The Prophet Mohammed, the founder of Islam, is reported to have said that a time would come when all mankind would take riba, or interest, and those that did not would still smell it.

The growth of modern Islamic finance has been an attempt to avoid this prophecy by creating a parallel financial system without interest, which is prohibited under Islam. A whole series of new financial products have been developed over the past few decades that allow Islamic banks and investors to mirror conventional market products, such as bonds, corporate lending and even complex derivatives, but without being charged interest.

At heart, there is a serious problem that the Islamic finance sector has struggled to overcome. Conventional banks borrow in the interbank market to make up for overnight or one-week shortfalls against their liabilities. Other lenders with excess liquidity charge interest for allowing banks to use their excess reserves to cover their liabilities.

This is how the interbank market operates and it provides a benchmark for most lending. Even Islamic banks have used the London interbank offered rate (Libor), the most commonly used benchmark, to price loans.

Resource management

In addition, interbank lending is an essential part of managing the resources of a bank and Islamic banks need a sharia-compliant short-term, liquid investment tool to manage their resources.

The flow of sharia-compliant funds into the conventional banking system, is estimated to be hundreds of billions of dollars. Much of this is through Islamic banks putting deposits into conventional interest-bearing accounts as part of liquidity management.

“I think [the IIBR] has the potential to have a bigger impact than the first Islamic equities index”

Rushdi Siddiqi, Thomson Reuters

On 22 November, data provider Thomson Reuters tried to address this issue with the launch of the Islamic Interbank Benchmark Rate (IIBR) at the World Islamic Banking Conference in Bahrain. Not keen to underplay the occasion, it was heralded as “a new beginning for Islamic finance” and a sign that the sector was “developing into an efficient, mature market that could rely on its own benchmarks”, by Sayd Farook, global head of Islamic capital markets at Thomson Reuters.

In reality, it could take a long time before the IIBR replaces the use of conventional benchmarks for pricing Islamic deals.

In Malaysia, where a similar ringgit denominated benchmark already exists, adoption of the rate took time. “From Malaysia’s experience, it does take a while for the rate to start to be used in syndicated loan and sukuk [Islamic bond] pricing,” says Khairul Nizam, deputy secretary-general of the Accounting and Auditing Organisation for Islamic Financial Institutions (Aaoifi). “But once the market in general is convinced that the rate correctly gives an indication of funding costs, then its use picks up.”

No syndicated loans or sukuk transactions have been done using the IIBR rate yet, but some bankers are optimistic it will not take long before the first one is completed.

One attraction of using the IIBR rate right now is that over short durations it is currently lower than Libor, says Boyd Winton, director of financial services business development at Bahrain’s Economic Development Board. “Because of that, I don’t think it will be too long before people start to use it,” he says.

The new rate is based on the average profit rate of bids on sharia-compliant interbank funding transactions. These include Murabaha, which is based on the idea of cost plus profit value attached to a contract, and wakala, which is based on a lending bank agreeing to fund the sharia-compliant investments of another. The people behind the rate say the scope for including other types of Islamic contracts is there and, because the transactions are already assessed for sharia compliance by scholars working for the banks, there is no need for the IIBR to confirm the Islamic nature of the contracts, although it does have its own advisory board of sharia scholars.

At launch, 16 banks are contributing information to help set the rate, including Saudi Arabia’s Alinma, Islamic Development Bank and National Commercial Bank, Bahrain Islamic Bank, the UAE’s Dubai Islamic Bank, Noor Islamic Bank and Al-Hilal Bank, as well as Kuwait Finance House and Qatar Islamic Bank. Thomson Reuters says several other large banks are also in talks to join the list of contributors, including the Islamic banking operations of some large international banks.

No guarantee

The involvement of some of the region’s largest Islamic banks is not a guarantee that use of the rate will catch on. “We are a very young industry that continues to feel its way forward,” says Yusuf Talal DeLorenzo, one of the sharia scholars involved in establishing the IIBR.

A lot of development has already occurred over the past few years in the Islamic finance sector. Rushdi Siddiqi, global head of Islamic finance at Thomson Reuters, has been involved in the Islamic finance sector for many years and says the IIBR should catch on. He was previously involved in the launch of the DJ Islamic market index, the first Islamic equities index, in 1999.

“In 1999, when we launched the first Islamic equities benchmark, we managed to generate a buzz and get some of the most important banks involved,” says Siddiqi. “And this time, we think banks are talking about this and will be benchmarked to this because we are bringing accountability and transparency to a space that is not known for it.

“I think this has the potential to have a bigger impact than the first Islamic equities index,” he adds. “The short-term liquidity deployment needs in the Islamic finance sector are huge.”

Breaking convention

When Libor was launched between 1984-86, which is also calculated and published by Thomson Reuters, it took a while before it was widely adopted as an industry standard. “You can’t bring the level of market efficiencies that Libor created to the Islamic banking market overnight,” says Siddiqi.

It is hoped that as knowledge of the rate expands and participant numbers grow, the Islamic finance sector will be able to break free of the use of Libor. As a result, leakage into the conventional finance system will decrease.

As the Islamic finance industry develops, it will increasingly look to break away from conventional market instruments, such as Libor, to demonstrate it is truly independent. The World Islamic Banking Competitiveness Report 2011-12, by consultancy firm Ernst & Young, estimates that Islamic banking assets will reach $1.1 trillion in 2012, up from $826bn in 2010. By 2015, Islamic banking assets in the Middle East and North Africa region alone are estimated to hit $990bn.

“For this to really start catching on, the Islamic rate will have to appear more attractive than the conventional one”

Riyadh-based Islamic banker

The industry, however, is still hampered by a lack of standardisation, particularly between regional Islamic finance centres, such as the Gulf and Malaysia, typified by the two now having separate benchmark funding rates. Central banks also worry they do not have the same liquidity management tools as conventional banks. Proponents argue that standardisation is gradually occurring and because it prohibits the kind of off-balance or speculative activities that have caused recent problems in the conventional finance system, it will continue to grow strongly over the next few years.

With an industry of that size, the development of its own benchmarks is inevitable. Yet, a few weeks after the launch of the IIBR, several syndications bankers at large Islamic banks say they know little about the rate.

For an industry already plagued by complexity, an additional layer could make pricing transactions with a mixture of conventional and Islamic loans, both priced from different benchmarks, a step too far. For agnostic borrowers, bankers say it will probably push them just to go for whichever option is cheapest.

Encouraging usage

“For this to really start catching on, the Islamic rate will have to appear more attractive than the conventional one,” says a banker at an Islamic bank in Riyadh. “It will also be very difficult to compare the liquidity situations of Islamic banks in Saudi Arabia with Islamic banks in the UAE, for example.”

Both those banking systems are experiencing very different liquidity conditions. There are plans for country- and currency-specific versions of the IIBR to be launched if the demand is there, but for now it will remain a regional dollar-denominated rate. It could be some time before new versions of the rate are launched, although the ringgit one is already in use.

Concerns about maintaining the purity of Islamic banking are growing as fast as the industry itself. In contrast to other aspects of the Islamic financial system, regulators, such as Aaoifi, do not have the authority to force banks to start using IIBR to avoid leakage. But for an industry that relies on the piety of its customers, banks that can claim to be truly divorced from riba will have a reputational advantage.

The steps taken by the industry in late 2011 are an important part of the development of a truly independent and transparent Islamic financial system. Yet it could still take several years before it can truly claim to have freed itself from the smell of riba.