Can Islamic banks have their own benchmark?

This paper attempts to answer whether Islamic banks can have their own benchmark rate. In so doing, the paper investigates the nature of the relationship Islamic interbank benchmark rate (IIBR) and its comparable conventional counterpart, London interbank offer rate (LIBOR). The dynamics of the two series are investigated to examine the stability of the spread between IIBR and LIBOR, referred to as ‘Islamic premium’ or ‘piety premium’. The findings suggest that there are both long-term and short-term dynamic relationships between the two rates providing significant evidence of their convergence and co-movement. Our results also show that the existence of the IIBR-LIBOR spread is a reflection of the cost of funding and profit potential of the participating IIBR rate-setters. We find that, in addition to the determinants of the credit spreads, fundamental news of the panel banks are dominant factors driving the ‘piety premium’. We argue that the Islamic banking industry is operating in a global context, where it is highly improbable that its rates can decouple from the global benchmarks. Given that Islamic banking products and their risk return profile are similar to conventional products, arbitrage activities force Islamic rates to converge with the global benchmark rates.