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Bank of England Rolls Out Alternative Liquidity Facility for Islamic Banks after Long and Comprehensive Process of Consultation and Development

The supervision and regulation of Islamic financial institutions (IFIs), especially in non-traditional markets, took a major step forward as the Bank of England rolls out its pioneering Alternative Liquidity Facility (ALF) to help IFIs in the UK manage their short-term liquidity management requirements and capital buffers under the Basle capital and liquidity regimes on a Sharia’a compliant basis.

“The Alternative Liquidity Facility (ALF) will be open for business from the first quarter of 2021. The new facility will provide UK Islamic banks (and indeed any other UK banks with formal restrictions on engaging in interest-based activity) with greater flexibility in meeting High Quality Liquid Assets (HQLA) requirements, enabling them to hold a reserves-like asset in a non-interest-based environment,” confirmed Andrew Hauser, Executive Director, Markets at the Bank of England (BoE).

Speaking at the UK Islamic Finance Week 2020 in December, Hauser explained that “the ALF will be structured as a Wakalah or fund-based facility: a commonly used model in Islamic finance. In simple terms, that means that participant deposits will be backed by a fund of assets, the return from which, net of hedging and operational costs, will be passed back to depositors in lieu of interest.”

A BoE source was happy that Hauser’s speech “was well received by the market.  In terms of next steps, we’re currently finalising the operational testing of the facility and the legal documentation and intend to commence the onboarding of participant Islamic banks shortly.”

The UK is home to four exclusively Islamic banks with assets of over GBP5 billion, more than a dozen conventional banks offering Sharia’a compliant services, a host of investment firms, and a thriving legal, advisory and intermediation sector.

The BoE and its partners have worked and consulted on ALF since 2015. The strengths of this Wakalah model, says Hauser, include its relative simplicity – conceptually and practically – and its flexibility to accommodate future changes in what is a still fast-developing market.

Hitherto IFIs have been ad a disadvantage because they could not use the range of interest-based high-quality liquid assets to meet deposits and payments obligations, including cash and central bank reserves; government and corporate debt; and asset backed securities and commercial paper available to conventional banks. The latter can also borrow in secured and unsecured money markets and, as a backstop, from central 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 haircuts or other conditions. “The consequent increase in demand for Sukuk from banks,” according to 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. As a result, while Sukuk can provide a reliable medium-term store of value, the relative scarcity of HQLA-eligible stock can give rise to uncertain price movements, especially in stressed markets, reducing the value that is readily realisable, and making it harder for banks to increase their holdings quickly when required.”

Hence the ALF works in a unique way – the BoE prefunds the ALF with an interest-free loan, which is used to purchase eligible Sukuk and any hedges required to insulate the fund from FX risk. Islamic banks then place deposits in the ALF, the principal value of which is guaranteed by the Bank to ensure the facility is HQLA-compliant. In the event the aggregate value of participating bank deposits do not reach the aggregate value of the fund, the Bank will step in as co-depositor for the residual amount. The rate of return on the deposit is based on the rate of return on the portfolio backing it, net of hedging and other operational costs; and on maturity the return from the fund is paid over to participating banks, and the principal amount is returned or rolled over.

“The ALF will grow as the UK Islamic bank sector grows. And it will be well placed to exploit the growing diversification of available HQLA-eligible Sukuk assets. Over the coming months, we will finalise legal documentation, complete our operational testing and begin the onboarding process for eligible applicants. Firms should expect to commence this work from January 2021,” he said.

The BoE rationale is that once operational, the ALF should help put the UK Islamic finance sector on a more level footing with the rest of the market, giving firms here greater flexibility in meeting their liquidity requirements, and helping them to compete with conventional peers while staying true to their founding principles.

There is a promise that the UK’s Islamic finance proposition is an on-going process. “The liquidity facility,” reminded Hauser, “is in no small part a product of close and committed co-operation between the Bank, industry bodies and the private sector. It’s a real step forward, but it’s only one step. Through continued engagement and focused effort, together we can build a more innovative, diverse and inclusive marketplace: one which really can meet the needs of every part of our society.”

Those needs are currently very much due to the fore with the health and economic impact of the COVID-19 pandemic, which has been enormous and has affected countries all over the world, particularly in parts of the Muslim world.

“Some worry that COVID might slow the pace of growth in Islamic finance, as economic activity declines, and market participants revert to more conventional tools to meet the daunting financing needs of the crisis. That needn’t be so – because key aspects of Islamic finance make it particularly well suited to financing the post-Covid recovery,” maintained Hauser.

The philosophical focus on equity-like sharing of risk and reward, he observes, will become increasingly relevant as market participants get to grips with the scale of debt accumulated in response to Covid. The attractions of debt are obvious when interest rates are so low – particularly for those able to lock in long-term fixed rates in local currencies. But those borrowing at floating rates, at short maturities, or in foreign currencies, face sharp negative income shocks when rates rise, debt rolls over, or local currencies depreciate.

To him, risk-sharing contracts, including those promoted by Islamic finance, pose materially lower medium-term risks to stability. “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. In fact, says Hauser, “it was pro-ESG before the term was ever invented! Issuance of so-called ‘green Sukuk’ has risen sharply in the past three years– and the Islamic Development Bank issued an innovative US$1.5 billion sustainability Sukuk in June. But these are still quite modest numbers relative to the vast sums of money now looking to invest in credible ESG assets. There’s plenty of scope for further growth.”

Hauser also sees the prohibition on many forms of traditional banking in Islamic finance as a natural incentive to explore more innovative forms of intermediation, especially Islamic fintech like Sharia’a compliant e-money platforms and peer-to-peer lenders, to tackle a range of issues, including financial inclusion, in which the UK is a world leader. As at December 2020 the UK had 26 Islamic fintech firms registered compared with 22 in Malaysia and 17 in the UAE.

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