Benchmark reform: The impact of IBOR transition on the Islamic banking industry

On July 27, 2017, Andrew Bailey, the chief executive of the UK Financial Conduct Authority (the FCA), announced that the FCA did not intend to use its power to compel panel banks to submit to the London Interbank Offered Rate (LIBOR) beyond 2021 and that market participants should not rely on LIBOR being available in its current form after 2021. The announcement by the FCA was the first step in an attempt to implement an orderly transition away from LIBOR to risk-free rates (RFRs).

In this briefing, we will examine the following issues relevant to Islamic banking facilities that will arise from LIBOR transition and explore potential structuring solutions:

• Issue 1 – Fallbacks: Where an Islamic banking facility references LIBOR and the term of that facility extends beyond the end of 2021, the transaction parties will need to consider if any fallback provisions in that facility that apply upon LIBOR being unavailable are, if included, appropriate and satisfactory.
• Issue 2 – Practical issues related to using RFRs: LIBOR is a forward-looking term rate whereas the proposed replacement RFRs are backward-looking daily overnight rates. The timing and basis of calculation of interest and/or profit rates under finance documentation will therefore need to be amended were RFRs are used instead of LIBOR. The use of non-term RFRs may also create issues in terms of budgeting and banks’ operational systems.
  Forward-looking term RFRs (Term RFRs) may be developed for some currencies, but it is unclear if these will be available prior to the cessation of LIBOR as an approved benchmark and their use is likely to be restricted to specific markets and circumstances.
• Issue 3 – Value transfer and spread adjustment: RFRs are typically based on the overnight deposit rate of the relevant central bank and do not include term liquidity premium and bank credit risk inherent in LIBOR. Simply replacing the LIBOR with the RFR without any spread adjustment will reduce the overall financing cost and reduce the economic value of the financing arrangement to the bank.
• Issue 4 – Structural issues for Islamic banking facilities: Islamic banking facilities will have specific additional challenges in adapting to the use of backward-looking RFRs due to the fact such facilities typically use cash flows received from an asset or the provision of services to generate a return on the financing that must, under Shariah principles, be determined at the time the asset-based transaction is taking place or the provision of services is agreed.

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