Bank of England Boost to UK Islamic Finance Market as Pioneering Wakala-based Alternative Liquidity Facility Goes Live with the Acceptance of First Deposits from UK-based Islamic Banks

The Bank of England’s (BoE) much anticipated Alternative Liquidity Facility (ALF) went live on 2 December 2021 when it started taking deposits from participating UK-based Islamic banks and Islamic Banking Windows (IBWs) of conventional banks for the first time.

The ALF was launched in a speech given by Andrew Hauser, Executive Director for Markets at the BoE, in December 2020. It is a non-interest-based deposit facility, the first of its kind offered by a Western central bank, designed to provide banks that cannot pay or receive interest with a similar ability to place funds at the Bank of England as conventional banks.

ALF could become a model both for non-traditional and traditional Islamic finance markets bereft of short-term liquidity facilities for Islamic banks and windows to manage their liquidity requirements and reserves with the central bank authorities.

This is an important step in providing a level playing field and enabling greater flexibility in meeting regulatory requirements under Basel III prudential rules. “As part of its commitment to diversity, innovation and financial inclusion,” said the BoE, “the Bank has established the ALF. This will help level the playing field by enabling Islamic banks – and any other UK banks facing formal restrictions from engaging in interest-based activity – to hold deposits at the central bank.”

Under the ALF model, participant deposits are backed by a fund of high quality Sukuk. The return from these instruments, net of operating costs, will be paid to depositors in lieu of interest. In the first instance, the fund has purchased ‘AAA’ rated Sukuk issued by the Islamic Development Bank (IsDB).

According to Rhys Phillips, Head of Sterling Markets at the BoE, “the ALF will help the UK Islamic finance sector to compete with conventional peers while staying true to their founding principles; and will further strengthen the United Kingdom’s role as the leading international financial centre for Islamic finance outside the Muslim world.”

Although ALF was launched a year ago, it has taken a year to finalise its operational and IT testing and its legal documentation. ALF has been welcomed by UK-based Islamic banks including Al Rayan Bank and Gatehouse Bank.

Danesh Mahadeva, Chief Financial Officer at Gatehouse Bank, confirmed that the bank had already started using the Facility to deposit funds. “The creation of a banking facility for UK Islamic banks,” he added, “is a significant step forward for Sharia’a compliant finance and the Bank of England. Just as the UK has led the way as the first nation outside the Islamic world to issue Islamic bonds, known as Sukuk, this will further cement the UK’s reputation as a global Islamic financial centre.  Gatehouse can now deposit funds with the strongest and most trusted financial institution in the country, levelling the playing field for us within the banking sector.”

The five main drivers behind the BoE’s initiative are rapid market growth; financial hub ambitions; financial inclusion and diversity; innovation; and ESG and sustainable finance considerations. The UK, post-Brexit is also championing Global England as a conduit for inward Islamic investment and finance.

Islamic finance is an important niche of the mainstream global financial system, considered by the IMF and World Bank as a “priority” in their funding mix for OIC member countries. Its growth dynamics suggest a continuing upward trajectory. Refinitiv, in its Islamic Finance Development Report 2021 published last month, reports a steady increase in total assets under management (AUM) from US$2.964 trillion in 2019 to US$3.374 trillion in 2020 to reach a projected US$4.940 trillion in 2025.

What the BoE innovates often becomes a model for other regulators to emulate. The UK is the pre-eminent centre for Islamic finance outside the Muslim world, underpinned by its strong historical and colonial relationships with the wider Muslim world; and its deep expertise in financial market origination, intermediation and distribution, embedded in a mature legal and regulatory framework. Most international Sukuk issuances have English law as their governing law.

Islamic financial institutions in many jurisdictions are at a disadvantage because they cannot use the wide range of interest-based high-quality liquid assets (HQLA) to meet deposits and payments obligations, including cash and central bank reserves; government and corporate debt; and asset backed securities and commercial paper, that are available to conventional banks. To try to make a more level playing field, the Basel liquidity rules give national supervisors discretion to treat Sukuk as HQLA, subject to various conditions.

“The consequent increase in demand for Sukuk from banks,” according to the BoE’s Hauser, “was one factor boosting issuance in recent years. But the proportion of Sukuk classed as eligible for regulatory buffers remains relatively modest compared to demand.”

Hauser believes that the philosophical focus of Islamic finance on equity-like sharing of risk and reward will become increasingly relevant as market participants get to grips with the scale of debt accumulated in response to the impact of the Covid-19 pandemic.

“The Bank of England has long advocated the risk-sharing merits of GDP-linked instruments, which could be packaged in Sukuk form. Together with HM Treasury and the FCA, we have recently announced a high-level working group to consider ways to foster a longer-term financial markets culture to support productive investment,” he revealed.

That Islamic finance seeks to avoid investing in socially detrimental activities is also a major advantage. “Islamic finance,” added Hauser, “was pro-ESG before the term was ever invented! Issuance of so-called ‘green Sukuk’ has risen sharply in the past three years although from a low base, and there is plenty of scope for further growth.”

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