Islamic finance and Britain’s economic recovery from COVID-19
ISLAMIC finance has an important role to play in supporting Britain’s recovery from COVID-19, according to the Bank of England, as the lender becomes the first Western central bank to release a Sharia-compliant, non-interest based deposit facility.
Andrew Hauser, executive director of markets at BoE, said the facility, in which deposits from Islamic banks will be backed by a return-generating fund of Sharia-compliant assets, will strengthen the United Kingdom’s role as the leading financial centre for Islamic finance outside the Muslim world, particularly as it emerges from the pandemic.
“The core principles of Islamic finance are strikingly well-suited to responding to some of the biggest challenges we will all face in rebuilding our economy once Covid has passed,” Mr Hauser told delegates at the virtual UK Islamic Finance Week.
These include “prioritising equity-like risk-sharing over debt”, he said, as well as “factoring ethical and environmental considerations into investment decisions and embracing innovative financial solutions beyond traditional banking.”
The global Islamic finance services industry grew 11 per cent in 2019, when compared to a year earlier, with assets of $2.4 trillion making it one third bigger than it was in 2015.
Three-quarters of those Islamic finance assets are held by banks, with the industry also comprising a nascent Islamic insurance industry (takaful) and a much larger capital market. This is anchored by the growing stock of sukuk issued by companies and governments, and more than 1,500 Sharia-compliant investment funds.
The UK now has four exclusively Islamic banks with assets of more than £5bn, and more than a dozen conventional banks offering Sharia-compliant services, alongside a growing band of investment firms and advisory companies.
The human and economic cost of COVID-19 has hit the Muslim world hard, said Mr Hauser, which is why some might worry that the pandemic will “slow the pace of growth in Islamic finance, as economic activity declines.”
Market participants may then revert to more conventional tools, to meet the daunting needs of the crisis, he said.
Scott Levy, chief executive of London-based Bedford Row Capital (BRC), which specialises in issuing sharia-compliant debt for small-to-medium-enterprises, said the UK’s mid-market sukuk industry is severely undersupplied, but has huge growth potential as there are not currently enough products to meet demand from international and Middle East investors.
“The UK environment will increase through better education and supporting companies in the UK to actually go out to market and talk about it,” he told The National.
“There is an Islamic finance aspect of the City in the UK which talks about London being a hub for Islamic finance. But unless people like us actually do something, it’s not going to happen.”
BRC was set up in 2015 to try to plug the financing gap for SMEs as banks became increasingly reluctant to lend.
Sukuk bond issuance now makes up about 70 per cent of the firm’s business, with the company expecting to bill between $500m and $1bn in sukuk issuance next year, with at least half of the funds made up of inward investment into the UK, mainly from the Middle East. Much of that funding will go towards the supply chain for the food industry, Mr Levy said, to ensure that food security is not compromised during the pandemic.
“Because of Covid, [conventional] banks are being even more conservative about what they invest in. And the less the banks do, the more opportunities there are for us.
“Nobody knows the future, so the people that would traditionally look at medium-term investing now won’t, so people are sitting on cash, desperate to find something to do with their money. So this is why we are looking at food security,” he said.
In September, the company unveiled multi-currency denominated Sharia-compliant and conventional short-dated Insured Money Market Certificates (IMMC), which aims to raise €250m ($301.2m) by targeting the agricultural sector and offering a positive return to investors.
“With so much uncertainty and rates at record lows or in negative territory, investors are hungry for secure benchmark-beating returns,” Mr Levy said.
Professor of banking and finance at the Business School Thorsten Beck said London had the potential to take the lead on sukuk debt issuance because of its historical relationship with Islamic finance and the infrastructure it has in place to support product development and new kinds of funding.
This position could be compromised, he said, when the UK finally ends the Brexit transition period on December 31.
“If you asked whether London could also become a European Centre for Sharia-compliant finance, I have to be a bit more sceptical because we have to see what is going to happen with Brexit. There are other competitors such as the Netherlands, for example, that also want to tap this market,” Mr Beck told The National.
Mr Hauser said the UK’s historical relationship with the sector, from the commodity-based short-term liquidity management and trade finance of the 1970s to the first UK Islamic bank, investment funds and takaful in 1980s, make it the pre-eminent centre for Islamic finance.
“That reflects its significant, well-established domestic Muslim population; its strong relationships with the wider Muslim world; and its deep expertise in financial market origination and distribution, embedded in a mature legal and regulatory framework,” he said.
Key aspects of Islamic finance also make it particularly well-suited to financing the post-COVID-19 recovery.
“First, the philosophical focus 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 Covid,” he said.
When interest rates are low, the attractions of conventional debt are obvious, Mr Hauser said, particularly for those able to lock in fixed-term rates in local currencies. Those borrowing at floating rates, short maturities or in foreign currencies, however, face “sharp negative income shocks” when rates rise, debt rolls over or local currencies depreciate.
“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,” he said.
The lender has teamed up with the finance ministry and the UK Financial Conduct Authority to form a high-level working group to consider ways to foster a longer-term financial markets culture to support productive investment.
Other benefits of Islamic finance, said Mr Hauser, include the fact it avoids investing in socially detrimental activities, something that offers plenty of scope for further growth.
“Issuance of so-called ‘green sukuk’ has risen sharply in the past three years – and the Islamic Development Bank issued an innovative $1.5bn sustainability sukuk in June. But these are still quite modest numbers relative to the vast sums of money now looking to invest in credible environmental, social and governance assets,” he said.
Islamic banks often face challenges in efficiently managing their liquidity, because the ban on the payment or receipt of interest prevents them from accessing the tools to do so.
Mr Hauser said the BoE’s new Alternative Liquidity Facility (ALF) would “help level the playing field” as it allows Islamic banks to hold a reserves-like asset in a non-interest based environment.
Set for release in the next few months, the ALF will be structured as a wakalah or fund-based model often used by the sector.
“The strengths of this model include its relative simplicity – conceptually and practically – and its flexibility to accommodate future changes in what is a still fast-developing market,” Mr Hauser said.
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.”
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