Articles on Islamic Finance

Distinctive Profit Rate Benchmark in Islamic Banking

Salman Ahmed Shaikh

In contemporary monetary system, interest based T-bills are not Islamic since they involve Riba, which is prohibited in Islam. Islamic principles prohibit a predetermined interest rate, but permit variable returns in productive enterprise based on equity participation, trade and other economic activities.

As a substitute to T-bills, the governments can issue Treasury Sukuk Ijarah Bills to source funds. This instrument can also be used in open market operations. In place of reverse repo and repo, ready buy-deferred sale can be used to inject and mop up funds.

If the commercial banks want to deposit funds with the central bank, they will buy Treasury Sukuk Ijarah Bills at a lower price on spot and sell at a higher price in future. Likewise, if they want to access funds from the central bank, they will sell Treasury Sukuk Ijarah Bills at a lower price on spot and buy at a higher price in future.

The difference in price will be the financial cost to the party that is obtaining funds and return to the counterparty that is providing funds. A unilateral undertaking will separate the two legs of the transaction. To ensure that it is not an outright buyback transaction, it is important to ensure proper identification of Ijarah asset, transfer of ownership, constructive possession and prior valid offer and acceptance to execute the sale of Ijarah assets.

In outright open market operations where the objective is to buy and hold the treasury securities till maturity, Murabaha Sukuk can also be used where there is no need for secondary market and for multiple sales between counterparties during the life of the security.

The question arises as to what should be the profit rate benchmark. To solve this issue, the government can setup a trading corporation that trades in commodities like food crops and petroleum products. In some countries, such a trading corporation already exists and the governments procure goods through these trading corporations to achieve the objectives of i) smooth supply, ii) exports of surplus and imports of shortage, iii) protect the small growers and iv) regulate prices.

In these trading operations, the government can set prices to reflect its target profit rate knowing the cost as well as the selling price. This target profit rate can become a benchmark for issuing Treasury Sukuk Ijarah Bills and affect the other rates of returns in Islamic short term financing instruments. For time preference, Zakat rate can be used as discussed in this article Zakat Rate as Base Risk Free Rate.

Nonetheless, this instrument shall be used domestically in national currency and the investment shall not be open to foreign investors. It is because if national infrastructure is used as a subject matter in these Treasury Sukuk Ijarah Bills, any default might result in transfer of significant national wealth if the Treasury Sukuk Ijarah Bills are not denominated in national currency and are open to foreign investors.

Open market operations would involve injecting and mopping up funds. This will be achieved through purchasing and selling Treasury Sukuk Ijarah Bills. Credit controls can utilize Qard e Hasan ratio (for cash reserve ratio) and sovereign investment ratio (for statutory liquidity ratio) where investments are made in Treasury Sukuk Ijarah Bills.

From the perspective of rules governing Islamic finance, this proposal would be appropriate since it is using a real sector oriented profit rate benchmark rather than interest based benchmark. Furthermore, the instrument ‘Treasury Sukuk Ijarah Bill’ will also enable effective conduct of monetary policy, liquidity management in Islamic interbank market and distinct pricing of Islamic banking financing products with a close link to the real economy.

Table 1: Pros and Cons of Using Bottom-Up Approach

Potential Strengths of the OptionPossible Challenges
Pricing is based on real economic activity.Such real economy based pricing does not have a zero-floor and can be more volatile.
Instrument can serve the monetary functions for central bank.There is no term premium. It will have to be added separately.
Instrument can resolve liquidity management issues of IFIs.If sufficient numbers of Sukuk Ijarah Bills are not there, then there will be constraints to support big transaction volumes.

Implied Profit Rate on Commercial Contracts and Projects

The profit rate paid by the government in government contracts and projects can also be explored as a potential benchmark. For instance, government procures commodities from the agriculture sector. In such commodity operations, the profit rate can be imputed from the transactions.

Likewise, governments offer profit rate to independent power producers and other suppliers. In such transactions, as a monopsony and regulator, the government can influence price and hence the profit rate. Such profit rates are strictly and directly based on real-economy based transactions.

On the other hand, there are certain projects where it is possible to launch Musharakah Sukuk and enable profit sharing on pure pass on basis, such as railways (yielding fare revenue), airlines (yielding fare revenue), energy production and distribution (yielding sales revenue) and roads (yielding toll taxes), for instance.

Table 2: Pros and Cons of Implied Profit Rates

Potential Strengths of the OptionPossible Challenges
Pricing is based on real economic activity.Projects vary in risk, maturity and scale. Unlike output growth rates, profit rates on individual contracts in particular can have a long range from negative to positive.
There are certain projects where the implied profit rate is known to be positive through the contracted prices like in energy and construction projects. Such implied profit rates can be used to derive target profit rate.Ex-post profit rates on short term and long term projects need not be based on maturity premium. Therefore, for term premium, separate adjustments maybe required.
Avoids reference to interest based benchmarks and reflects profits on actual commercial transactions.Implied profit rates from commercial contracts may not be universally and transparently available to all market players.

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