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  • Establishing a workable Islamic pricing benchmark is indeed crucial

In 2022, the Federal Shariah Court of Pakistan directed the government to adopt Shariah-compliant modes while borrowing from domestic or foreign sources and set a five-year timeline to convert the economy into an equitable asset-based, risk-sharing and interest-free economy by 2027. State Bank of Pakistan’s strategic plans for 2023-2028 also include transforming existing conventional banks into Islamic banks by bringing the total share of Islamic banks in assets and deposits up to 30% by 2025. These developments are to be understood in the backdrop of future prospects of interest-free banking in Pakistan wherein the industry stands at US$53 billion at the end of 2023.

The market share of Islamic banking has continually been rising for the last five years presently standing at 19.6% (assets) and 22.5% (deposits) at the end of September 2023. A number of conventional banks are converting to Islamic banks due to growth potential. Faysal Bank has completely turned into an Islamic bank in 2023. Summit Bank secured approval from SBP to change its name to Bank Makramah and is transitioning into an Islamic bank whereas Bank of Punjab has announced its plans to convert into an Islamic bank very soon.

While it is too early to assess if the government will achieve its Shariah-conversion targets, there are numerous challenges that could dampen the growth potential of interest-free banking in Pakistan such as liquidity issues, the mingling of funds, product and distribution gaps, lower pricing competitiveness and operating environment etc. One such challenge is the use of conventional benchmarks like KIBOR or LIBOR when pricing a Sukuk or Islamic finance transaction. The concern becomes all the more important as to what Islamic financial institutions will do when conventional benchmarks cease to exist after the conversion of the financial system in Pakistan. The proponents of Islamic banking desire a more customized benchmark for Islamic finance that aligns with their unique requirements and values.

From a regulatory point of view, there is no issue with it as it will reflect a positive impact on the economy since it will be less prone to market manipulation. From a Shariah perspective, the governing body in Bahrain allows the use of conventional benchmark rates for pricing an Islamic transaction given that it fulfills all the parameters of Islamic rules of contract. However, the scholars argue that even though it is allowed, it is not preferable to use conventional benchmarks to determine profits in Islamic finance. They recommend the development and linkage of the benchmark based on Islamic markets to some real economic parameters. One such attempt was made when Reuters came up with Islamic Interbank Benchmark Rates (IIBR) as a possible solution addressing concerns related to interest-based benchmarks. This approach could be developed further given the fact that it could remove the confusion of the common man and create a positive image for the industry’s growth. A separate benchmark could enhance trust among different stakeholders and help differentiate Islamic financial products. SBP has also acknowledged the need for a separate benchmark for the Islamic banking industry to boost public confidence.

From the market competition point of view, the development of a separate Islamic benchmark will be interesting since it will require greater Shariah compliance and industry collaboration, wider dissemination and close monitoring within the Islamic finance community. A lot will depend on the market dynamics, calculation methodology used, market share of Islamic banks and various underlying factors such as accounting for the Shariah-compliant funding costs.

It is the need of the hour for all the stakeholders be it policymakers, regulators, market players or academia to sit together with Shariah scholars and explore options for the development of a workable Islamic pricing benchmark. The move will not only bring in trust and confidence among customers but will also boost the growth of Islamic finance in Pakistan.