In a consultation paper (CP5/14) published in March, the UK Central Bank, the Bank of England, revealed it is looking at ways of raising the number of Shari'ah- compliant assets permissible in the UK that Islamic financial institutions (IFIs) may include in their liquid assets buffer.
Under the UK prudential regulatory standard BIPRU 12.7, there is currently only one asset that meets the eligibility criteria for inclusion in the liquid assets buffer of any of the 22 IFIs operating in the UK in which a Shari'ah-compliant firm may invest: Sukuk issued by the designated multilateral development bank, the Islamic Development Bank (Moody's: Aaa; Standard & Poor's: AAA). This limitation increases concentration risk, as the regulatory buffers of the Shari'ah-compliant firms are composed entirely of one asset.
In its consultation paper, the Bank of England said, "Recognising only one asset also potentially limits the growth of existing Shari'ah- compliant firms and creates barriers to entry for new Shari'ah-compliant firms due to the difficulties that can be experienced obtaining the asset.
"The Prudential Regulation Authority (PRA) proposes to amend eligibility criteria in BIPRU 12.7 to allow Shari'ah-compliant firms to include a wider set of assets in their liquid assets buffers. These proposals are intended to help reduce the risks of concentration in Shari'ah-compliant firms' liquidity buffers and they are intended to help remove potential barriers to growth and entry."
SOVEREIGN & CORPORATE SUKUK
The suggestions being put forward by the UK Central Bank broadly follow the approach to liquid assets set out in the Basel III Liquidity Coverage Ratio. "Consistent with the PRA's current regime, Sukuk issued by the highest- rated sovereigns may be included in a firm's liquid assets buffer without a haircut. In addition to these highest- quality assets, the PRA proposes to recognise Sukuk issued by sovereigns with lower credit ratings and other Sukuk that are not issued by a member of the financial sector. These lower- quality assets would be subject to haircuts and caps. The haircuts proposed use the Basel text as a benchmark, though in some instances the PRA proposes to increase the haircut to account for a less developed secondary market."
However, the Bank of England specifically rules financial sector Sukuk as not eligible for the liquid assets buffer, saying that this decision reflects the risk that such assets could become illiquid during financial sector stress which would be exactly when the firm might need to realise its liquid assets.
Looking forward, the European Commission is to adopt legislation by 30 June 2014 to specify the definition, calibration, calculation and phase-in of the Liquidity Coverage Requirement for implementation in 2015. The European Banking Authority's 'report on impact assessment for liquidity measures under Article 509(1) of the CRR includes a section on 'the definition of Shari'ah-compliant financial products as an alternative to assets that would qualify as liquid assets for the purposes of Article 416, for the use of Shari'ah-compliant banks'.
The Bank of England's consultation paper said, "The PRA will consider, among other things, the Commission's delegated act as it comes to a view on the alterations to its liquidity framework that it considers appropriate.
The proposed amendments to the UK regulatory framework are intended to be available to firms that fall within the new definition of a Shari'ah-compliant firm. Islamic banking currently accounts for a small proportion of the UK finance sector - of the 22 banks which provide Islamic financial services in the UK, only six are fully Shari'ah-compliant.
The Bank of England noted that it is important that 'the BIPRU 12 liquidity regime takes account of the specific requirements of Shari'ah-compliant firms and that the Shari'ah-compliant assets eligible to meet BIPRU 12 requirements are reasonably liquid'.
Despite the fast-growing nature of Islamic finance around the world it is a fact of life in the sector that Shari'ah- compliant firms have greater exposure to concentration risks due to the limited number of investments they may hold.
The UK Central Bank said, "This creates two risks in relation to liquidity risk management:
??Shari'ah-compliant firms will optimize liquidity mismatch to a greater extent than similar non-Islamic firms would do limiting balance sheet growth and entry of Shari'ah-compliant firms; and
??the liquid assets buffer of Shari'ah- compliant firms is more concentrated than that of similar non-Islamic firms resulting in comparatively higher risks to the safety and soundness of Shari'ah-compliant firms."
While developing a definition of liquid assets specific to Shari'ah- compliant firms which is different from the general definition may, said the UK Central Bank, give rise to level playing field concerns, unlike Shari'ah-compliant firms, conventional firms can hold non-Shari'ah assets to meet their liquidity requirements and therefore the proposals would allow Shari'ah-compliant firms to hold a similarly diverse liquidity buffer.
However, separate treatment for Shari'ah-compliant firms arguably leads to an inconsistent liquidity measure, as comparison of individual liquidity guidance across the Islamic and conventional sectors will be more difficult given that the assets held are different. Despite this concern, the Bank of England said, "Given the size and the limited number of Shari'ah- compliant firms in the UK, the impact of this difference of measurement is currently negligible."
PROMOTING SAFETY AND SOUNDNESS
In conclusion, the Bank of England said its proposals contribute to the PRA's general objective to promote the safety and soundness of firms as they are intended to help ensure that Shari'ah- compliant firms' liquid assets buffers are not concentrated in one asset.
"These proposals apply to banks, building societies and designated investment firms subject to BIPRU 12, including mutuals, who are unlikely to be affected as we do not believe any mutual currently meets the definition of Shari'ah-compliant firm.
"The PRA has considered matters to which it is required to have regard and believes that this statement is compatible with the Regulatory Principles. The proposals enable firms and the PRA to make judgements about concentration and liquidity risks in the liquid assets buffer and so advance the PRA's objectives. The proposals ensure that the affected firms are able to compete on an even footing with conventional firms.
"The PRA assessed whether the proposals in this consultation facilitate effective competition in the markets for services provided by PRA-authorised persons in carrying on regulated activities. This consultation does not constrain firm behaviour. The PRA has therefore not identified any constraints on competition from these proposals.
"The PRA has considered the equality and diversity issues that may arise from the proposals in this consultation. The conclusion reached is that the proposals will have a positive impact on equality in terms of the protected characteristic of faith."
Given the size and the limited number of Shari'ah-compliant firms in the UK, the impact of this difference of measurement is currently negligible