Islamic banks operate at a level which is lower than the optimal efficiency level
resulting in artificially higher liquidity management costs. Under these circumstances and given
the small size of the industry any average benchmark rate of the Islamic banking industry will be
higher than it would have been with the availability of Islamic Window Facility; thus not
reflecting the true sentiments of the market.
Page 28 of 40
8.0
Independence of IIBOR-K from KIBOR
Islamic banks are financial institutions and like all financial institutions they are agents of
financial intermediation. That is all financial institutions including Islamic banks have two major
core functions to play. The first function relates to the accumulation of funds from the surplus
units of the economy; i.e. those sources having surplus liquidity. The second function relates to
the placement or transfer of the accumulated funds to the deficit units of the economy; i.e. those
individuals, firms, factories, etc which require these funds to produce goods and services which
add value to the society. Hence by playing this role the financial institutions help deploy idle
capital to productive uses. Islamic banks play the same role albeit in a manner which complies
with Shariah. The Pakistani Islamic
Figure 1 - Money Market Equilibrium
banking sector also plays the same
20%
KIBOR & IIBOR-K
18%
function within the wider financial
16%
14%
intermediation market. However the
12%
Demand
10%
Supply
8%
6%
problem with the Pakistani Islamic
banking sector is the same as
4%
2%
discussed earlier that it is merely a
0%
0
2000
4000
6000
8000 10000
Liquidity Supplied & Dem anded (in
PKR Bns)
9.7% of the total banking industry.
Without going into the statistics the
Islamic interbank market is even smaller than this figure would suggest due to it’s under
developed nature and small volume transactions among Islamic banks. Under this scenario even
if the IIBOR-K is launched as per the proposed mechanism it is almost certain that the rates of
IIBOR-K would be more or less equal to the KIBOR. The reason for this possibility is that
financial markets like all markets are driven by the forces of demand and supply which interact
Page 29 of 40
in the market to achieve the equilibrium price. The price in the financial market is the interest
rate at which the liquidity is demanded and supplied. The typical demand curve of liquidity is
negatively sloped as can be seen in Figure 1.
The negative slope is due to the fact that lower the interest rate the higher is the demand for
liquidity for a specified period of credit; which is assumed to be 6-months in Figure 1. The
figure also shows the supply curve of liquidity which is positively sloped denoting the fact that
higher the interest rates higher will be the amount of liquidity that financial institutions are
willing to supply for a specified period of credit. The money market equilibrium is the point
where the demand for liquidity and supply of liquidity interact denoting the fact that supply and
demand are equal at that point of interest rate. In Figure 1 the money market equilibrium is at the
point where KIBOR is equal to 8%. Other things remaining constant, any one institution
charging rates higher than this point say for instance 10% will realize that it is unable to find
sufficient borrowers to lend to since there would be other financial institutions offering credit at
much cheaper rates of 8% in the market. Hence this institution would be forced to decrease its
rates for supplying credit to the market up to the rate of 8% since any rates above than this
market equilibrium rate would not get the required number of borrowers. Similar will be the case
if we bring in IIBOR-K into this market. Other things remaining constant, if five Islamic banks
and certain number of Islamic banking windows were to quote their rates as per the proposed
mechanism of IIBOR-K and if that rate were to be higher than the prevailing market equilibrium
rate of KIBOR these host of Islamic institutions will face the same situation as faced by the
institution which quoted 10% rate in our hypothetical example. If 6-month IIBOR-K is quoted at
10% on any single day with equilibrium KIBOR being 8% Islamic banks will not be able to find
sufficient interbank and even corporate customers to provide financing to. Contrastingly since
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IIBOR-K is proposed to be a two way rate the bid rate of IIBOR-K will also be higher than 200
basis points than the bid rate of KIBOR. This will provide arbitrage opportunities to the market
participants who will start borrowing from the conventional system at 8% and place the
borrowed funds at 10% with Islamic banks. Even conventional banks will find it profitable to
start placing their excess liquidity with Islamic banks at 10%. This situation will result in Islamic
system being flushed with excess liquidity and contracting avenues for deployment of this
liquidity. As a result Islamic banks and windows will have to reduce their quotes for the
following days up to the point where IIBOR-K is equal to KIBOR or the equilibrium rate.
If the IIBOR-K rates are quoted below the equilibrium KIBOR rates the process will be reverse.
For instance if the equilibrium 6-month KIBOR is 8% and the 6-month IIBOR-K is quoted at 6%
the Islamic banking institutions will witness long queues of interbank as well as corporate
customers desiring to avail funding from them. The arbitrageurs including conventional banks
will also find an opportunity to avail funding from the Islamic system and place these funds with
the conventional system. On the other hand depositors who are indifferent regarding Shariah
compliance will start to withdraw their deposits from the Islamic system and deposit their funds
with the conventional system. This pressure on withdrawals and high demand for Islamic funds
would create a liquidity crunch situation for Islamic banks which they would require to resolve
through replenishing of liquidity from the interbank market, with other Islamic banks facing the
same situation and non availability of FOLRF from SBP the Islamic banks would be bound to
approach the KIBOR priced conventional system for availing the required liquidity through
Tawarruq which would be higher than the IIBOR-K rates. Hence being a dwarf to the
conventional system the Islamic banks would be forced to increase their quoted rates for the
following periods to stem the outflow of funds from its system as well as to ease the pressure on
Page 31 of 40
its financing side. The rates would have to be increased upto the point where IIBOR-K is equal
to the KIBOR rates baring transactional cost of arbitrage.
In the scenarios discussed above the question arises why would the Islamic system be forced to
revise its rates rather than the conventional system? The answer lies in the fact that Islamic
banking is merely a 9.7% of the total Banking industry in Pakistan and hence is not a dominant
position to dictate its rates. Hence the conventional system is currently the market maker and is
the major market for financial intermediation; any solo action on the part of Islamic participants
does not and will not move the market. Hence as far as the economic theory of market forces is
concerned the IIBOR-K launched at this stage will not be independent from KIBOR and will
have to toe its line. However it remains to be seen for which we don’t have any empirical
evidence in any other market regarding how will the market move when Islamic banking
captures a major share of around 50% or 60% of the banking market. Even in such cases it is
highly likely that the two rates would be more or less the same baring transaction costs of
arbitrage since with no barriers to the free flow of funds between the two systems the market
forces would able to play their free role and equate the two rates up to the point where there are
no further opportunities of arbitrage. However it is certain that in such a scenario IIBOR-K will
not follow KIBOR since both the rates will have same level of presence on ground and both the
rates will be in a position to move the market.
8.1
Independence of IIBOR-K with a Bar on free flow of funds
The placement of excess liquidity by Islamic banks with conventional interest based institutions
is a matter of concern among various quarters and is not viewed favorably by various Shariah
scholars since it results in facilitating conventional banks to make riba based lending whereas the
Holy Quran forbids Muslims from helping one another in wrong doing and transgression (Surah
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Al Maidah 5:2). Indeed it seems undesirable and unjust that on the one hand Islamic institutions
discourage customers from depositing with conventional banks due to presence of Riba while at
the same time they place their funds in a wholesale manner with conventional banks through
controversial products like commodity murabaha/Tawarruq. In this section we look at the effects
on independence of IIBOR-K where there is a complete ban on placement of funds by Islamic
banks with conventional banks either from the Shariah scholars or the regulator. While at the
same time we also assume that there is no bar on conventional banks placing funds with Islamic
banks since the majority of the funds of the conventional banks consist of deposits from the
general public and is deemed to be halal by the majority of the scholars (Usmani c. 1999). The
following two figures depict the probable scenarios in such a case:
In the Figure 2 (a) the market
Figure 2 (a) - Money Market Equilibrium
equilibrium is shown in a
20%
situation where there is no bar
KIBOR & IIBOR-K
18%
16%
on free flow of funds between
14%
12%
Demand
10%
the two systems. The market
Supply
8%
equilibrium
6%
4%
KIBOR
and
IIBOR-K is achieved at 8%
2%
0%
0
2000
4000
6000
8000
10000
Liquidity Supplied & Dem anded (in PKR Bns)
assuming other things are
constant and there are no
transaction costs of arbitrage. The supply in this figure is the total supply of money being the
aggregate of supply of the Islamic market and the conventional market. The same is the case
with demand which is the aggregate of the two markets.
Page 33 of 40
The Figure 2 (b) shows the
Figure 2 (b) - Conventional Money Market Equilibrium
conventional
20%
18%
The
demand in the conventional
16%
14%
KIBOR
market.
market is the same as the
12%
Supply
10%
Demand
8%
Supply**
6%
demand in figure 2 (a) since
the Islamic banks are not
4%
barred from accepting funds
2%
0%
0
2000
4000
6000
8000
from
10000
the
conventional
Liquidity Supplied & Dem anded (in PKR Bns
system. However the supply
in figure 2 (b) is less than the supply level in figure 2 (a) since the Islamic banks are not allowed
to place funds with conventional banks. Hence the supply curve (Supply**) in figure 2 (b) is to
the left of the supply curve (Supply) in figure 2 (a); the gap between the two curves depicts the
unavailable Islamic money supply. Due to this shift in the money supply the equilibrium KIBOR
of the conventional market at
Figure 2 (c) - Islamic Money Market Equilibrium
10% comes out to be higher
20%
18%
than the equilibrium that
16%
IIBOR-K
14%
would have been in case free
12%
Demand
10%
Supply
Demand**
8%
6%
flow of funds was allowed
between the two systems as
4%
2%
depicted in Figure 2 (a). Now
0%
0
2000
4000
6000
8000
10000
Liquidity Supplied & Demanded (in PKR Bns)
let’s look at Figure 2 (c)
which represents the Islamic
money market; notice that the supply curve in Figure 2 (c) is at the same level as in Figure 2 (a)
Page 34 of 40
since the conventional banks can place/offer their funds with/to the Islamic market; the supply in
the Islamic market will be same as supply of funds in Figure 2(a). However since conventional
banks are not allowed to accept funds from Islamic banks the demand for the Islamic funds will
be less than the demand shown in Figure 2 (a). Hence the demand curve (Demand**) in Figure 2
(c) is to the left of the demand curve (Demand) in Figure 2 (a). This decrease in the demand
would result in equilibrium IIBOR-K at 6% in the Islamic market being less than the equilibrium
IIBOR-K which would have been in case free flow of funds were allowed between the two
systems as depicted in Figure 2 (a).
Hence with the restrictions in place and no arbitrage opportunities available it is highly likely
that IIBOR-K will be different and lower than the KIBOR rate at all times due to excess supply
and lower demand for funds in the Islamic market; making IIBOR-K largely independent from
the KIBOR fixing. It is important to note that the explanation discussed above assumes that there
will be no indirect leakages from the Islamic system towards the conventional system. In the real
world scenario it is highly likely that even though direct placement from Islamic banks into
conventional system would be restricted other economic agents such as firms and corporate
entities; especially those which are indifferent regarding Shariah principles; would start availing
funding from the Islamic system while placing their excess liquidity with the conventional
system thereby resulting in an indirect arbitrage. However the magnitude and the pace of this
arbitrage will determine the impact it will have on the two benchmark rates; which remains to be
seen. Irrespective of the effects; as far as the independence of IIBOR-K is concerned a restriction
on flow funds is bound to make it a reality.
8.2
Independence hampered due to nature of Islamic Banking financing:
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Currently the nature of financial intermediation undertaken by Islamic banks is similar to that
taken by conventional banks. Both systems have adopted debt based approach for financial
intermediation. While both the deposit side and the financing side of the conventional system is
based on debt; Islamic banks rely on non debt based contracts for accumulation of deposits and
debt based transactions for financing purposes. These debt based financing of Islamic banks
comprises the following modes murabaha, tawarruq, istisna, musawamah, etc. Under these
modes the basic underlying risk effecting the decision making of Islamic banks is the credit
default risk which is similar to the underlying risk of the conventional lending based products.
Hence the price that the market or the customers are willing to pay for this risk is justifiably
similar to the prevailing price at which the conventional system is willing to provide funding for.
Hence Islamic banks also need to charge the same rate which is equal to the market equilibrium
KIBOR. KIBOR has also been used as a benchmark by Islamic banks for providing car financing
and house financing through the lease based modes of ijarah and musharakah mutanaqisa instead
of using the prevailing market rates of car and property rental rates of different areas. While
financing based on Shirkatul Aqd based modes is a rarity even the mechanism of such
transactions when executed has been financially engineered to restrict the returns of the financier
to the KIBOR while remaining in the ambit of Shariah principles. The reason for this adherence
to KIBOR even when using such modes is partly due to the fact that Islamic banks have targeted
those markets and customers who have traditionally been banking with the conventional banks
and partly due to the small size of the Islamic banking industry. The customers who have the
option of availing financing at lower rates from conventional banks will not find any attraction in
entering into partnership based financing modes with Islamic banks and share their profits
without any ceiling. Hence in such a scenario; even if Islamic banks gain a majority share of the
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banking market; any separate Islamic benchmark will not be independent of KIBOR and will not
achieve its purpose of being based on the value system of Islam and being a means for achieving
distributive justice as outlined earlier.
As has been stressed by many observers and scholars that Islamic banks need to move on into
adopting modes which are based on the principles of profit and loss sharing; rather than low
risky debt based modes; which are more aligned in achieving the distributive justice as outlined
by Islam. Use of such modes on the financing side will also ensure returns on the deposit side
which may be variable but more in line with the higher objectives of Maqasid alShariah. While
Islamic banks cannot and should not curtail their financings to the existing markets and
customers it is necessary that they venture out into areas which have been untouched by the
traditional form of financial intermediation. For instance Islamic microfinance involving
partnerships with poor people in their businesses; private equity investments in growing small
and medium sized venture; partnerships with young entrepreneurs in promising startups; equity
partnerships with small and poor farmers who have the capability but no resources; taking direct
equity stakes in projects of national interest like extraction of coal in the Thar desert and
development of coal fired power plants; etc. These are areas which have been neglected by the
conventional finance so much so that 88% of the country’s population is unbanked. With vast
untapped potential in agriculture, power, mining, service industry, etc markets and customers
which have been denied access to finance up till now would be more willing to enter into
partnership based financings where losses, risks and profits are shared with the Islamic banks as
per the actual performance of the underlying business. These projects may result in higher risks
but also result in high profits which are not capped by the KIBOR rate; while at the same time it
is possible to hedge the risks through diversification. Hence along with the existing portfolio
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Islamic banks should focus on developing this portfolio of shirkatul aqd based activities. Upon
significant size of this portfolio Islamic banks will have two types of assets those which are debt
based and capped to a certain level of risk and profit rates; and secondly the portfolio which is
partnership based with managed risk but higher returns without any capping. With these inherent
characteristics; irrespective of their size or share in the industry; Islamic banks will provide
IIBOR-K quotes which would be different and independent from KIBOR reflecting their own
liquidity status, placement opportunities, expected returns and risk.
9.0
Conclusion
The proposed mechanism for IIBOR-K is a workable option; however the paper has explained in
detail various practical issues and challenges which have hampered the development of this
benchmark. These issues and challenges range from market dynamics, standardization, strength
of the industry players, under developed interbank market, role of the regulator and deficient
interbank infrastructure. A strategy needs to be evolved by the Islamic financial institutions,
Shariah scholars, regulators and other stakeholders to resolve these challenges for not only
providing a favorable environment for the launch of IIBOR-K but also for the development of an
integrated and efficient Islamic financial system in the country. The analysis also concludes that
in the current scenario if the IIBOR-K is launched it will not be independent from the
conventional KIBOR; even if the Islamic banking industry captures a higher market share the
IBOR-K would still be expected to be equal to the KIBOR given the fact that there are no
restrictions of flow funds from Islamic to conventional system under the current scenario. If
restrictions are placed on such flows the IIBOR-K is expected to be lower than the KIBOR. The
paper also suggests that real independence can be ensured if the Islamic banks adjust the nature
of their financial intermediation according to the higher motives of Maqasid AlShariah.
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