S3H Working Paper Series

Number 06: 2015

ALTERNATIVE TO KIBOR FOR ISLAMIC BANKING:

A CASE STUDY OF PAKISTAN

Asaad Ismail Ali

M. Zahid Siddique

September 2015

School of Social Sciences and Humanities (S3H)

National University of Sciences and Technology (NUST)

Sector H-12, Islamabad, Pakistan

S3H Working Paper Series

Faculty Editorial Committee

Dr. Zafar Mahmood (Head)

Dr. Najma Sadiq

Dr. SeharUnNisa Hassan

Dr. LubabaSadaf

Dr. Samina Naveed

Ms. Nazia Malik

S3H Working Paper Series

Number 06: 2015

ALTERNATIVE TO KIBOR FOR ISLAMIC BANKING:

A CASE STUDY OF PAKISTAN

Asaad Ismail Ali

Graduate, School of Social Sciences and Humanities, NUST

Zahid Siddique

Assistant Professor, School of Social Sciences and Humanities, NUST

September 2015

School of Social Sciences and Humanities (S3H)

National University of Sciences and Technology (NUST)

Sector H-12, Islamabad, Pakistan

iii

Contents

Abstract…………………………………………………………………………………………….v

1 Introduction………………………………………………………………………………….....1

2 Literature Review……………………………………………………………………………….2

3 Theoretical Framework…………………………………………………………………………5

4 Methodology and Results……………………………………………………………………….7

5 Conclusion……………………………………………………………………………………..20

References……………………………………………………………………………………...21

List of Tables

4.1 Illustration for the Existing Ijarah Model………………………………………….................8

4.2 Illustration for the Proposed Ijarah Model………………………………………………….10

4.3 Required Rental to Equate Profit of both Models for Different Contract Periods n………..12

4.4 Illustration for the Existing Diminishing Musharakah Model……………………………….13

4.5 Illustration for the Proposed Diminishing Musharakah Model……………………………...14

4.6 Required Rental to Equate Profit of both Models for Different Contract Periods n ……….16

4.7 Average Rental Rates………………………………………………………………………17

4.7 Average Price Index of Houses…………………………………………………………….17

4.8 Average Wages and Average Wage Increase Over the Past Years…………………………..18

4.9 Price Index and Average Price Increase/Inflation of CPI’s List of Items Financed by Islamic

Banks………………………………………………………………………………………19

APPENDIX TABLE-A: Simulations of Proposed Ijarah for n = 5……………………..…..24

APPENDIX TABLE-B: Simulations of Proposed Diminishing Musharkah for n = 10…..…25

v

Abstract

Existing practice of Islamic banking is struggling to match the theory proposed about Islamic

banking at its inception – i.e., linking the return on investment with its productivity in businesses

where it is used (i.e., the real side of economy). Profits of most of the business contracts in Islamic

banking are determined on the basis of interest rate (KIBOR or LIBOR) as benchmark which is one

of the major criticisms against Islamic banking. This study proposes alternative models for ijarah,

diminishing musharakah and murabaha by linking their profitability with prices determined in the

commodity market. The house and car prices and rental data from different sectors of Islamabad

was collected through a survey to check the feasibility of the proposed models. The results show

that the proposed models for ijarah and diminishing musharakah are also as much profitable as the

existing models whereas the proposed model for the murabaha is less profitable. The study

recommends that Islamic banks should adopt the proposed models because they are more

consistent with the theory of Islamic banking and they should avoid using interest rate benchmarks

for setting the profit rates.

Key words: Islamic banking, interest, money market.

1

1. Introduction

Islamic banking has been growing in leaps and bounds receiving response from all over the

world. There remained several issues regarding the authenticity of this system, e.g., (1) according to

some Muslim jurists, the different modes of financing used by Islamic banks are not completely in

line with Islamic law (JUIBT, 2008; Abbasi, 2013; and Saeed, 2010); (2) to some scholars, Islamic

banking system is an instrument of capitalism (Ansari, 2004); and (3) some others claim that

fractional reserve banking system is not according to the teachings of Islam and yet Islamic banks

are involved in the system (Kameel & Larbani, 2009). One of the criticisms is the use of interest rate

(LIBOR, KIBOR, etc.) by Islamic banks as bench mark for determining profit rates in different

financing modes. Usmani (2007) and (AAOIFI - Accounting and Auditing Organization for Islamic

Financial Institutions, 2004) claim that using interest rate benchmark for determining profit of a

permissible transaction is not impermissible (haram). Usmani adds that even though this measure is

permissible yet not desirable and Islamic banks as well as other financial institutions should adopt

some alternative bench mark. Saeed (2010) says that this measure is not permissible because from

Islamic point of view, money is not a commodity, hence setting profit on investment equivalent to

the rental rate links Islamic banking to money market which negates the very idea of Islamic

banking. These criticisms gave birth to the idea of creating other alternatives than interest rate for

Islamic banking.

Different alternatives for Islamic banks are proposed to determine their profit rate. Ghazali (1994)

gave a model known as “Rate of Profit Mechanism Model”, Umar (1995) presented the model

known as “Rate of Dividend of Islamic Banks Deposits and Investment Accounts Model”, Usmani

(2007) proposed the idea of “The Creation of an Inter Islamic Bank Market Based on Islamic

Principles” while Hassan (2009) proposed “A Benchmark that can fit both Islamic & Conventional

Banks”. Another idea known as “Islamic Interbank Benchmark Rate (IIBR)” was given by a group

of 16 banks working with industry associations and data provider Thomson Reuters. However,

almost all of these alternatives are based on money market measures without highlighting how they

relate to real economy. This paper presents an alternative model for Islamic banks which can help

them avoid using interest rate bench marking in most of their transactions by using commodity

market prices for setting their profit rates. This model is expected to have more compliance with the

Islamic laws and regulations, i.e., Shariah as compared to using KIBOR, as this is based on the

2

commodity market prices. Section 2 discusses the relevant literature review. Section 3 presents the

theoretical framework of the study and the proposed models. Methodology and results are discussed

in section 4 while section 5 concludes the study.

2. Literature Review

Discount rate is the rate at which the banks borrow from central bank (Phaneuf, 2005 and

Roberts, 2012). Banks usually use this rate to divert/influence the flow of money to their desired

direction. The discount rate can also refer to the interest rate used in DCF – discounted cash flow

analysis to determine the present value of future cash flows. In simple words, it is the rate at which

someone is willing to trade off today’s benefits for future. Initially, Islamic banking was conceived in

terms of profit and loss sharing modes, however later on sale and rent based financing modes were

also proposed (Khan, 1987). Islamic banks use interest rate as bench mark in sale (Murabaha) and

rent (Ijarah and diminishing Musharkah) based financing modes. In case of former, banks make profit

on spot and deferred price differential while in case of latter profit takes the form of rental amounts

charged on rented asset. In both the cases, profit and rent is set keeping in view the ongoing market

interest rate. Because discount rate is also considered riba (interest rate) by Islamic jurists, therefore,

using “discount rate” as bench mark for profit margins becomes questionable in the Islamic banking

system. Islamic banks structure their financing largely around these sale and rent based modes.

These financing modes ensure fix return to Islamic banks. According to the Islamic banking

bulletins 2010-2015 (State Bank of Pakistan), the shares of these three fixed rate financing modes in

Pakistani Islamic banking industry over the past few have remained as shown in the chart

below.Since Ijarah, diminishing Musharakah, and Murabaha (out of the fixed return based modes of

Islamic banking) are the only modes with major shares in the Islamic banking industry, the research

is focused on developing the models for these three modes.

3

Figure 2.1: Share of Different Modes in the Islamic Banking Industry

Source: SBP (2008).

Using KIBOR/LIBOR as a Benchmark

There is difference of opinion among jurists about this practice. Usmani (2007) and (AAOIFI

- Accounting and Auditing Organization for Islamic Financial Institutions, 2004) claim that using an

interest rate benchmark for determining profit of a permissible transaction is not prohibited (haram).

Usmani explains his argument through an analogy: Mr. A and Mr. B are two traders. Mr. A sells

liquor, which is prohibited, and earns a profit of say x. Mr. B being a Muslim sells only halaal drinks

say soft drinks and dislikes Mr. A’s dealing in liquor. Mr. B wants his business to earn as much profit

as Mr. A’s so he decides to sell halaal (permissible) drinks at the same profit rate, i.e., x. So Mr. B has

tied his profit with that of Mr. A’s business – which is prohibited. One may argue that Mr. B’s

benchmark for profit rate is not desirable, but no one can say that it is haram. Usmani adds that even

though this measure is permissible but not desirable and Islamic banks as well as other financial

institutions should leave this process as soon as possible.

Another opinion is that using interest rate benchmark or even something resembling the

interest rate for determining profit of any transaction is prohibited (JUIBT, 2008). This position

asserts that the restriction and non-permissibility of the use of interest in Islam is of utmost

significance and even using it as a benchmark would be the same as the use of interest itself.

Moreover, Islamic banking was meant to link the return on investment with its productivity in

2 0 1 0 2 0 1 1 2 0 1 2 2 0 1 3 2 0 1 4 2 0 1 5

42.45 43.93 39.47 39.08 30.70 27.20

13.70 11.60 10.17 8.50

8.50 7.90

2.38 2.75 0.87 3.45

9.54 11.40

30.40 31.60 36.13 33.10 34.62 35.40

0.20 0.10 0.17 0.20 0.18 0.10

10.90 9.95 13.20 15.55 16.49 17.90

PERCENT SHARE

Murabaha Ijarah Musharakah Diminishing Musharakah Mudaraba Others

4

commodity markets. Because money is not considered a commodity like any other and charging

profit on money is deemed riba by Islamic jurists, hence, linking the profit rates of investment and

financing of Islamic banks with the interest rate cannot be justified because it negates the very

theory of Islamic banking.

Scholars have suggested a number of alternative bench marks of KIBOR. Ghazali (1994) gave

a model known as “Rate of Profit Mechanism Model”. This model suggests that a rate for Islamic

banks should be set by predicting the rate of profits of the money market and using that as a

measure for rate of return instead of the conventional banking systems’ rate. But there has been

some criticism on this model that what would be the concept of profit. Would it be from a particular

project or a group of projects or many groups of projects? The best way was to take the profits of

the whole economy. But this idea isn’t enough as it requires extensive research and more

information on the subject to make it even possible to work. Umar (1995) presented the model

known as “Rate of Dividend of Islamic Banks Deposits and Investment Accounts Model”. This

model gave the idea that a benchmark can be set for Islamic banks through the dividends that

Islamic banks give to their depositors. A rate of profit would be set or defined, instead of an interest

rate, through a mathematical index. Usmani (2007) came up with the idea of “The Creation of an

Inter Islamic Bank Market Based on Islamic Principles”. The idea proposed was to create a common

pool which would invest in asset backed instruments. This pool would consist of items which would

actually be assets like a property or a car etc. Later these assets can be sold or purchased as per

banks’ desire for liquidity purposes and for setting an interest free market for the banks. The profits

would in this case be determined on the current net value of the assets at the time of selling. Hassan

(2009) gave an idea “A Benchmark that can fit both Islamic & Conventional Banks”. He first

explained the process of Overnight Policy Rate (OPR) to determine the interest rate for a bank. The

OPR is determined by Bank Negara Malaysia (BNM). Based on OPR, different banks set their

different interest rates accordingly. Additionally, the OPR is based on some of the elements that are

not compatible with Shariah. The idea proposes that a new OPR be formed by doing an in depth

study on the market realities. This newly formed OPR would be based on real supply and demand in

the market and hence would be compatible with Shariah. Another idea known as “Islamic Interbank

Benchmark Rate (IIBR)” was given by a group of 16 banks working with industry associations and

data provider Thomson Reuters. The idea was to collect the different rates the Islamic branches of

conventional banks were offering and set a rate through a mechanism known as “fixing”, i.e., to

5

remove the top and the bottom rates and then taking an average of the middle 8 rates and setting

that as a final rate for the Islamic banks. This idea is based on forecasting the returns on banks’

receivables and using it as bench mark instead of interest.

None of these alternative models are currently operational. Additionally almost all of the

models are financial/money market based and not directly linked with the commodity/production

side of economy. Recently, after realizing the need, State Bank of Pakistan has given a strategic plan

for Islamic Banking Industry of Pakistan (2014 – 2018) in which it has asserted the need to link

Islamic modes of finance with market based profit rates. No specific model has been proposed by

SBP in this regard. This paper attempts to present such models for Murabaha, Ijarah and diminishing

Musharkah which are commodity market based.

3. Theoretical Framework

Conventional banks provide loan at interest irrespective of whether client needs it for car, house

or commodity. On the other hand, Islamic banks have multiple contracts to satisfy customers’

needs. Ijarah contracts is used for assets especially car financing, Murabaha for commodity financing

and diminishing Musharkah for financing house. The detail of how different banking systems work for

different kinds of loans is given below.

a) Ijarah Model

Ijarah means sale of usufruct, commonly known as leasing. Islamic banks buy the underlying

asset and rent it out to the client at a pre-determined rental rate for a specified time. The rent is set

such that Islamic bank gets back investment on asset plus a certain amount of profit. At the end of

the contract the product’s ownership is transferred to the client (either by gift or sale at depreciated

value).Bank does a contract with the client for a fixed period of time in which bank leases an item

(e.g., car) to the client. The client chooses the vender and the asset. Vendor delivers the asset to the

client. Bank pays price to the vendor and gets delivery. The item remains in possession of the client

and he continues to pays periodic rent to the bank for using the asset. At the end of the contract, the

asset reverts back to the bank, which the bank then transfers to the client through a gift or sale

(Obaidullah, 2005). The rate of rent/profit of the bank in this case is decided using KIBOR as a

6

bench mark, e.g., the rate of rent/profit rate is KIBOR + 3% per annum for Meezan Bank of

Pakistan (Meezan Bank Limited, 2015).

The Proposed Model

Bank and client enter into Ijarah contract for say 5 years in which bank buys a car on behalf

of the client. The car will be in the possession of the client and client will pay the market rent (not

KIBOR) of the car. At the end of each year, the car’s (depreciated) value will be reassessed and the

new rent will be defined on the basis of this depreciated value. Bank will transfer the ownership of

the car to the client at the end of the contract period through a sale at depreciated value of car. The

depreciated value of car at the end-of-contract-period may be distributed equally across payment

period for the ease of customer (example will illustrate the idea). The rate of rent/profit of the bank

in this case is determined on the basis of rental rates of the car.

b) Diminishing Musharakah Model

Diminishing Musharakah is a kind of technique in which bank and client participate in a joint

ownership of a product, usually land or house. Bank purchases the property on behalf of

Musharakah. Client takes the property on lease from the bank. The property generates rental income

for the bank where rents is usually determined around KIBOR. The share of bank is divided into

different number of units which the client purchases periodically. When the transfer of the shares is

completed, bank transfers the ownership to the client.

The Proposed Model

Bank will form a partnership with the client of a property say bank pays 80% and the client

20% with a 5 year contract. The customer will pay rent for the share owned by the bank i.e. 80% and

an additional amount for transfer of shares. At the end of each year, the property’s value will be

reassessed (by historical data of house price index gathered through market surveys) and the new

rent as well as additional amount (if house price appreciates) for transfer will be redefined according

to re-assessed value. At the end of the period of contract, the client will have the ownership. The

rate of rent/profit of the bank in this case is decided using market prices (house prices and rental

data) as benchmark. Hence, while in the prevailing model bank’s profit depends only on rental

7

payment, it depends upon rental payment as well as house prices in the proposed model. Moreover,

this model links the bank’s investment with risk associated with housing market prices.

c) Murabaha Model

Murabahais a sale contract in which the seller announces his cost as well as his profit at the

time of the contract. This type of financing technique is used by the Islamic banks as a contract with

their clients wherein the bank purchases a particular item and sells it to its client at a declared profit

at deferred price. The payment from the client to the bank is usually in installments. Murabaha

contracts are generally used for durable and fixed assets. The rate/profit of the bank in this case is

decided using KIBOR as a benchmark. The rate/profit rate is KIBOR + 3% per annum (Meezan

Bank Limited, 2015).

The Proposed Model

Bank and client will do Murabaha contract in which bank will buy an item, sell it to the client

at a higher deferred price. Here, the difference between spot and future price will be determined

through price index calculated on items financed by the Islamic bank. The asset will remain in the

possession of the client. The client will pay the bank the cost + profit in installments. The

rate/profit of the bank in this case is decided using market prices (e.g., CPI) as a benchmark.

4. Methodology and Results

This section explains the working methodology of each proposed model. It explains how

these models would function and how to develop their financial feasibility criterion (i.e. whether

they will be profitable for Islamic banks to adopt or not). We have checked the feasibility of these

models using car, house and several fixed asset price data for Islamabad city.

a) Ijarah Model

The annuity of the total amount paid by the client in the existing Ijarah model of Islamic

banking is calculated through standard annuity formula:

(

) … (1)

8

where,

Ai Annual paymentbased on interest rate

P Principal Amount (of the car)

i Interest rate/KIBOR rate + 3%

n Number of years of the contract

For example, if a client wants to buy a car worth Rs.1 Million in the market through Islamic bank for

a 5 year contract at 10% market interest rate, the cash flow and payment schedule will look like as

shown in Table 4.1 (for simplicity we have considered annual payment and not monthly). With

KIBOR + 3% (i.e., i), the rental amount of each year of the contract will be i*C (rental rate

multiplied by the remaining balance of capital in each year). Ai is the annuity calculated through

formula (1) which shows the total annual payment the client will have to pay. It gives the annual

payment that would consist of an amount of capital as well as the interest for each year to recover

the total capital and the interest at the end of the contract. CR shows the capital recovered by the

bank in each year {it is the difference between the annuity (Ai) and the rental rate (i*C)}.

Table 4.1: Illustration for the Existing Ijarah Model

1 2 3 4 = 2*3 5 6 = 5 - 4 7 = 3 – 6

t i P i*P Ai CR RBC

0 1000000 1000000

1 0.10 1000000.00 100000.00 263,797.48 163797.48 836202.52

2 0.10 836202.52 83620.25 263,797.48 180177.23 656025.29

3 0.10 656025.29 65602.53 263,797.48 198194.95 457830.34

4 0.10 457830.34 45783.03 263,797.48 218014.45 239815.89

5 0.10 239815.89 23981.59 263,797.48 239815.89 0.00

TOTAL 318,987.40 1,318,987.40 1,000,000

Source: Authors’ self-generated illustration.

9

where,

t Time Period (Number of years)

P Capital/Principal amount at the start of each period

RBC Left over or remaining balance of capital at the end of each period

The left over balance (RBC) at the end of for example year one is Rs.836202.52. At the end of the

contract the total recovered capital is 1 million, i.e., the loan/initial capital (the value of the car). The

remaining capital in the final year of the contract becomes zero. The total revenue of the bank at the

end of the contract is Rs.1318987.40. Deducting the amount of the loan gives the profit earned by

the bank, i.e., Rs.318987.40.

Calculation for the Proposed Model of Ijarah

The cash flow for the Islamic banks in the proposed Ijarah model will be calculated by

considering market rental rate of the car and its depreciated value after each year. Table 4.2 gives the

illustration. For comparison purpose, value of the car is again assumed to be Rs.1 million, number of

years to be 5 and 10% market rental rate. With 10% rental rate (r), the rental payment of each year

will be r*C (profit rate multiplied by the total/remaining capital of each year).d is the average

depreciation rate of the car which is 5% in this example. The car’s value will be evaluated each year

after discounting for depreciation rated. At the end of contract, the salvage value of car (or RBC) is

Rs.773780.94 at 5%. This bank can recover this capital from its customer by distributing it equally

across the contract period. In this example, bank divides this amount in five equal payments of

Rs.154756.19 (shown in CR column). Thus, CR is car’s depreciated value at the end of the contract

period divided equally across the period. Ar is the annual payment that the client is supposed to pay

each year (average rental rate + the amount for the transfer of ownership, i.e., r*C + CR). RBC

shows the remaining balance of capital at the end of each year after adjusting for depreciation. The

total revenue of the bank at the end of the contract is Rs.1203597.16 (given by the sum of Ar).

Deducting the amount of the loan/initial capital gives the profit earned by the bank i.e.

Rs.203597.16. In other words, the bank is earning money the profit on car through by using market

rental rate as a benchmark and will give the car to the client at its depreciated value after the

completion of the contract.

10

Table 4.2: Illustration for the Proposed Ijarah Model.

Source: Authors’ self-generated illustration.

where,

r Average Rental Rate (of the cars)

d Average Depreciation Rate (of the car)

Ar Annuity based on market rent

By comparing the total profit earned through the existing model (Rs.318987.40) and the proposed

models (Rs.203597.16), we can see that when r is equal to i, i.e. the rental rate of the existing model

is equal to the rental rate of the proposed model, the profit in the proposed model is less than the

existing model. It is because d (depreciation rate of the car) is also incorporated in the proposed

model. For the proposed model to be as feasible as the existing one, we need to find the rental rate

(r*) that would equate the sum of amount earned (annuities) in both the models. It should be noted

that the amount earned of Islamic bank in the existing model depends upon i while in our model it

depends upon r and d. One may be tempted to conclude that this r can be calculated by simply

taking the difference between i and d (as i seems to equal r plus d), however the required rental rate

cannot directly be derived by the difference of i and d (to be discussed below). The simulation has

been performed for different values of n (number of years or duration of contract) with different

interest rates (i), market rental rates (r), and car depreciation rates (d). This simulation is performed

1 2 3 4 5 = 2*4 6 7 = 5+6 8 = 4

t r d P R*P CR Ar RBC

0 1000000.00 1000000.00

1 0.10 0.05 950000.00 95000.00 154756.19 249756.19 950000.00

2 0.10 0.05 902500.00 90250.00 154756.19 245006.19 902500.00

3 0.10 0.05 857375.00 85737.50 154756.19 240493.69 857375.00

4 0.10 0.05 814506.25 81450.63 154756.19 236206.81 814506.25

5 0.10 0.05 773780.94 77378.09 154756.19 232134.28 773780.94

Total 429816.22 773780.94 1203597.16

11

to find (r*) for each given n, i and d. The simulation tables have been constructed keeping in view

the following different observations:

n: The banks usually offer car financing contracts to their clients for 2 years, 3 years, 4 years

or 5 years. The simulation tables have been created for all of the mentioned number of years.

i: Historical data of the past 10 years of KIBOR in Pakistan shows that it has varied between

5 to 13 percent. Therefore, the table has incorporated interest rate values from 5% to 15%.

d: Usually the depreciation rate of the car is around 20% in the first year and then it lowers

down to 15% to 10% over the years (Stefanac, 2014). Appendix Table-A incorporates

different depreciation rates from 1% to 50%.

Keeping in view the above two illustrations, the simulation tables for each value of n, d, and i are

created.The tables show the rental rate at which the difference of the revenues of the existing and

the proposed models will become zero, i.e.,

∑ ∑

where,

Ar*d Annual payment in the Proposed Model

Ai Annuity of the Existing Model

One of such detailed simulation table is given in Appendix A for five year contract. Summary of

these tables is given in Table 4.3. The value 0.1553, for example, against d = 10 and i = 5 shows the

required market rental rate of car (r*) to make the profit of Islamic bank equal in both payment

streams. Thus, if going interest rate is 0.05 and depreciation rate is 0.10, then annual market rent of

car must be 0.1553 for proposed model to be as good as the existing one in terms of profitability.

To check the feasibility of above listed Ijarah model, car prices and rental data is acquired

through a survey in Islamabad. The data of all the cars generally available for rent in Islamabad have

been captured through this survey. Relevant data for several types of cars (Toyota Corolla, Toyota

Hilux, Honda Civic, Honda City, Suzuki Mehran, Suzuki Cultus, Suzuki Vitz, etc.) are collected.

12

Table 4.3: Required Rental to Equate Profit of both Models for Different Contract Periods n

n = 2

n = 3

i

i

d 5 10 15

d 5 10 15

1 0.0485 0.0874 0.1270

1 0.0447 0.0803 0.1169

10 0.1553 0.2002 0.2458

10 0.1528 0.1957 0.2398

20 0.3025 0.3558 0.4099

20 0.3021 0.3557 0.4108

30 0.4921 0.5566 0.6220

30 0.4949 0.5632 0.6334

40 0.7454 0.8254 0.9065

40 0.7531 0.8421 0.9336

n = 4

n = 5

i

i

d 5 10 15

d 5 10 15

1 0.0429 0.0772 0.1129

1 0.0420 0.0758 0.1114

10 0.1525 0.1957 0.2407

10 0.1531 0.1977 0.2445

20 0.3042 0.3609 0.4198

20 0.3076 0.3686 0.4328

30 0.5008 0.5763 0.6548

30 0.5084 0.5929 0.6818

40 0.7647 0.8673 0.9739

40 0.7786 0.8973 -

Source: Authors’ generated values.

The yearly average rental rate of different cars in Islamabad is calculated to be 40.694%. Data reveal

that a car remains out of rent for almost 8 days a month (roughly 25%), so the yearly average is

calculated for 9 month (because Islamic banks give car for whole year). Comparing this value to the

simulation table for an average depreciation rate, i.e., 15% and the average KIBOR (for the past ten

years) i.e. 13% gives us the following rates:

31.02% for a five year contract

30.38% for a four year contract

30.02% for a three year contract

30.30% for a two year contract

This shows that the proposed Ijarah model will be more profitable than the existing Ijarah model in

Islamabad with an average depreciation rate 15% and prevailing KIBOR +3%.Note that these

simulation tables can be used for any country or city. The data of any city can be oriented with these

simulated tables to check the feasibility of Islamic banks in those particular areas.

13

b) Diminishing Mushrakah

The following illustration shows how the existing model of Islamic banks calculates its profit

and revenues under a diminishing Musharakah contract, say for 5 years at 10% interest rate for

amount financed equal to Rs.5 million.

Table 4.4: Illustration for the Existing Diminishing Musharakah Model

1 2 3 4=2*3 5 6=5+4 7=3-5

t I P i*P CR Ai RBC

0 5000000 5000000

1 0.10 5000000 500000 1000000 1500000 4000000

2 0.10 4000000 400000 1000000 1400000 3000000

3 0.10 3000000 300000 1000000 1300000 2000000

4 0.10 2000000 200000 1000000 1200000 1000000

5 0.10 1000000 100000 1000000 1100000 0.00

Total 1500000 5000000 6500000 Source: Authors’ self-generated illustration.

The rental amount of each year of the contract will be i*C (rental rate multiplied by the total

remaining capital of each year). CR shows the capital recovered by the bank in each year (it is the

total capital divided by the number of years of the contract for each year). Ai is the annuity which

shows the total annual payment the client will have to pay (i*C + CR). It gives the annual payment

that would consist of an amount of capital as well as the interest for each year to recover the total

capital and the interest at the end of the contract. The left over balance (RBC) at the end of for

example year one is Rs.4000000. At the end of the contract the total recovered capital is Rs.5

million, i.e. the loan/initial capital (the value of the house). The remaining capital in the final year of

the contract becomes zero. The total revenue of the bank at the end of the contract is Rs.6500000.

Deducting the amount of the loan/capital gives the profit earned by the bank i.e. Rs.1500000.

14

Calculation for the Proposed Model of DM

The cash flow and profit for the Islamic banks in the proposed diminishing Musharakah

model will be determined by two components: the market rental rate of the house and the house’s

(appreciated) value each year. The following illustration shows it for r equal to 10% and g (growth

rate of house prices) 5%.

Table 4.5: Illustration for the Proposed Diminishing MusharakahModel

1 2 3 4 5=2*4 6 7 8

t r G P r*P CR Ar RBC

0 5000000

1 0.10 0.05 5250000.0 525000.0 1050000.0 1575000.0 4200000.0

2 0.10 0.05 4410000.0 441000.0 1102500.0 1543500.0 3307500.0

3 0.10 0.05 3472875.0 347287.5 1157625.0 1504912.5 2315250.0

4 0.10 0.05 2431012.5 243101.3 1215506.3 1458607.5 1215506.3

5 0.10 0.05 1276281.6 127628.2 1276281.6 1403909.7 0.0

Total 1684016.9 5801912.81 7485929.7 Source: Authors’ self-generated illustration.

With the average rental rate/profit rate (r) – which will be calculated through the data collected by

the survey of different houses in Islamabad – the profit of each year of the contract will be r*P

(profit rate multiplied by the total/remaining capital of each year). The house value will be evaluated

each year after accounting for appreciation rate g (0.05 in this example). At the end of contract, the

salvage value of house (or RBC) becomes zero. Ar is the annual payment that the client is supposed

to pay each year (average rental rate + the amount for the transfer of ownership i.e., r*P + CR).

RBC shows the remaining capital value each year after appreciation. The total revenue of the bank at

the end of the contract is Rs.7485929.7 (given by the sum of Ar). Deducting the amount of the

loan/initial capital gives the profit earned by the bank, i.e., Rs.2485929. By comparing the total

profit earned through the existing model (Rs.1500000) and the proposed models (Rs.2485929.7), we

can see that when r is equal to i, and g is positive, the profit in the proposed model is more than the

15

existing model. It is because g (appreciation rate of the house) is also incorporated in the proposed

model. For the proposed model to be as feasible as the existing one, we need to find that rental rate

(r*) that would equate the sum of amount earned (annuities) in both the models. It should be noted

that the amount earned by Islamic bank in the conventional/existing model depends upon i while in

our model it depends upon r and g. One may be tempted to conclude that this r can be calculated by

simply taking the sum between i and g (as i seems to equal r minus g); however, the required rental

rate cannot directly be derived by the difference of i and g (to be discussed below). A comparison of

the two different models is not possible directly. So the comparison is carried out by creating

simulations to find r*. The simulation has been performed for different values of n (number of years

or duration of contract) with different interest rates (i), market rental rates (r) and house appreciation

rates (g). The simulation tables have been constructed keeping in view the followings:

n: The banks usually offer house financing contracts to their clients for 2 to 25 years. The

simulation tables have been created for all of these numbers of years.

i: Same as above in Ijarah model.

g: May be negative, but usually takes positive value on average. The table will incorporate

different appreciation rates ranging from 1 to 15.

Simulation tables for each value of n, g, and i are created such that the difference of the profit of the

existing and the proposed models will become zero adjusting the values of rat given i and g, . i.e.,

∑ ∑

where,

Ar*g Annual payment in the Proposed Model

Ai Annual payment in the Existing Model

The simulation tables created by this methodology are universal as well. One of the detailed tables of

the simulations derived for the diminishing Musharakah model is shown in Appendix Table-B. The

simulations have shown that:

16

If g > i ⇒ πp > πe

If g < i ⇒ πp ⋚ πe

i.e., whenever the growth/appreciation rate of the house price (g) is greater than the interest rate (i),

the profit of the proposed model (πp) will be more than the profit of the existing model (πe)

regardless of the rate of rent. But when the growth/appreciation rate of the house is less than the

interest rate, the profit of the proposed model can be less than, equal to or greater than the profit of

the existing model depending upon the rate of the rent. A summary of the tables is as follows:

Table 4.6: Required Rental to Equate Profit of both Models for Different Contract Periods n

n = 5

n = 10

i

i

g 5 10 15

g 5 10 15

1 0.0389 0.0878 0.1366

1 0.0381 0.0862 0.1342

5 - 0.0415 0.0860

5 - 0.0341 0.0749

10 - - 0.0283

10 - - 0.0087

n = 15

n = 20

i

i

g 5 10 15

g 5 10 15

1 0.0373 0.0846 0.1318

1 0.0365 0.0830 0.1294

5 - 0.0270 0.0643

5 - 0.0203 0.0543

Source: Authors’ generated values.

These tables show the rental rates for different values of i and g at which the difference between the

profits of the existing and the proposed models is zero for different length of contracts (n). The

illustration of the existing model of diminishing Musharakah shows that the current design of the

Islamic banking system is such that the main focus is on recovering the capital/loan paid to the

client by the bank whereas the illustration of the proposed model reveals that it is essentially a profit

and loss sharing model. If the price of the property goes up, the bank will share the profits of the

appreciation just like a partner would (of its share of the property owned).

To check the feasibility of the proposed diminishing Musharakah model, data of house prices

and rentals was collected from different sectors (E11, F8, F10, F11, G9, G10, G11, I9, I10) of

17

Islamabad through a survey. For simplicity, average of the whole city of Islamabad is taken to check

the feasibility of the proposed diminishing Musharakah model. Following tables show the average

rent percentages and the price index of Islamabad for the past five years (calculated through the

actual market rental and prices data of different houses in Islamabad) that will be compared with the

simulation tables created through illustrations:

Table 4.7(a): Average Rental Rates Table 4.7(b): Average Price Index of Houses

ISLAMABAD

ISLAMABAD

2011 4.49%

RENT PRICE

2011 1.00 1.00

2012 4.55%

2012 1.10 1.08

2013 4.55%

2013 1.24 1.21

2014 4.49%

2014 1.36 1.33

2015 4.52%

2015 1.56 1.53

Average

4.520%

Average Increase 0.12 0.11

Source: Survey Conducted.

Table 4.7(a) shows the average rental rates of the past five years and Table 4.7 (b) shows the average

price index for the past 5 years in Islamabad. The yearly average rental rate of houses in Islamabad is

4.52%. Comparing this value to the simulation table for an average appreciation rate, i.e.,11% and

the average interest rate (of the last ten years) 13% gives us a rental rate of 0.19% for the proposed

model to be as or more profitable as the existing model. Since the yearly average rental rate of

houses in Islamabad is 4.52%, which is more than 0.19%, it is concluded that the profit of the

proposed model will be more than the existing model of Islamic banks in Islamabad.

Incorporating house price increase in the model raises the question about feasibility of the

proposed model from client’s point of view. If house prices increase by more than nominal wages,

the default risk would increase. Thus, we compare the average wage increase per year with that of

house prices. Table 4.8 shows the data for wages over the past years.

18

Table 4.8: Average Wages and Average Wage Increase Over the Past Years

Year Average Monthly

Wages (Rs)

Average Yearly

Wages (Rs)

Index Percentage

Increase

2006 4994 59928 1

2007 5768 69216 1.154986 0.154985983

2008 6612 79344 1.323989 0.146324549

2009 7635 91620 1.528835 0.154718693

2010 8623 103476 1.726672 0.12940406

2011 9715 116580 1.945334 0.126638061

Average 0.142414269

Source: ILO (2014).

The data show that average wage increase in Pakistan from 2006 to 2011has been around 14%. The

average appreciation rate of the house was calculated to be around 11% (Table 4.9). Therefore, it

can be concluded that because the average wage increase is more than the average appreciation rate

of the houses in Islamabad, the default risk associated with house price increase is minimal in

Pakistan.

c) Murabaha Model

The existing Murabaha model of Islamic banking uses KIBOR to determine its profit rates.

The proposed model determines the profit rates through CPI prices data (base: year 2008 – 2009)

from 2008 to 2014. There can be three different ways to link the profit rates of this model to the

CPI prices list instead of KIBOR:

a) Overall CPI: Using the average inflation rate/average rate of price increase as the benchmark for

setting the profit rate of the complete list of items given in the CPI prices data. The little issue

with this measure is that CPI list includes many food items as well as items that are not financed

by Islamic banks

b) Basket Specific CPI: Using specific inflation of those commodities that are financed by Islamic

banks. If data of all items financed Islamic banks is available, this basket specific CPI can be

calculated and then used as bench mark for all goods. The following variables from CPI’s list of

19

items are chosen to construct a basket specific price index: Refrigerator, D-Freezer, Air

Conditioner, Split AC, Air Cooler, Washing Machine, Geyser, Gas Burner.

c) Commodity Specific CPI: Using the average inflation rate of the specific item to be financed by

Islamic banks. The benefit of using this measure is that the profit rate calculated through this

measure can be used for all of the items financed by Islamic banks even those that are not

available in the CPI list of items.

Table 4.9: Price Index and Average Price Increase/Inflation of CPI’s List of Items Financed by Islamic Banks

Source: CPI Prices Data (2008 to 2014), Pakistan Bureau of Statistics.

The data of daily (1 year) KIBOR from May 2004 to June 2015 has been taken to compare the profit

rates of the proposed model with the existing model (KIBOR data from 2004 to 2015 has been

taken from PKRV Reuters through Alfalah Bank). The average CPI between 2008-14 remained

9.51%.This profit rate is less than the average KIBOR +3% of the past 10 years 13.63%. Same holds

for basket specific inflation (6.58%) as well as commodity specific inflation rates (which are all less

than 13.63%) as shown in Table 4.9.

Product 2008 2009 2010 2011 2012 2013 Averages

REFG. DAWLENCE 10 CFT. D.DOOR

1.00 1.05 1.11 1.21 1.32 1.37 6.54%

D-FREEZERWAVES 8 cft.

1.00 1.10 1.17 1.31 1.43 1.47 8.10%

AIRCONDITIONER 1.5 TON PEL

1.00 1.11 1.19 1.35 1.44 1.46 7.95%

SPLIT AIR CONDITIONER 1.5 TON

1.00 1.10 1.18 1.29 1.36 1.38 6.73%

AIRCOOLER SUPER ASIA

1.00 1.01 1.06 1.15 1.25 1.28 5.13%

WASHING MACHINE SINGER

1.00 1.21 1.09 1.10 1.10 1.12 2.78%

GIZER LARGE SIZE 30 GALLON CAPACITY

1.00 1.06 1.10 1.22 1.37 1.45 7.80%

GAS BURNER DOUBLE SPFY.BRAND

1.00 1.06 1.13 1.24 1.39 1.44 7.59%

20

5. Conclusion

Prevailing statistics of Islamic banking shows that it has been growing in leaps and bounds.

Governments all over the world including Pakistan’s have welcomed the idea of Islamic banking

with open arms. Despite the current response and growth of Islamic banking, there has been many

issues and controversies regarding the Islamic bank’s being Islamic. One of such controversial and

important issues with the current Islamic banking system has been the use of interest rate bench

marking which goes against the basic ideology of Islamic banking. Using this bench marking for

determining the profit and rental rates is considered undesirable even by those who consider it

permissible.

This study has proposed an alternative method of determining profit and rents. These

models are commodity production/trade based and use market prices for the determination of

profit rates instead of KIBOR or LIBOR. The paper devised a methodology to develop feasibility

criterion which can be used to compare the existing and proposed models. The results of the study

have shown that the proposed models for Murabaha will not be as profitable as the existing models

used by Islamic banks in Pakistan. On the other hand, the proposed Ijarah and diminishing

Musharakah models are more profitable than the existing models. These proposed models are based

on the basic ideology of Islamic banking proposed at the start of Islamic banking that the profit

rates should be linked with the commodity markets rather than financial market. Therefore, it will be

rather appropriate for Islamic banks to adopt these proposed models instead of the existing

practices. The study recommends that the data of car rental rates and house prices should be

gathered annually country wide by Islamic banks to undertake these contracts with their customers.

The study also recommends that even if the profit of some of the proposed models comes out to be

less than the existing models, Islamic banks should adopt the proposed models because they are

more consistent with the theory of Islamic banking and they should avoid using interest rate

benchmark for setting the profit rates.

21

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24

APPENDIX TABLE-A: Simulations of Proposed Ijarah for n = 5

n = 5

I

d 5 6 7 8 9 10 11 12 13 14 15

1 0.0420 0.0486 0.0553 0.0621 0.0689 0.0758 0.0828 0.0899 0.0970 0.1042 0.1114

2 0.0533 0.0601 0.0670 0.0740 0.0810 0.0882 0.0954 0.1026 0.1100 0.1174 0.1248

3 0.0648 0.0719 0.0790 0.0862 0.0934 0.1008 0.1082 0.1157 0.1232 0.1309 0.1386

4 0.0766 0.0839 0.0912 0.0986 0.1061 0.1137 0.1213 0.1290 0.1368 0.1447 0.1526

5 0.0887 0.0961 0.1037 0.1113 0.1190 0.1268 0.1347 0.1427 0.1507 0.1588 0.1670

6 0.1010 0.1087 0.1165 0.1243 0.1323 0.1403 0.1485 0.1567 0.1650 0.1733 0.1817

7 0.1136 0.1215 0.1295 0.1377 0.1459 0.1542 0.1625 0.1710 0.1795 0.1882 0.1969

8 0.1265 0.1346 0.1429 0.1513 0.1598 0.1683 0.1770 0.1857 0.1945 0.2034 0.2123

9 0.1396 0.1481 0.1566 0.1653 0.1740 0.1828 0.1917 0.2007 0.2098 0.2190 0.2282

10 0.1531 0.1618 0.1707 0.1796 0.1886 0.1977 0.2068 0.2161 0.2255 0.2349 0.2445

11 0.1669 0.1759 0.1850 0.1942 0.2035 0.2129 0.2224 0.2319 0.2416 0.2513 0.2612

12 0.1811 0.1904 0.1997 0.2092 0.2188 0.2285 0.2382 0.2481 0.2581 0.2682 0.2783

13 0.1956 0.2051 0.2148 0.2246 0.2345 0.2445 0.2545 0.2647 0.2750 0.2854 0.2959

14 0.2104 0.2203 0.2303 0.2403 0.2505 0.2608 0.2713 0.2818 0.2924 0.3031 0.3139

15 0.2256 0.2358 0.2461 0.2565 0.2670 0.2777 0.2884 0.2993 0.3102 0.3213 0.3324

16 0.2412 0.2517 0.2623 0.2731 0.2839 0.2949 0.3060 0.3172 0.3285 0.3399 0.3514

17 0.2572 0.2680 0.2790 0.2901 0.3013 0.3126 0.3241 0.3356 0.3473 0.3591 0.3709

18 0.2735 0.2847 0.2961 0.3075 0.3191 0.3308 0.3426 0.3545 0.3666 0.3787 0.3910

19 0.2903 0.3019 0.3136 0.3254 0.3374 0.3494 0.3616 0.3740 0.3864 0.3989 0.4116

20 0.3076 0.3195 0.3316 0.3438 0.3561 0.3686 0.3812 0.3939 0.4068 0.4197 0.4328

21 0.3253 0.3376 0.3501 0.3627 0.3754 0.3883 0.4013 0.4144 0.4277 0.4411 0.4546

22 0.3435 0.3562 0.3691 0.3821 0.3952 0.4085 0.4220 0.4355 0.4492 0.4630 0.4770

23 0.3621 0.3753 0.3886 0.4020 0.4156 0.4293 0.4432 0.4572 0.4714 0.4856 0.5000

24 0.3813 0.3949 0.4086 0.4225 0.4366 0.4507 0.4651 0.4795 0.4941 0.5089 0.5238

25 0.4010 0.4151 0.4292 0.4436 0.4581 0.4727 0.4875 0.5025 0.5176 0.5328 0.5482

26 0.4213 0.4358 0.4504 0.4653 0.4803 0.4954 0.5107 0.5261 0.5417 0.5574 0.5733

27 0.4421 0.4571 0.4723 0.4876 0.5031 0.5187 0.5345 0.5505 0.5666 0.5828 0.5992

28 0.4636 0.4790 0.4947 0.5105 0.5265 0.5427 0.5590 0.5755 0.5922 0.6090 0.6259

29 0.4856 0.5016 0.5178 0.5342 0.5507 0.5674 0.5843 0.6013 0.6185 0.6359 0.6534

30 0.5084 0.5249 0.5416 0.5585 0.5756 0.5929 0.6103 0.6280 0.6457 0.6637 0.6818

31 0.5318 0.5489 0.5661 0.5836 0.6013 0.6192 0.6372 0.6554 0.6738 0.6924 0.7111

32 0.5559 0.5735 0.5914 0.6095 0.6278 0.6462 0.6649 0.6837 0.7027 0.7219 0.7413

33 0.5807 0.5990 0.6175 0.6362 0.6551 0.6742 0.6935 0.7129 0.7326 0.7524 0.7724

34 0.6064 0.6253 0.6444 0.6637 0.6833 0.7030 0.7229 0.7431 0.7634 0.7839 0.8046

35 0.6328 0.6524 0.6721 0.6921 0.7123 0.7328 0.7534 0.7742 0.7953 0.8165 0.8379

36 0.6601 0.6803 0.7008 0.7215 0.7424 0.7635 0.7849 0.8064 0.8282 0.8501 0.8723

37 0.6883 0.7092 0.7304 0.7518 0.7734 0.7953 0.8174 0.8397 0.8622 0.8849 0.9078

38 0.7174 0.7391 0.7610 0.7831 0.8055 0.8281 0.8510 0.8741 0.8973 0.9209 0.9446

39 0.7475 0.7699 0.7926 0.8155 0.8387 0.8621 0.8857 0.9096 0.9337 0.9581 0.9826

40 0.7786 0.8018 0.8253 0.8490 0.8730 0.8973 0.9217 0.9465 0.9714 0.9966 -

41 0.8108 0.8349 0.8592 0.8837 0.9086 0.9337 0.9590 0.9846 - - -

42 0.8442 0.8691 0.8942 0.9197 0.9454 0.9714 0.9976 - - - -

43 0.8787 0.9045 0.9305 0.9569 0.9835 - - - - - -

44 0.9145 0.9412 0.9682 0.9955 - - - - - - -

45 0.9516 0.9793 - - - - - - - - -

25

46 0.9901 - - - - - - - - - -

47 - - - - - - - - - - -

48 - - - - - - - - - - -

49 - - - - - - - - - - -

50 - - - - - - - - - - -

APPENDIX TABLE-B: Simulations of Proposed Diminishing Musharkah for n = 10

n = 10

I

g 5 6 7 8 9 10 11 12 13 14 15

1 0.0381 0.0477 0.0573 0.0670 0.0766 0.0862 0.0958 0.1054 0.1150 0.1246 0.1342

2 0.0265 0.0358 0.0450 0.0542 0.0634 0.0727 0.0819 0.0911 0.1003 0.1096 0.1188

3 0.0152 0.0240 0.0329 0.0418 0.0506 0.0595 0.0683 0.0772 0.0861 0.0949 0.1038

4 0.0041 0.0126 0.0211 0.0296 0.0381 0.0466 0.0551 0.0636 0.0721 0.0807 0.0892

5 - 0.0014 0.0096 0.0177 0.0259 0.0341 0.0422 0.0504 0.0586 0.0667 0.0749

6 - - - 0.0061 0.0139 0.0218 0.0296 0.0375 0.0453 0.0531 0.0610

7 - - - - 0.0023 0.0098 0.0173 0.0248 0.0324 0.0399 0.0474

8 - - - - - - 0.0053 0.0125 0.0197 0.0270 0.0342

9 - - - - - - - - 0.0074 0.0143 0.0213

10 - - - - - - - - - 0.0020 0.0087

11 - - - - - - - - - - -

12 - - - - - - - - - - -

13 - - - - - - - - - - -

14 - - - - - - - - - - -

15 - - - - - - - - - - -

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