The launch of the world's first Islamic interbank rate is a key step in the industry's efforts to distinguish itself from conventional finance and achieve greater standardisation. The measure of its success will only come with time, however, and is dependent on its ability to offer competitive pricing, its inclusion of more currencies and its application to a range of financial instruments. 

With the prohibition of interest being one of the central tenets of Islam, the Islamic finance industry's reliance on the London interbank offered rate (Libor) to price its bank funding was proving contradictory to its underlying principles. Therefore, the launch of the world’s first Islamic interbank benchmark rate (IIBR) by Thomson Reuters on November 22, 2011, marked an important milestone for the industry. 

Designed to provide an objective indicator for the average expected return on sharia-compliant short-term interbank funding, the dollar-denominated IIBR is compiled using the contributed rates of 16 Islamic banks and the Islamic subsidiaries of three conventional banks to provide a reliable and much-needed alternative for pricing a range of Islamic instruments. The fundamental difference between the benchmarks is that while Libor measures interest, IIBR measures profit.

“I think the key trigger for the launch of the IIBR is the demand for Islamic finance to differentiate itself from the conventional system,” says Ashar Nazim, executive director and Middle East and north Africa head of Islamic financial service's at accountancy firm Ernst & Young.

“The economic problems in Europe and the US right now have raised a lot of questions about how effectively the capitalist banking model is working. The IIBR will go a long way in enhancing the credibility of the Islamic industry. It might seem like a small step but it is a giant leap for the industry.”

Credibility value

Indeed, while Islamic finance has emerged as a serious contender in many countries over the past decade, it has increasingly had to defend its sharia identity in light of accusations that it simply replicates conventional products and relies on Western banking practices.

“The fact that Islamic finance was using Libor to price its interbank funding was not harming the industry much in terms of actual volumes, but it was in terms of
perception,” says Khalid Howlader, a senior credit officer at ratings agency Moody’s.

“It is difficult to argue a sukuk is not an interest-based debt when the cashflows are solely driven by Libor with no asset or equity risk. But one needs to bear in mind that there is often a disconnect between the needs of the scholars in terms of sharia compliance, and the needs of the borrowers in terms of funding – it is the latter that drives the evolution of the market.”

Critics of the IIBR have been quick to seize on the fact that while it has been established to serve as a global benchmark for the Islamic markets, Gulf banks constitute 16 of the 19 contributing institutions. However, the unique benefit of being so heavily weighted towards Gulf banks is that most, if not all, of these banks have substantial reserves and/or exposure in US dollars.

“With the exception of the Kuwaiti dinar, which is linked to a basket of currencies in which the US dollar has the largest weighting, the Gulf currencies are all pegged to the US dollar,” says Rushdi Siddiqui, global head of Islamic finance at Thomson Reuters.

“So the lay of the landscape is dollar-denominated and it is the most liquid currency. As this matures, we will have local currency fixings.”

Widening the field

Indeed, just as Libor is calculated for 10 currencies, Mr Siddiqui says he can foresee the IIBR being linked to multiple currencies.

“There are 57 Muslim countries but Malaysia is a hub for Islamic finance, and so is the Gulf. Other obvious candidates would be the three Muslim countries included in the G20 – Indonesia, Saudi Arabia and Turkey. So it is a function of where the aggressive demand is coming from and we will cater to those demands. As Islamic finance becomes increasingly cross-border, it makes sense for us to follow the path that it has blazed.”

The strategy going forward is to get a wide range of banks from different countries to come on board in order to make the benchmark more inclusive and global. “We have been approached by banks in countries as diverse as Pakistan, Turkey, Indonesia and Bangladesh, which have all expressed an interest in adopting the IIBR,” says Mr Siddiqui. 

Given the dominance of Gulf banks in the panel, the IIBR is particularly keen to increase the number of contributing Malaysian banks from the current three. Malaysia already has its own Islamic interbank rate system (Kuala Lumpur interbank offered rate, or Klibor) based on contributions from domestic sharia institutions in the local currency, the ringgit. However, these institutions have many cross-border issuances, and the advantage of the IIBR being a global US dollar rate is that it can complement the ringgit’s rate.

For the IIBR to enjoy any real success, it needs both volume and liquidity, and in this sense, the Malaysians are a crucial participant. Malaysia continues to dominate the sukuk (Islamic bond) market, accounting for 78%, or $39.8bn, of total issuances in 2010. However, adoption of the IIBR by a wide range of Islamic institutions drawn from different countries is likely to take some time as the industry familiarises itself with the new system.

Full application

The IIBR can be used to price a number of Islamic instruments including common overnight to short-term treasury investment and financing instruments such as murabaha (cost plus financing), wakala (investment agency) and mudaraba (investment management), retail products such as property and car finance, sukuk and other sharia-compliant fixed-income instruments.

It can also be used for the pricing and benchmarking of corporate finance and investment assets, but it is hoped that it will expand to a range of other instruments in the future.

While the full application of the IIBR may take some time, the consensus among industry insiders is that this mechanism will better reflect the funding costs of Islamic banks, which often face different funding issues to those in mainstream financing.  

If their cost of dollar funding is lower, it could mean Islamic banks are potentially more efficient in managing their liquidity and can compete more effectively in the overall market. Conversely, if their cost of funding is higher, it could mean Islamic banks are potentially less efficient in managing their liquidity, which will hopefully prompt them to carry out the necessary steps to improve their performance. Either way, having transparent information available vis-à-vis liquidity efficiency should help facilitate the flow of funds between banks which, in turn, will aid the development of the Islamic finance industry.

But while the the IIBR is largely regarded as a positive first step, some industry players believe it is still inherently flawed.

“First and foremost, the IIBR is still a replication of the method used to price conventional debt, and as such is no more asset/equity risk driven or tangible than Libor. It is still form over substance,” says Mr Howlader.

“Islamic finance needs to focus on what is different – asset finance plus equity – to truly differentiate itself and really add value or else Islamic issuers will pay a premium for the perception of compliance. As I said earlier, it is currently the needs of the borrowers that drive the market. Many are conventional issuers so if IIBR works out to be significantly higher, they will stick to Libor.”

Test of time

Of course, the question of whether the IIBR will always be offered at a premium to the conventional rate is one that can only be answered by time.

“Whether IIBR is at a premium or not will primarily depend on liquidity management efficiency,” says Khairul Nizam, deputy secretary-general of the Bahrain-based Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) and a member of the IIBR’s benchmark committee.

“We hope Islamic banks will be at least as efficient as conventional banks. If and when that is the case, then there should not be any premium. From a pure analysis of historical rates over the past three weeks since launch on November 22, 2011, we have seen that on average IIBR is cheaper on the short end of the curve (overnight), while dearer on the longer end of the curve (one year).”

Indeed, the overnight rate for the IIBR on December 13, 2011, stood at 0.1179 compared to 0.1505 for Libor. In contrast, the one-year IIBR was noticeably higher at 1.1229, compared to 1.0934 for the equivalent one-year Libor rate. 

Questions have also been raised about how Thomson Reuters will ensure the accuracy of the IIBR. During the onset of the global financial crisis in 2008, banks using Libor were increasingly complaining that the cost of funding had risen above the rate at which they were lending, sparking debates over how accurate it was as a benchmark. Furthermore, concerns surfaced that banks were under-reporting the cost of funding to the British Bankers’ Association (BBA) as they did not want to be perceived to be having liquidity issues, which was distorting the average rate of lending the BBA produced.

The performance rates of IIBR versus Libor since launch

Checks and balances

The IIBR is presided over by an Islamic benchmark committee which includes AAOIFI, the Dubai-based Hawkamah Institute for Corporate Governance, the Association of Islamic Banking Institutions Malaysia and the Bahrain Association of Banks.

“This committee will check for errors, tolerance, standard deviation and outlier verification so we have fail-safe mechanisms in place,” says Mr Siddiqui. “Plus each contributor has signed a contract which states that any bank that is found to have provided factually incorrect data will be expelled from the benchmark. So we are doing our best to ensure the integrity of contributed figures through as air-tight an overview process as possible.

"For the very first time, a standardised rate can be seen on our screens by the world at large so we are shining a spotlight on an area that has been opaque and somewhat dark. It is then up to deposit-placing institutions to look at counterparty risk.”

The challenge for the Islamic finance industry now is to ensure that this important first step is sustainable. The financial markets – both conventional and Islamic – will be watching very carefully to see how the IIBR performs over the next few years. If the IIBR is able to successfully link the availability and price of capital more closely with the real performance of the economy then it will prove to be a very powerful tool that could change the dynamics of the industry.  

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