Monday, November 30, 2009

Ribh-al-mithl: Issues and Challenges

1.0 Re-appraisal over benchmarking use by Islamic Banks

Ribh-al-mithl (matching rate of profit) use by the Islamic banks are clearly parallel with conventional banks which solely dependent on one benchmark or reference rate, that is the interest rate or basically Base Lending Rate (BLR). According to Ayub (2007), using any interest-based benchmark for the pricing of goods and their usufruct in trade and Ijarah-based activities of Islamic banks does not make their operations un-Islamic so long as other rules of trade and Ijarah are applied. A simple analogy could be illustrate to the practices above is when a seller wanted to price his product based on his neighbor or market price, he may charge higher or lower depend on his strategy of competing with the market price. Thus there is not much Shari’ah issue over it.

Therefore it is argued that as far as other requirements of Shari’ah for a valid lease are properly fulfilled, the ijarah contract may use any benchmark to determining the amount of rental. There is no harm to earn the same profit as what done by the competitors as we are in a free market economy. It is also reasonable that if the Islamic banks fixed the rental rate upfront, the appreciation of the rental rate due to internal or external factors may deem injustice to the parties (particularly the banks) involved in the ijarah contract.

In contrast with the first opinion, adopting BLR as the benchmark raises some critiques by some of the scholars like what Shaikh Nizam Yacuby and Muhammad Taqi Usmani mentioned in their 1998 fatwa (Meera & Razak, 2005 p.13; Chong, 2009 p.10). Taqi Usmani (2005) further criticize those who hold the view of benchmarking the Islamic banks products over interest based system argues on two fundamentals ground where as it can be concluded that it may affect the ijarah contract when there would be a major possibility in existence of the elements of gharar (uncertainty) and jahalah (ignorance). Thus in other words, the transaction is rendered akin to an interest based financing.

The elements of gharar (uncertainty) and jahalah (ignorance) come into picture when the variations of the rate of interest being unknown. Taqi Usmani (2005) argues that:
“If we tie up the rental with the future rate of interest, which is unknown, the amount of rent will remain unknown as well. This is the Jahalah or Gharar which renders the transaction invalid” (Taqi Usmani, 2005, p.8).

The third opinion regards to this benchmark issue is deemed to be more moderate, in order to mitigate the risk involves in such possibilities, there are some contemporary scholars that allowed the usage of tie up rental rate and the interest rate subjected to limit or ceiling rate. This view is being practice by Islamic banks in Malaysia regards to products and services under what they call as floating rate.

However, it is important to be noted that the use of the rate of interest merely as a benchmark does not render the contract invalid as an interest-based transaction. It just that it is advisable at all times to avoid using interest even as a benchmark, this is because according to Muslim scholar’s view, it is good for Islamic transaction is to be distinguished from an un-Islamic one, without having any resemblance of interest whatsoever in it (Gamal; 2004 & 2006; Taqi Usmani, 2005,p.8;).

2.0 What others says about use of LIBOR as benchmark by Islamic Banks

Sh. Yusuf DeLorenzo (Chief Shariah Officer, Shariah Capital Inc)

“Shariah boards have approved any number of less than ideal devices when convinced that these will assist in promoting the industry in general. A good example is the use of LIBOR as a benchmark for pricing a murabahah or an ijarah when floating rates are to be preferred over fixed rates. In the absence of a stable and widely-published alternative, LIBOR has been used repeatedly and will likely continue to be used until the industry can develop and then agree upon a benchmark, or a set of benchmarks, based on criteria of its own, i.e., Shariah-compliant criteria. In the final analysis, a benchmark is no more than a number, and therefore nonobjectionable from a Shariah perspective. If it is used to determine the rate of repayment on a loan, then it is the interest-bearing loan that will be haram. LIBOR, as a mere benchmark, has nothing to do with the actual transaction or, more specifically, with the creation of revenues or returns.”

Safdar Alam (Head of Islamic Structuring, JPMorgan)
“Benchmarking to LIBOR is indeed widespread in Islamic money markets and financing (where it is probably used without exception) and also in the capital markets (i.e. sukuk). The reason for this is that we operate effectively as a sub-sector of the conventional banking and money system which has to use LIBOR to price any deferred cash flows, adding the appropriate credit-related spread. This is difficult to move away from.

However, the first step towards improvement is for market players to work together and agree that we need to progress with a collective plan in place. It is extremely difficult, as the balance sheet of Islamic financial institutions are typically comprised of LIBOR-related assets and liabilities, with the only “equity- type” assets being linked to stocks and real estate sectors. We also need to agree that although technically we can structure money market and capital market products that have asset-related cash flows, this is not really progressive as long as the pricing of such cash flows is still benchmarked to LIBOR. So even though a product like commodity murabaha may technically be widely accepted as Shariah compliant, we also need to accept that such products are not helping the industry in the very necessary step of moving away from a LIBOR benchmark to one that is related to investment, enterprise, and generally the profitable activities that resource-mobilisation results in.

Given that commodity murabaha has been in use since the 1970’s, this fundamental shift in thinking has yet to occur. Until we, as an industry, have the courage to take that step, Islamic Finance will always be seen (correctly) as just another system with impressive values but failure to convert those values in real developments in line with genuine and true adherence to the spirit of Shariah.”

Ehsan Waquar(Member Shariah Committee/Manager Shariah Compliance Emirates Global Islamic Bank)
“To begin with, two points must be addressed essentially:
1. Permissibility of employing any interest-based index for Islamic Shariah compliant products and transactions.
2. Devising an independent yardstick for the Islamic Financial Industry as an alternative.

The first point is very palpable. All that is required is to understand the definition of Riba and the limitation set by Shariah. Usually people get confused about the valid definition of Riba. Secondly, people try to outlaw much transaction because of their presumption and misunderstanding regarding Shariah rulings.

“Any conditional and stipulated gain over and above the principle in any form; cash or kind or services without any due consideration merely against time is defined as Riba.” This definition responds to all such ambiguity. It is also noticeable that the major element that differentiates legitimate profit and prohibited Riba, is the secured gain that is associated with transactions primarily without any involvement of an under lying asset.

It means that the profit, earning and reward are always associated with risk and exposure to uncertainty. This is the gist behind the prohibition. Now, tainting Islamic financial instrument with a conventional interest based index will not at all classify it as impermissible. Any income associated will be absolutely justified and entirely compliant with Shariah. However involving such indices will reflect dependency upon such benchmarks that subsequently creates misunderstanding.

Developing an alternate will demonstrate the ideal and independent picture of the Islamic financial system. This requires that all IFIs mutually develop a consensus that they indefinitely lend and borrow among themselves only, unless there is unavailability of funds. Secondly, their rates based on whatever calculation, projection and anticipation, must be quoted on the money market screen as an independent index termed IIBOR; Islamic Interbank Offer Rate. This will at least provide a track for IFIs to adopt and it will gradually improve with time. However the criteria for quoting an offer rate will be dependent on matters like desired and historic yields of assets, quality of the assets, NPL and so on and so forth. Similarly additions of participants and inclusion of innovative instruments in the Islamic Money Market will also diversify and enrich the index. This will finally lead towards a mature, independent and pure Islamic index. But initiating at this stage will need lot of audacity and innovation.”

Sh. Faizal Manjoo (Lecturer in Islamic Law & Finance Markfield Institute of Higher Education)
“Usage of LIBOR, strictly speaking, cannot be declared haram (prohibited), however when one is to analyse holistically the Islamic financial market, there are other more appropriate indices which can be used, such as the Rent index if one is working with ijarah for example.

If one is to argue that Islamic banking is asset-backed compared to conventional banking, then one should be more consistent with what is being preached. The asset market is definitely not the same as the money or debt market!

In any case who determines the rate of interest is definitely not the market force! Hence one should be prudent about which rate to apply when calculating the profit or rental However, if it is argued that Islamic banks are to compete with conventional banks and hence the need to work with the LIBOR; the counterargument is that in any case their pricing is most of the time higher than conventional banks! There is a Judgment from one of the High Courts in Malaysia on this issue. So does it really matter that one works with LIBOR and attracts unnecessary criticism?”

Dr. Azeemuddin Subhani (Shariah Compliance Advisor)
“The use of LIBOR in Islamic finance is not a compromise on the industry. The prohibition of riba lies not in the quantum of the financial return or its similarity or equality with something else but entirely in the method of its generation. If the financial return is not self-generating (money on money), it is permitted regardless of its equality with any other financial return (eg LIBOR). If the financial return is self-generating, it is prohibited even if it is not equal to any other financial return (eg LIBOR).”

3.0 Benchmark: The Way Forward

A holistic application of the Shariah, both ex-ante and ex-post, shall warrant Islamic banks to ensure the products are Shariah -compliant particularly in view of the inherent reputational risk in Islamic transactions and governance. Benchmarking against interest based system may be considered as a small matter to some practitioners, but it is understandable that theoretically, any change in the interest rate would lead customers who are guided by the profit motive to substitute Islamic financing for conventional bank loans and vice versa.

Against this backdrop, in order for the Islamic banking institutions to become leaders in the industry, compete effectively and at the same time preserve their niche, there is a need to re-evaluate their marketing strategies, especially their pricing strategy. Bank Negara Malaysia (2001) in its ‘The Financial Sector Masterplan’ stated in its recommendation toward Islamic banking and Takaful that to:
“Introduce a benchmarking programme: Benchmarking is essential for IBIs to be at par with international best practices. Hence, a benchmarking programme will be introduced to facilitate IBIs in evaluating their relative efficiency, identifying the performance gaps and formulating strategies to improve and deliver the best results.”

The index suggested may just a suggestion to diverge Islamic banking industry from imitating conventional way of pricing its products. Hence, it is essential for IFIs to intensify research and development efforts in Islamic financial product innovation. This will involve Islamic banking institutions to consider the possibility of forming strategic alliances to tap the research and development expertise developed outside the banking industry to create the range of Islamic financial products capable of meeting the customer requirements.

It is important to note that according to Radiah and Leong (2009) that the uses of interest based system as benchmark expose Islamic bank financing in the dual system to interest rate risks despite operating on interest free principles. BLR in Malaysia has been falling or remained at low levels during that period. This implies that Islamic bank financing has been relatively more expensive than conventional loans during falling of interest rates. It follows that the demand and growth of Islamic financing would have been slower relative to conventional loans during the period. Through the market index suggested, it can be revised periodically to reflect real market conditions and lead Islamic bank to a better position to mitigate the interest rate risks.

[1] Opalesque Islamic Finance Intelligence, The Use Of Libor By Islamic Banks, Issue 1,23 June 2009.
p/s:Please feel free to download my research paper on "Investigating Into Alternative Pricing Mechanisms for Maybank Islamic Products MMTF-i" at this link

Ibn Yusof
1 December 2009/14 Dzulhijjah 2009
9:13 a.m

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