A Step Forward For Islamic Finance Authenticity: IIBR

By Rushdi Siddiqui, Global Head of Islamic Finance, Thomson Reuters

‘Don’t cheat the world of your contribution. Give it what you’ve got.’ - Steven Pressfield

On November 22, 2011, the world’s first Islamic interbank benchmark rate (IIBR) was launched. It is the result of a collaborative approach taken by many Islamic financial institution, industry associations, and Shariah scholars, over the course of 24 months, to a decades-old industry challenge: how to decouple Islamic finance from a conventional Western pricing benchmark (LIBOR) and the law of necessity when an ‘Islamic’ alternative was not available. The objective was to support and preserve Islamic finance authenticity.

The IIBR is an interbank benchmark that offers a reliable and realistic benchmark to better measure the cost of funding for Islamic financial institutions. The IIBR, contributed pricing for Shariah compliant funding, is the DNA of Islamic banking, as the industry, today, is commercial banking over investment banking.

While the launch of the first Islamic equity benchmark index, Dow Jones Islamic Market index, was important lagging indicator, the launch of IIBR is of historical importance as its one of the first leading indicators in Islamic finance. IIBR is a major indication to the wider world that Islamic finance has now come of age and can be seen as a sustainable and rapidly developing feature of global financial markets.

The chronological importance of the IIBR in the contemporary history of Islamic finance is after launch of Islamic Bank of Britain:

1. Launch of Tabung Haji- savings invested in Shariah compliant manner to address one of the five pillars in Islam

2. Launch of Islamic Development Bank- Muslim world’s World Bank

3. Launch of Dubai Islamic Bank for GCC and Bank Islam in Malaysia

4. Launch of AAOIFI and IFSB- standard setting bodies

5. Issuance of first internationally distributed corporate and sovereign Sukuk out of Malaysia

6. Launch of the Dow Jones Islamic Market Index (DJIM)

7. Launch of Islamic Bank of Britain- first deposit taking Islamic bank in G5 country

Pragmatic not Dogmatic

Since the launch of IIBR, there has been much attention in the press and across the world. People from within and outside the Islamic finance industry on the whole are recognizing the initiative for the positive step forward that it is.

John Ewan, Managing Director of BBA LIBOR ltd, said, ‘The evolution of a benchmark is a sign of the maturity of a financial market, so everyone involved in Islamic finance will welcome the creation of the Islamic Interbank Benchmark Rate. We welcome this new product, and the choice and flexibility it offers market participants. We wish the Islamic Interbank Benchmark Rate and all those involved with its operation every success.'”

Understandably though, the significance of IIBR and what it means for the Islamic finance industry, indeed the very position of Shariah-finance in Islam and the wider world, means that it also provokes strong opinion and debate. And we must address the critics if we are to reach full potential for this initiative – these commentators are people, factions and institutions that are important additional stakeholders.

All collaborations start with open minds and transparent dialogue and so we hope to address some of the key points raised.

The point is not necessarily to convince, but to inform.

Who are the IIBR stakeholders to take it to next level?

Obviously, the Shariah scholars, who have been asking for an alternative to LIBOR reference, have the opportunity to have the Islamic banks they advise to use IIBR. Second, industry bodies, like AAOIFI, IIFM, IILM, IFSB, etc., incorporate IIBR as part of their guidelines; (3) law firms, (4) regulators, and academic institutions.

The contributing IIBR banks range in size from small to large and IIBR is GCC centric, how is this representative and reflective of global Islamic finance treasury funding costs?

Presently we have three major Malaysian banks and are in conversations with others, and we have already started conversations with banks in Turkey, Pakistan, and other jurisdictions. It must be understood that this is only a beginning. The intention is to expand the pool of contributing banks, as Islamic banks from various parts of the world begin to contribute, IIBR will reflect the pulse of global Islamic banking. This becomes an important indicator on market conditions for lenders of last resort, central banks, especially in Muslim countries.

It is unreasonable to expect ‘conventional efficiency’ from an embryonic industry. The Islamic finance industry will get there, but on its own terms, in its own time and at its own pace, and the IIBR is a prime example of an innovation that took (the necessary) few decades to arrive.

How will IIBR address cross border funding costs, as GCC centric?

The pre-condition for cross border funding is establishing local rates, and we are starting dialogue with more countries with an established Islamic banking industry. The more important point is that a transparent process or methodology is in place for price contributions, and its integrity is overseen by our benchmark committee with rules that will punish banks, including expulsion, that violate the agreement they have signed.

What does IIBR represent, is it just numbers that happen to be contributed by Islamic banks?

The IIBR rates represent the aggregate risk profile of Islamic financial institutions, by way of their assets on the balance sheet, and the geographies they operate in. LIBOR is European centric, with all the market environment issues in the region, and there is disconnect with Islamic banks in terms of geography, operating business models, exposure, and so on. For example, Shariah prohibitions on speculation (Maysir) and uncertainty (Gharar) prevented Islamic banks from having CDS, CDOs, and other exotic ‘assets.’

The important question becomes: why Islamic banks should be penalized (on cost of funding) when they stayed away from such derivatives?

IIBR price contributions are denominated in dollars, yet it is not the ‘official’ currency of the Muslim world where almost all the Islamic banks reside, so what connection is there to the man on the street?

IIBR is between and amongst Islamic banks, hence, it is a whole-sale offering. The whole-sale rates are the basic reference point used by Islamic banks for retail consumer financing, like Islamic mortgages, vehicle financing, and so on. Now, consumers will have knowledge of IIBR rates, and they can question their Islamic banks as to why the variance in rates, if any, for financing. Thus, the rates provide much needed empowerment and accountability.

Why is there variance in IIBR from LIBOR?

When we first started talking to Islamic banks about creating an interbank pricing benchmark for Islamic banks, an often stated comment was there will be no/minimal difference as prices referenced off of LIBOR. The commentators are incorrect because of the (1) Shariah funding cost of capital is based upon asset risk pricing and not interest earned, and (2) operating geography of contributing Islamic banks is different from the LIBOR contributing banks.

The table shows actual IIBR rates versus LIBOR over same tenors forNovember 29, 2011.

The contributed IIBR rates set the foundation for actual transaction rates or dealt rates. There is news coverage about some market participants wanting to have actual transaction rates as an alternative to the well established LIBOR rates. Here, we may have the opportunity to have Islamic dealt rates, as we are at the embryonic stage on an interbank pricing benchmark.

Thus, the dealt rates will go to the point of profit ratios over interest rates.

Finally, as IIBR rates will be out a few hours before LIBOR rates at 11 am GMT, it presents interesting dynamics going forward. As US equity markets take cue on how Asia markets close, will LIBOR rates eventually take cue from IIBR rates?