UK develops new liquidity tools for Islamic banks

In its quest to cement London’s status as one of the leading Islamic finance centres in the Western world in the wake of a looming Brexit, the UK’s financial regulation is keen to promote the market with new tools and innovative products that are Shariah-complaint.

One of those is a liquidity tool newly developed by the Bank of England for use by Islamic banks to back Shariah-compliant deposit facilities for retail lenders. Such a tool is necessary in the context of Islamic finance since, according to Shariah principles, Islamic lenders are not allowed to utilise conventional money market tools or interest-bearing products, which makes it difficult to meet regulatory requirements for liquid asset buffers.

What the UK’s central bank now presented is a proposal for a fund-based deposit model for a liquidity facility, which would enable Islamic lenders to offer both a wider retail product portfolio and achieve the necessary financial gearing under tighter banking regulations.

While the regulatory standard of Basel III recognises the challenge for Islamic banks in meeting their liquidity requirements and the rules allow them to use a wider range of assets for their buffer, the scarcity of the supply of suitable assets means that banks have limited secondary market liquidity.

“The Bank of England recognises that Islamic banks are currently unable to use the central bank’s existing liquidity facilities. In particular, the Sterling Monetary Framework is the mechanism by which the bank sets interest rates, and interest-based facilities are not deemed Shariah compliant,” the BoE said in its April 2017 consultation paper which has been sent to several Islamic banks in the UK asking for comment until May 23.

In detail, the BoE proposed the so-called wakalah model, which literally means “protection” or “remedying” on behalf of others. Legally, wakalah refers to a contract where a person authorises another to do a certain pre-defined legal action on his behalf through an agency, usually against a fixed fee. Wakalah is used in various Islamic products such as musharakah, mudarabah, murabaha, salam, istisna and ijarah and also in payment and collection of trade bills, fund management and securitisation.
The BoE’s proposal of a wakalah fund-based liquidity tool would consist of high-quality sukuk purchased at market value, and, if necessary, cash provided by the central bank at zero return in line with Shariah principles. The central bank would balance the sukuk so that the expected profit rate on the portfolio stays within a corridor of the conventional monetary policy rate.

To comply with liquidity standards, an Islamic bank would make a deposit with the central bank for a defined time period. The aggregate value of all Islamic banks’ deposits would not exceed the value of the fund, while the rate of return on the deposit would be based on the rate of return on the portfolio backing it. On maturity, the return from the fund would be paid to the Islamic bank, and the principal amount would be returned or rolled over and the wakalah fund would remain in place for further deposits.

To fully comply with Shariah standards, the BoE would keep the fund off its own balance sheet on a UK-incorporated special purpose vehicle to ensure effective segregation from its other activities. The vehicle, as a wakalah agent, would be a wholly-owned subsidiary of the BoE and hold the segregated Islamic bank deposits and Shariah-compliant sukuk on its own balance sheet.

Published in Pakistan Observer, April 14th, 2017