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.