How kibor works?Why we need Kibor ? Why kibor is wrong?

Alternate of
kibor ? How it will work?

Banks are using KIBOR, or Karachi inter-bank offered rate, as a reference

rate for pricing corporate loans. The State Bank of Pakistan (SBP) persuaded
all local and foreign banks to do this to make the interest rate structure more
market-based.

The central bank and the Pakistan Banks Association are using KIBOR as a
reference rate for corporate customers' lending in rupees from February 1,
2004.

KIBOR came to the fore in September 2001, when some major local and
foreign banks took up the challenge of creating a market-based benchmark
for interest rates. These banks started quoting inter-bank lending and
borrowing rates on daily basis. Reuters used these rates for working out
KIBOR and KIBID or Karachi inter-bank bid rates and started flashing them
across the world.

Since KIBOR reflected the average interest rate at which some banks of the
KIBOR club were willing to lend money to other banks of the club, it was
much lower than the average customers' lending rate.

Top businessmen soon took notice of it, and some of them started
demanding the banks to link their customers' lending rates with KIBOR. But
banks refused to do this because the determinants of the inter-bank lending
rates and customers' lending rates were very different.

The launch of KIBOR had, however, set the stage back in September 2001
for the interest rates to become market-based though its scope was limited to
the inter-bank market.

Then in December 2001, the government introduced Pakistan Investment

Bonds. The basic purpose of launching these three-year, five-year and 10-
year bonds was to establish a long-term curve so that corporates can price
their debt-raising instruments accordingly. These scripless bonds carried a
fixed coupon rate but their yields were to be determined according to their
demand and supply. The bonds did meet their objective and their cut-off
yields soon became a benchmark for corporates to price their term finance
certificates. So, whereas KIBOR set a reference rate for clean inter-bank
lending, PIBs became a benchmark for secondary market debt raising by the
close of 2001.

In the year 2002 the respective status of KIBOR and PIBs strengthened
further. Moreover, as anticipated by the policy makers both also started
reflecting changes in the monetary policy, to a certain extent, in their
respective areas.

The SBP also wanted the banks to come up with some benchmark for
customers' lending rates to ensure that the changes in monetary policy have a
desired impact on the price of corporate finance without delay.

The central bank found that the primary reason for the banks not responding
properly to the changes in the monetary policy was the absence of a
benchmark for their customers' lending rates.The SBP found that this was
also a key reason for the rising gap between the banks' lending and deposit
rates.

In November 2001, the SBP had set up a committee of top bankers drawn
from both local and foreign banks for identifying and developing a
benchmark for banks' customers' lending rates. The committee headed by the
Country Manager, ABN AMRO, Mr. Naved A. Khan, initially tried to
convince banks to develop their prime lending rates for this purpose.

The committee then believed that it would also be easier for the banks to
reflect changes in the SBP monetary policy through their prime lending rates
rather than by making across-the-board changes in their overall lending rates
structure. The term prime lending rate refers to the lending rates at which
banks lend money to their first class borrowers.

But the committee had to drop this idea because opinions were sharply
divided on this issue: whereas foreign banks having small branch networks
and smaller portfolios of bad loans found the idea feasible, local banks did
not.

Local banks particularly those with large branch networks and huge
portfolios of bad loans opposed the idea because their cost of financial inter-
mediation was much higher than that of the foreign banks. So, they would
have found it difficult to compete with foreign banks, had the concept of
prime lending rates been materialized. It took the committee more than a
year to develop a consensus alternative and finally all the banks agreed in
January 2004 to use KIBOR as a benchmark for corporate lending rates.

Kibor: Karachi Inter Bank Offer Rate

Karachi Inter-bank Offered Rate (KIBOR); quoted on Reuters by 20
commercial
banks (as selected by FMA - Financial Markets Association of Pakistan).
It is updated at 11.30 AM daily on Reuters by excluding Out-layers, 4
extremes on
higher and 4 extremes on lower side. Authenticity is confirmed by making
the
contributors liable to accept Bid/Offer within 15 minutes from the time of up
date up
to Rs 100million of Lot Size by Contributor Banks. Financial Market
Association of
Pakistan ensures timely and error-free availability of the rates. With effect
from 31st
January 2004 Karachi Inter-bank Offered Rate (KIBOR) is used as the
benchmark for
all-corporate lending. Currently KIBOR is quoted for tenors ranging from 1-
week to
3-years. Initially KIBOR of one-month; three-month and six-month was
used as a
benchmark for all corporate lending in the local currency from next month
banks had
agreed on extending the KIBOR tenures to one year by March 31, 2004 and
then to
three years by December 31, 2004 for using it to price corporate loans of
similar
tenures. The main purpose of this is to introduce some uniformity in
corporate lending
rates and this also promote the culture of floating rate lending and will make
corporate
more efficient in cash flow management. The use of KIBOR as a reference
rate (for
corporate lending) will make the monetary policy more effective. Six
months KIBOR is most widely used for benchmarking
 Moreover, the use of KIBOR as a benchmark for bank customers' lending
will initially remain limited to corporate finance only. It will not apply on (i)
export finance and (ii) consumer financing and lending to small and medium
enterprises. It will also not apply on (iii) overdrafts and running finance
facilities existing before January 31, 2004, (iv) term finance
certificates/commercial papers approved by the SECP or submitted to any
stock exchange before January 31, 2004; and (v) all term loans with the
agreements executed before January 31, 2004. Export finance rates will
continue to be determined by adding a spread of 1.5 percentage point on the
SBP refinance rate that is linked with the cut-off yield on six-month treasury
bills.

As for consumer financing and lending to SMEs, banks will determine the
mark-ups keeping in view their own cost of funds and the risks involved in
such financing besides meeting the requirements of SBP's Prudential
Regulations for both.

As for depositors, an efficient use of KIBOR by the banks for benchmarking

their corporate loan prices may reduce their operational costs and create
room for them to improve the rates of return on deposits. But that may take
the banks quite some time.

Why KIBOR is wrong

Interest-free liquidity management is the major concern for Islamic banks.

The State Bank of Pakistan (SBP) requires Islamic banks and conventional
banks to maintain the same Cash Reserve Requirement (CRR) of five per
cent and Statutory Liquidity Requirement (SLR) of eight per cent.

Alternate of KIBOR

Islamic banks can hold their required reserver in special current accounts
with SBP or with the National Bank of Pakistan. Any return on these
accounts is the absolute discretion of the SBP. Recently, the SBP has
introduced new SLR policy for the Islamic banks allowing them to invest in
Wapda Sukuk but not exceeding five per cent of their investment potfolio.

Efforts are being made since 1979 to Islamise the financial system for which
. the SBP initially introduced 12 Islamic modes of financing to replace
interest-based instruments. The Council of Islamic Ideology (CII) in a
separate report in 1980 advised the SBP to replace the money market
discount rate with the arrangement whereby the SBP would be empowered
to finance the banks on profit and loss sharing basis. Among other
recommendations one was to set up interest-free ‘common pool of funds’ on
cooperative basis to replace the existing interest bearing government
securities.

The SBP initially took drastic steps towards the development (and
implementation) of financial instruments based on Islamic principles. Later
the whole process came to a standstill. No effort had been made towards the
elimination of interest from inter bank transactions; inter-government
transactions and foreign currency accounts.

Pakistan has witnessed the second wave of Islamisation of financial system

since 1999. This time the Supreme Court of Pakistan asked the government
to take steps towards the elimination of interest from the economy. A
meeting held under the chairmanship of the president of Pakistan decided to
allow Islamic banks to operate parallel to conventional banks. In addition,
conventional banks were also allowed to offer Islamic banking services
through dedicated Islamic windows.

Now, six Islamic banks and 13 conventional banks with a total network of
200 branches offer Islamic banking products and services. In addition, non-
bank financial institutions such as Islamic Mutual Funds, Takaful
companies, Mudaraba companies, House Building Finance Corporation etc.
are also the active participants. Efforts are also been made for the
development of Islamic Sukuk (bond) market. Islamic banking is targeting to
capture 10 per cent of the total financial sector in the years to come.

Islamic banking is asset-based banking. History proves that assets prices

increase with the increase in GDP while the interest rate decreases at the
same time. In other words, interest rate and the assets prices have inverse
relationship with each other. Concerns are raised then how can the Islamic
money market operate as efficiently as the interest based money market
under the current parallel banking concept. Here an attempt has been made
to develop a conceptual framework to address this important issue.

Conventional banks operate under the concept of lender-borrower

relationship where interest is considered as the rental income on capital. The
depositors are assumed to be capital providers. Profits of the banks are
distributed at the discretion of the bank managements.

But the Islamic banks follow the concept of Mudaraba (profit sharing) based
on investor-entrepreneur relationship. Here Islamic banks consider
depositors as entrepreneurs. The profits generated through this relationship
are divided between the two parties as per agreed ratio.

Further, researchers divide Islamic bank customers into three broader

categories (a) religiously motivated customers (b) high profit motivated
customers (c) customers who are religiously motivated but also expect
returns at least similar to conventional banks. Customers of second and third
categories generally dominate in terms of numbers in any Islamic bank.
They expect returns on deposits similar to conventional banks.

In the money market, the main objective is to meet short-term liquidity

requirements. The market facilitates banks with deficit in cash to borrow
from the banks having surplus money. Islamic money market conducts a
similar function of meeting the short-term liquidity needs. Instead of
interest, it allows Islamic banks to share surplus capital on profit -sharing
basis.

Islamic and conventional money markets can be assumed to offer similar

returns on investments. Low returns in Islamic money markets may badly
affect the overall profitability of Islamic banks in the initial stages of their
development. Even if, Islamic money market offers returns higher than
conventional market, the Islamic banks may still not enjoy an advantageous
position.

The present parallel banking set-up allows conventional banks to transact in

the Islamic money market through their separate Islamic branches and earn
returns equal to Islamic banks. Existing Islamic banking arrangement thus
puts Islamic banks in a disadvantageous position as they would transact only
in the Islamic money market. But at the same time, other banks through their
Islamic and conventional branches can deal in both Islamic and the
conventional money markets. The scenario leaves the SBP with no option
but to manage the Islamic and conventional money markets returns at the
same level.

Special attention should also be paid for developing Islamic money market
instruments to meet the liquidity requirements plus to match the current
market financing rates on constant basis. Current available Islamic financial
instruments are either long-term or fixed in nature which create funding
mismatch problem.

At present, Islamic banks use short- term deposits on variable rates to

finance medium and long-term projects. The situation leads Islamic banks
either to maintain high liquid ratios or to avoid long-term financing that can
affect the overall profitability.

Various Islamic countries have developed Islamic money market

instruments under the concepts of Wakala (agent), short-term Sukuk
(bonds), and securitisation of assets etc. There are many others short- term
instruments which are acceptable in one Muslim country but are subjected to
some restrictions in other Muslim countries--- especially those issued under
the concept of buy-back agreements and Bai Al-Inah (sale of debt).

Likewise, Islamic money market is also facing serious research deficiencies

in the area of oversight of financial instruments. Innovations are needed to
facilitate Islamic banks to manage their liquidity gap as efficiently as the
conventional banks.

Cost of Capital for IFSI

_ Cost of Capital is the cost of finance needed to acquire
the physical capital
_ Cost of capital determines the minimum return
required by the firm on capital deployed
_ In the absence of an Islamic Rate of Return, IFI’s use
the interest rate mechanism (KIBOR) as a benchmark
for procurement and placement of funds
_ Due to current market focus and high priority
development areas, little emphasis is being made on
developing an alternative to KIBOR
_ As the Islamic Financial Services Industry is no longer
a niche market, perhaps an Islamic Rate of Return is
needed
KIBOR – Halal or Haram?
_ Shari’a Scholars ruling is that if the transaction fulfils
all the Shari’a requirements, then merely using an
interest rate as a benchmark for determining the profit
of the underlying instrument does not render the
transaction as haram or invalid, because the
transaction itself does not contain interest
_ Some Scholars are of the view that this practice should
be phased out, because
• Using the rate of interest as an ideal for halal business is
not desirable and
• It does not advance the basic philosophy of Islamic
economy having no impact on the system of distribution
7
An Alternative to LIBOR- Abbas
Mirakhor Approach
_ Proposes that Cost of Capital can be measured
without resort to a fixed and predetermined
interest rate
_ The benchmark could be created based on Tobin q
theory
_ Main assumption:
• In the absence of a fixed and predetermined rate of
interest, equity financing becomes the only source of
financial capital, and as such, the economy’s
financial system becomes equity-based and hence,
the equity market would provide a measure of the
cost of capital
An Alternative to LIBOR- Sheikh
Taqi Usmani Approach
_ A Benchmark can be achieved by creating a common
pool which invests in asset-backed instruments like
musharakah, ijarah etc.
_ If majority assets are in tangible form, its units can
be sold and purchased on the basis of their net asset
value determined on periodical basis
_ These units may be negotiable and maybe used for
overnight financing
_ The banks having surplus liquidity can purchase
these units and when they need liquidity, they can
sell them
_ This arrangement may create inter-bank market and
the value of the units may serve as
an indicator for determining the profit
8
15
An Alternative to KIBOR Malaysian
Approach
_ Bank Negara Malaysia introduced the “Framework of
the Rate of Return” to standardize the methodology
on the calculation of distributable profits and the
derivation of the rates of return to the depositors
_ The objectives of the framework are:
• Set the minimum standard in calculating the rates of
return
• Provide the same playing level and term of reference
for the Islamic banking institutions (IBIs) in deriving
the rates of return; and
• Provide Bank Negara Malaysia with an effective
yardstick to assess the level of efficiency of the IBIs
16
An Alternative to KIBOR Malaysian
Approach
_ The framework comprises two main components i.e.
the calculation table and the distribution table
_ The calculation table prescribes the income and
expense items that need to be reported and sets out the
standard calculation in deriving the net distributable
income
_ The distribution table sets out the distribution of the
net distributable income posted from the calculation
table among demand, savings and general investment
deposits according to their structures, maturities and
the pre-agreed profit sharing ratios between the bank
and the depositors
9
17
An Alternative to KIBOR Malaysian
Approach
Example: Mudarabah Inter-bank Investments (MII)
_ The rate of return is based on the rate of gross profit
before distribution for investments of one year of the
investee bank
_ The profit sharing ratio is negotiable among both
parties
_ The investor bank at the time of negotiation would not
know what the return would be, as the actual return
will be crystallized towards the end of the investment
period
_ The principal invested shall be repaid at the end of the
period, together with a share of the profit arising from
the used funds by the investee bank

Islamic Inter-bank market in Pakistan –

Current scenario
• Islamic banks managing reserve requirements by high
cash reserves and low liquidity reserve
• Absence of level playing field with conventional
banks,
– unavailability Shariah compliant securities
– no lender of last resort
• Quantum requirement of Islamic inter-bank market
estimated at US$ 1- 1.5 billion
• Number of players on the increase (2 in 2001 to 16 in 2006

• Sukuks of various tenors, issued or guaranteed by

Federal Government
• Musharaka certificates (work-in-progress at SBP)
• Commodity Murabaha – short term fixed income product
(allows for interaction between Islamic and conventional
banks)
• Equity (Shares) not ideal for use in an inter-bank market
• Islamic benchmark rate should be developed (although
KIBOR can be used initially)
• Islamic rating needs to be developed

Cross-border Market
Where Pakistani Banks can invest in international Shariah
compliant securities and vice versa
• To benefit from frequent sukuk issues in the GCC market
(International Islamic Sukuk issues over US$ 8B)
• Will result in 2 way capital flow (in USD and EUR)
• However Net inflows from (capital exporting) GCC countries
will far exceed outflows into foreign issues
• Foreign currency exposures would be controlled through regulatory / risk
limits

Structure of Islamic inter-bank market

• Islamic banks should be given prime dealer roles to
avoid crowding out by stronger conventional banks
• Islamic banks should take the lead in market making
to create an actively traded secondary market
• This market will not be limited to Islamic players,
conventional banks will also actively participate if risk/return features are
attractive

Implementation
• Islamic banks must securitize exposures to enhance
the quantum and quality of the inter-bank market
• This will compel obligors to adopt good corporate
governance and seek ratings, (this will improve the
quality of the overall banking market)
• Islamic industry grouping needed to encourage
issuance of Shariah compliant government securities
• Need for a robust Islamic regulatory framework