The demise of LIBOR: Is it an issue for Islamic banking?

A cura di:

In brief...

LIBOR’s demise is not only a major issue for conventional banks, but also for Islamic financiers across the world. This article provides insight into how Islamic banks are tackling the challenges of the discontinuance of LIBOR and some of the alternatives being considered in the background.

Ever since the Financial Conduct Authority announced that the London Interbank Offered Rate (LIBOR) is to be discontinued by December 2021, the question of what a post-LIBOR world will look like has been a topic of much discussion among financial institutions, regulators and in global financial markets more generally.

The impact of the discontinuance of LIBOR is also an issue for the Islamic finance industry, where LIBOR is widely used as a benchmarking rate for Islamic financing arrangements involving USD transactions. Any proposal as to how Islamic financial arrangements should be implemented and documented post-LIBOR has the added complexity of needing to ensure that any mechanics applied to those financial arrangements comply with Sharia law principles.

While, in the context of conventional debt, the regulators and market stakeholders have settled on LIBOR being replaced by so-called backwards-looking overnight Risk Free Rates (i.e. the Secured Overnight Financing Rate (SOFR) for USD transactions and the Sterling Overnight Index Average (SONIA) for GBP transactions), this approach is not a viable solution for the majority of Islamic finance arrangements. The reason for this lies in the differences between how LIBOR is calculated as compared to how a Risk Free Rate is determined. LIBOR is a look-forward term rate which can therefore be used to calculate interest at the start of a calculation period, whereas (as mentioned above) the Risk Free Rates are backwards-looking overnight rates that, if applied to a calculation period, can only be determined at the end of that period.

This is problematic for many Islamic financing products given that, in order for these products to comply with Sharia law principles, a transaction must be entered into and pricing must be determined at the start of the relevant period. For example, a murabaha structure sees a financier provide credit to a customer as part of an asset sale which involves the financier buying an asset from a supplier and selling it to the customer on a deferred payment basis, with pricing determined when that asset is sold. The immediate sale and transfer of the asset in question (with a deferred payment obligation) is key to a murabaha product being Sharia compliant, so if the pricing was set at a later date, then this would not be acceptable to Sharia law scholars.

This particular problem was not so long ago acknowledged by the Working Group of the Bank of England, who suggested that that in order “to continue with the current market practice, alternate rates should be considered for [...] Islamic finance which can pay variable rates of return so long as the variable element is pre-determined.”

“ In this context, some commentators feel that it might now be the right time for the Islamic finance industry to move away from the use of LIBOR or conventional benchmark rates and instead establish an alternative benchmark rate created by, and suitable for, Islamic banks.”

Coming up with a new international Islamic rate based on asset transactions may be seen as a long-term (more sustainable) alternative. In addition, cutting ties with a conventional benchmark is likely to be a welcome change from a strict Sharia law perspective. However, whether this is feasible in such a short timeframe is questionable. This is because the establishment of an international Islamic benchmark rate presents a number of technical and economic challenges. What would the agreed methodology and basis of calculation be? Also, is there currently a sufficient volume of underlying transactions on which an international Islamic rate could be built? Who would be responsible for determining such rate? Would that rate be sufficiently robust?

Many questions remain unanswered and the clock is ticking. Institutions such as the International Islamic Financial Market (IIFM) and the Accounting and Auditing organization for Islamic Financial Institutions (AAOIFI) are actively working in the background to come up with a viable solution. However, Islamic financiers should not simply wait and see, as action needs to be taken now. Islamic banks need to be more proactive in examining their LIBOR exposures, even if that involves breaking away from conventional benchmarks altogether.