Shari'ah Compliant Central Bank Liquidity Facilities

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1. A response by the British Bankers Association to the Bank of England ’s consultative document on: Establishing Shari’ah compliant central bank liquidity facilities April 2016 Introduction The BBA is pleased to respond to the Bank of England’s consultation paper on establishing Shari’ah compliant central bank liquidity facilities1. The BBA is the leading association for UK banking and financial services, representing members on the full range of UK and international banking issues. It has over 200 banking members active in the UK, which are headquartered in 50 countries and have operations in 180 countries worldwide. Eighty per cent of global systemically important banks are members of the BBA. All the major banking groups in the UK are members of our association as are large international EU banks, US and Canadian banks operating in the UK as well as a range of other banks from Asia, including the Middle East, China, Africa and South America. The integrated nature of banking means that our members are engaged in activities ranging widely across the financial spectrum from taking deposit, making loans and other more conventional forms of retail and commercial banking to products and services as diverse as trade and project finance, primary and secondary securities trading, insurance, investment banking and wealth management. Together BBA members manage more than £7 trillion in UK banking assets, employ nearly half a million individuals nationally, contribute over £60 billion to the UK economy each year and lend over £150 billion to UK businesses. Importantly in the context of the consultation most of the UK’s purely Islamic banks are BBA members and therefore have closely supported the BBA in responding to this Bank of England consultation on their behalf. Key Messages The BBA welcomes the Bank’s consultation with the industry on its plans to offer Shari’ah compliant central bank deposit and liquidity insurance facilities and strongly supports this initiative. Islamic finance has grown considerably over the past few years in the UK; there are several Islamic banks based in the UK, with further lenders offering Islamic financial products and services to customers. 1 http://www.bankofengland.co.uk/markets/documents/scfgreenpaper.pdf
2. 2 The UK has already demonstrated its commitment in becoming a partner of choice for Islamic finance in 2014 ; the UK became the first country outside the Muslim world to issue a Sukuk bond and our members would welcome more such issuance. But the proposed initiative would be a welcome complement to this existing activity. Islamic banks currently do not have access to the Bank of England’s facilities, which are extensively used by other banking institutions, as such facilities are not compliant with Islamic law. This complicates their compliance with their Liquid Asset Buffer (LAB) requirements. So, we very much welcome the opportunity to respond to the Bank’s CP on how to establish a central bank deposit and liquidity insurance model that is Shari’ah compliant and therefore available for use by Islamic banks, an initiative we called for in the BBA’s recent publication Winning the Global Race2. Overall, our members are more inclined to support the adoption of a wakalah model which we believe would be somewhat more straight forward to operate for the Bank, compared with a commodity murabaha approach. We note that the Bank has prioritised the deposit facilities, though members observe that liquidity provision facilities could be implemented contemporaneously with a deposit facility. Our highest priority however is for the establishment of a Shari’ah compliant deposit facility. Whichever model is chosen its operation will be greatly facilitated by the development of standard documentation. The BBA would be happy to work with its members and the Bank in the creation of master agreements for Shari’ah compliant facilities. 1. How would you evaluate your scale of usage of a wakalah fund based facility? What factors would be important to this decision (and, in particular, how sensitive would your usage be to the expected profit rate paid by the fund)? Shari’ah compliant banks currently hold their LAB in the form of sukuk holdings – with attendant FX exposure as the stock of sterling denominated sukuk is very low - or in unremunerated nostro accounts. They typically hold stocks of shari’ah compliant HQLA in excess of their LAB requirement to ensure changes in balance sheet composition do not result in a breach of their LAB. A Shari’ah compliant deposit facility at the Bank of England would enable our Islamic bank members to reduce their aggregate LAB holdings, leading to greater and beneficial efficiency in balance sheet management. Islamic banks would also welcome the payment of a profit rate on their deposit facility although the achievement of a return is not the prime benefit they see from being able to access a facility at the Bank of England. It would seem reasonable however that the expected profit rate would be the same as the return received by non-Islamic banks on their Reserve Account holdings. 2 https://www.bba.org.uk/publication/bba-reports/winning-the-global-race-2/ BBA response to the Bank of England’s CP on establishing Shari’ah compliant central bank liquidity facilities
3. 3 2 . What operational, legal or financial risks/challenges do you foresee, either for the central bank or for participants, in the implementation of a wakalah fund based model? Although banks do not expect to access their wakalah based deposit holdings frequently, certainly not on an intraday basis, changing business and market conditions may mean that Islamic banks could wish to access their LAB holdings every few days. We appreciate very much that the Bank is contemplating managing any attendant foreign exchange, market or credit risk arising from holdings in the sukuk fund. It will of course be crucial to demonstrate that these activities are entirely separate from the fund itself, in order that continuing Shari’ah compliance can be transparently maintained. So it will be important that Islamic banks, as well as the Bank of England, have robust operational procedures in place to ensure this separation. The BBA would be pleased to work with members and the Bank to ensure these are in place. We recommend that all parties move quickly to work together once the Bank has had the opportunity to consider responses to this consultation, should a decision be made to develop a wakalah based model, which is our preferred solution. Our member banks have indicated that they would wish to work together to create standard legal documentation that would be acceptable to both the Bank and their own Shari’ah boards. This would helpfully avoid the need for bilateral negotiation of Shari’ah compliant documentation. Again the BBA would be pleased to work with the Bank and members to facilitate this. Such documentation could be the precursor to the development of more widely and internationally accepted Shari’ah financing documentation which would be of real benefit to the wider Islamic banking market as it grows. It would also help to further establish and enhance the reputation of London as an international centre for Islamic banking. As participants would be incurring credit risk on the fund assets (as the agent for the wakalah fund the Bank of England will not be guaranteeing the performance of the underlying assets) a question arises about the treatment by their participating bank for LAB purposes. Would the bank be able to treat this as a Bank of England eligible LAB asset or would this be determined by the underlying assets? 3. What assets would you deem to be acceptable (and what assets would you deem to be unacceptable) within a wakalah fund? It is of course crucial that the assets included in the wakalah fund are fully aligned with Islamic investment principles and supported by a Fatwa. Interpretations of these may differ between scholars and also regionally. So we would initially recommend a conservative approach based on sukuk and bank notes although our members look forward to working with Islamic scholars and the Bank to identify additional asset classes, which may include government-backed export credit financing structures. BBA response to the Bank of England’s CP on establishing Shari’ah compliant central bank liquidity facilities
4. 4 4 . What instruments would be available to the Bank to hedge FX, profit rate and other financial risks in the wakalah fund without compromising the Shari’ah compliant status of the facility? Would it be acceptable for the Bank to use conventional hedging instruments to manage financial risks in the wakalah fund? It is of course crucial to the acceptability of the wakalah model that it is not mixed with non-Shari’ah hedging mechanisms. It must remain entirely ring fenced from any hedging activity undertaken by the Bank to ensure that the fund itself remains compliant with Islamic investment principles. We look forward to exploring with the Bank and relevant scholars the availability of spot FX transactions, Forward and Options as a hedging tool - we believe there may be the possibility of using them in a Shari’ah compliant manner. Typically these would be documented under the ISDA-Tahawwut Master Agreement (shari’ah compliant equivalent of ISDA Master Agreement). 5. Are there any other issues, concerns or comments regarding the wakalah fund based model that the Bank should consider? Time period of deposit We note that figure one contemplates that the Islamic bank would make a deposit for a defined period of time. Of course conventional banks are no longer required to average their reserves over a specific period. We understand that a Shari’ah compliant deposit facility will be operationally more complex and that experience will be gained once the preferred approach is decided upon. We look forward to working with the Bank to understand the period of deposit that it is contemplating which, we believe, should be based on a balance of operational expediency and reasonable access to funds. Initially at least we would envisage a deposit period of no more than one week. Expected profit rate Our expectation is that by blending assets the Bank should be able to generate an expected profit rate on the wakalah fund that intends to mirrors the rate on conventional deposits. We recognise that any return in excess of the expected profit rate should be retained by the Bank. 6. How would you evaluate your scale of usage of a commodity murabaha facility? What factors would be important to this decision? A commodity murabaha facility may have a number of advantages over a wakalah fund based model including access to a greater stock and diversity of assets and the ability to more easily scale up the size of the facility in the future. But we note that different central banks have different perceptions of what type of commodity assets are eligible. On balance however the ease of operation of the wakalah model leads us to conclude that a wakalah based deposit facility, rather than one based on commodity murabaha is the preferable alternative. Usage In is unlikely that the usage by our Islamic bank members of either a wakalah or commodity murabaha based deposit facility would vary significantly. BBA response to the Bank of England’s CP on establishing Shari’ah compliant central bank liquidity facilities
5. 5 7 . What operational, legal or financial risks/challenges do you foresee, either for the central bank or for participants, in the implementation of a commodity murabaha model? We anticipate that the operation of a commodity murabaha model, whilst not significantly more difficult would, because of the greater number of parties involved, require more time and testing to establish. This would not create anything more than short term complexity but is a factor that the Bank should take into account as it makes its decision about the chosen Shari’ah compliant deposit model. Start-up hiccups could impact the reputation of the facility more widely and should of course be avoided. There are many operational aspects related to the commodity murabaha model which will require due diligence by the Bank of England, although all the existing UK Islamic banks are already familiar with these. The Bank of England will need to undertake its own due diligence into the practice of the commodity brokers and ensure it is comfortable with the outcome. For instance legal advice will need to be sought by the Bank of England about the impact of an insolvency of a counterparty or commodity broker before the commodity trades have settled. In addition the Bank of England should explore automated methods of entering into these transactions to avoid having to execute numerous paper confirmations, which builds in operational al risk. As with a wakalah facility, standardised murabaha master documentation would have to be developed. Again the BBA would be happy to play its part in facilitating such development with the objective of ensuring that it has international applicability. 8. What commodities (or other assets) would you deem to be acceptable for trading within a commodity murabaha facility? As we note above different central banks have different views about the range of assets suitable for inclusion in murabaha fund based deposit facilities. Should the Bank choose a murabaha based model we would advise it takes a conservative approach in relation to the assets included in the facility, focusing on base metals, excluding gold and silver, to ensure the widest acceptability. 9. To what extent do you believe that a commodity murabaha based facility may become less acceptable over the longer term? If so, how might this risk be mitigated? We understand that different scholars take different views on the acceptability of using commodity murabaha for the purpose of cash generation. Many scholars have raised concerns about the compliance of this structure with the spirit of the Shari’ah and others have accepted it to assist Islamic finance in general and agreed that, given the dearth of alternative structures, it is acceptable for short term liquidity management. 10. Are there any other issues, concerns or comments regarding the commodity murabaha model that the Bank should consider? Although at first sight a commodity murabaha based deposit facility appears more operationally complex, our Islamic bank members have plenty of experience in using this model and thorough testing should ensure that it can be operated without significant operational risk were the Bank to choose this approach. BBA response to the Bank of England’s CP on establishing Shari’ah compliant central bank liquidity facilities
6. 6 We note a number of factors that the Bank has highlighted in paragraph 3 .10 that could be considered as reasons for a re-assessment of the suitability of murabaha based models, but do not believe that these pose a realistic risk to the long term acceptability of the commodity murabaha model. 11. What, if any, operational, legal or financial risks/challenges do you foresee, either for the central bank or for participants, in the implementation of a CCM model? We think that Islamic banks seeking to access liquidity via a collateralised commodity murabaha model would already have appropriate assets in a murabaha based deposit facility making a murabaha liquidity provision model quite straightforward to implement. We assume that the Bank of England would require collateral delivered to it with full legal title and not via a pledged account with a third party custodian. It is important to note that not all Islamic banks are comfortable with the title transfer approach because of concerns that the collateral receiving party may use the collateral in non-Shari’ah compliant activities for instance via rehypothecation of the securities in the market. 12. Are there any Islamic finance specific issues relating to the selection and use of collateral in CCM, or in Shari’ah compliant liquidity facilities in general? Some Islamic banks do not approve of the collateral receiving counterparty having the right to re-use the collateral during the term of the financing. So there will be restrictions on the use of the collateral by the Bank. It will not be permissible under Shari’ah law, for example, for the collateral to be loaned to another party or dealt with it in any way other than for the purposes of enforcement. 13. Are there any other issues, concerns or comments regarding the collateralised commodity murabaha model that the Bank should consider? We have not identified any. 14. What operational, legal or financial risks/challenges do you foresee, either for the central bank or for participants, in the implementation of a sale and buy back model? The collateralised commodity murabaha model is the most prevalent Shari’ah compliant repo equivalent product in the market today. For instance the sale and buy back model is a structure which is only acceptable in Malaysia. To ensure the structure cannot be characterised as a prohibited Bai al Inah sale (sale with immediate repurchase) the Sukuk should not be sold and bought back at different prices within a short period of time. 15. Are there any other issues, concerns or comments regarding the sale and buy back model which the Bank should consider? Shari’ah compliant repo has yet to come of age. Greater interest in this financing technique could be stimulated were the Bank to introduce a sale and buy back liquidity provision model which would have a further advantage of encouraging the development of widely acceptable Shari’ah compliant repo documentation. The BBA would be pleased to play its part in developing this. BBA response to the Bank of England’s CP on establishing Shari’ah compliant central bank liquidity facilities
7. 7 16. Are there any other models of Shari’ah compliant deposit or liquidity insurance not detailed in this consultation paper (including the Appendix) that should be considered? If so, please give details of the model. None that we are aware of. Responsible executive Simon Hills British Bankers Association +44 (0) 207 216 8861