2017 q3 topical article islamic banks and central banking
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Quarterly Bulletin 2017 Q3
© Bank of England 2017ISSN 2399-4568
Topical articleIslamic banks and central banking
156 Quarterly Bulletin 2017 Q3
Islamic banks and central banking
By Arshadur Rahman of the Bank’s Sterling Markets Division.(1)
• Islamicbankingisarelativelyyoungbutgrowingsectorofthebroaderfinancialservicesindustry.NumerousbanksaroundtheworldofferIslamic,orShari’ahcompliant,financialproducts.
• SomecentralbanksofferShari’ahcompliantliquidityfacilitiestoIslamicbanks,affordingthemsimilarflexibilitytootherfirmsinmanagingtheirliquidity.Suchfacilitiesavoidthepaymentorreceiptofinterest,whichisotherwisethemostcommonbasisforoperatingaliquidityfacility.
• TheBankisestablishingaShari’ahcompliantfacility,specificallyadepositfacilitytoallowUKIslamicbankstoholdcentralbankassetsaspartoftheirliquidassetsbuffer.Thisarticleexploresthevariouswaysinwhichthiscanbedone,alongwiththemodeltheBankhaschosentoadopt.
(1) TheauthorwouldliketothankJamesSouthgateforhisfeedback,andalsoUKIslamicfinancemarketparticipantsandcolleaguesfromcentralbanksaroundtheworld,whoseinputhelpedtoinformthisarticle.
Overview
IslamicfinanceisactivityconductedinaccordancewithIslamiccommercialjurisprudence,whichisinturninformedbythehigh‑levelprinciplesofIslamiclaw,orShari’ah.Amongotherthings,thisemphasisesreal‑economyactivityandaprohibitiononpaying/receivinginterest.TheglobalIslamicfinancemarkethasgrownoverrecentdecades,andbysomeestimatescurrentlystandsatapproximatelyUS$1.9trillion,thoughthisisstilllessthan1%oftheglobalfinancialservicessectoroverall.
WithinthebroaderIslamicfinanceindustry,theIslamicbankingsectorhasalsogrown,andintheUnitedKingdom
therearecurrentlyfivestandaloneIslamicbanks.ThesearefirmswhichonlyconductactivityonaShari’ahcompliantbasis(unlikesomeconventionalbanks,whichofferIslamicfinanceproductsaspartofabroaderserviceoffering).Liketheirconventionalcounterparts,Islamicbanksmusteffectivelymanagetheirliquidity(thatis,theabilitytomeettheirfinancialobligationsastheyfalldue),whichincludesadheringtotheBaselIIIliquidityrules.Amongotherthings,therulesrequirefirmstoholdabufferofhigh‑qualityliquidassets(HQLA)whichtheycanrundowniftheyexperienceasuddenfinancialstress.Thisbufferwilltypicallybeintheformofassetsknownassukuk,instrumentsprovidingabeneficialinterestinanunderlyingShari’ahcompliantassetoractivity.However,thesupplyofHQLA‑eligiblesukukislimited(seesummary chart).Islamicbanksthereforedonothavethesameflexibilityasconventionalbanksinmanagingtheirliquidity.AsidefromholdingHQLAintheformofsukuk,anotherwaytomeettherequirementistoholddepositsatthecentralbank;thesecanbequicklywithdrawntomeetasuddenliquiditystress.However,theBankofEngland’scurrentfacilitiesareallinterestbearing,andsoinaccessibletoIslamicbanks.
ToaffordUKIslamicbankssimilarflexibilityinmanagingtheirliquidity,theBankthereforebeganworkin2015tofirstassessthefeasibilityof,andthenestablish,aShari’ahcompliantdepositfacility.ThisarticlesetsouttheresultsoftheBank’sanalysis.
2001 03 05 07 09 11 13 15 17
Estimated non-HQLAEstimated HQLA
Sukuk outstanding
Islamic fund assets
Takaful contributions
Islamic banking
US$ billions
US$ billions
1,493.4
318.556.125.1
0
50
100
150
200
250
300
350
400
450
Summary chart Size of global Islamic finance industry, and growth of sukuk market over time
Sources:Islamic Financial Services Industry Stability Report 2017andBloomberg:USforeignexchangeconversiondateforlatter7June2017.
Topical articles Islamic banks and central banking 157
Centralbanksaroundtheworldusearangeoftoolstoensuremonetaryandfinancialstability.Theseincludeprovidingaccesstothecentralbankbalancesheetbyacceptingdepositsfromcommercialbanks,whichareremuneratedattheprevailingcentralbankinterestrate.Suchdepositscanbeusedasaliquiditybufferassetandbepromptlyliquidatedbyafirmexperiencingasuddenfinancialstress.However,becausesucharrangementstypicallyinvolvethepaymentandreceiptofinterest,theycannotbeusedbyIslamicbanks,whichareprohibitedfromengagingininterest‑basedactivityunderShari’ahprinciples.
ThisarticleexplainshowcentralbanksaroundtheworldstructureliquidityfacilitiesinaShari’ahcompliantmanner(thatis,avoidingthepaymentorreceiptofinterest),toprovideIslamicbankswithsimilarflexibilitytoconventionalbanksinmanagingtheirliquidity.ThisisrelevantbecausetheIslamicbankingsectorgloballyisgrowing.Withthatgrowththefinancialstabilityrisksassociatedwiththesectorareincreasing,andsoisdemandforcompatiblecentralbankliquidityfacilitiestohelpmanagethoserisks.Yetthemeansbywhichsuchfacilitiesareorcanbestructuredisnotcommonlyunderstood.
TheBankofEngland(‘theBank’)isitselfintheprocessofestablishingaShari’ahcompliantliquidityfacility(SCF),aspartofitsstrategytobroadenaccesstoliquidityprovision.ThefirststageofthisworkinvolvedasurveyofShari’ahcompliantcentralbankliquidityfacilitiesalreadyavailablearoundtheworld.ThesecondstageentailedselectingthemostappropriatemodelfortheUnitedKingdom,bearinginmindtheBank’sspecificobjectivesandthenatureofthelocalmarket.
TheSCFwillenablethefiveUKIslamicbanks,whichconductbusinessonapurelyShari’ahcompliantbasis,toplacedepositsatthecentralbank,asconventionalbanksarealreadyabletodo.ThestructuretheBankhasselected,basedoninternalanalysisandmarketfeedback,iscalledawakalah(agency‑based)fundmodel,whichwillbeadjustedtomeetthespecificregulatoryandlegalrequirementsoftheUnitedKingdom.
What is Islamic finance?
IslamicfinancereferstocommercialactivityconductedinaccordancewithIslamicjurisprudence,or‘fiqh’.Thisinturnisinformedbythehigh‑levelprinciplesofIslamiclaw,or‘Shari’ah’.ProductsandservicesinIslamicfinancearethereforesometimesreferredtoas‘Shari’ahcompliant’.Shari’ahprinciplesincludetheviewsthat:
(i) Moneyhasnointrinsicvalue.Itcanserveonlyasamediumofexchange.
(ii) Thepaymentorreceiptofinterestisprohibited.Tradingorinvestmentincomeishoweverpermissible.Debtisalsoallowed,thoughitcanonlybetransferredatparvalue.
(iii) Thereshouldbeafocusonreal‑economyactivity,andanemphasisonfairapportionmentofriskandreward.Bothspeculationontheonehand,andrent‑seekingontheother,shouldbeavoided.
(iv) Investmentinactivitiesconsideredtobesociallydetrimentalshouldbeprohibited.Thisincludesinvestmentinsectorssuchastobacco,alcoholandpornography.
Islamicfinancethereforesharesanumberofcommoncharacteristicswiththebroaderethical/sustainablefinancesector.
Duetotheprohibitiononinterest,firmswhichofferShari’ahcompliantproducts,eitherexclusively(thatis,as‘standalone’Islamicfinancefirms),oraspartofabroaderproductrange(normallyofferedthroughseparatebusinessunitsknownas‘windows’)muststructuretheirproductsdifferentlytogenerateareturn.Thistypicallyinvolvestheuseofanunderlyingassetinsomeway.Forexample,aprofitcanbemadefromtradinginassets(suchascommodities),orleasingorsellinganassetininstalments(suchasproperty,plantorequipment).(1)Table AprovidesasimplifiedbreakdownofIslamicfinanceproductsacrossdifferentfinancialsectors.
The Islamic finance market and the UK regulatory approach
The global Islamic finance industryTheglobalIslamicfinanceindustryhasgrownrapidlyoverthepastfifteenyears.Whilereliablefiguresaredifficulttoobtain,someestimatesputthesizeofthemarketatapproximately£1.9trillionasofend‑2016.Approximatelythreequartersofthisisconstitutedofbankingassets,withmostoftheremaindercapitalmarketsandasmallproportionofShari’ahcompliantinsurance.MuchoftheactivityisconcentratedincountrieswithsignificantMuslimpopulations,especiallyintheMiddleEastandAsia.(2)
The Islamic finance industry in the United KingdomIntheUnitedKingdom,therearecurrentlyfivestandaloneIslamicbanks(Table B).Thesefirmshaveanaggregatebalancesheetofapproximately£3.5billion.Therearealsoover20conventionalbanksintheUnitedKingdomoperatingShari’ahcompliantwindows,andnumerousinvestmentmanagement,advisoryandinsurancesectorfirms.
(1) Formoredetailontransactiontypes,seeGlossary,page7;www.imf.org/~/media/files/publications/cr/2017/cr17145.ashx.
(2) Seewww.ifsb.org/docs/IFSB%20IFSI%20Stability%20Report%202017.pdf.
158 Quarterly Bulletin 2017 Q3
The UK regulatory approach to Islamic financeIntheUnitedKingdom,allfinancialfirmsaresupervisedunderthesameunitaryandprinciples‑basedregulatoryframework;firmsengaginginIslamicfinancearenotsubjecttoseparaterules,asthismightgiverisetoregulatoryarbitrage,thatis,theriskofparallelregulatoryregimesinwhichonesetofrequirementsisconsideredtobemorefavourableorlessonerousthantheother.TheUKauthoritiesemphasiseanon‑discriminatoryapproach,endeavouringtoensurealevelplayingfieldforallfinancialfirms,tothegreatestextentpossible.
SupervisionoffinancialfirmsisdividedbetweenthePrudentialRegulationAuthority(PRA),whichispartoftheBankofEngland,andtheFinancialConductAuthority(FCA).ThePRAisresponsiblefortheprudentialregulationofapproximately1,500banks,buildingsocieties,creditunions,insurersandthelargestinvestmentfirms.TheFCAisresponsibleforregulatingtheconductofallfinancialfirmsintheUnitedKingdom—this
coversprotectionofconsumersandfinancialmarkets,andpromotionofeffectivecompetition.Itisalsoresponsiblefortheprudentialregulationofapproximately18,000generallysmallerfirms.
Compliance with Shari’ah principlesIslamicfinancefirmswillnormallyappointaShari’ahSupervisoryBoard(SSB)ofIslamicscholars,tocertifyandevidencethefactthattheiractivitiesandproductsarecompliantwithShari’ahprinciples.Thesescholarsaretrainedinthespecialisedreligiousjurisprudencerelatingtocommercialactivity(‘fiqhalmu’amalat’),inadditiontohavingageneralgroundinginbothjurisprudenceandconventionalfinance;notallreligiousscholarswillbequalifiedtositonSSBs.Insomejurisdictions,SSBscholarsareapprovedcentrallybytheregulator,whileinothers—suchastheUnitedKingdom—theyarenot,havinginsteadsimilarstatustoafirm’sexternallegalcounselorauditors.
BankingActivitywillbeconductedviaexistingconventionalbankingentitiesas‘windows’,throughaseparateIslamicbankingbranchnetwork,orthroughaseparatestandalonelegalentity.
InvestmentsActivitywillbeconductedthroughaseparatelegalentity,orthroughaconventionalfirmmanagingafundunderaShari’ahcompliantmandate.
Insurance (takaful)ActivitywillbeconductedunderaShari’ahcompliantmutualstructure,orthroughalimitedcompanywithownsharecapitalandreserves.Ifthelatter,takafuloperatorcanprovideaninterest‑freeloan(‘qard’)totopuptheunderwritingfundincaseofdeficit,repaidfromanysubsequentunderwritingsurpluses.
Currentaccounts,depositandinvestmentaccounts.
Mortgages/homepurchaseplansandotherfinancing.
Fundsandsukuk. Generalinsurance,family/lifeinsurance,pensions.
Howisincomegenerated? Howisthecostoffinancingcovered?
Howisreturngenerated? Howcantheinsurancebeused?
Wakalah(agencybased)—inwhichdepositsareusedbythebankunderadelegatedauthoritytoinvestinShari’ahcompliantactivity.
Ijarah(leasing)—inwhichthecustomerleasesthepropertyforthecontractterm,withmonthlypaymentscomprisedofachargefortheleaseandalsoarentalcomponent,astheyarelivinginthepropertyatthesametime.
By investing in: equitiesoffirmswhichare(a)engagedinShari’ahcompliantactivityand(b)notexcessivelyleveraged(indebted);cashatzeroreturnasa‘safe’diversificationasset;sukuk,whichareinstrumentsrepresentingabeneficialinterestinaShari’ahcompliantassetoractivity,butexcludingshares(sowithoutvotingrights);tangibleassetssuchaspropertyandmachinery.
By underwriting:onlyShari’ahcompliantrisks;premiumscanbeinvested,butonlyinShari’ahcompliantassetsasperinvestmentprinciples.
Murabaha(costplusmark‑up)—inwhichthebanktradesincommoditiestogenerateareturn,whichispassedbacktothecustomerinlieuofinterest.
Diminishing musharaka(partnership)—inwhichthecustomerandbankbecome‘co‑owners’ofthepropertyinproportiontotheirinitialdepositvsfinancingamount.Monthlypaymentsareusedtograduallyincreasethecustomer’sownershipstakeintheproperty,andtitletransfersuponconclusionofthecontract.
Cannot invest in: bondsbearinginterest(includingzero‑couponbondsinwhichtheinterestisembedded),orinderivativesusedforspeculativepurposes.
Cannot underwrite:non‑Shari’ahcompliantriskssuchaspubsordistilleries.Also,someinsuranceproductscannotbeofferedviatakafulduetoentailingexcessiveuncertainty(‘gharar’),suchaswholeoflifepoliciesordefinedbenefitpensions.Mudarabah(silentpartnership)
—onepartnerprovidescapital(depositor),theotherprovidesexpertise(firm),withprofitsharedproportionately.
Table A Common forms of Islamic finance activity
Topical articles Islamic banks and central banking 159
IntheUnitedKingdom,theauthoritiescannotopineonwhetheraparticularIslamicfinanceactivityorproductisShari’ahcompliantornot.Thisisbecauseassecularinstitutions,theycannottakeaviewonreligiousstandards.Anditwouldbedifficulttodosoeveniftheycould,becauseopinionsonwhatispermissibleunderShari’ahdiffer,bothbetweenandwithinjurisdictionswherethisaspectisregulated:thehigh‑levelprinciplescanbeinterpretedindifferentways.However,intheUnitedKingdom,thebasisuponwhichagivenproductispromotedasbeingShari’ahcompliantmustalwaysbecommunicatedtothecustomerinamannerwhichisclear,fair,andnotmisleading,inaccordancewiththeapproachoftreatingcustomersfairly.Financialdisclosurerulesapplytoallfirms,andcustomersmustbeinpossessionofallthefactsrequiredtomakeaninformedpurchasingdecision.
AlthoughtheUKauthoritiesdonotregulateShari’ahcompliance,theBanknonethelessrecognisestheimportanceofdialoguewithotherauthoritiesontheeffectivesupervisionofwhatisayoungbutgrowingindustry.Tothisend,theBankbecameanassociatememberoftheIslamicFinancialServicesBoard(IFSB)inNovember2015.TheIFSBisaninternationalbodywhichaims,amongotherthings,topromotethedevelopmentofaprudentandtransparentIslamicfinancialservicesindustry,andtoprovideguidanceontheeffectivesupervisionandregulationofIslamicfinancefirms.
The liquidity rules
The liquid asset buffer (LAB) requirementBaselIIIliquidityrules(whichareimplementedintheEuropenUnion(EU)throughtheCapitalRequirementsDirectiveandCapitalRequirementsRegulation(together,CRDIV)andrelatedsubordinatemeasures)requirebankstoholdaliquidassetbuffer(LAB)ofunencumberedandhigh‑qualityliquidassets(HQLA)atalltimes.Theassetsinthisbuffershouldbereadilyaccessibleandeasytoconvertintocashinprivatemarkets,tomeetanysuddendemandsforliquiditythefirmmayface.Thisshouldholdtrueespeciallyduringperiodsoffirm‑specificstress,ormoregeneralmarketdisruption.(1)
Allbanks,includingstandaloneIslamicbanks,mustcomplywiththerequirementtoholdanLAB.However,Islamicbanksareunabletoholdassetsthatearninterest,orarebasedonactivitywhichisotherwiseprohibitedunderShari’ahprinciples.IntheUnitedKingdom,thepoolofassetsthatarebothsuitableforusebyIslamicbanksandofsufficientlyhighqualityislimited:onesuchasset,theUKGovernment’s2014£200millionsovereignsukuk,washeavilyoversubscribedonissue.(2)
1970s Shari’ahcompliantaviationleasingcontractsofferedinLondon.
Londonmarketbrokersofferwholesaleliquiditymanagementusingcommodities.
1980s EarliestIslamicmortgagesofferedintheUnitedKingdombyAlbarakaBank.
1997 IslamicmortgagesofferedintheUnitedKingdombyUnitedBankofKuwait(nowAhliUnitedBank).
2003 HSBCAmanahlaunchesIslamicmortgagesandbankaccountsintheUnitedKingdom.
2004 AlRayanBankplcauthorised(formerlyIslamicBankofBritain).
CourtcaseofBeximcovsShamilBankofBahrainestablishesprinciplethatsecularauthoritiescannotopineonShari’ahcompliance.
ABCInternationalBankoffersIslamicmortgagesunderAlBuraqbrand.
2005 Children’sMutuallaunchesShari’ahcompliantChildTrustFund.
LloydsTSBoffersShari’ahcompliantcurrentaccount.
2006 EuropeanIslamicInvestmentBankplcauthorised(convertedtoinvestmentfirmin2014—Rasmalaplc,nolongerauthorised).
2007 BankofLondonandtheMiddleEastplcauthorised.
InvestmentfirmAmiriCapitalauthorised.
FSAoutlinesregulatoryapproachtoIslamicfinancein:‘IslamicfinanceintheUnitedKingdom:regulationandchallenges’.
2008 QIB(UK)Ltdauthorised(formerlyEuropeanFinanceHouse).
GatehouseBankplcauthorised.
BritishIslamicInsuranceHoldings/PrincipleInsuranceauthorised(dissolvedin2015).
ConsultationpaperCP08/22outlinestheliquidassetbufferrequirementforallbanks.
2012 ADIB(UK)Ltdauthorised.
HSBCAmanahexitsUKmarket.
2013 CobaltUnderwritingauthorised.
2014 UKGovernmentissuesitsfirstsovereignsukuk.
InvestmentfirmArabesqueAssetManagementauthorised.
2015 IslamicInsuranceAssociationofLondonestablished.
BankofEnglandcommencesShari’ahcompliantfacilities(SCF)project.
2017 Shari’ahcompliantcrowdfundingfirmYieldersauthorised.
Table B Islamic finance in the United Kingdom — timeline of selected events
(1) Seepage7;www.bis.org/publ/bcbs238.pdf.(2) Seewww.gov.uk/government/news/government‑issues‑first‑islamic‑bond.
160 Quarterly Bulletin 2017 Q3
Anumberofjurisdictions(Bahrain,Qatar,TurkeyandMalaysiaforexample)havealsoissuedsovereignsukuk,whichcanbeusedbytheirrespectiveIslamicbanksforlocallyimplementedbufferrequirements.(1)However,asillustratedinthesummary chart,thegeneralandglobalscarcityofhighquality,liquidandShari’ahcompliantassetscontinuestoposeachallengefortheindustry.
BaselIIIrecognisesthechallengeforIslamicbanksinmeetingtheirLABrequirements.Therulesallowthemtouseawiderrangeofassetsfortheirbuffer,whicharesubjecttohaircuttingtoavoidfavourabletreatmentoverconventionalfirms.(2)ThisrecognitionisalsoreflectedinrelevantEU‑levellegislation.(3)Theunderlyingscarcityofthesupplyofsuitableassetsmeansthatbanksfrequentlyholdthemtomaturity,resultinginlimitedsecondarymarketliquidity.Nevertheless,theassetsrepresentastoreofvalueastheycanbereadilysold,althoughtheydonotprovideameansofmanagingliquidityonaday‑to‑daybasisastheymaybedifficulttoreplace.
The role of central bank facilities in meeting liquidity requirementsTherearetwomainwaysinwhichcentralbankscanprovideliquidityfacilitiesforusebycommercialbankstomanagetheirliquidityandmeettheBaselIIIrequirements.Thefirstisbyacceptingdeposits,whichcanbewithdrawnatanytimetomeetaliquiditystress.IntheUnitedKingdom,theBankoffers
reservesaccountswhichcanbeusedinthisway.Thesecondisbyprovidingaliquidityupgrade,bygivingHQLAtocommercialbanksintheformofcentralbankfundsorgovernmentsecurities,inexchangeforarangeoflessliquidassetssuchascorporatebondsandloanportfolios.Afewjurisdictions,suchasTurkey,IndonesiaandPakistan,allowtheuseofsukukintheiropenmarketoperations(OMOs)underaformofShari’ahcompliantrepo,toprovideIslamicbankswithfurtherflexibilityintheirliquiditymanagement.Theboxaboveshowshowthisworksinpractice.TheBankprovidesthisupgradethroughtheIndexedLong‑TermRepo(ILTR)operationsandDiscountWindowFacility(DWF).AllthesearrangementsareofferedviatheBank’sSterlingMonetaryFramework(SMF),andcanhelptocontributetowardscommercialbanks’LABrequirements.
TheBankremuneratesreservesaccountbalances,typicallyattheratesetbytheMonetaryPolicyCommittee—BankRate.Insodoing,theBankestablishesashort‑termrisk‑freerate.Thisrateinfluencestheratesconventionalbanksarewillingtochargeorpayonshort‑termloansorborrowingsinthe
(1) Malaysiastoppedissuingshort‑datedsovereignsukukin2015;www.sukuk.com/sukuk‑profile/.
(2) Seeparagraph68:www.bis.org/publ/bcbs238.pdf.(3) SeeinparticularArticle12oftheCommissionDelegatedRegulation(EU)2015/61,
availableathttp://eur‑lex.europa.eu/legal‑content/EN/TXT/PDF/?uri=CELEX:32015R0061&from=EN.
Shari’ah compliant open market operations (OMOs)
Openmarketoperations(OMOs)areatoolwhichcentralbanksusetoeitherinjectordrainliquidityfromthemarket.TheBankofEnglandprovidesOMOs,currentlythroughtheIndexedLong‑TermRepo(ILTR).(1)Shari’ahcompliantOMOsnormallyentailusingawa’ad(promise)basedmodel.Underthisarrangement,theIslamicbankfacingaliquiditystresswouldsella(Shari’ahcompliant)asset,suchasasukuk,tothecentralbank,whowouldsubsequentlyselltheassetbackatamark‑up(Figure A).Thistransactionissimilartoaconventionalcollateralisedloanarrangementcalledarepurchaseagreement(‘repo’),andthemark‑uponthesalechargedbythecentralbankonthesecondtransactionmaybebasedontheconventionalreporatetomakeiteconomicallyequivalent.
Wherethewa’admodeldiffersfromaconventionalrepoisinthesecondlegofthetransaction,whichistreatedinShari’ahcompliancetermsasadiscretionarypromiseratherthanacontractualobligation:thecentralbankwilleitherpromisetosellthesecuritybacktotheIslamicbank,ortheIslamicbankwillpromisetobuythesecurityfromthecentralbank.Havingthisseparationtechnicallyavoidswhatiscalled‘baialinah’(salewithimmediaterepurchase),whichisnotallowedunderShari’ahprinciplesbecauseitisconsideredtobeoverlysyntheticbysomeShari’ahscholars.However,opinionsstilldovarybetweenjurisdictionsontheoverallpermissibilityunderShari’ahofthistransactionalmodel,whichiswhyitisnotusedinsomecountries.RegardlessofwhetheritisthecentralbankortheIslamicbankwhichisactingasthepromisor,theunderlyingcommercialdocumentationisnormallystructuredasadeedtobecontractuallybinding—imposinginlegaltermsanobligationintheabsenceof‘consideration’,orpayment.Thisprovidescomforttobothcounterpartiesthatthesecondtransactionlegwillbecompleted.
(1) FormoreinformationontheILTR,seetheBankofEngland’s‘RedBook’,availableatwww.bankofengland.co.uk/markets/Pages/sterlingoperations/redbook.aspx.
Islamic bank Central bank1
2
Figure A The wa’ad based liquidity support model
1 TheIslamicbanksellssecuritytocentralbank.2 Onmaturity,thecentralbanksellssecuritybacktotheIslamicbank,atamark‑upthatmaybebasedontheequivalentconventionalreporate.
Topical articles Islamic banks and central banking 161
market.(1)RemunerationofreservesisthereforefundamentaltotheBank’sframeworkforimplementingmonetarypolicy.(2)TherateschargedontheILTRandDWFareatamark‑uptoBankRate,andarethereforealsointerest‑based.AsIslamicbanksareprohibitedfromreceivinginterestunderShari’ahprinciples,theBank’sexistingfacilitiesundertheSMFareinaccessibletothem.
TheBankthereforecommencedworkinthesecondhalfof2015,toassessthefeasibilityofestablishingaShari’ahcompliantliquidityfacilityforUKIslamicbanks.ThiswouldprovidethemwithgreaterflexibilityinmanagingtheirliquidityandmeetingtheBaselIIIliquidityrules(asimplementedintheEU).
Overview of Shari’ah compliant deposit facility models
The Bank’s preliminary surveyTheBankcommencedworkin2015onassessingthefeasibilityofestablishingaShari’ahcompliantfacility.ThefirststageofthisconsistedofasurveyofSCFmodelsusedaroundtheworldbyothercentralbanks,(3)toprovidebothdepositandliquiditysupportfacilities.(4)Thesurveyfoundthatcentralbanksusedadiverserangeofmodelstounderpintheirfacilities,andtherewasnouniversallypreferredstructure.
Thepurposeofthesurveywasnottoprovideanexhaustivelistofallthefacilitiesusedinalljurisdictions,buttogainasenseoftheoptionstheBankmightbeabletodrawuponindevelopingitsownfacility.Inconsideringthevariousmodelsinuse,theBankhasnottakenaviewonwhethersomemodelsareinherentlybetterorworsethanothers,sincesuitabilitywilldependonthespecificobjectivesandrequirementsofeachindividualcentralbank,aswellasthenatureoftheirlocalmarketandregulatoryframework.
Oftheninecentralbankswhichconfirmedtheyprovidedsomeformoffacility,atleastoneofferedtoacceptdepositsatzeroreturn,andsomeoffered(orwereplanningtooffer)emergencyliquiditysupportwithoutcharginginterest(knownasa‘qardhasan’).(5)
However,themostcommonmethodusedtounderpinfacilitieswasthecommoditymurabahamodel(CM),usedforbothdepositsandliquiditysupportinKuwait,Malaysia,SaudiArabiaandtheUnitedArabEmirates.(6)Murabahasimplymeanstopurchaseanasset,andthensellitonatadisclosedmark‑up.Inaddition,severalothermodelswerefoundtobeinusespecificallyfordepositfacilities:
• Wakalah(agency‑based)fundmodel—usedinBahrain.
• Wadiah(safecustody)model—currentlyusedinMalaysia;previouslyalsousedinIndonesia.
• Ju’alah(remunerationforaspecifiedtask)model—usedinIndonesia.
Thesemodelsarediscussedinmoredetailinthenextsection.
The commodity murabaha modelIntheCMmodel(Figure 1),thecentralbankusesdepositsfromIslamicbankstoundertakeaseriesoftradesinanunderlyingcommodity.(7)Thereturnfromthistrading,minuscostsandfees,isreturnedtotheIslamicbanksinlieuofinterest.
(1) Formoreinformation,seetheBank’s‘RedBook’,availableatwww.bankofengland.co.uk/markets/Pages/sterlingoperations/redbook.aspx.
(2) ForfurtherinformationontheBank’sSterlingMonetaryFramework,seewww.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q210.pdf.
(3) TheBank’ssurveyfocusedoncentralbanksinjurisdictionsinwhichbothIslamicandconventionalbanksoperate,similartotheUKmarket.
(4)Basedonmarketfeedback,theareaofmostpressingneedforUKIslamicbanksisintheprovisionofdepositfacilities,sothishasbeenprioritised.TheBankintendstoconsiderthefeasibilityofestablishingliquiditysupportfacilitiesatalaterdate.
(5) Somecentralbanksusedmorethanonetransactionalmodel.(6) TheCentralBankoftheUnitedArabEmiratesusesthemurabahastructureto
underpincertificatesofdeposit.(7) Thesewouldtypicallyincludenon‑preciousmetalssuchassteel,tinorzinc,butcan
alsopotentiallycoverothersufficientlystandardised‘soft’commoditiessuchaspalmoil,sugarorrice—thescopeofacceptablecommoditieswouldbesubjecttoagreementbythecounterpartiestothetradeandtheirrespectiveShari’ahscholars.Shari’ahprinciplesexcludetheuseofgoldorsilverforthistransactionalmodelasthesecommoditiesareconsideredtobetoo‘money‑like’—thatis,theyfallintothecategoryofassetswhichshouldbetreatedonlyasamediumofexchange.
Broker A
Broker B
Islamic bank Central bank
23
56
1
4
Figure 1 The commodity murabaha deposit model
1 TheIslamicbankpurchases£1millionofcommoditiesfromBrokerA.
2 TheIslamicbanksellsthecommoditiestocentralbankattheoriginal£1millionprice,plusamark‑up(eg£2,000),onadeferredpaymentbasis(egoneweek).
3 ThecentralbankappointstheIslamicbankasagenttosellthecommoditiesbackintomarket.
4 TheIslamicbanksellsthecommoditiestoBrokerBattheoriginalpriceof£1milliononbehalfofcentralbank,forimmediatepayment.
5 TheIslamicbankcreditsthe£1millionproceedsfromthesaletoBrokerBtothecentralbank.
6 Onmaturity(afteroneweek),thecentralbankmakesthedeferredpaymentof£1,002,000totheIslamicbank.
162 Quarterly Bulletin 2017 Q3
ThecentralbankbasedCMarrangementdetailedinFigure 1hasbeensimplified—variationswillexistbetweendifferentjurisdictions.TwobrokersarerequiredforthismodeltobeShari’ahcompliant:usingonlyonebrokertobothsourceanddisposeoftheassetwouldmakethetransactionresembletoocloselya‘baialinah’(salewithimmediatepurchase).Itishoweverpossibleforthetwobrokerstonetoffexposurestoeachotherbilaterally,sothatthefirstbrokerobtainstheunderlyingcommodityagainattheendofthetransaction,allowingittousethisforthenextCMtransaction.
TheCMtransactionisnormallyveryshortinduration—allthestepsinthemodeltypicallycompletewithinanhour,apartfromthedeferredpaymentleginstepsix.Asaconsequence,thecommodityisnotleftonthebalancesheetofeitherthecentralbankortheIslamicbankforanysignificantperiodoftime.
Asthepurposeofthetransactionistofacilitateliquiditymanagementratherthantobecomeactivelyinvolvedinaparticularcommoditymarket,thepriceandmark‑upwillbefixedattheoutset.Thismitigatestheriskofadversemovementsinthemarketpriceoftheunderlyingcommodityaffectingthereturn.
The wakalah modelWakalah(agency‑based)modelsarefrequentlyusedintheinterbankmarketforbothdeposit‑takingandinvestmentactivity,aswellasintheprovisionofcentralbankdeposits.Underthismodel,oneinstitutionactsasagent(‘wakil’)inmanagingthedepositorinvestmentofaprincipal(‘muwakkil’)inafundofShari’ahcompliantassets(Figure 2).
Inonevariantofthecentralbankwakalahmodel,thecentralbankplacesthedepositsofIslamicbanksintoafundofsukuk(Figure 2).Banknotescanalsobeincludedinthefundasnon‑interest/returngeneratingassets,therebybalancingtheoverallportfolioreturntotargetanexpectedprofitrate(EPR).TheEPRmightmatch,sitwithinacorridorof,orindeedbecompletelyunrelatedto,theequivalentcentralbankinterestrateofferedtoconventionalbanks,dependingontheobjectivesofthecentralbank.
Iftherateofreturnonawakalahdepositfacilityisarrangedtobesimilartothecentralbankpolicyrate,thismaybelowerthanthereturnanIslamicbankwouldotherwiseearnfromholdingthesukukdirectly.However,Islamicbanksmayswapthehigherreturnonthesukukforgreaterliquidityfromacallablecentralbankdeposit,andalsotoreducetheirconcentrationriskbydiversifyingtheircounterpartyexposurestoincludeexposuretoacentralbank.
The wadiah and ju’alah based modelsInthewadiahmodel,thecentralbankholdstheIslamicbank’sdepositincustody.Althoughtheprincipalmustremaincertain,theIslamicbankmaypermitthecentralbanktousethefundstoengageinShari’ahcompliantactivitytogenerateareturn.Thisreturnisusedtocoverthecostofoperatingthefacility,andpartofitmaybereturnedtothedepositingIslamicbankintheformofa‘hiba’(discretionarygift).Ifthecentralbankisnotpermittedtousethedepositstogenerateareturn,itwouldneedtochargetheIslamicbankafeeforholdingthedeposittomakethearrangementeconomicallyviable.
Theju’alahbasedmodelisastructureinwhichthecentralbankacceptsdepositsfromtheIslamicbanks,andprovidesaunilateralpromisetopayacertainreturnuponcompletionofaspecified(Shari’ahcompliant)taskorachievingaspecificoutcome.Thestructureofthisarrangementisonlyspecifiedathighlevel,leavingconsiderableflexibilityintheimplementation.
The Bank’s preferred deposit model
Further internal analysis and public consultationUponcompletingthepreliminarysurvey,theBankdeterminedthatthetwodepositmodelsmostlikelytobeviableintheUnitedKingdomweretheCMmodelandthewakalahfundbasedmodel.ThesewereoriginallyincludedinapublicconsultationinFebruary2016,whileatthesametimebeingsubjecttofurtherinternalanalysisonthefinancial,operationalandlegalrisks.(1)Bothmodelswerebrokendownintotheirconstituentsteps,andexaminedinfurtherdetail,tounderstandpreciselyhowtheywouldworkinthecontextof
Islamic bank
Wakalah fund
Central bank
1
1
52
43
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Figure 2 The wakalah deposit model
1 Thecentralbankestablishesafundconstitutedofsuitablesukuk,andbanknotesifrequired.
2and3TheIslamicbankplacesadepositwiththecentralbank,whichiseitherinvesteddirectlyinthewakalahfund,orheldseparatelyandbackedbythewakalahfund(Bankproposedmodel).
4and5Thecentralbankreturnstheprincipal,plusanyprofitonthefund,totheIslamicbankuponmaturity.
(1) Seewww.bankofengland.co.uk/markets/documents/scfgreenpaper.pdf.
Topical articles Islamic banks and central banking 163
theUKlegalandregulatoryenvironment,andparticularlywithintheframeworkoftheBank’sexistingprocessesandinfrastructure.Eachmodelwasassessedagainstacommonsetofevaluativecriteria(seetheboxabove).
Responsestothefirstconsultationexercise,fromthecorestakeholderpopulationofUKIslamicbanksandtheirrespectiveSSBscholars,suggestedthatthewakalahmodelwouldbeconsideredmoreShari’ahcompliantoverall(thoughrespondentsalsoindicatedthatbothmodelswouldhavebeenacceptablestructurestounderpinacentralbankdepositfacility).FromtheBank’sperspective,thewakalahmodelwasconsideredtobemoreoperationallystraightforward,requiringfewerchangestointernalsystems,andwithfewerdependenciesonexternalthirdparties.TheBankissuedafollow‑upconsultationpaperinApril2017,announcingitsintentiontoestablishanSCFusingthewakalahfundbasedmodel.TheBank’sdecisionwasinformedbyacombinationofinternalanalysisandmarketfeedbackfromtheconsultationexercise.
Thepreferredwakalahfundbasedmodelisdetailedinthissection(Figure 3),andthealternativeCMmodelisdetailedintheannex.ThediagramsprovidedareintendedtoillustratehowthesedepositmodelscouldworkwithinaUKcentralbankingcontext;therewillbevariationsinthedetailfromhowthemodelsarecurrentlyimplementedbycentralbanksinotherjurisdictions,andalsoinhowtheyareimplementedinapurelycommercialsetting.
IntheUnitedKingdom,awakalahbasedcentralbankdepositfacilitywouldentaildepositsplacedbyIslamicbankswiththe
centralbankbeingbackedbyafundcontainingShari’ahcompliantassetssuchassukuk.TheIslamicbankdepositwouldbeheldbythecentralbankseparatelyfromotherassetsonitsbalancesheet(topreventitbecomingmixedwithnon‑Shari’ahcompliantassetsoractivity),andtheIslamicbankwouldreceiveareturnfromthewakalahfundinlieuofinterestearnedonaconventionaldeposit.
The rate of return on the facilityRatherthanincludingcashinthefundatzeroreturntoadjusttheoverallreturnonthefacility,intheBank’sproposedarrangementthefundwouldlikelybemadeupentirelyofsukuk.If,asislikelyinmostscenarios,theoverallfundreturnexceedsthestatedEPR,anysurplusafteradministrativecostswouldbeusedtograduallybuildupareserve.Thiswouldthenactasacushionduringperiodsinwhichthefundisnotabletogenerateasufficientreturn.Bearinginmindtheoriginalassessmentprinciples,insettingtheEPRtheBankwouldneedtoensurethefacilitypaysareturnwhichissufficientlyconsistentwiththatpaidtoconventionalSMFparticipants,whileatthesametimenotsimplyreplicatingBankRate.
Pre‑establishing the fund and hedging riskEstablishingthefundinadvanceofacceptingdepositsisnecessary,becauseintheUnitedKingdomthereisascarcityofreadilyavailableandsuitablehigh‑qualityliquidassetstoputintoit.Inotherjurisdictionsoperatingcentralbankdepositfacilitiesonthismodel,pre‑establishmentmightnotbenecessaryifthecentralbankalsoregularlyissuesitsownsukukforuseinthefund.
Evaluation criteria used by the Bank to assess deposit models
• Themodelistransparentandsimpletoexplainandunderstand,maximisingthepossibilityofitbeingrecognisedasmeetingtheneedsofcurrentandpotentialusers.WhiletheBankwouldaimtoensurethatanyselectedSCFmodelissufficientlytransparent,theonuswouldfallontheIslamicbankstosatisfythemselvesonShari’ahcompliance.ThisisbecausetheBankasasecularbodywouldbeunabletoprovidethisassurance.
• ThemodelhelpsIslamicbankstobettermeettheirLABrequirementsundertheliquidityrules,orprovideseffectiveliquiditysupporttoIslamicbanksintheeventofafirm‑specificormarket‑widestress.
• TherisksarisingfromthemodelfitwithintheBank’stolerancethresholds,includingwithrespecttocredit,market,liquidity,operational,counterpartyandlegalrisk.
• ThemodeliscompatiblewiththeSterlingMonetaryFramework(SMF)—anySCFshouldnotconflictwithmonetarypolicy,norunderminetheBank’sexistingliquidityfacilities.
• Themodelisaccessiblespecificallytoinstitutionswhich,intheirarticlesofincorporation/association,areprohibitedfromengagingininterest‑basedactivity.ThisisnecessarytoensurethattheexistingSMFfacilitiesremaintheprimarytoolintheUnitedKingdomformonetarypolicyimplementationandliquidityprovision.
• ThepricingofthemodelissufficientlyconsistentwithequivalentconventionalfacilitiesforittoberegardedasattractiveandfairforIslamicbanks.
• BankresourcesrequiredtooperateanySCFinsteady‑stateareproportionatetothesizeofthefacility.
• Themodelcanbeappliedwithoutbeingcontingentonfuturemarketdevelopments.
164 Quarterly Bulletin 2017 Q3
Thesukukfundforthisdepositfacilitywillincurtwomainformsoffinancialrisk.Thefirst,andmostsubstantive,isforeignexchange(FX)risk,giventhatalargeproportionofHQLA‑eligiblesukukarelikelytobeUSdollar‑denominated,whiletheobligationsundertheSCFwillbeinsterling.ItwouldbepossibletohedgeFXriskintheportfoliousingShari’ahcomplianthedginginstruments,thecontractualtermsofwhichhavebecomeincreasinglymorestandardisedover
recentyears.Thesecondfinancialriskisprofitraterisk,theriskthattherateofreturnontheconstituentsukukintheportfoliofallsshortofthestatedEPR.Thisisanalogoustointerestrateriskforequivalentconventionalfixed‑incomeinstruments.However,thisriskcanbemitigatedbyreducingtheactualprofitratepaidouttoavoidashortfall;theEPRisonlyanindicativerate,notafixedobligation.Inaddition,thefacilitycanbecarefullymanagedbyensuringthatonly
Islamic Bank A
Islamic Bank B
Islamic Bank C
Central bank
£ Sukuk US$ Sukuk US$ FX hedge
Special Purchase Vehicle
Structured deposit(segregated and Shari’ah compliant)
Non-interestbearing deposits
Return-generatingsukuk fund
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5Initial cash flow
Deferred cash flow
Bank guarantee
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Figure 3 Detailed analysis of the wakalah fund based deposit facility at the Bank
1 TheBankestablishesthefacilityinthefirstinstance,byplacingadepositwiththeSPVwhichisequaltotheaggregatevalue(atcost)ofsukuktobepurchasedforthebackingfund.
2and3TheSPVpurchasessukukforthefund.Atthesametime,wheresukukaredenominatedinanon‑sterlingcurrency(mostlikelyUSdollars),anaccompanyingFXhedgeispurchasedfromoneoftheBank’sexistingcounterparties.AsShari’ahcomplianthedginginstrumentsareavailableinthemarket,theuseofconventionalhedgescanbeavoided.
4 Islamicbanksareinvitedtoparticipateinthefacility,payinganannualaccessfeecommensuratewiththatforanequivalentconventionalfirmaccessingtheSMF.IslamicbanksplacedepositswiththeSPV,onatermbasisandforanexpectedprofitrate(EPR)whichwouldbesetatthestartofthetransaction.Thetermwillbesetatoneweek,butwillbebreakablebyIslamicbanksatanytime.TheBankreducesitsowndepositinthefacilitybyanamountcorrespondingtotheaggregatedepositsplacedbytheIslamicbanks,toensurethefacilityremainsfullyutilised—itwillremainaco‑depositorforanyresidualamount.TheBankwillreceivethesameEPRonitsdepositsastheIslamicbanks,meaningtheSPVwillnotengageinanyinterest‑basedactivity.
5 TheBankguaranteestoeachIslamicbanktheprincipalamountofthedepositsplacedbyitintotheSPV.Thiswouldbeanoverarchingor‘master’guaranteetocovertheaggregateprincipaldeposit,soastoavoidtheneedforanewguaranteetobeenteredintoeachtimeafirmincreasesorreducesitsdeposit.TheBankwouldnotberemuneratedfortheguarantee,norwouldtheguaranteeimposeanyfinancialorcommercialobligationuponthedepositorIslamicbanks.
6 Onmaturityofthedeposit,areturnispaidtoalldepositorsinthefacilityinproportiontotheirholdings.Thiswilldependontheperformanceofthesukukportfolio,andmayormaynotbeequaltotheEPR.Thisprofitratereferencesthereturnonthefund,netofanyhedgingorotheroperationalcosts,andcontributionstoareservefund.
Topical articles Islamic banks and central banking 165
high‑qualityinstrumentsusingstructureswhichenablepredictablecashflowsareincludedinthefund.Thesewouldincludeinstrumentsissuedbyhighlyratedsovereignsandmultilateraldevelopmentbanks.
Guaranteeing the principal of depositsAkeycriterionfortheSCFisthatthefundsheldintheSPVcanbetreatedas‘Level1’HQLAfortheLiquidityCoverageRatio(LCR)underCRDIV.Toachievethis,theBankwillundertaketotheparticipatingIslamicbankstoguaranteetheprincipal—butnotthereturn—offundstheyplaceinthefacility.Thiswillbedoneinordertoestablishaclaimguaranteedbythecentralbank.Inotherjurisdictionsofferingwakalahdeposits,thisguaranteemaybeimplicit.IntheUnitedKingdom,theguaranteewillbeprovidedinlinewiththemarketstandardforIslamicbanks,thatis,itwillgranttheIslamicbanks,asdepositors,adiscretionaryrighttoaclaimagainstthecentralbankforanylossofprincipalvalue.
Underapurerisk‑sharingarrangement,wheretheIslamicbanksdidnothavearighttocallupontheguarantee,theconsequentlosswouldautomaticallypassthroughtoIslamicbanksintheformofareductionintheprincipalamountreturned.However,thiswouldnotbesufficienttoconstituteaclaimuponthecentralbank.WhiletheBankrecognisesthetensionwhichexistsbetweenregulatoryandShari’ahcompliancerequirementsontheissueoftheprincipalguarantee,italsonotesthattheonlyscenarioenvisagedinwhichthisundertakingcouldbecalleduponbytheIslamic
bankswouldbethedefaultofasukukinthebackingfund.Giventhatonlyhigh‑qualityinstrumentswouldbeeligibleforthefund,theprobabilityofsuchadefaultwouldbeverylow.
Conclusion
FollowingtheclosureofthesecondconsultationexerciseinMay2017,theBankhasbeguntoimplementthewakalahfundbasedmodel.AmongotherthingsthisinvolvesworktointegratethefacilityintotheBank’sexistinginternalsystemsandprocesses,andcreateasetofstandardisedtermsandcontractualdocumentation,similartothoseusedbyparticipantsoftheBank’sexistingSMF.Thedocumentationwillincludedetailsonthetermofdepositsandfrequencyofaccess.
WhilethefacilitywillbestructuredtobeacceptableforusebyUKIslamicbanks,consistentwithBaselIIIandEUliquidityrules,itwillalsobeavailabletoanyotherbankswhicharepreventedfromengagingininterest‑bearingactivityintheirarticlesofassociationorincorporation.ThiswillmeanthatcommercialbanksintheUnitedKingdomwillbeabletoaccesseithertheBank’sconventionalSMFfacilities,ortheSCF—butnotboth.TheSCFprojectrequiresasubstantialexpenditureofresource,andthefacilityisthereforeunlikelytobereadybeforeSpring2018.Furtherdetailsonimplementation,includingtimeline,willbepostedontheBank’swebsiteinduecourse.
166 Quarterly Bulletin 2017 Q3
Annex Detailed analysis of the alternative commodity murabaha based deposit facility
Aspartofitsanalysis,theBankalsoconsideredtheimplementationofadepositfacilityusingthecommoditymurabahamodel.Thisannexoutlineshowsuchadepositfacilitywouldhaveworkedinpractice,iftheBankhadchosentoimplementit.
Central bankcommodity account
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Figure A1 Detailed analysis of the alternative commodity murabaha based deposit facility
1 IslamicbankmakesrequesttocentralbanktomakeShari’ahcompliantdeposit,instructscentralbankasagenttopurchasethecommodities.2 CentralbanknotifiesBrokerAofIslamicbank’srequesttomakedeposit.3 BrokerAissuescombinedSeller’sOfferandPurchaser’sAcceptancetocentralbank.4 CentralbanksignsandreturnsPurchaser’sAcceptancetoBrokerA.5 BrokerA,actingascustodian,transfersspecifiedcommodityfromowninventorytocommodityaccountofcentralbank.6 CentralbankissuesPurchaseConfirmationtoIslamicbankwithdetailsofcommoditypurchasedbycentralbankasagentforIslamicbank.7 Islamicbankpaysagreedspotpurchasepriceforcommodity.8 CentralbankcreditsBrokerA’ssettlementaccountwithspotpurchaseprice.9 BrokerAissuescommoditycertificateandwarrantlistingtocentralbank.10 CentralbankissuesSaleConfirmationtosignandreturnbyIslamicbank.11 CentralbankdebitsBrokerA’ssettlementaccount,creditsBrokerB’ssettlementaccountwithpurchaseprice.12 CentralbanksendsrequesttoBrokerBtoissuecombinedPurchaser’sOfferandSeller’sAcceptance.13 BrokerBissuescombinedPurchaser’sOfferandSeller’sAcceptancetocentralbank.14 CentralbanksignsandreturnsSeller’sAcceptancetoBrokerB.15 CentralbankdebitsBrokerB’ssettlementaccountwithsaleprice(sameasoriginalspotpurchaseprice)andcreditsitsownaccount.16 CentralbankissuesDeliveryNoticetoBrokerAconfirmingcommoditysoldtoBrokerB.17 BrokerAactingascustodiantransferscommodityfromcentralbankcommodityaccounttoBrokerB’scommodityaccount.18 BrokerBsellsbackcommoditytoBrokerA.19 BrokerAactingascustodiantransferscommodityfromBrokerB’scommodityaccounttoitsowngeneralinventory.20Uponmaturity,centralbankmakesdeferredpayment(includingmark‑up)toIslamicbank.
Topical articles Islamic banks and central banking 167
Although there are a number of notification steps in the process, these are typically automated, through the use of Broker A’s web‑based CM system. This is important, because if any of the steps are missed or fall out of sequence, the overall transaction may be deemed non‑Shari’ah compliant. This also highlights the importance of Broker A to the CM arrangement more generally. If their system suffers an outage, or if the broker is otherwise unavailable, the transaction cannot proceed and the policy objective of the SCF cannot be fulfilled. Selection of the CM model would therefore entail careful due diligence of Broker A’s trading systems as well as their general capability as a trading intermediary.
Similarly, this model would require the Bank to open settlement accounts in respect of Brokers A and B, to net off exposures with the commodity brokers. This way, the only actual cash flows are between the Bank and the participating Islamic banks. For the Bank, a minimum of four accounts would likely be required, if two brokers are used on a regular basis, with two additional brokers as a contingency. Selection of a range of brokers to diversify counterparty risk could however be challenging, since only a small number of firms are active in this highly specialised market. It might be possible to mitigate this risk by transacting via commodity exchanges rather than directly with brokers, but ultimately oversight of this form of central banking activity could not be outsourced — responsibility would have to remain with the Bank.
Under the murabaha model, if an Islamic bank wished to break their deposit it would require them to initiate a countervailing trade with the Bank, running through all the process steps in Figure A1, but with the flows reversed. As noted previously, there would be a number of steps involved, but system automation would reduce the operational burden.
Use of commodities and commodity accountsSelection of the specific commodity to be traded is an important consideration. The Bank would have to give due regard to market preference on the list of permitted commodities for CM transactions, since this is primarily a question of Shari’ah compliance, and the commodities in question will be held by the broker rather than the Bank itself. The Bank might though find certain commodities to be less suitable for operational reasons: soft commodities such as cocoa and coffee would need to be transacted in greater quantities to reach the same transactional values, and some which are liquid, such as palm oil, might be problematic due to Shari’ah concerns over commingling in storage. A balance would need to be struck between having a suitable range of commodities to transact with, and ensuring each eligible commodity has a sufficiently high unit value and liquid market.
Broker A needs to open commodity accounts in respect of the central bank, and Broker B. This means that commodities are actually held by the broker; they are not held directly by either the central bank or the Islamic bank. This is sufficient to constitute constructive possession under Shari’ah standards, and reduces the need for the Bank to change/adjust its systems to be able to hold commodities, which central banks do not normally do. In commercial terms, it also makes it easier for Broker A to net off their commodity holdings with those of Broker B, especially if/when Broker B sells the commodity back to them. However, it is commonly understood that even if constructive possession is sufficient, physical delivery must be at least possible, even if seldom effected in practice. In terms of current market practice, where physical delivery is required by broker clients (which is rare), this must be requested prior to the initiation of a CM transaction.
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Glossary of selected Islamic finance terms
‘Aqd—Acontract.
Bai—Asale.
Bai al inah—Asalewithimmediaterepurchase—normallydeemedimpermissibleasitcanbeusedtoreplicateaconventionalinterest‑bearingtransaction.
Fiqh—Islamicjurisprudence,theinterpretationofthehigh‑levelprinciplesofIslamiclaw.Commonlydividedinto‘fiqhalmu’amalat’(jurisprudencepertainingtoactivitiesbetweenpeople)and‘fiqhalibadah’(jurisprudencepertainingtoactsofworship).
Gharar—Excessiveuncertaintyinacontract,whichmaygiverisetodispute.
Halal—PermissibleunderShari’ah.
Haraam—ImpermissibleunderShari’ah.
Ijarah—Alease‑basedcontract.
Islamic—Adheringto,orconsistentwith,thevaluessystemofIslam.
Ju’alah—Acontractinwhichonepartyoffersspecifiedremunerationtoanotherinreturnforthecompletionofaspecificpieceofwork.
Mudarabah—Asilentpartnershiparrangementinwhichoneparty(the‘rabbalmaal’)providescapitalandtheother(‘mudarib’orentrepreneur)providestime/expertisetoanenterprise.
Murabaha—Asaleofaparticularassetatadisclosedmark‑up.OftenusedinconjunctionwithcommoditiestogenerateareturnforShari’ahcompliantdeposits.
Musharakah—Apartnershiparrangementbetweentwoormoreparties,inwhichrisksandrewardaresharedproportionately.
Qard hasan—Aninterest‑freeloan,oftenusedforcharitablepurposes.
Riba—Technically,‘excess’orexcessivecompensation;theArabictermforinterestorusury.
Shari’ah—Thehigh‑levelprinciplesofIslamiclaw,commonlyderivedfrom(inorderofhierarchy):theQur’an,Sunnah(therecordedacts,sayingsandtacitapprovalsoftheProphetMuhammad),ijma’(consensusoftheearlyMuslimcommunity)and‘qiyaas’(reasoningbyanalogy).
Sukuk—Technically,pluralof‘sakk’.AcertificateentitlingtheholdertoabeneficialinterestinaShari’ahcompliantactivityorunderlyingasset,butexcludingshares.IntheUnitedKingdom,sukukareoftendesignatedundertheapplicablelegislationasAlternativeFinanceInvestmentBonds(AFIBs).Theeconomicandriskprofileofsukukwillvarydependingontheunderlyingstructure—somebehavelikeconventionalfixed‑incomeinstruments,whileotherswillresembleequitiesbutwithoutthevotingrights.
Takaful—Technicallymeaning‘tomutuallyguarantee’,aformofShari’ahcompliantinsurance.
Wa’ad—Apromise,normallyprovidedintheformofanundertakingtocarryoutaspecifiedactionatsomepointinthefuture.Commonlyenactedaseitherunilateral(inwhichapromisorprovidesanundertakingtoapromisee,wherethelatterisundernoobligation),orbilateral(knownas‘muwa’ada’inwhichtwopartiesproviderespectivelybindingundertakingstoeachother).Canbeusedtounderpinopenmarketoperationsorfinancialriskhedgingactivity.
Wadiah—Asafecustodyarrangement.Insomeinstances,abankholdingdepositsunderwadiahmaybepermittedtousethefundstogenerateaprofit,inwhichcasetheycanofferadiscretionaryreturn(‘hiba’,orgift)tothecustomer.
Wakalah—Anagency‑basedarrangement,inwhichaparty(‘wakeel’)actsasagentforaprincipal(‘muwakkil’).Commonlyusedasthebasisforbanking,investmentandinsuranceactivity.
Topical articles Islamic banks and central banking 169
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