HAMDARD INTITIUT OF MANAGEMENT SCIENCES ISLAMIC BANKING – REPORT ON IBOR ALTERNATIVES
Money Market In finance, the money market is the global financial market for short-term borrowing and lending. It provides short-term liquid funding for the global financial system. The money market is where short-term obligations such as Treasury bills, commercial paper and bankers' acceptances are bought and sold. The money market consists of financial institutions and dealers in money or credit who wish to either borrow or lend. Participants borrow and lend for short periods of time, typically up to thirteen months. Money market trades in short term financial instruments commonly called "paper". This contrasts with the capital market for longer-term funding, which is supplied by bonds and equity. Common money market instruments: Bankers' acceptance - A draft issued by a bank that will be accepted for payment, effectively the same as a cashier's check. Certificate of deposit - A time deposit at a bank with a specific maturity date; largedenomination certificates of deposits can be sold before maturity. Repurchase agreements - Short-term loans—normally for less than two weeks and frequently for one day—arranged by selling securities to an investor with an agreement to repurchase them at a fixed price on a fixed date. Commercial paper - An unsecured promissory notes with a fixed maturity of one to 270 days; usually sold at a discount from face value. Eurodollar deposit - Deposits made in U.S. dollars at a bank or bank branch located outside the United States. Federal Agency Short-Term Securities - (in the US). Short-term securities issued by government sponsored enterprises such as the Farm Credit System, the Federal Home Loan Banks and the Federal National Mortgage Association. Federal funds - (in the US). Interest-bearing deposits held by banks and other depository institutions at the Federal Reserve; these are immediately available funds that institutions borrow or lend, usually on an overnight basis. They are lent for the federal funds rate. Municipal notes - (in the US). Short-term notes issued by municipalities in anticipation of tax receipts or other revenues. Treasury bills - Short-term debt obligations of a national government that are issued to mature in 3 to 12 months. For the U.S., see Treasury bills. Money market mutual funds - Pooled short maturity, high quality investments which buy money market securities on behalf of retail or institutional investors. Source: Wikipedia.org
Page 1 of 11 By: M. Faisal Panawala GR # 2200649
HAMDARD INTITIUT OF MANAGEMENT SCIENCES ISLAMIC BANKING – REPORT ON IBOR ALTERNATIVES
Money Market Benchmark? The core of the money market consists of banks borrowing and lending to each other, using commercial paper, repurchase agreements and similar instruments. These instruments are often benchmarked to LIBOR. The London Interbank Offered Rate (or LIBOR) is a daily reference rate based on the interest rates at which banks offer to lend unsecured funds to other banks in the London wholesale money market (or interbank market).
Scope LIBOR rates are widely used as a reference rate for financial instruments such as:
forward rate agreements short term interest rate futures contracts interest rate swaps floating rate notes syndicated loans variable rate mortgages currencies, especially the US dollar & Euro They thus provide the basis for some of the world's most liquid and active interest rate markets. For the Euro, however, the usual reference rates are the Euribor rates compiled by the European Banking Federation, from a larger bank panel.
Page 2 of 11 By: M. Faisal Panawala GR # 2200649
HAMDARD INTITIUT OF MANAGEMENT SCIENCES ISLAMIC BANKING – REPORT ON IBOR ALTERNATIVES
Difference between LIBOR & KIBOR: Libor:
London Inter Bank Offer Rate
LIBOR is published by the British Bankers Association (BBA) after 11:00 am (and generally around 11:45 am) each day, London time, and is a filtered average of interbank deposit rates offered by designated contributor banks, for maturities ranging from overnight to one year. There are 16 such contributor banks and the reported interest is the mean of the 8 middle values. The shorter rates, i.e. up to 6 months, are usually quite reliable and tend to precisely reflect market conditions. The actual rate at which banks will lend to one another will, however, continue to vary throughout the day. LIBOR is often used as a rate of reference for Pound Sterling and other currencies, including US dollar, Euro, Japanese Yen, Swiss Franc, Canadian dollar, Australian Dollar, Swedish Krona, Danish Krone and New Zealand dollar. Six-month LIBOR is used as an index for some US mortgages. In the UK, the 3 month LIBOR is used for some mortgages especially for those with adverse credit history.
Kibor:
Karachi Inter Bank Offer Rate
Karachi Inter-bank Offered Rate (KIBOR); quoted on Reuters by 20 commercial banks (as selected by FMA - Financial Markets Association of Pakistan). It is updated at 11.30 AM daily on Reuters by excluding Out-layers, 4 extremes on higher and 4 extremes on lower side. Authenticity is confirmed by making the contributors liable to accept Bid/Offer within 15 minutes from the time of up date up to Rs 100million of Lot Size by Contributor Banks. Financial Market Association of Pakistan ensures timely and error-free availability of the rates. With effect from 31st January 2004 Karachi Inter-bank Offered Rate (KIBOR) is used as the benchmark for all-corporate lending. Currently KIBOR is quoted for tenors ranging from 1-week to 3-years. Initially KIBOR of one-month; three-month and six-month was used as a benchmark for all corporate lending in the local currency from next month banks had agreed on extending the KIBOR tenures to one year by March 31, 2004 and then to three years by December 31, 2004 for using it to price corporate loans of similar tenures. The main purpose of this is to introduce some uniformity in corporate lending rates and this also promote the culture of floating rate lending and will make corporate more efficient in cash flow management. The use of KIBOR as a reference rate (for corporate lending) will make the monetary policy more effective. Six months KIBOR is most widely used for benchmarking
Page 3 of 11 By: M. Faisal Panawala GR # 2200649
HAMDARD INTITIUT OF MANAGEMENT SCIENCES ISLAMIC BANKING – REPORT ON IBOR ALTERNATIVES
Skepticism on Islamic Banking 1. Commercial banks as well as Islamic bank use KIBOR as basis for pricing their products 2. If interest is strictly prohibited in Islam, how is that interest-based financial institutions have been working quite successfully in Muslim countries? 3. What factors induced Muslims to restructure their financial sector according to the injunctions of Islam? 4. If interest, which lies at the heart of modern economy, is abolished, how the economy could be run according to the teachings of Islam? 5. How Islamic banking has fared in practice?
Responses to Skepticism 1. Commercial banks as well as Islamic bank use KIBOR as basis for pricing their products Reply: Shariah Advisors have permitted the use of LIBOR as a benchmark for the calculation of rent on the basis that it is well known, easily available and so there can be no dispute over how our rent is calculated. Such clarity is a key part of Islamic finance. According to Mr. Najmul Hassan, Meezan Bank The use of the Karachi Interbank Offered Rate (KIBOR) as a benchmark by Islamic banks in calculating the selling price of their commodities in murabaha sale transactions is not only justified, but also necessary, to remain competitive given the current banking industry dynamics in which Islamic banks have a pretty low share. However, it is not permissible under Shari’ah to price loans using KIBOR, as many conventional banks do. Najmul Hassan, general manager for corporate and business development, Meezan Bank, explains the underlying differences in approach. Unlike conventional banking based on interest-bearing loans, funds invested in an Islamic bank are used essentially for trade. According to capitalist theory, there is no difference between money and commodity in so far as commercial transactions are concerned. Islamic principles differ from this concept because money and commodity have different characteristics. However, the way these two financial systems function Page 4 of 11 By: M. Faisal Panawala GR # 2200649
HAMDARD INTITIUT OF MANAGEMENT SCIENCES ISLAMIC BANKING – REPORT ON IBOR ALTERNATIVES
with respect to core defining parameters is very different. Many things look the same but are, in essence, fundamentally different. In response to Abdulkader’s (Abdulkader Thomas, president and CEO, Shape Financial Corporation) question on the need to develop a unique Islamic benchmark, Rafe (Rafe Haneef, head of Islamic banking, Citigroup Asia) said that as long as the Islamic product fits within the mainstream product, there is no need to develop a unique Islamic benchmark. “In my opinion, we could not create another benchmark for an Islamic product that fits within the mainstream product (Sukuk is like a bond) because the dominant benchmark (the conventional benchmark in this case) will force the new benchmark to converge. This is the law of one price in economics. However, if we change the way we structure our product (for example, if the redemption price of Sukuk is based on market price), then the pricing criteria would be different. We would have to look into the internal rate of return [IRR] in that case. If we don’t change the product, neither will the price,” he concluded. 2. If interest is strictly prohibited in Islam, how is that interest-based financial institutions have been working quite successfully in Muslim countries? Reply: Before the introduction of interest-based Western banks in the 19th century, there were no modern banks in the Muslim countries. However, these countries did have a financial system which was run by "moneychangers". Savers and traders did business efficiently without banks There are three reasons why Western banks have succeeded in establishing themselves in the Muslim countries, even with the prohibition of interest. First, with the fall of Ottoman Empire and the rise of Western colonialism, Muslims lost their political and economic power. Most Muslim countries came under the direct or indirect control of a colonial power, either Britain or France. Western powers were able-to set up institutions, including banks, firmly and successfully. Second, the Western banking system was powerful, efficient, and innovative. Third, many highly educated and liberal Muslims as well as some religious schools considered Western banks desirable 3. What factors induced Muslims to restructure their financial sector according to the injunctions of Islam? Reply: Islamic banking; is based on the abolition of interest which requires a complete restructuring and innovations in the financial sector. To replace interestbased modes of financing, Muslim experts in banking and finance have devised novel financial techniques. In Islamic banking deposits are treated as shares and depositors purchase equity position regardless of where the bank invests their capital. The financial techniques used by Islamic banks are mostly based on equity participation. These techniques, with the closely comparable Western techniques, are: Page 5 of 11 By: M. Faisal Panawala GR # 2200649
HAMDARD INTITIUT OF MANAGEMENT SCIENCES ISLAMIC BANKING – REPORT ON IBOR ALTERNATIVES
1. Mudarabah (Silent partnership) 2. Muqaradah (debt and equity financing) 3. Murabaha (mark -up) 4. Musharika (limited partnership) 5. Salam (forward purchase) 6. Muzara (share cropping) These techniques arc considered Islamic because they do not carry interest or "a disguised form of interest". Furthermore, these techniques, because of close compatibility with their Western alternatives, do not pose logistic and administrative problems 4. If interest, which lies at the heart of modern economy, is abolished, how the economy could be run according to the teachings of Islam? Reply: Islamic banking is superior to interest-based banking in terms of efficiency and stability for three reasons. First, an Islamic monetary system has a wellbehaved and smooth velocity of money. Second, an Islamic; financial system has "stable public demand" for financial assets. Third, interest-free monetary assets can be used as an appropriate intermediate policy target because policy makers have effective control over these assets 5. How Islamic banking has fared in practice? Reply: The revival of Islamic values during the 1970s has led to the creation of financial institutions with the aim of translating Islamic ideal into practical business solutions. Muslim economists have demonstrate that an Islamic banking system is superior to an interest-based banking system because the Islamic system is not based on exploitation and has the capability to adjust to shocks which lead to banking crises. The Islamic banking experiment is of comparatively recent origin and thus is difficult to judge its viability and credibility conclusively. Evidence of its performance is scanty and mixed. Islamic banking, however, has great potential for growth because of a fundamentalist wave which is invading most of the Muslim countries of the world.
Page 6 of 11 By: M. Faisal Panawala GR # 2200649
HAMDARD INTITIUT OF MANAGEMENT SCIENCES ISLAMIC BANKING – REPORT ON IBOR ALTERNATIVES
Alternative Benchmark for Pricing Islamic Banking Products 1. 2.
3. 4.
MII: Mudharabah interbank investments Weighted Price Inflation Index CPI: Consumer Price Index SPI: Sensitive Price Index WPI: Whole Sale Price Index WACC: Weighted Average cost of capital for Islamic Banks Precious Metal Weighted Index
MII: Mudharabah interbank investments MII refers to a mechanism whereby a deficit Islamic banking institution ("investee bank") can obtain investment from a surplus Islamic banking institution ("investor bank") based on Mudharabah (profit-sharing). The period of investment is from overnight to 12 months, while the rate of return is based on the rate of gross profit before distribution for investments of 1-year of the investee bank. The profit-sharing ratio is negotiable among both parties. The investor bank at the time of negotiation would not know what the return would be, as the actual return will be crystallised towards the end of the investment period. The principal invested shall be repaid at the end of the period, together with a share of the profit arising from the used of the fund by the investee bank. Beginning February 2, 1996, Bank Negara Malaysia introduced the minimum benchmark rate for the MII i.e. the prevailing rate of the Government Investment Issues plus a spread of 0.5 per cent. The purpose of the benchmark rate is to ensure that only banks with reasonable rate returns participate in the MII. Source: Bank Negara Malaysia (http://iimm.bnm.gov.my/)
Page 7 of 11 By: M. Faisal Panawala GR # 2200649
HAMDARD INTITIUT OF MANAGEMENT SCIENCES ISLAMIC BANKING – REPORT ON IBOR ALTERNATIVES
CPI: Consumer Price Index Consumer Price Index (CPI) is the main measure of price changes at the retail level. It measures changes in the cost of buying a representative fixed basket of goods and services and generally indicates inflation rate in the country. SPI: Sensitive Price Index The Sensitive Price Indicator (SPI) is computed on weekly basis to assess the price movements of essential commodities at short intervals so as to review the price situation in the country. The SPI is being presented in the Economic Coordination Committee of the Cabinet (ECC).
WPI: Wholesale Price Index The Wholesale Price Index (WPI) is designed to measure the directional movements of prices for a set of selected items in the primary and wholesale markets. Items covered in the series are those which could be precisely defined and are offered in lots by producers/manufacturers. Prices used are generally those, which conform to the primary sellers realization at ex-market, ex-factory or at an organized Wholesale level. Following are the inflation rates based on CPI, SPI and WPI for the period of three years and three months with respect to the corresponding period/month are given below:JULY-JANUARY OVER CORRESPONDING PERIOD OF LAST YEAR Series CPI SPI WPI
2007-2008 8.56 11.79 11.01
2006-2007 8.14 11.84 7.44
2005-2006 8.48 6.58 10.97
JULY-JANUARY OVER CORRESPONDING PERIOD OF LAST YEAR
The inflation rates based on CPI, SPI and WPI for the year 2007-08 increased by 8.56%, 11.79% and 11.01% respectively over the corresponding period of 2006-07. It increased by 8.14%, 11.84% and 7.44% respectively in 2006-07 over the corresponding period of 2005-06. In 2005-06, the rate of inflation increased by 8.48%, 6.58% and 10.97 % respectively over the same period of 2004-05. An analysis of data for last three years for the same period indicates that CPI & WPI were higher as compared to last two years but SPI was higher as compared to 2005-2006 while lower as compared to 2006-07. Page 8 of 11 By: M. Faisal Panawala GR # 2200649
HAMDARD INTITIUT OF MANAGEMENT SCIENCES ISLAMIC BANKING – REPORT ON IBOR ALTERNATIVES
Yearly Inflation Rates of Pakistan ( 1990-91 = 100) Inflation Rates based on Sensitive Price Indicator (SPI), Consumer Price Index (CPI) and Wholesale Price Index (WPI)
Period 1991-1992 1992-1993 1993-1994 1994-1995 1995-1996 1996-1997 1997-1998 1998-1999 1999-2000 2000-2001 2001-2002 2002-2003 2003-2004 2004-2005 2005-2006
SPI 10.54 10.71 11.79 15.01 10.71 12.45 7.35 6.44 1.83 4.84 3.37 3.58 6.83 11.55 7.02
CPI 10.58 9.83 11.27 13.02 10.79 11.80 7.81 5.74 3.58 4.41 3.54 3.10 4.57 9.28 7.92
WPI 9.84 7.36 11.40 16.00 11.10 13.01 6.58 6.35 1.77 6.21 2.08 5.57 7.91 6.75 10.10
Note: Yearly Inflation rate of Pakistan from the year 2001-2002 to date based on the base year (2000-01=100)
It is evident from above that all above inflationary indices are very close with interest rates of respected years. A comprehensive inflationary trend indicator, or combination of CPI and WPI, based on more representative sampled can fulfill the need of Islamic Banking benchmarking. The reason why we are focusing on inflationary trend indexes, because inflation is the major and only uncontrollable and phenomenal factor in the KIBOR. Source: GOVERNMENT OF PAKISTAN STATISTICS DIVISION FEDERAL BUREAU OF STATISTICS MONTHLY REVIEW OF PRICE INDICES (2000-01 = 100) JANUARY, 2008 Summary Inflation Rates Based on Consumer Price Index (CPI) Sensitive Price Indicator (SPI) Wholesale Price Index (WPI)
Page 9 of 11 By: M. Faisal Panawala GR # 2200649
HAMDARD INTITIUT OF MANAGEMENT SCIENCES ISLAMIC BANKING – REPORT ON IBOR ALTERNATIVES
WACC: Weighted Average cost of capital for Islamic Banks Abbas Mirakhor Approach Cost of Capital can be measured without resort to a fixed and predetermined interest rate which was proposed by Abbas Mirakhor. The benchmark could be created based on Tobin q theory. Main assumption: In the absence of a fixed and predetermined rate of interest, equity financing becomes the only source of financial capital and as such, the economy’s financial system becomes equity-based and hence, the equity market would provide a measure of the cost of capital Sheikh Taqi Usmani Approach A Benchmark can be achieved by creating a common pool which invests in assetbacked instruments like Musharakah, Ijarah etc. If majority assets are in tangible form, its units can be sold and purchased on the basis of their net asset value determined on periodical basis These units may be negotiable and maybe used for overnight financing The banks having surplus liquidity can purchase these units and when they need liquidity, they can sell them This arrangement may create inter-bank market and the value of the units may serve as an indicator for determining the profit
Page 10 of 11 By: M. Faisal Panawala GR # 2200649
HAMDARD INTITIUT OF MANAGEMENT SCIENCES ISLAMIC BANKING – REPORT ON IBOR ALTERNATIVES
Precious Metal Weighted Index CBOE GOLD INDEX (Chicago Options:^GOX)
Index Value:
205.17
Trade Time: Change: Prev Close: Open: Day's Range: 52wk Range:
3:29PM ET 5.85 (2.77%) 211.02 211.02 20.37 - 211.02 120.35 - 211.94
1d 5d 3m 6m 1y 2y 5y max
Source : Yahoo Finance
As we can see from the above chart of Gold Rate on CBOE (Chicago board of Exchange) that Gold and other precious metal do absorb inflationary aspects in their prices but their prices are very fluctuative to have an alternative to KIBOR.
Conclusion: To develop the above mentioned hypotheses Islamic bank needs real devotion & time. In my opinion the most best suited alternative to IBOR is Weighted Price Inflationary Index because it is based on commodity prices bearing inflation & the data for calculation is easily available too.
Page 11 of 11 By: M. Faisal Panawala GR # 2200649