Pricing Transactions Linked to Interest rate Benchmark

There are continuing debates on whether the spirit of Shari`ah is being violated by the practice of "benchmarking" linked interest rate benchmark such as London Interbank Offered rate (LIBOR) plus an agreed mark-up in also pricing returns on Islamic finance transactions . At a very fundamental level, the reason for the debates is the lack of understanding to clearly discern the difference between the use of LIBOR as a benchmark for pricing and the use of non-Shari’ah compliant assets as a determinant for returns.

Profit-and-Loss Sharing

While Islam employs various practices that do not involve charging or paying interest, the Islamic financial system promotes the concept of participation in a transaction backed by real assets, utilising the funds at risk on a profit-and- loss-sharing basis. Such participatory modes used by Islamic banks are known as Musharakah and Mudarabah. This by no means implies that investments with financial institutions are necessarily speculative. This can be excluded by careful investment policy, diversification of risk and prudent management by Islamic financial institutions.

Pricing Transactions Linked to Interest rate Benchmark

There are continuing debates on whether the spirit of Shari`ah is being violated by the practice of "benchmarking" linked interest rate benchmark such as London Interbank Offered rate (LIBOR) plus an agreed mark-up in also pricing returns on Islamic finance transactions . At a very fundamental level, the reason for the debates is the lack of understanding to clearly discern the difference between the use of LIBOR as a benchmark for pricing and the use of non-Shari’ah compliant assets as a determinant for returns.

However, benchmarking touches upon the integrity of Islamic Finance as a whole, and the concept of Shari’ah-compliance vs Shari’ah-based approach in particular. There are practical challenges delaying a switch to participation-based structures, such as Musharakah and Mudarabah, that require financiers to participate in the underlying asset in a financing transaction.

Islam's Approach to Ethical Investment

Given that many ethical funds have similar characteristics as Islamic funds, it is important for ethical investors attracted by the appeal of Islamic principles as well as the performance of Islamic investments to understand that there are additional prohibitions that must be applied on the products offered. These restrictions which are essentially self-imposed based on belief and conviction act a moral compass; the monitoring of the prohibitions by a Religious (Shari’ah) Supervisory Board may have prevented Islamic financial institutions to deviate from a faith-based system and absorb the shocks within the conventional financial system.
The important principles for Islamic financial instruments for participation and investments that require strict adherence, while providing good returns, are:

Status of Islamic Banking

Islamic banking is no longer a novel experiment. When the concept of Islamic banking with its ethical values was propagated, financial circles the world over treated it as a utopian dream. Having lived for centuries under the ‘valueless’ capitalist economic system, they asked what ethics had to do with finance?

Islamic Economics Order

Islamic banking is an instrument for the development of an Islamic economic order. Some of the salient features of this order may be summed up as:

1. While permitting the individual the right to seek economic well-being, Islam makes a clear distinction between what is halal (lawful) and what is haram (forbidden or unlawful) in pursuit of such economic activity. In broad terms, Islam forbids all forms of economic activity, which are morally or socially injurious.
2. While acknowledging the individual's right to ownership of wealth legitimately acquired, Islam makes it obligatory on the individual to spend his wealth judiciously and not to hoard it, keep it idle or to squander it.
3. While allowing an individual to retain any surplus wealth, Islam seeks to reduce the margin of the surplus for the well-being of the community as a whole, in particular the destitute and deprived sections of society by participation in the process of Zakat (a tax on wealth that is distributed to the needy).
4. While making allowance for the ways of human nature and yet not yielding to the consequences of its worst propensities, Islam seeks to prevent the accumulation of wealth in a few hands to the detriment of society as a whole, by its laws of inheritance.
5. Viewed as a whole, the economic system envisaged by Islam aims at social justice without inhibiting individual enterprise beyond the point where it becomes not only collectively injurious but also individually self-destructive.

Wealth and Islam

Islam has a unique dispensation on the theme of wealth, its ownership, distribution and social relationship. Islam enjoins wealth creation not for its own sake.

The theme of Islamic dispensation of wealth is treated as a deeply moral study of self and society. The true nature of wealth in Islam requires social preferences and market exchange mechanisms that are ethicised by human consciousness of the Moral Law. Islam gives precise moral injunctions as to what are, and are not acceptable kinds of wealth. They point out how individual preferences on wealth formation ought to be utilised within the social meaning.

According to Shaikh Yusuf Talal DeLorenzo, well-known and respected Shari’ah advisor and Islamic scholar as well as also author of the three volume “Compendium of Legal Opinions on the Operations of Islamic Banks” the first English reference on the fatwa (religious ruling) issued and published by the Institute, business, in the Qur'anic sense of "profitable trade" or tijarat'un rabihah is business that brings blessings to those who conduct it. Obviously, profits are important as ends, but the means by which those profits are earned are even more important. Indeed, the reason for the emphasis in the Shari’ah on proper transacting is that Islam accords great importance to the economic welfare of society.

Prohitbition of Interest

Riba best translated today as the charging of any interest, meaning money earned on the lending out of money itself. The prohibition on paying or receiving fixed interest is based on the Islamic tenet that money is only a medium of exchange, a way of defining the value of a thing; it has no value in itself, and therefore should not be allowed to give rise to more money, via fixed interest payments, simply by being put in a bank or lent to someone else. The human effort, initiative, and risk involved in a productive venture are more important than the money used to finance it.

Islamic Banking Principles

The Shari’ah prohibits the payment of charges for the renting of money (riba, which in the definition of Islamic scholars covers any excess in financial dealings, usury or interest) for specific terms, as well as investing in businesses that provide goods or services considered contrary to its principles (Haram, forbidden). While these principles were used as the basis for a flourishing economy in earlier times, it is only in the late 20th century that a number of Islamic banks were formed to apply these principles to private or semi-private commercial institutions within the Muslim community.