An Islamic pricing benchmark?

Within the Islamic finance industry, the use of interest rate benchmarks has led to occasional hand-wringing about the need for an 'Islamic' pricing benchmark. Several academics were commissioned by ISRA to study the issue and they write a paper[1] that was recently released (available on the ISRA website).

In their analysis, the authors created an alternative pricing benchmark based for Malaysia that they compared to KLIBOR based on industrial production, the money supply, equity prices and the Ringgit exchange rate (plus a suggestion for incorporating firm- and sector-specific factors). Using historical data, they found that their benchmark was more stable than the KLIBOR alternative.

However, there were a number of questions that the article raised about whether the effort was productive in terms of giving the Islamic finance industry a useful alternative to interest rate benchmarks like LIBOR/KLIBOR/etc. One of the biggest issues that I have with their methodology is that they use 'real' economy factors to determine their benchmark when it is not clear that the cost of financing in the Islamic finance industry as it operates today should be based on these factors and not an interest rate. What I mean by this is that the structure of Islamic banks' financing are much more debt-like and resemble the products offered by conventional banks in their risk (and return) profiles.

For example, the most common financing contract is murabaha, where a good is sold with a markup and deferred repayment. Although the bank is technically liable for some brief period of time, their main risk is the same as a conventional bank that loans money to a customer for the purchase of that good. The bank is concerned with the probability of default and its returns compared with its own cost of funds. To be fair, there is something to the argument that the cost of capital of Islamic banks should be different than conventional banks because their sources of capital may be forced to endure losses without creating a 'default'.

For example, most depositors are profit-sharing account holders, who are liable for loss of principal (although the regulatory regime in many regions limits the ability of depositors to be forced to accept a loss of principal and in others, the bank and its shareholders are in some ways subordinated to the depositors through reserve accounts that smooth the distributions to depositors, as well as absorb any losses. In addition, with the changes instituted by AAOIFI on mudaraba and musharaka sukuk, the sukuk holders may also be forced to receive redemption below par without a default if the underlying bank's profitability is not sufficient to pay the full value of the coupon plus final redemption. In both these situations, the bank does not have to absorb losses entirely and so their cost of capital is effectively lower than a conventional bank. This would make a conventional benchmark the incorrect metric to use when pricing loans (although the bank could adjust the spread over the benchmark it charges customers to compensate for this lower cost of capital).

However, apart from the possibility that an Islamic bank could have lower cost of capital from profit-sharing deposit accounts and debt financing, the interest rate benchmark may be more appropriate. For one thing, as the authors note, if there were a different benchmark for Islamic banks, it could attract arbitrageurs who would trade away any difference in the benchmark between conventional and Islamic banks, at least in normal conditions where the loss-sharing features of deposit accounts and sukuk were not in force. This would eliminate the benefit of having two different benchmarks because in most cases the benchmark rate would be identical.

While the article provided an interesting look at potential benchmarks for Islamic banks distinct from the interest-based rates they use now, the necessity of such a benchmark seems lacking. The use of an interest-based benchmark does not taint the Islamic banking industry and an attempt to create a distinct Islamic pricing benchmark could distract the industry from other, more pressing challenges, like liquidity management and deciding the place for profit-sharing and non-profit-sharing products. It would also deprive the industry of the ability to tap the knowledge of a much broader group of participants in the global financial system for information on the baseline cost of capital. Moving away from the interest-rate benchmark might impose costs on the industry's growth and would provide few apparent benefits except for those around 'perception' of the industry and its relationship with the conventional banking industry.

[1] Omar, Mohd Azmi, Azman Md Noor and Ahamed Kameel Mydin Meera. 2010. "An Islamic Pricing Benchmark", ISRA Research Paper No. 17/2010.