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HAMDARD INTITIUT OF MANAGEMENT SCIENCES

ISLAMIC BANKING – REPORT ON IBOR ALTERNATIVES

ƒ 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; large-
denomination 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

ƒ 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

ƒ 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 inter-
bank 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

ƒ 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?

ƒ 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

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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 interest-
based 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:
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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 well-
behaved 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

ƒ Alternative Benchmark for Pricing Islamic Banking Products

1. MII: Mudharabah interbank investments


2. Weighted Price Inflation Index
ƒ CPI: Consumer Price Index
ƒ SPI: Sensitive Price Index
ƒ WPI: Whole Sale Price Index
3. WACC: Weighted Average cost of capital for Islamic Banks
4. Precious Metal Weighted Index

ƒ 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

ƒ 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.

ƒ 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).

ƒ 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 2007-2008 2006-2007 2005-2006


CPI 8.56 8.14 8.48
SPI 11.79 11.84 6.58
WPI 11.01 7.44 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 SPI CPI WPI


1991-1992 10.54 10.58 9.84
1992-1993 10.71 9.83 7.36
1993-1994 11.79 11.27 11.40
1994-1995 15.01 13.02 16.00
1995-1996 10.71 10.79 11.10
1996-1997 12.45 11.80 13.01
1997-1998 7.35 7.81 6.58
1998-1999 6.44 5.74 6.35
1999-2000 1.83 3.58 1.77
2000-2001 4.84 4.41 6.21
2001-2002 3.37 3.54 2.08
2002-2003 3.58 3.10 5.57
2003-2004 6.83 4.57 7.91
2004-2005 11.55 9.28 6.75
2005-2006 7.02 7.92 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

ƒ 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 asset-


backed 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: 3:29PM ET
Change: 5.85 (2.77%)
Prev Close: 211.02
Open: 211.02
Day's Range: 20.37 - 211.02
1d 5d 3m 6m 1y 2y 5y max
52wk Range: 120.35 - 211.94
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.

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By: M. Faisal Panawala GR # 2200649

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