PRICING OF ISLAMIC INSTRUMENTS-AN ECONOMIC PERSPECTIVE

June 18,2012-Dubai Dr Nasser Saidi, Executive Director

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Contents

Market Information, Efficiency & Governance Growth of Islamic Assets & Market Pricing of Islamic Instruments The IIBR and Pricing of Islamic Instruments

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Market Efficiency & Market Information are inextricably related Examples: price dispersion in China after availability of telephones; car prices on internet Efficient markets –financial markets especially- dependent on availability of reliable, consistent, verifiable, information about current and expected future ‘states of the world’ ‘Public Good’ aspect of information

Market Efficiency & Economic Information

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Better information improves resource allocation and economic efficiency Disclosure of financial information directs capital to its most productive uses Transparency: flow of timely & reliable economic, social & political information about policies, outcomes Transparency: Access, Relevance, Quality, Reliability

Market Efficiency & Market Information

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Financial Market Indicators

Asset prices and their indices are forward looking, discount expected future actions, policies and events Tend to be leading indicators of economic activity More volatile than real economic indicators

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Economic Information & Good Governance

Good Governance i.e. traditions, institutions by which authority is exercised for the common good, requires transparency, efficiency and accountability Good Governance= function( Knowledge & Information, Leadership, Collective action) Increased Globalization places emphasis on transparency and comprehensiveness of information

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Currently there is no centralised collection and dissemination of statistics & information about Islamic Finance Industry Need to apply accepted international Data Dissemination Standards (GDDS, SDDS) for collection & dissemination of Islamic finance data & statistics Need central responsible body with authority & competence to collect & disseminate: candidates include IsDB, IMF, BIS

Islamic Finance Industry & Statistics

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Growth of Islamic Finance Global Assets

From an Organisational perspective: enhances transparency and performance. From a product perspective: measurable standard for best-in-class achievement. From the capital and money market perspective: helps derive a yield curve across a range of maturities.

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Source: UKIFS Islamic Finance 2012

Distribution of Islamic Finance Assets by Sector

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Source: UKIFS Islamic Finance 2012

Banks account for the bulk of Islamic assets globally with funds and Takaful making up the balance. Banks and funds are major investors in Sukuk, which strengthened in 2011. Sukuk issuance was up 60% to a record $84bn: two thirds by Malaysian institutions.

Islamic Finance Potential

10 Source: UKIFS Islamic Finance 2012

Considerable potential exists for expansion of Islamic finance :The Banker estimates that only 12% of Muslims worldwide use IF products. Extent of the industry’s penetration varies substantially. In Bangladesh, for example, Islamic banking accounts for 65% of total banking assets but only 4% to 5% in Turkey, Egypt and Indonesia.

More countries are looking to expand the Sharia offering. New Sharia compliant institutions have been reported by The Banker in, for example, Australia, Azerbaijan, Nigeria, Oman, Pakistan, Qatar and Russia. Oman is the last of the Gulf Co-operation Council (GCC) states to open the door to Islamic banks.

Pricing of Islamic Instruments

Islamic financial instruments have emerged as a viable alternative asset class, augmenting the investible asset space with assets with different risk/return characteristics & allowing risk diversification In the absence of reference price indicators specific for Islamic finance, the Islamic finance industry still relied on interest rate-based benchmarks (such as LIBOR). Hence the need to introduce an alternative efficient price indicator for Islamic finance instruments to reduce reliance on the prevailing interest rate-based benchmarks. Transparency and disclosure of the pricing mechanisms will lead to increased investor confidence which will ultimately drive up the volumes traded, increasing liquidity in the market.

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Why are Standardisation & Benchmarking Important?

Standardisation implies comparable characteristics, terms & conditions of products and services, facilitating price formation & discovery and reducing trading & transaction costs Standardisation leads to improved market information and disclosure Standardisation facilitates the design of market trading rules & lowers trading costs

Benchmarking provides a reference price or rate for comparing product/services prices/rates and for measuring performance Benchmarks facilitate the design & development of new contracts, products and services based on the benchmark

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The IIBR vs Conventional Rates

The IIBR measures expected profit while conventional benchmarks such as LIBOR measure interest rates. The IIBR explicitly refers to the cost of raising Shari’a compliant funding. The IIBR is based on returns generated by Islamic assets, hence is a reference to an Islamic asset risk profile.

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The Muashshir al Ribh bayn al Masarif al Islamiyah (Islamic InterBank Benchmark Rate) is intended to provide a reliable and objective indicator of the average expected return on Shari’a compliant short term interbank market funding for the Islamic Finance industry. Utilising the contributed rates of major Islamic banks and Islamic banking windows, the IIBR is calculated for every business day and is available on Thomson Reuters terminals.

The IIBR and Pricing of Instruments

IIBR will lead to the development of a yield curve or a profit curve for various maturity terms. IIBR rate provides a reference rate for pricing of non-bank corporate and private borrowings, contracts and transactions (conventional and Shari’a). Market Breadth & Depth:

Availability of IIBR will encourage issuers to tap the markets as they would have an Islamic benchmark rate to use for pricing their instruments Existence of a benchmark can lead to development of new products based on the benchmark

The IIBR can be used as a market price indicator that Central Banks can use for assessing market developments and for policy intervention.

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The Islamic Benchmark Rate Committee is responsible for providing the commercial and technical advice required for the proper implementation and on-going integrity of the IIBR. The Islamic Benchmark Committee is also responsible for selecting, admitting and excluding banks for the contributor panel. The members are: • Thomson Reuters • Hawkamah Institute for Corporate Governance • Islamic Development Bank • Accounting and Auditing Organisation for Islamic Financial Institutions • Association of Islamic Banking Institutions Malaysia • Bahrain Association of Banks • Statistical Economic and Social Research Center for Islamic Countries ; and •Participating contributor panel banks

The IIBR Committee

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The IIBR Contributor Banks

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The participating Contributory Panel banks include:

Bahrain Islamic Bank

National Bank of Kuwait

Sharjah Islamic Bank

Masraf Al Rayan

Barwa Bank

Dubai Islamic Bank

Abu Dhabi Islamic Bank

Al Baraka Bank

Qatar Islamic Bank

Kuwait Financial House

Noor Islamic Bank

Alinma Bank

Ahli United Bank

Al Hilal Bank

Ithmaar Bank

Al Salam Bank

Saudi National Commercial Bank

The IIBR Shari’a Committee

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The IIBR is also overseen & regulated by an independent Shari’a committee (comprising 5 scholars) which vets the procedures and methodology utilised by Thomson Reuters to calculate and publish the Benchmark. The Shari’a Committee members include: Sheikh Yusuf Talal Delorenzo (Chairman) Dr. Akram Laldin Dr. Abdul Rahim Sultan Al Olama Mohammad Daud Bakar Sheikh Mudassir Siddiqui

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0.40

0.60

0.80

1.00

1.20

11/21/2011 12/21/2011 1/21/2012 2/21/2012 3/21/2012 4/21/2012 5/21/2012

ON

SW

1M

2M

3M

6M

9M

1Y

Nov 21,2011-June 14,2012

LIBOR

Source: Thomson Reuters

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0.00

0.20

0.40

0.60

0.80

1.00

1.20

1.40

1.60

11/22/2011 12/22/2011 1/22/2012 2/22/2012 3/22/2012 4/22/2012 5/22/2012

ON

SW

1M

2M

3M

6M

9M

1Y

IIBR

Nov 22,2011-June 14,2012

Source: Thomson Reuters

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Some final thoughts

• Market information, efficiency & good governance are inextricably linked

• Islamic Finance needs a central body to compile and disseminate data & statistics

• Standardisation of securities and instruments is essential for building markets and efficiency

• IIBR is important IF market building block

THANK YOU!

www.hawkamah.org

Hawkamah – The Institute for Corporate Governance

DIFC Gate Village 2, Level 1, PO Box 506767, Dubai, UAE T: +9714-362-2551 F: +9714-362-2552

E: info@hawkamah.org

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