Islamic Capital Markets and New Product Development - Establishing alternative pricing and valuation benchmarks and delinking

from conventional benchmarks.

Issues and Challenges for developing an Islamic Inter-bank !enchmark in Pakistan"

#uthor"s Name$ Suleman Muhammad Ali #uthor"s current affiliation % position$ Manager Product Structuring and Research; Product Development & Shariah Compliance Meezan an! "imited#$ Email addresses of the author$ sulemanmuhammadali%gmail#com &elephone number$ &'( )**(+,(,)( #bout the #uthor$ Mr. 'uleman Muhammad #li holds an M A -.inance/ degree 0rom 1nstitute o0 usiness Administration2 3arachi and is a Chartered 1slamic .inance Pro0essional -C1.P/ 0rom 14C51.2 3uala "umpur# Currentl6 he is the Manager7 Product Structuring & Research at Meezan an! "imited leading the product structuring and Shariah compliance 0unction related to 1slamic Structured 0inance2 Su!u! 1ssues2 8reasur6 and Corporate .inance# Mr# Ali is also a reputed 1slamic 9an!ing trainer2 has conducted various corporate :or!shops;seminars across Pa!istan and is a regular spea!er on the su9<ect at 41 A. 7 a training arm o0 State an! o0 Pa!istan -S P/# =e :as involved in the structuring o0 Pa!istan>s 0irst ever short term 3APC? Su!u! and the development;presentation o0 proposal regarding the launch o0 Islamic Interbank Offered Rate - Karachi (IIBOR - K) in Pa!istan to S P#
$

Competing 1nterest@ Author>s emplo6ment :ith Meezan an!#"imited# Page $ o0 A*

#bstract Purpose$ 8he purpose o0 this paper is to identi06 and discuss the issues and challenges involved in developing an 1slamic inter9an! 9enchmar! in Pa!istan# Design(approach$ 8o achieve this o9<ective the paper initiall6 evaluates the need and the purpose 0or having a separate 1slamic 9enchmar!# Su9seBuentl6 the paper compares the mechanisms o0 interest 9ased 9enchmar! prevailing in Pa!istan and the 1slamic inter9an! 9enchmar! rate launched recentl6 in the international mar!et :ith the proposed mechanism o0 1slamic 9enchmar! in Pa!istan# 8his proposed mechanism is 0urther criticall6 evaluated regarding its practicalit6 and the challenges involved in ma!ing the 9enchmar! a relia9le representative o0 the 1slamic inter9an! mar!et are discussed at length# 8he crucial Buestion :hether this 1slamic 9enchmar! :ill 9e independent 0rom the prevailing conventional 9enchmar! is anal6zed along :ith suggested scenarios under :hich the 1slamic 9enchmar! shall 9e de7lin!ed 0rom the conventional 9enchmar!# Methodolog)$ 8he stud6 is 9ased on the revie: o0 various scholarl6 :ritings on the importance and reBuirement o0 1slamic 9enchmar! rate2 revie: o0 industr6 statistics2 revie: o0 relevant data on prevailing 9enchmar!s2 direct o9servation o0 9ehavior o0 industr6 participants2 author>s personal eCperience and association :ith the industr6 including involvement in the development o0 the proposed mechanism 0or 1slamic 9enchmar! in Pa!istan and various minutes o0 the meetings held 0or implementation and launch o0 the proposed 9enchmar!# *indings % Practical implications$ 8he stud6 identi0ies the issues hampering the development o0 a relia9le 1slamic 9enchmar! in Pa!istan and concludes that in the prevailing circumstances the 9enchmar! i0 launched :ill not 9e independent 0rom the conventional 9enchmar! unless certain regulator6 and other measures are ta!en# 8he anal6sis conducted provides avenues 0or 0urther research and :ill 0acilitate regulators and industr6 pla6ers in 0ormulating strategies and policies in pursuit o0 developing the 1slamic 9enchmar! in Pa!istan# +e)words$ 3arachi 1nter79an! ?00ered Rate -31 ?R/; standardization; 9enchmar!2 mar!et 0orces; independence; 1slamic 1nter9an! ?00ered Rate 3arachi -11 ?R73/

,.-

Introduction

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A0ter the de9acle in the attempts to introduce 1slamic renaissance in Pa!istan :hen in (**( Meezan 0ledged 1slamic

an!ing in the $'D*s the industr6 sa: a

an! "imited -M "/ :as given the 0irst 0ull

an!ing license in Pa!istan -M " Annual Report (*$*/# 8he progress during

the past $* 6ears has 9een phenomenal# .rom a meager Rs# D n Deposits in (**) the industr6 has gro:n to a level o0 Rs#+*, n as on Decem9er (*$( -1slamic an!ing ulleting7State an! o0 Pa!istan E1 7S PF Decem9er (*$(/# Similarl6 the 8otal Assets o0 the industr6 have gro:n 7S P Decem9er (*$(/# Aided :ith

0rom Rs#$) n in (**) to Rs# D)+ n during this period -1 these 0igures the 1slamic

an!ing industr6 has no: captured around '#+G share o0 the overall 7S P Decem9er (*$(/# 8hese 0igures seem all the more an!s operate in an environment :hich is 0iercel6

9an!ing mar!et in terms o0 deposits -1

impressive given the 0act that the 1slamic

dominated 96 conventional 9an!s operating in the countr6 0or the last ,H 6ears# =o:ever despite these achievements the dominant conventional climate has led 1slamic 9an!s to 0ollo: the 0ootsteps o0 conventional 9an!s in matters ranging 0rom product design2 pac!aging2 pricing2 mar!eting2 customer service2 costing2 pro0it rates and other areas# 8his imitation o0 conventional products in 0orm although does not necessaril6 result in Shariah non compliance o0 the 1slamic 0inancial products i0 the su9stance structure and operational eCecution o0 the transaction is 9ased on Shariah principles rather than the riba 9ased Qard structures o0 the conventional 9an!s; the imitation in 0orm has 9ecome a 9one o0 contention in convincing the masses regarding the Shariah compati9ilit6 o0 the current 1slamic 9an!ing s6stem and products in Pa!istan# =ence this reputational road 9loc!; despite the gro:th in recent 6ears; has hindered 1slamic 9an!s to ma!e an6 signi0icant inroads in areas untouched 96 conventional 9an!s so much so that :ith onl6 $*G o0 the countr6>s population having a 0ormal 9an! account -Iorld an! (*$$2 JIorld an!

.inancial 1nclusion Data>/ the un9an!ed section o0 the countr6>s population still stands at a

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massive '*G# 8he 'hariah .eputation .isk is a uniBue 0eature 0aced 96 an 1slamic 0inancial institution in addition to the reputational ris! related to the solvenc6 o0 the 0inancial institution# Ihile 1slamic 0inancial institutions ma6 sustain the con0idence in the pu9lic regarding their a9ilit6 to pa6 their de9ts as the6 0all due at the same time an6 dent in con0idence regarding the level o0 Shariah compliance adhered to 96 these institution can also have disastrous e00ects causing a 9an! run on deposits or dr6ing up o0 credit dis9ursements causing a liBuidit6 crises :hich can in turn ultimatel6 lead to the insolvenc6 and de0ault o0 the institution# Ihile the issue o0 imitation o0 conventional products in 0orm is a common phenomenon through out the glo9al 1slamic 0inancial mar!ets; the issue is a serious threat in the conteCt o0 Pa!istan given the cheBuered eCperience o0 the pu9lic :ith the 1slamic 9an!ing eCperiment o0 the $'D*s 8he eCperiment :as declared un71slamic 96 .ederal Shariat Court -.SC/ o0 Pa!istan in $''$ and 96 Shariah Appellate ench -SA / o0 the Supreme Court o0 Pa!istan in $''' -Ksmani (**+/#

Similar apprehensions eCist among the general pu9lic regarding the Shariah compati9ilit6 o0 the current 1slamic 0inancial s6stem# /.&he use of +I!0. as a benchmark$

1n Pa!istan the representative 9enchmar! used 96 commercial 9an!s to price their 0inancing products is the 3arachi 1nter9an! ?00ered Rate -31 ?R/# 8he mechanism 0or calculating 31 ?R :ill 9e discussed in the later section; ho:ever the 31 ?R :as launched in Lanuar6 (**A and all the commercial 9an!s :ere reBuired; upon the instructions o0 S P - PD Circular4o#$2 ($ Lanuar6 (**A/; to price their corporate lending 9ased on 31 ?R# e0ore the launch o0

31 ?R the commercial 9an!s either used the prevailing rates o0 various tenors o0 the sovereign 8reasur6 ills issued 96 S P or the S P discount :indo: rates as the 9ase rates 0or pricing their lending products# Iith the esta9lishment o0 Meezan an! "imited -M "/ as the 0irst

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commercial 1slamic 9an! in (**(; the 9an! also started to use the 8reasur6 ill rates as the 9ase rate 0or pricing its products# Su9seBuentl6 :ith the incorporation o0 31 ?R the 9an! started to price its products 9ased on this 9enchmar!# 8he use o0 interest 9ased 9enchmar!s is prevalent in all the 1slamic 0inancial mar!et and is :idel6 9eing used 96 1slamic 9an!s 0or 0inancing their products; the main reason 0or this is the a9sence o0 an6 :orth:hile mar!et representative 1slamic 0inancial 9enchmar!# 8he use o0 these 9enchmar!s has 9een allo:ed 96 1slamic scholars 9ased on the 0act that i0 the underl6ing transaction is 9ased on the compensator6 contracts2 procedures and principles allo:ed 96 Shariah rather than the contract o0 Qard -as is the case :ith conventional 9an!s/ the mere usage o0 a conventional 9enchmar! 0or calculating the price or the pro0it amount does not render the transaction haram or impermissi9le# Ksmani -$''D2 p#$$'/ states@ 10 a Mura9aha transaction 0ul0ills all the conditions enumerated in this chapter2 merel6 using the interest rate as a 9enchmar! 0or determining the pro0it o0 mura9aha does not render the transaction as invalid2 haram or prohi9ited 9ecause the deal itsel0 does not contain interest# Similarl6 the <uristic pronouncement given 96 the Shariah 9oard o0 the 1slamic 1nter9an! enchmar! Rate -11 R/ -(*$$2 p#$/ states that@ in the a9sence o0 9enchmar!s that have evolved 0rom ShariMa precepts 0or transacting2 1slamic 0inancial institutions have 9een ma!ing regular use o0 "1 ?R -the "ondon 1nter9an! ?vernight Rate/ :hich is 9ased on interest and is there0ore in no :a6 re0lective o0 1slamic values and principles# 1t is 0or this reason that such a 9enchmar! is ill7suited as an accurate indicator o0 value :ithin 1slamic mar!ets even though 0iBh councils and committees have ruled that it is la:0ul to use such 9enchmar!s as re0erences in the a9sence o0 an6thing else# =ence 0rom these Buotes it is clear that :hile the scholars have given the approval 0or the usage o0 the conventional interest 9ased 9enchmar!s the usage is considered undesira9le and onl6 on the condition that the representative 1slamic 9enchmar!s are not availa9le# Commenting on the use o0 conventional 9enchmar!s Ksmani -$''D2 p#$$'7$(*/ 0urther states@

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1t is2 ho:ever true that the 1slamic 9an!s and 0inancial institutions should get rid o0 this practice as soon as possi9le2 9ecause2 0irstl62 it ta!es the rate o0 interest as an ideal 0or a halal 9usiness :hich is not desira9le2 and secondl6 9ecause it does not advance the 9asic philosoph6 o0 1slamic econom6 having no impact on the s6stem o0 distri9ution# 8here0ore the 1slamic 9an!s and 0inancial institutions should strive 0or developing their o:n 9enchmar!# 8he development o0 indigenous 1slamic 0inancial 9enchmar! in Pa!istan is not onl6 the desire o0 the countr6>s 1slamic 0inance scholars 9ut is also the reBuirement 0or the industr6 to ma!e 0urther inroads into the countr6>s 0inancial landscape and even more so to 9ring the '*G un9an!ed population in to 0inancial inclusion :hich has largel6 9een untouched 96 the conventional s6stem 0or the last ,, 6ears# 1.&he ingredients of an Islamic benchmark$

Ihile commenting on the need 0or an 1slamic 9enchmar! the 0at:a o0 the Shariah 9oard o0 the 11 R -(*$$/ states@ Since the ShariMa o0 1slam insists on transacting :ith <ustice and the doing o0 good2 it reBuires the development o0 instruments that measure :hat occurs in the mar!ets in accordance :ith values and principles that correspond :ith the ShariMa o0 1slam# Knless a 9enchmar! is derived 0rom :ithin the value s6stem on :hich the 1slamic 0inancial services industr6 is 9ased2 that 9enchmar! can never serve as a true and accurate point o0 re0erence 0or the industr6# 8his is :h6 there is such a pressing need toda6 0or 9enchmar!s that descri9e 1slamic mar!ets :ith precision :hile also according :ith authentic 1slamic modes o0 transacting# 1n the previous section :e have loo!ed at the reBuirement o0 an indigenous 1slamic 0inancial 9enchmar! 9oth 0rom the Shariah as :ell as the commercial perspective# e0ore discussing the

possi9ilities2 issues and options 0or launching such a 9enchmar! it is important to eCtract and outline the 9road o9<ectives and goals that such a 9enchmar! must 0ul0ill 0rom 9oth the perspectives@ 8he 9enchmar! must 9e a relia9le standard representative o0 the 1slamic 0inancial mar!ets> liBuidit6 situation 0or unsecured ris!2 placements and acceptances#

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1t must 9e derived 0rom the value s6stem and contracts 9ased on the principles o0 Shariah and 1slamic modes o0 0inancing#

8he 9enchmar! must 9e accepta9le to the industr6 participants to the eCtent that it used 0or their internal pricing and 0or pricing their :holesale2 retail and inter9an! 0inancing transactions#

8he 9enchmar! must 9e a means o0 achieving the distri9utive <ustice as outlined 96 the principles o0 1slamic economics# 2.Mechanism of +I!0.

3arachi 1nter79an! ?00ered Rate -31 ?R/ uses the Reuters in0rastructure 0or its dail6 Buotations# 8he contri9utors o0 31 ?R are around (* conventional commercial 9an!s -as selected 96 .inancial Mar!ets Association o0 Pa!istan -.MA// operating in Pa!istan# As per the .MA -Master CommuniBue> on 3i9or (**'/ the contri9uting 9an!s contri9ute their t:o :a6 id and As! rates dail6 96 $$@(* am -Pa!istan Standard 8ime/ to the Reuters 0or the tenors ranging 0rom overnight to ) 6ears# 8he Reuters cancels out the highest and lo:est rates as outliers and calculates the arithmetic mean o0 the remaining rates# 8he .MA also acts as the guardian o0 the 31 ?R setting process# 1nitiall6 rates o0 onl6 $7month2 )7month and ,7month tenors :ere Buoted; the Buoted rates 0or various tenors have 9een eCtended over the 6ears# 8he ,7month and the $76ear 31 ?R are the most :idel6 used rates 0or pricing long term and short term 0inancial transactions# Rules and Mechanism o0 31 ?R as per .MA -Master CommuniBuN on 3i9or (**'/@ All 31 ?R contri9utor 9an!s are reBuired to Buote their t:o :a6 prices 0or minimum amount o0 P3R$**mn2 :ithin the allo:a9le maCimum 9id;o00er spreads 0or the relevant tenor as indicated 9elo:@

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7 ?vernight $month 7 ) and , months 7 ' months2 $( months2 ( & ) 6ears

H*9asis points (H 9asis points H* 9asis points

8he Buoted prices :ould remain valid 9et:een $$@)* am $$@H* am 0or all 31 ?R tenors# 31 ?R contri9uting 9an!s should have unsecured contri9uting limits 0or at least (HG o0 other 31 ?R contri9uting 9an!s# 1n cases :here unsecured lending limits 0or an6 particular 31 ?R contri9uting 9an! do not eCist or are temporaril6 0ull2 the Buoting 9an! is reBuired to honor its 31 ?R Buoted 9id price# an!s :hich 0ail to su9mit 31 ?R rates to Reuters 0or A usiness Da6s during an6 calendar month :ould 9e suspended 0or the neCt $ month 0rom the list o0 31 ?R contri9utors# S P :ill monitor this regularl6 and instruct the Reuters to compl6 :ith the said instructions under advice to .MA 3.Proposed Mechanism of Islamic Interbank 0ffered .ate 4 +arachi 5II!0.-+6 an!

1n this section :e loo! at the proposed mechanism o0 11 ?R 3 developed 96 Meezan

"imited and presented to the State an! o0 Pa!istan on A th Lune (*$*# As 0ar as the structure o0 the mechanism is concerned it is similar to the :a6 other 9enchmar!s li!e "1 ?R and 31 ?R are derived; :ith 1slamic an!s and 1slamic an!ing Iindo:s o0 conventional 9an!s

contri9uting rates each da6 0or various tenors 9ased on their liBuidit6 position and their 0orecasts 0or the 0uture trend o0 the mar!et# 8he 0ollo:ing mechanism and speci0ic rules :ere outlined 0or the 11 ?R 3 in the proposal put 0or:ard 9e0ore the S P@ $/ an!s that can contri9ute shall 9e 1slamic an!s -1 s/ and 1slamic Iindo:s -1Is/# =o:ever initiall6 onl6 the siC 0ull70ledged 1slamic 9an!s shall 9e the contri9utors# 1slamic :indo:s shall <oin in at a later stage

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(/ All contri9utor 9an!s shall 9e reBuired to Buote their t:o :a6 eCpected pro0it rates on 1nter9an! Mudara9ah;Mushara!ah;Ia!ala Placements 0or the amount o0 P3R (H million2 :ithin the allo:a9le maCimum 9id;o00er spreads 0or the relevant tenor as indicated in 8a9le $ 9elo:# 8he Buoted prices :ould remain valid 9et:een $$@AHam7$(@** pm Pa!istan Standard 8ime -PS8/ 0or all 11 ?R73arachi tenors# 1nitiall6 onl6 rates 0or $7:ee! to ,7months tenor shall 9e Buoted# )/ 10 the 9an! is hit on its 11 ?R73arachi price once in an6 tenor2 it can then change the price 0or an6 11 ?R73arachi tenor in a su9seBuent Buote# =o:ever2 the 9id;o00er spread in case o0 an6 su9seBuent price must not 9e more than the allo:a9le 9id;o00er spread as per 8a9le $# Table 1 1 week, 2 weeks and 1 month 100 basis points 50 asis 3 and 6 months points

A/ 11 ?R73arachi contri9utor 9an!s should have unsecured placement limits in place 0or at least (HG o0 other 11 ?R73arachi contri9uting 9an!s# 1n cases :here unsecured placement limits 0or an6 particular 11 ?R73arachi contri9uting 9an! do not eCist or are temporaril6 0ull2 the Buoting 9an! is reBuired to honor its 11 ?R73arachi Buoted 9id price# an!s :hich 0ail to su9mit 11 ?R73arachi rates to Reuters 0or + usiness Da6s during an6 calendar

month :ould 9e suspended 0or the neCt $ month 0rom the list o0 11 ?R73arachi contri9utors# H/ ?ther Miscellaneous Ouidelines a/ All 11 ?R73arachi Contri9utors to su9mit their rates to Reuters latest 96 $$@)H am PS8# 9/ 8o calculate 11 ?R73arachi .iCings2 Reuters :ill eCclude highest and lo:est prices as per 8a9le ( and calculate the arithmetic mean 0or the remaining values#

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c/ All 11 ?R73arachi inter9an! related deals should 9e mentioned properl6 in reporting through mone6 mar!et Central Reporting S6stem -CRS/ to S P# Table 2 Number of Outlier ri!es to be Contributing Banks "emo#ed $ess than or %&ual to ' None Between 5 ( ) 1 highest ( 1 lowest *ore than ) 2 highest ( 2 lowest 7.#nal)sis and comparison of proposed II!0.-+ mechanism with other benchmarks

8he mechanism 0or deriving 11 ?R 7 3 is Buite similar to the mechanism o0 other conventional 9enchmar!s and the 1slamic 1nter9an! enchmar! Rate -11 R/; the onl6 1slamic 9an!ing

9enchmar! launched in 4ovem9er (*$$ <ointl6 96 8homson Reuters -8R/ and AA?1.1# =o:ever compared to the 11 R :hich does not relate to an6 speci0ic region2 countr6 or <urisdiction -8R (*$$2 J11 R .act Sheet>/ the proposed 11 ?R73 is related to the cit6 o0 3arachi and the rate shall 9e the 9enchmar! 0or the 0inancings provided through out the <urisdiction o0 Pa!istan# Secondl6 the 11 R is the 9enchmar! rate 0or the 0inancings to 9e provided in the currenc6 o0 Knited States Dollars and not in an6 particular currenc6 o0 the countries to :hich the contri9utor 9an!s relate to; hence it is supposed to 9e the glo9al 9enchmar! 0or 1slamic 9an!s-8R (*$$2 J11 R .act Sheet>/# Iith the ma<or contri9utors o0 11 R 9eing 9an!s 0rom the OCC the 11 R ma6 represent the ground realities o0 liBuidit6 situation in the OCC 9ut surel6 ma6 9e in star! contrast to ground realities in other 1slamic 0inancial mar!ets li!e Mala6sia2 1ndonesia2 Pa!istan2 A0rica2 etc# .or this reason the use o0 11 R in KSD denominated 0inancing is non eCistent in the mar!ets outside the OCC# ased on o9servation and discussion :ith industr6 participants even in OCC the ma<or 9an!s; 9oth the contri9utors and non contri9utors to the 11 R; do not use 11 R as the pre0erred 9enchmar! 0or providing KSD 9ased 0inancings# 8his

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sho:s that there is a lac! o0 con0idence in 11 R 9eing the true representative o0 the industr6# Another ma<or di00erence 9et:een 11 R and 11 ?R73 is that :hile the 11 R is 9ased on the Buotes o0 the id rates -8R (*$$2 J11 R .act Sheet>/2 11 ?R73 is proposed to 9e a t:o :a6 rate 9ased on 9oth id and As! Buotes o0 the contri9uting 9an!s 0or various tenors# =ence the

11 ?R73 shall 9e Buoted in 0orm o0 a range rather than a single rate# 8o ensure that the range is not eCpansive the proposed mechanism has restricted the maCimum spread allo:ed :hen the Buote is made# oth the 9enchmar!s are not 9ased on 0iCed returns as is the case :ith

conventional interest 9ased 9enchmar!s 9ut are rather 9ased on eCpected rates; i#e# the contri9utors are as!ed to su9mit the eCpected rates that the6 :ould 9e :illing to provide;demand 0or certain amount o0 0unding# 8he reason 0or this is that :hile conventional rates are guaranteed as an o9ligation on the o9ligor in a contract o0 qard or loan the underl6ing 1slamic inter9an! transactions are 9ased on Mushara!ah2 Mudara9ah2 Ia!alah or Commodit6 Mura9aha under :hich the returns are not guaranteed 9ut are to 9e earned 9ased on the actual underl6ing per0ormance o0 investment or trade transaction# 8he mechanism o0 11 ?R73 also de0ines the minimum amount o0 acceptance ; placement 0or :hich the rates are to 9e Buoted :hich is P3R (Hmillion compared to the lot size reBuired under the rules o0 31 ?R; :hich is P3R $**million; this amount seems paltr6 ho:ever the same has 9een !ept due to the industr6 d6namics as :ill 9e discussed in the later sections# 1n contrast the mechanism o0 11 R does not outline an6 such minimum lot size amount 0or ma!ing the Buote 9ut re0ers to the mar!et amount o0 KSD in the Buestion as!ed to the contri9utors -8R (*$$2 J11 R .act Sheet>/# 8his can 9e a pro9lem since the contri9uting 9an!s to the 11 R currentl6 range 0rom OCC region to Mala6sia :hile there are plans to include more 1slamic 9an!s 0rom other regions; :ith each region having di00erent standards and levels 0or mar!et amount o0 KSD this mechanism is 9ound to discourage actual

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cross 9order inter9an! transactions 9ased on the 9enchmar! ma!ing it at 9est a Buoted 9enchmar! rather than a traded one# 8o ma!e the 11 ?R73 a practical industr6 representative 9enchmar! and to avoid arti0icial Buotes 96 the contri9utor 9an!s certain provisions have 9een 9uilt in its mechanism including the rule that the contri9uted rates shall remain valid 0or $H minutes 9et:een $$@AHam till $(@**pm and an6 9an! :hich is approached 0or its eCpected as! rate during this time period 96 an6 other contri9uting 9an! :ill 9e reBuired to honor its commitment and place 0unds :ith that investee 9an! provided the investor 9an! has su00icient room in its inter9an! placement limits 0or that investee 9an!# "i!e:ise to ensure that there is su00icient inter9an! 0lo: o0 0unds among 11 ?R73 contri9utors the rules also reBuire that each contri9utor 9an! must have unsecured placement limits in place 0or at least (HG o0 other 11 ?R7 3 contri9uting 9an!s# At the same time the rules ma!e it mandator6 0or the Buoting 9an!s to accept 0unds at the Buoted eCpected 9id rate i0 it is approached during the de0ined time period 96 an6 other contri9uting 9an!# Similarl6 to !eep trac! o0 the deals at the Buoted rates the proposed rules also reBuire the contri9uting 9an!s to speci0icall6 mention such inter9an! deals as 11 ?R7 3 related in the S P reporting s6stem# 4o such measures seem to have 9een incorporated in the 11 R mechanism :hich :ould ensure that the 11 R contri9uted rates are genuine and the rate actuall6 9ecomes an industr6 representative practical 9enchmar!# =o:ever under the 11 R mechanism 8R is reBuired to carr6 out the audit and revie: o0 the contri9uted rates 9e0ore calculating the average 11 R rate 0or the da6# Along :ith this audit reBuirement the 11 R is also supervised 96 a supervisor6 and technical advisor6 committee !no:n as the 1slamic enchmar! Committee -1 C/ comprising o0 representatives o0 all the contri9uting 9an!s2 AA?1.12 8homson Reuters2 1slamic Development an!2 etc# At 9est the 1 C 9ased on the recommendations o0 8R can include or eCclude an6 contri9utor 9an! in case o0 persistent out o0 the mar!et non genuine

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Buotes or an6 other 9reach o0 the agreement 9et:een the contri9uting 9an!s -8R (*$$2 J11 R .act Sheet>/# =o:ever as 0ar as measures reBuired to ma!e the 9enchmar! practical and trada9le is concerned the 11 R seems to 9e de0icient in this regard :hen compared to the proposed 11 ?R73 mechanism# At the same time it is important to note that there is no provision o0 an6 supervisor6 9od6 0or the 11 ?R73 to <udge the matter in case o0 con0lict or to implement the rulings li!e inclusion or eCclusion o0 contri9utors as an independent impartial part6# S P can pla6 this role as it is doing in case o0 31 ?R# 8.Issues and challenges in developing and launching II!0. - +

8he purpose o0 having 9enchmar!s is to have a relia9le 9arometer availa9le 0or the users to <udge the status o0 the liBuidit6 position o0 the industr6 :hich :ould help them in ma!ing an in0ormed 0inancial decision# =ence the 9enchmar! must 9e re0lective o0 the industr6 status and mar!et d6namics# 8here is no point in having a 9enchmar! :hich is not re0lective o0 the industr6 position o0 liBuidit6# Such 9enchmar!s :ould lead users to ma!e decisions :hich have not optimall6 ta!en in to account the liBuidit6 position o0 the mar!et and the level at :hich the inter9an! mar!et prices the ris! given the tenor o0 0inancing 0or clean unsecured 0inancing# 8he same :as the concern o0 the S P representatives on the proposal presented 9e0ore them# Ihile appreciating the e00orts o0 Meezan an!>s team and the via9ilit6 o0 the mechanism o0 the

11 ?R73 the S P reiterated the need 0or ma!ing it a true representative o0 the 1slamic 9an!ing industr6 and stressed that 0or this purpose Jall 1slamic 9an!s must not onl6 9e in consensus 9ut also 9e the contri9utors to the dail6 rates 0or deriving the 11 ?R 3 rates># Despite these promising developments in (*$* the launch o0 11 ?R 3 has 9een stalled to date due to impeding issues and challenges :hich need to 9e conBuered 0or developing a trul6 relia9le and

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representative 1slamic 9enchmar! rate 0or the 1slamic 9an!ing industr6 in Pa!istan# 8hese issues and challenges are discussed at length in the 0ollo:ing sections# 8., 'i9e of the industr)

Ih6 did the S P stress the need 0or including at least all the 1slamic 9an!s as contri9utors to the rate 9e0ore the 0inal launchP 8he ans:er lies in the small size o0 the industr6# Despite attaining around $*G mar!et share the 1slamic 9an!ing industr6 in Pa!istan is still d:ar0ed 96 the conventional 9an!ing s6stem o0 the countr6# As per the current 0igures -(*$( 6ear end/ there are H 0ul0ledged 1slamic an!s and $) 1slamic an!ing :indo:s -1 7S P Decem9er (*$(/# 8his is

in star! contrast to the size o0 the conventional 9an!ing mar!et :hich has around )( commercial 9an!s# ?ut o0 these )* 9an!s; up to (* are contri9utors to 31 ?R 0or various tenors# 8hese include top H commercial 9an!s !no:n as the ig H controlling H(G mar!et share o0 the 9an!ing industr6 namel6 MC an!2 Knited an! "imited2 4ational an! o0 Pa!istan2 Allied an!

"imited and =a9i9 an! "imited -Annual Reports (*$$/# =ence the 31 ?R is determined 9ased on contri9utions 0rom a ma<or portion o0 the 9an!ing industr6 and there96 representing the real mar!et sentiment# A9sence o0 one or t:o contri9utor 9an!s on an6 single da6 :ould not a00ect the status o0 31 ?R not re0lecting the industr6 status# =o:ever since 1slamic 9an!ing is relativel6 a small industr6 :ith onl6 0ive participants the a9sence o0 one or t:o participants or disBuali0ication o0 one or t:o participating 9an!s :ill render the 11 ?R73 as meaningless and not re0lecting the industr6 ground realities# 8./ Industr) D)namics

8he current 1slamic 9an!ing industr6 landscape is largel6 dominated 96 one large 1slamic 9an!# Meezan an! "imited -M "/ is the 0irst and largest 1slamic an! o0 Pa!istan controlling a

mar!et share o0 )(#H G in terms o0 deposits and ))G in terms o0 assets as o0 Decem9er (*$(

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-M " Annual Report (*$(/# 8he remaining num9ers are shared 96 A 1slamic 9an!s and $) 1slamic 9an!ing :indo:s# 1n terms o0 pro0ita9ilit6 M " ran!ed 'th in the :hole 9an!ing industr6 as per the results 0or the 6ear ended Decem9er (*$$ :ith a 9ottom line pro0it a0ter taC o0 P3R )#)'( 9illion# Compared to this the rest o0 the 0ull70ledged 1slamic 9an!s in the industr6 managed to secure a com9ined 9ottom line o0 P3R $#$$ 9illion; :ith an! 1slami "imited - 1"/ and Al ara!a an! Pa!istan "imited -A P"/ sho:ing earnings o0 P3R A$* million each Du9ai "/ made

1slamic an! -D1 / ma!ing an earning o0 P3R$'$million :hile ur< an! "imited -

a net loss o0 P3R (DD million# Iith this controlling sta!e in the mar!et other mar!et participants are anCious o0 9eing a partner contri9utor to an average industr6 9enchmar!# 8he relative strength o0 M " in terms o0 pro0ita9ilit6 has ena9led the 9an! to invest heavil6 in its 9ranch net:or! over the 6ears# Iith )$* 9ranches M " has the Dth largest 9an! net:or! in the industr6 -M " Annual Report (*$(/2 the closest to M " among 1slamic 9an!s is 1" :ith a 9ranch

net:or! o0 $*( - 1" Annual Report (*$(/# 8he total num9er o0 1slamic 9an!ing 9ranches in the countr6 as o0 6ear ending Decem9er (*$( :as $*'+ 9ranches -1 7S P Decem9er (*$(/# 8his

:idespread 9ranch net:or! provides M " :ith an eCtensive outreach and higher sources o0 generating lo: cost retail liBuidit6# 8his has resulted in M " having the lo:est average cost o0 deposit rate o0 H#)G in the 1slamic 9an!ing industr6 -M " Annual Report (*$$/# 1n 0act :hen loo!ing in terms o0 the :hole 9an!ing industr6 M " has the + th lo:est cost o0 deposits among )( commercial 9an!s# As per the 6ear ended (*$$ the rest o0 the 1slamic 9an!s eCperienced the 0ollo:ing costs o0 deposits -according to (*$$ annual reports/# Name of !ank an! 1slami "imited Du9ai 1slamic an! ur< an! "imited Al ara!a an! Pa!istan "imited Cost of Deposits ,#)G ,#AG D#AG D#+G

Page $H o0 A*

8he proportion o0 lo: cost Current Account and Saving Account -CASA/ deposits; an important statistical per0ormance 9enchmar! in the industr6; o0 M " as o0 Decem9er (*$$ :as ,HG# Comparativel6 other 1slamic 9an!s 0ared as per the 0ollo:ing ta9le -according to (*$$ annual reports/# Name of !ank Proportion of C#'# an! 1slami "imited AD#HG Du9ai 1slamic an! H)#DG ur< an! "imited AA#,G Al ara!a an! Pa!istan "imited AH#'G 1n terms o0 :holesale sources to 0unding M " due to its 9etter credit rating; as mentioned in the 0ollo:ing section; and strength o0 its 9alance sheet is a9le to have diverse lines :ith other conventional 0inancial institutions to accept and place 0unding through the modes o0 8a:arruB and commodit6 mura9aha# 8hese entire 0actors place M " into a ver6 strong position 96 a huge margin compared to its 1slamic 9an!ing counterparts creating a perception that M " :ill 9e a9le to control the 9enchmar! rates to its 9ene0it and to the detriment o0 other 9an!s# Such perceptions ma6 seem unreal given the mechanism o0 11 ?R73 as stated a9ove :hich reBuires@ i/ the rates Buoted 96 each 9an! to 9e eCecuta9le to control the rigging o0 the 9enchmar! and; ii/ the average :ill 9e a trimmed average 96 discarding the highest and the lo:est prices# =o:ever given the 0act that the rates o0 o00er;9id :ill onl6 9e given 0or a meager P3R (H million :hich :ill not have a huge impact on M " given the sheer size o0 its 9alance sheet and the 0act that i0 the contri9utor 9an!s on an6 given da6 0all 9elo: the num9er o0 0ive the trimmed average 0ormula :ill not 9e implemented ma!ing the controlling o0 the 9enchmar! 96 the industr6>s largest 9an! a certain possi9ilit6# 8he 11 ?R73 derived 0rom such a situation ma6 9e to lo: to 9e accepta9le to other 1slamic 9an!s in the industr6; :ho :ill have to charge a higher premium over and a9ove the 9enchmar! rate ma!ing it di00icult 0or them to mar!et their 0inancing products to their corporate and retail customers#

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8he lo: cost o0 deposits :ill certainl6 ena9le M " to Buote rates :hich are ver6 much lo:er than the rest o0 the mar!et# =ence even i0 :e consider that the num9er o0 contri9utors does not 0all 9elo: 0ive contri9utors the rates Buoted 96 M " shall 9e sidelined as outliers# 8he 11 ?R73 in such cases :ill then 9e 9ased on the remaining values# 8hese values ma6 9e contri9uted 96 a large num9er o0 1slamic 9an!s and 1slamic 9an!ing :indo:s 9ut the resulting 11 ?R73 rates ma6 not re0lect the true industr6 position nor 9e 9ased on the lo:est cost and ris! levels o0 the industr6 since a0ter all M " does represent ))G share o0 the industr6# 8.1 .atings

8he contri9uting 9an!s 0or "1 ?R and 31 ?R have similar ratings and 0inancial strength :hich allo:s 0or each o0 the contri9uting 9an!s to 0reel6 trade 0unds 9et:een them at the contri9uted rates# 8he ratings o0 the 9ig H group o0 9an!s; the ma<or contri9utor to the 31 ?R and the other second tier contri9utor 9an!s as at Septem9er (*$( is as 0ollo:s -S P (*$(/@ Name of !ank 4ational an! o0 Pa!istan Allied an! "imited Knited an! "imited MC an! "imited =a9i9 an! "imited an! Ala0alah "imited As!ari an! "imited .a6sal an! "imited an! Al =a9i9 "imited =a9i9 Metropolitan an! .ating #genc) LCR7Q1S PACRA LCR7Q1S PACRA LCR7Q1S PACRA PACRA PACRA PACRA PACRA 'hort .ating A7$& A$& A7$& A$& A7$& A$& A$& A$& A$& A$& &erm :ong .ating AAA AA& AA& AA& AA& AA AA AA AA& AA& term

As can 9e o9served the short term ratings o0 all the ma<or 9an!s contri9uting to the 31 ?R are same# 8his ensures that each 9an! has su00icient lending limits approved :ith other 9an!s 0or short term inter9an! placements# 8he 0ollo:ing is the ratings o0 1slamic 9an!s operating in Pa!istan -S P (*$(/@

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Name of !ank Meezan an! "imited an! 1slami "imited Du9ai 1slamic an! ur< an! "imited Al ara!a an! Pa!istan "imited

.ating #genc) LCR7Q1S PACRA LCR7Q1S LCR7Q1S LCR7Q1S

'hort .ating A7$& A$ A7$ A7$ A7$

&erm :ong .ating AA7 A A A A

term

Due to M ">s relative strength as mentioned earlier the 9an! has 9oth long term and short term ratings higher than its peers# 1n 0act M ">s short term ratings are eBual to the top tier commercial 9an!s in the industr6# As 0ar as other pla6ers in the 1slamic 9an!ing industr6 are concerned all o0 them have a one level lo:er short term credit rating o0 A7$# Due to this di00erence in credit ratings all 1slamic 9an!s do not have su00icient inter9an! credit lines :ith each other; there96 reducing the volume o0 transactions 9et:een them# 1nstead 1slamic 9an!s are more satis0ied :ith having inter9an! short term credit lines :ith the 1slamic 9an!ing :indo:s o0 conventional 9an!s :hich have the same credit rating as their conventional parent companies since ratings are issued 0or the institution as a :hole and not independentl6 0or the :indo: operations# Almost all o0 the conventional 9an!s mentioned in the ratings grid have conventional :indo:s eCcept Allied an! "imited# Secondl6 the development o0 product

structure o0 local commodit6 mura9aha in (**+ in Pa!istan has allo:ed 1slamic 9an!s to use this vehicle o0 8a:arruB 0or par!ing their eCcess liBuidit6 even :ith conventional 9an!s# Such measures have raised e6e9ro:s o0 various o9servers including the regulator; ho:ever the 1slamic 9an!s and their Shariah advisors have <usti0ied these measures in the past on the 9asis o0 non availa9ilit6 o0 su00icient Shariah compliant avenues 0or deplo6ment o0 eCcess liBuidit6 96 1slamic 9an!s and the 0act that the commodit6 mura9aha transaction structurall6 involves sale o0 goods rather than lending o0 0unds to conventional 9an!s# =ence the 1slamic 9an!s have other

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alternatives :ith 9etter ris! pro0iles to invest their eCcess liBuidit6 :ith rather than rel6 on other 1slamic 9an!s# 8he unavaila9ilit6 o0 su00icient lines :as also raised as one o0 the stum9ling road 9loc! restricting the development o0 1slamic inter9an! mar!et and practical via9ilit6 o0 11 ?R73 during the meetings 9et:een 1slamic 9an!s 0or the launch o0 11 ?R73# Since rates Buoted 0or 11 ?R73 need to 9e eCecuta9le as mentioned in the mechanism a9ove so as to avoid rigging o0 rates and ma!e the 9enchmar! a real representative o0 the industr6; the unavaila9ilit6 o0 su00icient lines :ould e00ectivel6 ma!e the contri9uted Buotes non7eCecuta9le hence increasing the chances o0 the 11 ?R73 rates 9eing rigged# 8.2 'tandardi9ation

Another important 0actor inhi9iting inter9an! 0lo: o0 0unds 9et:een 1slamic 9an!s is the 0act that di00erent 1slamic 9an!s and :indo:s use products 9ased on di00erent modes 0or acceptance and placement o0 0unds in the inter9an! mar!et# 8his :as also the main 0actor highlighted 96 8reasurers and Shariah advisors in the various meetings held 9et:een 1slamic consensus 0or the launch o0 11 ?R73# M "2 A P" and an!s to 9uild a

" use the Mushara!ah structure 0or uses the Ia!alah 9ased structure 0or 1" initiall6 had its inter9an! product

accepting and placing liBuidit6# ?n the other hand D1 placement o0 liBuidit6# 8he second largest 1slamic 9an!

structure 9ased on Ia!alah 9ut later discarded it citing Shariah compliance issues; the 9an! also :as not in 0avor o0 using Mushara!ah 9ased structure earlier 9ut no: seems to 9e settled :ith the same structure# As 0ar as 1slamic :indo:s o0 conventional 9an!s are concerned an! Al0alah 1slamic2 MC 1slamic2 =a9i9 Metropolitan 1slamic and =a9i9 an! 1slamic use the Mushara!ah 9ased structure 0or inter9an! activit6# .a6sal an! 1slamic2 Standard Chartered SaadiB and

Soneri an! 1slamic use the Mudara9ah Structure# Similarl6 the use o0 Commodit6 Mura9aha or

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8a:arruB has 9een a ma<or 9one o0 contention among 1slamic 9an!s in terms o0 its compliance to Shariah# Disapproval o0 the product gained its momentum a0ter the issuance o0 ruling regarding impermissi9ilit6 o0 organized 8a:arruB 96 1slamic .iBh Academ6# Ihile M "2 1" and D1 use it sparingl6 other 1slamic 9an!s have not allo:ed the use o0 this product# =ence it is clear that unli!e conventional 9an!ing s6stem :here there is onl6 one product structure; 9ased on lending; 1slamic 9an!s in Pa!istan use various di00erent structures 0or acceptance and placement o0 0unds in the inter9an! mar!et# 8o resolve this matter and to 9ring a certain level o0 standardization Mushara!ah and Ia!alah structures :ere selected 96 Shariah Advisors and 8reasurers 0or the purpose o0 standardization during meetings 0or the launch o0 11 ?R73 9ased on S P directives# 1n the initial round o0 circulation 0or 0inal approval the Mushara!ah 9ased structure and the 1nter9an! Master Mushara!ah Agreement :ere approved and 0inalized 96 M "2 Da:ood 1slamic an! -no: an! -no: merged :ith A "/2 A P" and 5mirates Olo9al 1slamic

P"/# 8he product :as disapproved 96 D1 and 1" citing Shariah

concerns# 8he Ia!alah 9ased structure and the Master Ia!alah Agreement :ere approved and 0inalized 96 M "2 A P" and D1 # =o:ever Da:ood 1slamic an! and 1" disapproved the

structure 9ased on Shariah reasons# Iithout divulging these Shariah reasons it is imperative to mention the nature o0 reasons 0or disapproval raised 96 each 9an!@ Da:ood 1slamic an! cited .iBhi concerns and Buestioned the permissi9ilit6 o0 Ia!alah 0or istithmar -investment/ purposes# 1">s concerns regarding Mushara!ah :here more related to operational aspects 0or instance use o0 hi9a2 :aad and the a9ilit6 o0 all 1slamic 9an!s to segregate and manage special investment pools 0rom its general pools#

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Regarding Ia!alah; 1" cited .iBhi concerns in using Ia!alah and giving a 0iCed 0ee to the :a!il in a special investment pool :here the Ia!eel is also participating as a partner along :ith the Mu:a!!il#

Regarding its non approval o0 Mushara!ah; D1 advised that Jits glo9al Shariah 9oard is not convinced regarding the Shariah compliance o0 the 1nter9an! Mushara!ah product and hence it is not possi9le 0or them to secede 0rom them>; hence the reason :as more o0 an internal polic6 matter rather than a purel6 Shariah issue#

Ihile the .iBhi issues are not the su9<ect o0 discussion o0 this paper it is pertinent to mention over here that hi9a and :aad are onl6 applied 96 1slamic 9an!s in Pa!istan :hen calculating and distri9uting monthl6 Mudara9ah pro0its to general pool o0 depositors; the same are not emplo6ed 96 1slamic 9an!s in inter9an! Mushara!ah transactions involving special investment pools as has 9een o9served over the 6ears 96 the author; hence unreal# =ence despite these e00orts the siC 1slamic an!s in (*$* 0ailed to agree on an6 single product structure and legal documentation to 9e used in the 1slamic inter9an! mar!et# =o:ever despite these set9ac!s since the Mushara!ah 9ased structure :as still largel6 accepta9le 96 a large num9er o0 1slamic :indo:s along :ith 0our 0ull70ledged 1slamic 9an!s; M " initiated a second level o0 consensus eCercise in :hich 1slamic Iindo:s o0 conventional 9an!s :ere as!ed to give their consent and approval 0or this products structure and its legal documentation# 8his received an over:helming response and the 0ollo:ing :indo:s gave their consent 0or the 1nter9an! Mushara!ah product@ .a6sal an! 1slamic an!ing2 As!ari an! 1slamic an!ing2 =a9i9 1">s concerns regarding this seem to 9e

Metropolitan 1slamic2 an! Al0alah 1slamic an!ing2 4ational an! 1slamic2 MC 1slamic and

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=a9i9

an! 1slamic# Despite this consensus the launch o0 11 ?R73 could not 9e achieved in

(*$* due to the a9sence o0 t:o !e6 pla6ers in the industr6 i#e# 1" and D1 # 8he current situation in (*$) is more or less the same :ith seven 1slamic :indo:s and three 0ul0ledged 1slamic 9an!s 9eing in consensus on the 1nter9an! Mushara!ah Structure; :hile three 0ul0ledged 1slamic 9an!s are in consensus 0or the Ia!alah structure# Iith this divided mandate the development o0 an e00icient 1slamic inter9an! mar!et and hence a via9le 9enchmar! remains a distant possi9ilit6# 8.3 :ow confidence regarding 'hariah compliance$

Due to di00erent schools o0 .iBh; scholars 0rom Mala6sia2 Pa!istan and Oul0 Region have di00erent opinion on di00erent issues :hich result in di00erent product structures prevailing in di00erent regions# 8his has hindered the process o0 standardization and integration o0 glo9al 1slamic 0inancial mar!ets; restricting the 0lo: o0 0unds 9et:een <urisdictions; since 1slamic investment opportunities li!e su!u! issues in Mala6sia ma6 not 9e accepta9le to scholars 0rom Pa!istan or OCC and vice versa due to underl6ing Shariah non compliance issues# Knrestricted 0lo: o0 0unds; as is the case :ith conventional 0inancial mar!ets; is crucial 0or the development o0 a :ell integrated and e00icient glo9al 1slamic 0inancial mar!et# Ihile inter regional di00erences are understanda9le intra regional di00erences are a real cause o0 concern :ithin the nascent 1slamic 0inancial mar!et in Pa!istan# 8he issue o0 standardization in Pa!istan is not related merel6 to the transaction structures in the inter9an! mar!et -as discussed a9ove/ 9ut eCtend to the general 9an!ing products that each 1slamic 9an! o00ers# 1n 0act this pro9lem is an eCtension o0 the issue o0 standardization in the glo9al 1slamic 0inancial mar!ets due to di00erent Shariah opinions in each <urisdiction# Ihile there is su00icient level o0 understanding among 1slamic 9an!s having local Pa!istani scholars on their Shariah 9oards or as

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Shariah advisors; products o0 1slamic 9an!s :ith 0oreign Shariah 9oards are seen :ith s!epticism# 8he local religious schools and their 0at:a issuing 9odies have onl6 certi0ied products o0 1slamic 9an!s :ith local Shariah scholars# Ihile the position o0 these institutions regarding 1slamic 9an!s :ith 0oreign scholars is that o0 anon6mit6; that is neither approving nor disapproving these institutions# 8his is also the position o0 the countr6>s t:o 9iggest religious institutions Lamia Darul Kloom and Lamia Al Rashid; 9oth the institutions hold heav6 in0luence among the general pu9lic# Again the ma<or reason underl6ing this issue seems to 9e the di00erence o0 opinion 9et:een the di00erent schools o0 thought since the =ana0i 0iBh is the ma<or school o0 thought prevailing in Pa!istan :hile scholars o0 Ara9 origin in other 1slamic 9an!s 0ollo: other schools o0 thought# =ence :hile M " has approved the Ia!alah 9ased inter9an! product structure o0 D1 the 9an! does not have an6 inter9an! placement lines :ith D1 # Similarl6 M " also does not have an6 placement lines :ith Standard Chartered -SC / SaadiB -Pa!istan/# Similar is the position o0 1" and " regarding these t:o institutions# 8he reason in 9oth these cases is the lac! o0

con0idence that prevails in the mar!et regarding the Shariah compliance level o0 the 0inancing products o0 these t:o institutions and the level o0 s6stems in place to ensure Shariah compliant eCecution o0 approved products :hich in turn leads to con0idence de0icit regarding the permissi9ilit6 o0 income earned 96 these institutions# 1t is important to note ho:ever that similar lac! o0 con0idence among local 1slamic an!s does not eCist regarding A P" even though the

9an! is a su9sidiar6 o0 Al ara!a an!ing Oroup -A O/2 a ahraini <oint stoc! compan6# 5ven the religious schools o0 the countr6 also have a positive opinion regarding the 9an!# 8his seems to 9e due to the 0act that the 9an!>s management has devised its Shariah governance structure according to the sentiments o0 the mar!et 96 incorporating a local panel o0 :ell reputed and

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Buali0ied Shariah scholars# 8here are three local Shariah scholars on its panel 0or managing Shariah matters o0 the su9sidiar6 along :ith the high pro0ile glo9al Shariah 9oard o0 the A O# 8he 9an! used to operate :ith one Shariah scholar previousl6 9ut reconstituted its local panel in (*$* :hen the 9an! acBuired 5mirates Olo9al 1slamic an!# 1n contrast D1 and SC SaadiB

9oth emplo6 one local Shariah scholar :ho :or!s under their glo9al Shariah 9oards# 8his issue has also hampered the development o0 clean inter9an! lines 9et:een 1slamic 9an!ing institutions restricting the 0ree and e00icient 0lo: o0 0unds 9et:een them# Resolution o0 this issue is crucial 0or the development o0 the 1slamic 9an!ing industr6 and the launch o0 an 1slamic 9enchmar! rate in the countr6# Qarious measures need to 9e ta!en to resolve this issue# 1nstitutions 0acing the pro9lem o0 mar!et perception and Shariah accepta9ilit6 need to rethin! on their Shariah governance structures and pro9a9l6 0ollo: in the 0ootsteps o0 A P"@ !eeping

intact their high pro0ile glo9al Shariah 9oards as :ell as creating a local committee o0 local Shariah scholars catering to the local demands and sentiments o0 the mar!et# 8his ma6 result in di00erent Shariah positions 9eing ta!en 96 these 9an!s 0or the same product 9eing o00ered in di00erent mar!ets; 0or instance re9ate on earl6 pa6ments in Mura9aha transactions :hich ma6 9e allo:ed in the OCC mar!ets 9ut prohi9ited in the Pa!istani mar!et; or di00erent products 9eing o00ered 0or di00erent mar!ets# =o:ever this is the strateg6 emplo6ed 96 success0ul multinational organizations :orld:ide; ta!e 0or instance the eCample o0 Pizza =ut and 3.C o00ering di00erent menus 0or di00erent mar!ets catering to the local tastes# Such di00erences o0 opinion can also 9e :eeded out through Shariah advisor level negotiations 9et:een 1slamic 9an!s# Alternativel6 the 1slamic 9an!s -especiall6 those :ith 0oreign Shariah scholars/ can approach the local religious and 0at:a institutions to resolve the issues and

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misunderstandings regarding their products# 8his :ill not onl6 help in 9ringing standardization 9ut also result in more mar!eta9ilit6 and accepta9ilit6 o0 their 9rand name# 8.7 .ole of Central !ank 'hariah !oard

Role o0 the central Shariah oard is crucial 0or the development and standardization o0 1slamic 9an!ing products in an6 <urisdiction# 8he State an! o0 Pa!istan -S P/ incorporated its Shariah oard in the 6ear (**A; t:o 6ears a0ter issuing the 0irst license 0or esta9lishing a 0ull70ledged 1slamic 9an! in the countr6# ?ver the past nine 6ears S P Shariah oard has 9een instrumental in achieving several crucial landmar!s 0or instance approval o0 5ssentials and Model Agreements 0or 1slamic Modes o0 .inancing; Structuring and launch o0 IAPDA Su!u! and a series o0 Sovereign 1<arah Su!u!; adoption and adaptation o0 0our AA?1.1 Shariah standards in Pa!istan; issuance o0 instructions and guidelines 0or 1slamic an!ing 1nstitutions; etc# Despite

these achievements the S P Shariah oard has not 9een a9le to ma!e an6 impact regarding the 0ollo:ing@ -$/ Achieving standardization;harmonization o0 Shariah interpretations among 1slamic 9an!s@ 8o date the S P Shariah oard has not ta!en an6 measures in resolving the di00erences o0 opinion prevailing in the mar!et as discussed in the previous section# ?ne reason 0or this is evident 0rom the roles o0 the S P Shariah oard -S P (**D2 Strategic Plan 0or the 1slamic an!ing 1ndustr6 in Pa!istan ESP1 1PF/ :hich does not reBuire individual 1slamic 9an!s to acBuire approval o0 S P Shariah oard 9e0ore launch o0 ne: products in the mar!et# 8his is unli!e the role o0

S6ariah Advisor6 Council -SAC/ o0 an! 4egara Mala6sia - 4M/ :hich reBuires the individual 9an!s to ta!e the approval o0 SAC -S P (**D2 SP1 1P/; this ensures an in 9uilt mechanism 0or achieving standardization across the industr6 :ithin 4M>s <urisdiction# Ihile recognizing its

9ene0its the strateg6 adopted 96 4M can also result in inertia2 lac! o0 innovation and creativit6

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in the industr6 96 slo:ing do:n the process o0 ne: product development and launch 96 erecting stum9ling 9loc!s o0 procedures2 policies and approvals o0 the regulator# Due to these reasons S P has adopted the current approach :hich has resulted in the development o0 diverse menu o0 products and solutions availa9le 0or 1slamic 9an!ing customers# =o:ever despite this polic62 standardization o0 the industr6 can 9e achieved in a harmonious manner i0 the regulator6 Shariah oard ma!es a pro7active intervention 96 reBuiring the 1slamic 9an!s and their Shariah advisors to sit together and :eed out the outstanding di00erences through a series o0 constructive discussions :ith the S P Shariah oard acting as a moderator# -(/ Resolution o0 long outstanding structural issues necessar6 0or the development o0 the 1slamic 9an!ing industr6@ Availa9ilit6 o0 Central an!>s "ender o0 "ast Resort .acilit6 0or .inancial

institutions -:hich :e :ill discuss in detail in the neCt section/ and sovereign short term mone6 mar!et instruments 0or managing liBuidit6; are necessar6 ingredients 0or 9uilding a strong in0rastructure 0or an e00ective 0inancial s6stem# Despite several proposals 0rom 1slamic 9an!s in this regard; the past nine 6ears have not seen an6 :orth:hile development in this area# -)/ Providing Shariah compliant alternates to S P>s pre0erential conventional 0inancing schemes@ Similarl6 1slamic 9an!s have developed appropriate solutions 0or other ma<or pro9lems 0acing the industr6 and su9mitted the proposals to the S P Shariah oard# 8hese proposals include the development o0 Shariah compliant alternates to "ong 8erm .inance .acilit6 0or eCport oriented pro<ects a 0acilit6 under :hich S P provides liBuidit6 at su9sidized rates to conventional 9an!s 0or providing su9sidized 0unding to eCporters2 solutions ena9ling 1slamic 9an!s to eCecute 0or:ard 0oreign currenc6 transactions :ith S P and proposed Shariah compliant structure 0or collateralized 1slamic inter9an! placement product an alternative to conventional repo and

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reverse repo transactions# 8hese issues are o0 vital importance 0or the development o0 1slamic mone6 mar!et 9ut no signi0icant progress or intent at the regulator6 level can 9e seen# A ma<or reason 0or this inertia and the dormant role pla6ed 96 S P>s Shariah oard lies in the governance structure o0 its Shariah 9oard; eCplained one 1slamic 9an!ing eCecutive during discussion :ith the author# 8he composition o0 the S P>s Shariah 9oard -S P (**D2 SP1 1P/ shall involve t:o Shariah scholars2 one accountant2 one la:6er and director o0 the 1slamic an!ing Department -1 D/ o0 S P :ho shall also act as secretar6 to the Shariah oard# 8he role o0 the accountant and the la:6er shall onl6 9e to provide technical help to the Shariah scholars# 8he authorit6 to ma!e 0inal decisions shall rest :ith the chairman o0 the 9oard :ho shall 9e 0rom among the t:o Shariah scholars# 8he pro9lem lies in the 0act that since its incorporation either one or 9oth o0 the scholars appointed on the S P Shariah 9oard has at the same time served as Shariah advisor o0 a particular 1slamic 9an!# Currentl6 one o0 the scholars on S P Shariah oard is also the Shariah advisor o0 D1 :hile the other scholar is the Shariah advisor o0 MC 1slamic# 8his is not the case in other <urisdictions 0or instance in Mala6sia the 4M SAC mem9ers are

not allo:ed to :or! in the Shariah committee o0 an6 0inancial institution# 8he eCecutive eCplained that this does not ensure independence o0 the Shariah 9oard :ith the 0ocus o0 the 9oard 9eing diverted to matters :hich are o0 more signi0icance to the 9an!s> the Shariah scholars are associated :ith rather than resolving the pressing matters o0 the overall industr6# 8.8 Non availabilit) of 'hariah compliant *inancier of :ast .esort *acilit) 5*0:.*6

?ne ma<or role that Central an! needs to pla6 is that o0 9eing the 0inancier o0 last resort to all the 9an!s in the industr6# Currentl6 S P provides this 0acilit6 to conventional 9an!s in Pa!istan through its ) Da6 discount :indo: 0acilit6 !no:n as reverse repo 0acilit6 at the prevailing discount rates -S P (**'2 DMMD Circular 4o#$/# 8he conventional 9an!s can avail this 0acilit6

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96 placing government papers as securities to the S P# 1n contrast there is no such 0acilit6 availa9le 0or 1slamic 9an!s# A Shariah compliant structure 0or this 0acilit6 9ased on the concept o0 Mudara9ah :as developed in consensus 96 1slamic 9an!s and su9mitted to S P on $( th Septem9er (*$$# Su9seBuentl6 the mem9ers o0 the development committee o0 the proposal also gave their presentation to S P# Knder the structure :henever an6 1slamic 9an! is short o0 0unds it can approach the S P 0or reBuirement o0 0unds# S P a0ter the usual scrutin6 can provide 0unds as Ra9ul Maal 96 investing in the general asset pool o0 the investee 1slamic 9an!; :hich is managed 96 the 1slamic 9an! as Mudari9# S P>s investment :ill 9e given a pro0it sharing :eightage# 8he tenor o0 S P investment can 9e 0rom $ ) da6s; to 9e decided at the time o0 application 96 the 1slamic 9an!# Kpon maturit6 o0 the investment period; pro0it o0 the pool :ill 9e calculated 0rom :hich the pro0it share o0 S P :ill 9e calculated as per the pre agreed pro0it sharing :eightage and distri9uted to S P along :ith the initial investment value# 8he structure is similar to that 0ollo:ed 96 the central 9an! o0 1ndonesia# =o:ever despite the e00orts the 1slamic 9an!s are still devoid o0 this 0acilit6# Iithout this 0acilit6 1slamic 9an!s are devoid o0 a source o0 liBuidit6 suppl6 :hich can act as a cushion in times o0 liBuidit6 crunch# Currentl6 in times o0 liBuidit6 crunch 1slamic 9an!s have to rel6 on the inter9an! mar!et to avail liBuidit6# Due to under development o0 1slamic liBuidit6 mar!et as discussed in previous sections arranging liBuidit6 0rom the inter9an! mar!et 9ecomes an uphill tas!# ConseBuentiall6 liBuidit6 can onl6 9e arranged at higher costs2 and more o0ten the overnight rates o00ered 0or the liBuidit6 are even higher than the S P :indo: rates availa9le 0or conventional 9an!s# Apart 0rom this the non availa9ilit6 o0 the 1slamic Discount Iindo: causes 1slamic 9an!s to ta!e a cautious approach in managing their 0unds# 8his impacts their dail6 and :ee!l6 liBuidit6 management

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approach since 1slamic 9an!s have to 0ul0ill dail6 and :ee!l6 statutor6 Cash Reserve ReBuirements -CRR/ o0 the regulator# 8his has resulted in a situation :here the 1slamic 0inancial mar!et and the 1slamic 9an!s operate at a level :hich is lo:er than the optimal e00icienc6 level resulting in arti0iciall6 higher liBuidit6 management costs# Knder these circumstances and given the small size o0 the industr6 an6 average 9enchmar! rate o0 the 1slamic 9an!ing industr6 :ill 9e higher than it :ould have 9een :ith the availa9ilit6 o0 1slamic Iindo: .acilit6; thus not re0lecting the true sentiments o0 the mar!et# ;.Independence of II!0.-+ from +I!0.

1slamic 9an!s are 0inancial institutions and li!e all 0inancial institutions the6 are agents o0 0inancial intermediation# 8hat is all 0inancial institutions including 1slamic 9an!s have t:o ma<or core 0unctions to pla6# 8he 0irst 0unction relates to the accumulation o0 0unds 0rom the surplus units o0 the econom6; i#e# those sources having surplus liBuidit6# 8he second 0unction relates to the placement or trans0er o0 the accumulated 0unds to the de0icit units o0 the econom6; i#e# those individuals2 0irms2 0actories2 etc :hich reBuire these 0unds to produce goods and services :hich add value to the societ6# =ence 96 pla6ing this role the 0inancial institutions help deplo6 idle capital to productive uses# 1slamic 9an!s pla6 the same role al9eit in a manner :hich complies
Figure 1 - Money Market Equilibrium 20% 18% K# $R & ## $R-K 16% 14% 12% 10% 8% 6% 4% 2% 0% 0 2000 4000 6000 8000 10000 Liquidity Supplied & Dem anded (in PKR n!"

:ith Shariah# 8he Pa!istani 1slamic 9an!ing sector also pla6s the same 0unction :ithin the :ider 0inancial intermediation mar!et# =o:ever the
Demand Supply

pro9lem :ith the Pa!istani 1slamic 9an!ing sector is the same as discussed earlier that it is merel6 a

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'#+G o0 the total 9an!ing industr6# Iithout going into the statistics the 1slamic inter9an! mar!et is even smaller than this 0igure :ould suggest due to it>s under developed nature and small volume transactions among 1slamic 9an!s# Knder this scenario even i0 the 11 ?R73 is launched as per the proposed mechanism it is almost certain that the rates o0 11 ?R73 :ould 9e more or less eBual to the 31 ?R# 8he reason 0or this possi9ilit6 is that 0inancial mar!ets li!e all mar!ets are driven 96 the 0orces o0 demand and suppl6 :hich interact in the mar!et to achieve the eBuili9rium price# 8he price in the 0inancial mar!et is the interest rate at :hich the liBuidit6 is demanded and supplied# 8he t6pical demand curve o0 liBuidit6 is negativel6 sloped as can 9e seen in .igure $# 8he negative slope is due to the 0act that lo:er the interest rate the higher is the demand 0or liBuidit6 0or a speci0ied period o0 credit; :hich is assumed to 9e ,7months in .igure $# 8he 0igure also sho:s the suppl6 curve o0 liBuidit6 :hich is positivel6 sloped denoting the 0act that higher the interest rates higher :ill 9e the amount o0 liBuidit6 that 0inancial institutions are :illing to suppl6 0or a speci0ied period o0 credit# 8he mone6 mar!et eBuili9rium is the point :here the demand 0or liBuidit6 and suppl6 o0 liBuidit6 interact denoting the 0act that suppl6 and demand are eBual at that point o0 interest rate# 1n .igure $ the mone6 mar!et eBuili9rium is at the point :here 31 ?R is eBual to DG# ?ther things remaining constant2 an6 one institution charging rates higher than this point sa6 0or instance $*G :ill realize that it is una9le to 0ind su00icient 9orro:ers to lend to since there :ould 9e other 0inancial institutions o00ering credit at much cheaper rates o0 DG in the mar!et# =ence this institution :ould 9e 0orced to decrease its rates 0or suppl6ing credit to the mar!et up to the rate o0 DG since an6 rates a9ove than this mar!et eBuili9rium rate :ould not get the reBuired num9er o0 9orro:ers# Similar :ill 9e the case i0 :e 9ring in 11 ?R73 into this mar!et# ?ther things remaining constant2 i0 0ive 1slamic 9an!s

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and certain num9er o0 1slamic 9an!ing :indo:s :ere to Buote their rates as per the proposed mechanism o0 11 ?R73 and i0 that rate :ere to 9e higher than the prevailing mar!et eBuili9rium rate o0 31 ?R these host o0 1slamic institutions :ill 0ace the same situation as 0aced 96 the institution :hich Buoted $*G rate in our h6pothetical eCample# 10 ,7month 11 ?R73 is Buoted at $*G on an6 single da6 :ith eBuili9rium 31 ?R 9eing DG 1slamic 9an!s :ill not 9e a9le to 0ind su00icient inter9an! and even corporate customers to provide 0inancing to# Contrastingl6 since 11 ?R73 is proposed to 9e a t:o :a6 rate the 9id rate o0 11 ?R73 :ill also 9e higher than (** 9asis points than the 9id rate o0 31 ?R# 8his :ill provide ar9itrage opportunities to the mar!et participants :ho :ill start 9orro:ing 0rom the conventional s6stem at DG and place the 9orro:ed 0unds at $*G :ith 1slamic 9an!s# 5ven conventional 9an!s :ill 0ind it pro0ita9le to start placing their eCcess liBuidit6 :ith 1slamic 9an!s at $*G# 8his situation :ill result in 1slamic s6stem 9eing 0lushed :ith eCcess liBuidit6 and contracting avenues 0or deplo6ment o0 this liBuidit6# As a result 1slamic 9an!s and :indo:s :ill have to reduce their Buotes 0or the 0ollo:ing da6s up to the point :here 11 ?R73 is eBual to 31 ?R or the eBuili9rium rate# 10 the 11 ?R73 rates are Buoted 9elo: the eBuili9rium 31 ?R rates the process :ill 9e reverse# .or instance i0 the eBuili9rium ,7month 31 ?R is DG and the ,7month 11 ?R73 is Buoted at ,G the 1slamic 9an!ing institutions :ill :itness long Bueues o0 inter9an! as :ell as corporate customers desiring to avail 0unding 0rom them# 8he ar9itrageurs including conventional 9an!s :ill also 0ind an opportunit6 to avail 0unding 0rom the 1slamic s6stem and place these 0unds :ith the conventional s6stem# ?n the other hand depositors :ho are indi00erent regarding Shariah compliance :ill start to :ithdra: their deposits 0rom the 1slamic s6stem and deposit their 0unds :ith the conventional s6stem# 8his pressure on :ithdra:als and high demand 0or 1slamic 0unds :ould create a liBuidit6 crunch situation 0or 1slamic 9an!s :hich the6 :ould reBuire to resolve

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through replenishing o0 liBuidit6 0rom the inter9an! mar!et2 :ith other 1slamic 9an!s 0acing the same situation and non availa9ilit6 o0 .?"R. 0rom S P the 1slamic 9an!s :ould 9e 9ound to approach the 31 ?R priced conventional s6stem 0or availing the reBuired liBuidit6 through 8a:arruB :hich :ould 9e higher than the 11 ?R73 rates# =ence 9eing a d:ar0 to the conventional s6stem the 1slamic 9an!s :ould 9e 0orced to increase their Buoted rates 0or the 0ollo:ing periods to stem the out0lo: o0 0unds 0rom its s6stem as :ell as to ease the pressure on its 0inancing side# 8he rates :ould have to 9e increased upto the point :here 11 ?R73 is eBual to the 31 ?R rates 9aring transactional cost o0 ar9itrage# 1n the scenarios discussed a9ove the Buestion arises :h6 :ould the 1slamic s6stem 9e 0orced to revise its rates rather than the conventional s6stemP 8he ans:er lies in the 0act that 1slamic 9an!ing is merel6 a '#+G o0 the total an!ing industr6 in Pa!istan and hence is not a dominant position to dictate its rates# =ence the conventional s6stem is currentl6 the mar!et ma!er and is the ma<or mar!et 0or 0inancial intermediation; an6 solo action on the part o0 1slamic participants does not and :ill not move the mar!et# =ence as 0ar as the economic theor6 o0 mar!et 0orces is concerned the 11 ?R73 launched at this stage :ill not 9e independent 0rom 31 ?R and :ill have to toe its line# =o:ever it remains to 9e seen 0or :hich :e don>t have an6 empirical evidence in an6 other mar!et regarding ho: :ill the mar!et move :hen 1slamic 9an!ing captures a ma<or share o0 around H*G or ,*G o0 the 9an!ing mar!et# 5ven in such cases it is highl6 li!el6 that the t:o rates :ould 9e more or less the same 9aring transaction costs o0 ar9itrage since :ith no 9arriers to the 0ree 0lo: o0 0unds 9et:een the t:o s6stems the mar!et 0orces :ould a9le to pla6 their 0ree role and eBuate the t:o rates up to the point :here there are no 0urther opportunities o0 ar9itrage# =o:ever it is certain that in such a scenario 11 ?R73 :ill

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not 0ollo: 31 ?R since 9oth the rates :ill have same level o0 presence on ground and 9oth the rates :ill 9e in a position to move the mar!et# ;., Independence of II!0.-+ with a !ar on free flow of funds

8he placement o0 eCcess liBuidit6 96 1slamic 9an!s :ith conventional interest 9ased institutions is a matter o0 concern among various Buarters and is not vie:ed 0avora9l6 96 various Shariah scholars since it results in 0acilitating conventional 9an!s to ma!e ri9a 9ased lending :hereas the =ol6 Ruran 0or9ids Muslims 0rom helping one another in :rong doing and transgression -Surah Al Maidah H@(/# 1ndeed it seems undesira9le and un<ust that on the one hand 1slamic institutions discourage customers 0rom depositing :ith conventional 9an!s due to presence o0 Ri9a :hile at the same time the6 place their 0unds in a :holesale manner :ith conventional 9an!s through controversial products li!e commodit6 mura9aha;8a:arruB# 1n this section :e loo! at the e00ects on independence o0 11 ?R73 :here there is a complete 9an on placement o0 0unds 96 1slamic 9an!s :ith conventional 9an!s either 0rom the Shariah scholars or the regulator# Ihile at the same time :e also assume that there is no 9ar on conventional 9an!s placing 0unds :ith 1slamic 9an!s since the ma<orit6 o0 the 0unds o0 the conventional 9an!s consist o0 deposits 0rom the general pu9lic and is deemed to 9e halal 96 the ma<orit6 o0 the scholars -Ksmani c# $'''/# 8he 0ollo:ing t:o 0igures depict the pro9a9le scenarios in such a case@ 1n the .igure ( -a/ the mar!et
Figure % (a" - Money Market Equilibrium

eBuili9rium is sho:n in a
20% 18% K# $R & ## $R-K 16% 14% 12% 10% 8% 6% 4% 2% 0% 0 2000 4000 6000 8000 10000 Demand Supply

situation :here there is no 9ar on 0ree 0lo: o0 0unds 9et:een the t:o s6stems# 8he mar!et eBuili9rium 31 ?R and

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Liquidity Supplied & Dem anded (in PKR n!"

11 ?R73 is achieved at DG assuming other things are constant and there are no transaction costs o0 ar9itrage# 8he suppl6 in this 0igure is the total suppl6 o0 mone6 9eing the aggregate o0 suppl6 o0 the 1slamic mar!et and the conventional mar!et# 8he same is the case :ith demand :hich is the aggregate o0 the t:o mar!ets#

Figure % (b" - &on'entional Money Market Equilibrium 20% 18% 16% 14% K# $R 12% 10% 8% 6% 4% 2% 0% 0 2000 4000 6000 8000 10000 Supply Demand Supply**

8he .igure ( -9/ sho:s the conventional mar!et# 8he

demand in the conventional mar!et is the same as the demand in 0igure ( -a/ since the 1slamic 9an!s are not 9arred 0rom accepting 0unds 0rom the conventional
Liquidity Supplied & Dem anded (in PKR n!

s6stem# =o:ever the suppl6 in 0igure ( -9/ is less than the suppl6 level in 0igure ( -a/ since the 1slamic 9an!s are not allo:ed to place 0unds :ith conventional 9an!s# =ence the suppl6 curve -Suppl6SS/ in 0igure ( -9/ is to the le0t o0 the suppl6 curve -Suppl6/ in 0igure ( -a/; the gap 9et:een the t:o curves depicts the unavaila9le 1slamic mone6 suppl6# Due to this shi0t in the mone6 suppl6 the eBuili9rium 31 ?R
Figure % ((" - #!lam i( Money Market Equilibrium 20% 18% 16% 14% ## $R-K 12% 10% 8% 6% 4% 2% 0% 0 2000 4000 6000 8000 10000 Liquidity Supplied & Dem anded (in PKR n!" Demand Supply Demand**

o0 the conventional mar!et at $*G comes out to 9e higher than the eBuili9rium that :ould have 9een in case 0ree 0lo: o0 0unds :as allo:ed

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9et:een the t:o s6stems as depicted in .igure ( -a/# 4o: let>s loo! at .igure ( -c/ :hich represents the 1slamic mone6 mar!et; notice that the suppl6 curve in .igure ( -c/ is at the same level as in .igure ( -a/ since the conventional 9an!s can place;o00er their 0unds :ith;to the 1slamic mar!et; the suppl6 in the 1slamic mar!et :ill 9e same as suppl6 o0 0unds in .igure (-a/# =o:ever since conventional 9an!s are not allo:ed to accept 0unds 0rom 1slamic 9an!s the demand 0or the 1slamic 0unds :ill 9e less than the demand sho:n in .igure ( -a/# =ence the demand curve -DemandSS/ in .igure ( -c/ is to the le0t o0 the demand curve -Demand/ in .igure ( -a/# 8his decrease in the demand :ould result in eBuili9rium 11 ?R73 at ,G in the 1slamic mar!et 9eing less than the eBuili9rium 11 ?R73 :hich :ould have 9een in case 0ree 0lo: o0 0unds :ere allo:ed 9et:een the t:o s6stems as depicted in .igure ( -a/# =ence :ith the restrictions in place and no ar9itrage opportunities availa9le it is highl6 li!el6 that 11 ?R73 :ill 9e di00erent and lo:er than the 31 ?R rate at all times due to eCcess suppl6 and lo:er demand 0or 0unds in the 1slamic mar!et; ma!ing 11 ?R73 largel6 independent 0rom the 31 ?R 0iCing# 1t is important to note that the eCplanation discussed a9ove assumes that there :ill 9e no indirect lea!ages 0rom the 1slamic s6stem to:ards the conventional s6stem# 1n the real :orld scenario it is highl6 li!el6 that even though direct placement 0rom 1slamic 9an!s into conventional s6stem :ould 9e restricted other economic agents such as 0irms and corporate entities; especiall6 those :hich are indi00erent regarding Shariah principles; :ould start availing 0unding 0rom the 1slamic s6stem :hile placing their eCcess liBuidit6 :ith the conventional s6stem there96 resulting in an indirect ar9itrage# =o:ever the magnitude and the pace o0 this ar9itrage :ill determine the impact it :ill have on the t:o 9enchmar! rates; :hich remains to 9e seen# 1rrespective o0 the e00ects; as 0ar as the independence o0 11 ?R73 is concerned a restriction on 0lo: 0unds is 9ound to ma!e it a realit6#

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;./

Independence hampered due to nature of Islamic !anking financing$

Currentl6 the nature o0 0inancial intermediation underta!en 96 1slamic 9an!s is similar to that ta!en 96 conventional 9an!s# oth s6stems have adopted de9t 9ased approach 0or 0inancial

intermediation# Ihile 9oth the deposit side and the 0inancing side o0 the conventional s6stem is 9ased on de9t; 1slamic 9an!s rel6 on non de9t 9ased contracts 0or accumulation o0 deposits and de9t 9ased transactions 0or 0inancing purposes# 8hese de9t 9ased 0inancing o0 1slamic 9an!s comprises the 0ollo:ing modes mura9aha2 ta:arruB2 istisna2 musa:amah2 etc# Knder these modes the 9asic underl6ing ris! e00ecting the decision ma!ing o0 1slamic 9an!s is the credit de0ault ris! :hich is similar to the underl6ing ris! o0 the conventional lending 9ased products# =ence the price that the mar!et or the customers are :illing to pa6 0or this ris! is <usti0ia9l6 similar to the prevailing price at :hich the conventional s6stem is :illing to provide 0unding 0or# =ence 1slamic 9an!s also need to charge the same rate :hich is eBual to the mar!et eBuili9rium 31 ?R# 31 ?R has also 9een used as a 9enchmar! 96 1slamic 9an!s 0or providing car 0inancing and house 0inancing through the lease 9ased modes o0 i<arah and mushara!ah mutanaBisa instead o0 using the prevailing mar!et rates o0 car and propert6 rental rates o0 di00erent areas# Ihile 0inancing 9ased on Shir!atul ABd 9ased modes is a rarit6 even the mechanism o0 such transactions :hen eCecuted has 9een 0inanciall6 engineered to restrict the returns o0 the 0inancier to the 31 ?R :hile remaining in the am9it o0 Shariah principles# 8he reason 0or this adherence to 31 ?R even :hen using such modes is partl6 due to the 0act that 1slamic 9an!s have targeted those mar!ets and customers :ho have traditionall6 9een 9an!ing :ith the conventional 9an!s and partl6 due to the small size o0 the 1slamic 9an!ing industr6# 8he customers :ho have the option o0 availing 0inancing at lo:er rates 0rom conventional 9an!s :ill not 0ind an6 attraction in entering into partnership 9ased 0inancing modes :ith 1slamic 9an!s and share their pro0its

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:ithout an6 ceiling# =ence in such a scenario; even i0 1slamic 9an!s gain a ma<orit6 share o0 the 9an!ing mar!et; an6 separate 1slamic 9enchmar! :ill not 9e independent o0 31 ?R and :ill not achieve its purpose o0 9eing 9ased on the value s6stem o0 1slam and 9eing a means 0or achieving distri9utive <ustice as outlined earlier# As has 9een stressed 96 man6 o9servers and scholars that 1slamic 9an!s need to move on into adopting modes :hich are 9ased on the principles o0 pro0it and loss sharing; rather than lo: ris!6 de9t 9ased modes; :hich are more aligned in achieving the distri9utive <ustice as outlined 96 1slam# Kse o0 such modes on the 0inancing side :ill also ensure returns on the deposit side :hich ma6 9e varia9le 9ut more in line :ith the higher o9<ectives o0 Maqasid alShariah# Ihile 1slamic 9an!s cannot and should not curtail their 0inancings to the eCisting mar!ets and customers it is necessar6 that the6 venture out into areas :hich have 9een untouched 96 the traditional 0orm o0 0inancial intermediation# .or instance 1slamic micro0inance involving partnerships :ith poor people in their 9usinesses; private eBuit6 investments in gro:ing small and medium sized venture; partnerships :ith 6oung entrepreneurs in promising startups; eBuit6 partnerships :ith small and poor 0armers :ho have the capa9ilit6 9ut no resources; ta!ing direct eBuit6 sta!es in pro<ects o0 national interest li!e eCtraction o0 coal in the 8har desert and development o0 coal 0ired po:er plants; etc# 8hese are areas :hich have 9een neglected 96 the conventional 0inance so much so that DDG o0 the countr6>s population is un9an!ed# Iith vast untapped potential in agriculture2 po:er2 mining2 service industr62 etc mar!ets and customers :hich have 9een denied access to 0inance up till no: :ould 9e more :illing to enter into partnership 9ased 0inancings :here losses2 ris!s and pro0its are shared :ith the 1slamic 9an!s as per the actual per0ormance o0 the underl6ing 9usiness# 8hese pro<ects ma6 result in higher ris!s 9ut also result in high pro0its :hich are not capped 96 the 31 ?R rate; :hile at the same time it

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is possi9le to hedge the ris!s through diversi0ication# =ence along :ith the eCisting port0olio 1slamic 9an!s should 0ocus on developing this port0olio o0 shir!atul aBd 9ased activities# Kpon signi0icant size o0 this port0olio 1slamic 9an!s :ill have t:o t6pes o0 assets those :hich are de9t 9ased and capped to a certain level o0 ris! and pro0it rates; and secondl6 the port0olio :hich is partnership 9ased :ith managed ris! 9ut higher returns :ithout an6 capping# Iith these inherent characteristics; irrespective o0 their size or share in the industr6; 1slamic 9an!s :ill provide 11 ?R73 Buotes :hich :ould 9e di00erent and independent 0rom 31 ?R re0lecting their o:n liBuidit6 status2 placement opportunities2 eCpected returns and ris!# <.Conclusion

8he proposed mechanism 0or 11 ?R73 is a :or!a9le option; ho:ever the paper has eCplained in detail various practical issues and challenges :hich have hampered the development o0 this 9enchmar!# 8hese issues and challenges range 0rom mar!et d6namics2 standardization2 strength o0 the industr6 pla6ers2 under developed inter9an! mar!et2 role o0 the regulator and de0icient inter9an! in0rastructure# A strateg6 needs to 9e evolved 96 the 1slamic 0inancial institutions2 Shariah scholars2 regulators and other sta!eholders to resolve these challenges 0or not onl6 providing a 0avora9le environment 0or the launch o0 11 ?R73 9ut also 0or the development o0 an integrated and e00icient 1slamic 0inancial s6stem in the countr6# 8he anal6sis also concludes that in the current scenario i0 the 11 ?R73 is launched it :ill not 9e independent 0rom the conventional 31 ?R; even i0 the 1slamic 9an!ing industr6 captures a higher mar!et share the 1 ?R73 :ould still 9e eCpected to 9e eBual to the 31 ?R given the 0act that there are no restrictions o0 0lo: 0unds 0rom 1slamic to conventional s6stem under the current scenario# 10 restrictions are placed on such 0lo:s the 11 ?R73 is eCpected to 9e lo:er than the 31 ?R# 8he

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paper also suggests that real independence can 9e ensured i0 the 1slamic 9an!s ad<ust the nature o0 their 0inancial intermediation according to the higher motives o0 MaBasid AlShariah# .eferences Allied an! "imited2 (*$(2 Annual Rep rt !"## Al ara!a an! Pa!istan "imited2 (*$(2 Annual Rep rt !"## an! 1slami "imited2 (*$(2 Annual Rep rt !"## an! 1slami "imited2 (*$)2 Annual Rep rt !"#! ur< an! "imited2 (*$(2 Annual Rep rt !"## Du9ai 1slamic an! Pa!istan "imited2 (*$(2 Annual Rep rt !"## .inancial Mar!ets Association o0 Pa!istan2 (*$*2 Master $ mmunique% n KIBOR & KO'IA rules and re(ulati n- !"")* vie:ed $* March (*$)2 http@;;:::#0ma#com#p!;Attachments;PD.;MasterG(*CommuniBueG(*onG(*31 ?R2 G(*3?41AG(*RulesG(*(**'#pd0 =a9i9 an! "imited2 (*$(2 Annual Rep rt !"## MC an! "imited2 (*$(2 Annual Rep rt !"##

Meezan an! "imited2 (*$(2 Annual Rep rt !"## Meezan an! "imited2 (*$)2 Annual Rep rt !"#! Meezan an! "imited2 Minutes f the meetin(s held f r the de+el pment f Islamic benchmark rate in ,akistan2 meetings held 0rom (**D 7 (**'# Miller and Qan =oose2 $'')2 M dern M ne- and Bankin(* McOra: =ill oo! Co2 Singapore# Mu0ti Muhammad 8aBi Ksmani2 $''D2 An Intr ducti n t Islamic .inance2 1daratul Ma>ari02 3arachi# Mu0ti Muhammad 8aBi Ksmani2 c# $'''2 .iBhi MaBalat2 vol# )2 an! deposits !a6 sharai ah!am2 trans# MA Memon2 Memon 1slamic Pu9lishers2 3arachi Mu0ti Muhammad 8aBi Ksmani2 (**,2 /he meanin(s f the ' ble Quran2 Ma!ta9a Ma>ari0ul Ruran2 3arachi#

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Mu0ti Muhammad 8aBi Ksmani2 (**+2 /he 0ist ric 1ud(ement n Interest deli+ered in the Supreme $ urt f ,akistan2 Ma!ta9a Ma>ari0ul Ruran2 3arachi# 4ational an! "imited2 (*$(2 Annual Rep rt !"## State an! o0 Pa!istan2 PD Circular 4o#A2 (**A2 Benchmarkin( $ rp rate 2endin( ,r ducts t KIBOR* vie:ed $* March (*$)2 http@;;:::#s9p#org#p!;9pd;(**A;C$#htm State an! o0 Pa!istan2 DMMD Circular 4o#$2 (**'2 Intr ducti n f interest rate c rrid r* vie:ed $* March (*$)2 http@;;:::#s9p#org#p!;dmmd;(**';C$#htm State an! o0 Pa!istan2 1slamic an!ing Department -1 D/2 (*$)2 Islamic Bankin( Bulletin 3ecember !"#!2 vie:ed *) April (*$)2 http@;;:::#s9p#org#p!;i9d;9ulletin;(*$(;1 7Sep7 (*$(#pd0 State an! o0 Pa!istan2 (*$(2 $redit Ratin(s f Banks* 3.Is 4 M.Bs2 vie:ed () March (*$)2 http@;;:::#s9p#org#p!;pu9lications;cTrating;Ratings7$(7Sep7(*$(#pd0 State an! o0 Pa!istan2 (**D2 Strate(ic ,lan f r the Islamic Bankin( Industr- in ,akistan* vie:ed $* March (*$) http@;;:::#s9p#org#p!;departments;pd0;StrategicPlanPD.;Strateg6 G(*Paper7.inal#pd0 8homson Reuters2 (*$$2 Islamic 1uristic ,r n uncement2 vie:ed () March (*$)2 http@;;thomsonreuters#com;content;0inancial;pd0;crossTasset;11 RT.at:aT5n#pd0 8homson Reuters2 (*$$2 IIBR .act Sheet2 vie:ed () March (*$)2 http@;;thomsonreuters#com;content;0inancial;pd0;crossTasset;ii9rT0actsheet#pd0 Knited an! "imited2 (*$(2 Annual Rep rt !"## Iorld an! (*$$2 56 rld Bank .inancial Inclusi n 3ata%2 vie:ed )* April (*$)2 http@;;datatopics#:orld9an!#org;0inancialinclusion;countr6;pa!istan

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