SBP widens Islamic banks' benchmark requirements

Despite a direct ban on charging interest, interest-based benchmarks are used as a pricing reference by a majority of Islamic banks, due in part to the absence of stable and widely-published alternatives.

In a circular, the State Bank of Pakistan said Islamic finance institutions would have to outline their alternative pricing mechanism for participatory financing schemes, replacing the use of the Karachi Inter Bank Offered Rate or KIBOR.

Since 2004, the central bank has required all banks to use KIBOR as a benchmark rate. The use of such benchmarks is viewed as a shortcoming of Islamic banking that discourages wider adoption, in particular among retail clients.

The government, however, wants to help develop Islamic finance, a sector which now holds 11.4 per cent of all banking assets and 13.2 per cent of all bank deposits in the Muslim-majority country.

The exemption applies with immediate effect to participatory modes of financing known as musharaka, mudaraba and wakala.

Such sharia-compliant contracts are well known but have traditionally been eclipsed by murabaha, a cost-plus-profit arrangement in Islamic finance.

Under murabaha contracts, one party agrees to purchase merchandise such as a commodity on behalf on another, which promises to buy it at an agreed mark-up.

That markup has been commonly set against a financial benchmark such as KIBOR or LIBOR for dollar-denominated deals.

This has been criticised by some religious scholars as not being sufficiently based on real economic activity, a key principle in Islamic finance.

The practice dates back to the beginnings of modern Islamic finance in the early 70’s, with scholars giving their blessings to what was deemed a temporary measure until alternatives could be developed.

Under the new directive, banks must ensure compliance with sharia standards issued by the Bahrain-based Accounting and Auditing Organisation for Islamic Financial Institutions, and must receive a sign-off from their internal sharia board.