Benchmark rate of return

Financial institutions when finance either an individual under consumer banking or corporates, the return or interest rates are not kept constant like 10%, 12% or 15%. Rather the rates are tied to a known benchmark representing market rate. This market rate varies daily and shows demand and supply of funds. Since banks are major dealers in money and interest, their mutual dealings create money market and from there rate of interest is derived.
This is called the KIBOR (Karachi Interbank Offered Rate) in Pakistan and the LIBOR (London Interbank Offered Rate) for international market. Now if an organisation is given a loan of hundred million for two years, it will be required to pay interest equal to market rate plus a margin say, 2%. This arrangement keeps both parties at a less riskier position. Islamic banks also use this market rate for charging rents of fixed assets financed and for incorporating profit in goods sold.
Since its inception, Islamic banking and professionals associated to it are facing one very common objection - how they are different from their conventional counterparts while both use KIBOR/LIBOR as benchmark. The pressure from general perception was (and certainly is) so intense that the big shots started thinking to devise an alternative.
Several options came under consideration from GDP of Muslim countries to average yield of the portfolios of Islamic banks, however, the consensus reached on the following arrangement. "All IIBOR contributors would be required to quote their two way expected profit rates on Interbank Mudarabah/ Musharakah/Wakalah Placements for minimum PKR 20 million, within the allowable bid /offer spreads for the relevant tenure.
These prices would remain valid between 11.45am-12.00am.If the bank is hit on its IIBOR price once, it can change the next price." Any person, having the knowledge that the KIBOR is the trimmed average of the rates offered by 20 contributor banks, will see no difference in the KIBOR and the IIBOR except that in latter case all contributors are Islamic banks.
Also relatively small size of the industry and consequent small size of their treasury's operation cast a doubt whether the contributors will be able to quote on daily basis. Even if the arrangement goes operational, the demur from industry that the IIBOR is the KIBOR of Islamic banks, will chase IIBOR. Development of alternative benchmark should not be aimed at just catering to the emotional demands.
Is the KIBOR/LIBOR, interest benchmark, an issue to Islamic finance? The answer is that it ought not be but has become. Money and monetary value of any thing is recognised by Islam. The price or reward of a factor is determined by its demand and supply. So is the case of money. But Islamic economics distinguishes between money and monetary value of goods.
A house worth 10 million can be let for 25,000 monthly rental, but 10 million money cannot be lent for 25,000 monthly payment in addition to principal. Although price money is not allowed, value of goods and rent of building and machinery etc is determined by their monetary value. Price of money can be deduced simply by calculating the yield earned by rentals of the leased assets.
Price of money can also be estimated by observing the profit sharing ratio between Mudarib (Fund manager) and Rabbul Maal (Investor) in a Mudarabah transaction. For example, if in a trading concern, run on Mudarabah basis, expected return is 15 percent.
And if Mr A, Mudarib, and Mr B, investor, share profit in the ratio of one-third and two-third respectively, it will be evident that return to money provider (or money), in a level of risk equal to the trading concern, is 10 percent. Now suppose that investment opportunities in the economy rises and demand of money as compared to skills rises, the fund provider (investor) would like to renegotiate the sharing ratio in his favour.
What does it imply? It suggests that the money does have price and like other factors, its price changes according to the demand and supply conditions. The only thing prohibited in Islamic economics is earning on lending. To avoid Riba first, convert your money into asset and then earn. The KIBOR or LIBOR just represent return required (also expected) by the fund provider for the lowest risk business.
The level of risk represented by the LIBOR/ KIBOR is not achievable in Islamic finance because it builds only counter-party default risk, which is very low in case of financial institutions. As we move above from liquid cash to tangible assets, the required yield will increase as asset risk will also creep into.
Therefore, if an Islamic bank's benchmark rate come into existence, it will (at least theoretically) always be greater than almost risk-free KIBOR/LIBOR. In addition to asset risk delayed payment risk, which is not compensable in Islamic finance also reinforce the assumption.
By Islamic bank's benchmark rate, we do not mean Islamic benchmark as we have discussed that conventional interest benchmarks just indicate the return at the level of risk not achievable in Islamic finance and on this basis, we can just say that the rate is suitable to lending transaction but not that the rate is non-Islamic.
Now a question arises why Islamic banks should rely on the benchmark developed by conventional banking system and why not their own benchmark because even though the KIBOR is not prohibited its use show that Islamic banks are following and not leading? This is not an unreasonable demand, but we have to calculate the cost of this differentiation attempt. Benchmark should be the representative of an ideal situation, which is attainable at the same time.
If we want to develop benchmark performance of labour on a particular task, we have to gather large data of labour performance on that task. We have then to exclude extraordinary performances. Scientific, statistical and behavioural analyses will be carried out and then a benchmark will be agreed upon.
Now consider the case of Islamic banks. They are few in numbers, small in size and represent only a fraction of total data. Their performances may be subject to extraordinary circumstances. Their mutual transactions are less than dealings in open markets. In short they do not provide enough eligible data to establish a new benchmark.
On the other hand, conventional benchmark incorporates all the characteristics of a good benchmark. It being the representative of more than 90 percent volume, is the best indicator of demand for and supply of money and best suited for pricing the products. Now if despite all these constraints, Islamic banks start to quote their two-way rates (bid and ask) on daily basis, many times they will not be able to honour their quote.
This is because of controlled spread between bid and ask. An Islamic bank might be willing to accept funds on 11%, but not able to place funds unless the return is 13% because of its already short position. Conventional banks that are contributory to the KIBOR are too big to be effected by an amount of 100 million as it constitutes a fractional part of their treasury. So operational difficulties also exist there in running the IIBOR.
We do appreciate strive for differentiation but its cost should not be efficiency. For the sake of removing any confusion we would clear that while discussing establishment of alternative benchmark, only local (Pakistan) market is taken into account, lest one should say that world Islamic finance industry is large enough to establish a separate benchmark.
This is because return, interest rates, inflation and business conditions vary from country to country and one single benchmark for all Islamic banks in the world is impossible at all. One year LIBOR at the time of writing is around one percent, while the KIBOR of the same tenure is hovering at 13 percent. Will a single benchmark be feasible for Islamic bank of Britain and a local Islamic bank both?
A superficial but frequently raised objection is that while financing houses/ buildings and setting the rent why can market rent of the property not be taken. We shall put a question before these arguers that yield on property letting is around four percent and bank deposits are offering above 10 percent, then why the former is still more attractive and why funds are not diverting to banks from properties? In fact, no sector in the economy can persistently earn a supernormal return.
Bank's rates are higher than the market rent because rupee depreciates over time due to inflation while property values do not suffer inflation but rise with inflation. Since banks while financing buildings sell the property to finances at its historical (lower) cost, they have to set higher rentals to earn a real yield equal to those who own property and let it on rent. One option might be to sell the units of property at market value and charge the rent at market.
This option calls for two types of survey at regular interval (at least annually); First one is property valuation and the second is market rent of the property. This option results in extra transactional cost that will have to be borne by the finance. Islamic banking products are either debt-based or equity-based.
In later case, no question of benchmark rate arises, however, for debt-based products since value-adding factor from bank (seller or lessor) is money provision, market cost of money seems indispensable for pricing the products. And this does not run counter to Shariah requirements.