Salman Ahmed Shaikh
From the Islamic finance industry perspective, an important criterion for the industry wide adoption of any benchmark, particularly one that is published every business day, is the simplicity, reliability and robustness of its methodology.
Additionally, to engender the confidence of financial market participants, an interbank benchmark must be calculated frequently enough with a transparent and simple methodology open to public scrutiny.
In Islamic finance, an additional and most the important aspect is Shari’ah compliance of the method as well as the instrument which is used in pricing.
In this regard, a key challenge is that are there currently a sufficient volume of underlying transactions on which an international Islamic interbank rate could be built? What would be the agreed methodology and basis of calculation? Who would be responsible for determining such rate? Would that rate be sufficiently robust?
Some additional challenges in transitioning to a different benchmark in Islamic finance include the following.
Rise in Commercial Displacement Risk
Since Islamic banks genuinely strive to pass through actual returns to investing depositors, any significant change in cash flows will affect profit distribution and may lead to loss of competitiveness. Paradox is that similarity in cash is beneficial from the perspective of risk, especially commercial displacement risk. However, it increases the reputation risk since people evaluating Islamic banking and conventional banking on cash flow terms find no major signs of difference in cash flows.
Risk of More Volatility and Uncertainty
In the absence of low interbank market activity in Islamic finance space, if a real economy based benchmark is used, it will expose Islamic banks to newer and different risks in the macro economy. Thus, there is increased risk of volatility.
Existence of Arbitrage Opportunities
If same benchmark is not used across financing types, then there is possibility of arbitrage opportunities by swapping assets.
Need Well-Behaved Yield Curve
If there are different benchmarks for different financing types, then it is difficult to find a well behaved yield curve and hence asset liability management will become a challenge.
Frictions in Borrowing
There is flexibility in providing finance, but not when one needs finance since the industry in most countries is dominated by interest-based banking. Therefore, the stakeholders do not just include Islamic banks and Islamic financial institutions. Rather, it is also important that any new alternative is also acceptable to the counterparties including both Islamic and conventional financial institutions in the financial market.
Willingness and Capacity of Stakeholders
Absorption capacity and willingness is required both from the bank as well as customers. Banks may be inclined to take on more risk, but the risk averse depositors may not prefer that. Bank as a delegated monitor of depositors is not using its own investment. Rather, it is an agent for the depositors to monitor the financing portfolio on investors behalf.
Dual Objective Problem
Pricing alternate is desired to be distinctive yet closely follow the market dynamics. Both objectives may not be complementary and compatible with each other.
Need for Multi-Functional Alternative
Sovereign rates or policy rates are primary pricing tools which affect interbank transactions as well. Policy rate not only serves as a pricing benchmark in financing transactions in interbank market, but also allows the central banks to effectively implement monetary policy by affecting money supply, controlling inflation, liquidity and hence aggregate demand. Changes in aggregate demand affect output growth and employment.
Predictability of Pricing Alternative Data for most real economic indicators from macroeconomics perspective is based on historical information. Such indicators should be forecastable to serve in determining forward looking expected profit rate.
Categories: Articles on Islamic Finance