Is interest-rate benchmarking good enough?

At the recent industry talk at INCEIF on Sukuk, a student asked the speaker Prof. Datuk Rifaat Abdul Karim about interest-rate benchmarking.  In reply, he said that there is no issue about the interest-rate benchmarking.  It is normal practice of Islamic financial institutions (IFIs) today to benchmark profit rates of Islamic financial instruments to LIBOR or in the case for Malaysia, KLIBOR.

We can refer to the Al-Baraka Fatwa on interest rate benchmarking, “There is no prohibition in relying on the interest rate benchmarking in pricing the Islamic products of which such use of benchmark does not contradict the products’ nature of conforming to the Shariah upon its usage”.

In other words, interest-rate benchmarking is permissible as long as the financial instruments do not involve loans or qard. Other solid reason is the absence of any worthwhile representative Islamic financial benchmark.

While not rejecting interest-rate benchmarking, Shaykh Taqi Usmani reminded us that, “It is however true that the Islamic banks and financial institutions should get rid of this practice as soon as possible, because, firstly, it takes the rate of interest as an ideal for a halal business which is not desirable, and secondly because it does not advance the basic philosophy of Islamic economy having no impact on the system of distribution. Therefore Islamic banks and financial institutions should strive for developing their own benchmark”.

Putting fiqh issues aside, interest rate benchmarking in Islamic finance today is even more doable given that most of the modes of financing are based on credit sales in the likes of commodity murabaha, tawaruq, bay enah, al-bai bithaman ajil, murabaha, ijara, istisna and salam.

As pricing of financial instruments is based on risks carried by the Islamic banks, major risk in Islamic credit sales is primarily associated with credit risk and so does risk in interest-bearing loans.   Hence, between Islamic credit sales and loans, we are comparing them like an apple for an apple.

However, when Islamic finance is propelled by risk-sharing and true sale credit financing, a new risk emerges namely business risk. In this respect, interest-rate benchmarking may not be good enough for Islamic finance given that interest-bearing loans do not carry business risk.

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