Islamic banks face extra complexities from IBOR transition - Fitch Ratings

Fitch Ratings-Dubai/London-18 November 2020 - Islamic banks face more complexities than conventional banks in the transition away from legacy interbank offered rates (IBORs), given their additional need to ensure sharia compliance, Fitch Ratings says. The transition to a new generation of IBORs based on overnight risk-free rates (RFRs) could affect Islamic banks' Viability Ratings if it weakens their profitability due to higher operational costs, margin compression or reputational risk, especially for banks with low rating headroom. But we do not expect rating changes in the near term and RFR-derived term rates could offer a fall-back solution once legacy IBORs are discontinued. IBOR transition is due by end-2021.

Islamic banks face similar uncertainties to conventional banks from IBOR transition, including increased exposure to profit-rate, basis, operational and legal risks, and unclear implications for derivatives hedging and accounting. But the transition could be more challenging due to sharia-compliance implications.

The sharia principle of gharar (uncertainty or speculation) requires up-front certainty on all fundamental contract terms in asset-based transactions and the provision of services, including certainty on pricing, timing, delivery and each party's obligations and rights. This is possible when using legacy IBORs, such as London Interbank Offered Rates (LIBOR), which are forward-looking and available at the start of the calculation period, but more challenging with overnight RFRs, such as Sterling Overnight Index Average (SONIA), which are by nature backward-looking.

For example, the profit mark-up on a bank's commodity sale under cost-plus (murabaha) financing must be fixed before the sale. Setting the pricing later might be challenging under sharia principles. Similarly, under lease (ijara) financing, any variable element of the rental payment must be fixed before the start of the rental period.

About 70% of Fitch-rated Islamic banks use sharia-compliant derivatives (tahawwut), such as profit rate swaps and currency forward contracts, often linked to LIBOR. If IBOR transition generates uncertainty about the timing or amount of benchmark-based cash flows, it could make hedges less effective, affecting the pricing and valuation of legacy Islamic derivatives contracts.

The value of floating-rate sukuk with IBOR reference rates could be adversely affected when the reference rates are discontinued. However, most sukuk instruments are fixed-rate and unaffected by the transition.

Many Islamic banks are still in the early stages of preparation for IBOR transition but some have already updated their existing and new financing and liabilities/deposit contracts. Several banks now incorporate fall-back provisions in their documentation. Forward-looking term rates using RFRs as a foundation are under development, and could greatly assist the migration of debt instruments from legacy IBORs.

Islamic financial products often lack standardisation. Adapting to new RFRs could therefore be time-consuming and costly, particularly when fresh sharia-compliance opinion for affected products is needed from sharia boards. This could be less problematic in jurisdictions with centralised sharia boards, such as Malaysia. IBOR transition could motivate stakeholders to develop alternative Islamic benchmarks, which could reduce reliance on interest-based conventional benchmarks such as RFRs.

The Indonesian Overnight Index Average (IndONIA) has been published since August 2018 and the Turkish Lira Overnight Reference Rate (TLREF) has been published since June 2019. But regulatory developments to support Islamic finance IBOR transition are still at early stages in several jurisdictions.

Malaysia and Saudi Arabia are still in the process of developing suitable RFRs, while regulatory authorities in Bahrain and the UAE have asked banks to identify their exposures and develop roadmaps for new RFRs. Islamic finance standard-setting bodies have yet to announce significant guidance for IBOR transition.

Our ratings do not imply any confirmation that an issuer or sukuk is sharia-compliant. We assess non-compliance with sharia principles if it has credit implications.

Copyright Press Releases 2020

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