IFSB WORKING PAPER SERIES

WP-26/12/2022

TRANSITIONING FROM LONDON

INTERBANK OFFERED RATE (LIBOR) TO
RISK-FREE RATES (RFRs): EARLY
POLICY RESPONSES IN SELECTED
JURISDICTIONS

December 2022
IFSB WORKING PAPER SERIES
Technical and Research Department

WP-26/12/2022
TRANSITIONING FROM LONDON INTERBANK OFFERED RATE
(LIBOR) TO RISK-FREE RATES (RFRs): EARLY POLICY
RESPONSES IN SELECTED JURISDICTIONS

Hechem Ajmi

December 2022

NOTE: IFSB Staff Papers are published by the IFSB to seek comments and encourage
discussion on issues that are pertinent to the specificities of the Islamic financial services
industry. IFSB Staff Papers present preliminary results of research in progress and represent
the views of the author(s); as such, they should not be reported as representing the views of
the IFSB.

Correspondence email: [email protected]

Published by: Islamic Financial Services Board (IFSB)

Level 5, Sasana Kijang, Bank Negara Malaysia

2, Jalan Dato’ Onn, 50480 Kuala Lumpur, Malaysia

Email: [email protected]; [email protected]

ISBN 978-967-5687-66-2

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© 2022 Islamic Financial Services Board

 ABOUT THE ISLAMIC FINANCIAL SERVICES
BOARD (IFSB)

The IFSB is an international standard-setting organisation which was officially

inaugurated on 3 November 2002 and started operations on 10 March 2003. The
organisation promotes and enhances the soundness and stability of the Islamic
financial services industry by issuing global prudential standards and guiding
principles for the industry, broadly defined to include banking, capital markets and
insurance sectors. The standards prepared by the IFSB follow a lengthy due
process as outlined in its Guidelines and Procedures for the Preparation of
Standards/Guidelines, which involves, among others, the issuance of exposure
drafts, holding of workshops and, where necessary, public hearings. The IFSB
also conducts research and coordinates initiatives on industry-related issues, as
well as organises roundtables, seminars and conferences for regulators and
industry stakeholders. Towards this end, the IFSB works closely with relevant
international, regional and national organisations, research/educational
institutions and market players.
For more information about the IFSB, please visit www.ifsb.org.

i
ABBREVIATIONS

AAOIFI Accounting and Auditing Organization for Islamic Financial Institutions

ARRC Alternative Reference Rates Committee
BHIROR Bahraini Dinar Interbank Offer Rate
BSRA Banking Regulation and Supervision Agency
BR Base Rate
CAPM Capital Asset Pricing Model
CBO Central Bank of Oman
CBN Central Bank of Nigeria
CME Chicago Mercantile Exchange
COF Cost of Fund
CSIA Compounded Setting in-Arrears
EONIA Euro Overnight Index Average
EIBOR Emirates Interbank Offered Rate
ESTR Euro Short-Term Rate
FCA Financial Conduct Authorities
FSB Financial Stability Board
ICE Intercontinental Exchange Benchmark Administration
ICM Islamic Capital Market
IndoNIA Indonesia Overnight index Average
IIFS Institutions Offering Islamic Financial Services
IIFM International Islamic Financial Market
IsDB Islamic Development Bank
IFSB Islamic Financial Services Board
ISDA International Swaps and Derivatives Association
JIBOR Jakarta Interbank Offered Rate
KIBOR Karachi Interbank Offered Rate
KLIBOR Kuala Lumpur Interbank Offered Rate
LIBOR London Interbank Offered Rate
MYOR Malaysia Overnight Rate
MYORi Malaysia Overnight Rate Islamic

ii
NIBOR Nigeria Interbank Offered Rate
OIS Overnight Index Swap

OMIBOR Oman Interbank Offered Rate

OMR Omani Rial

PKR Pakistani Rupee

QCB Qatar Central Bank

QCBDR QCB Deposit Rate

QCBLR QCB Lending Rate

QMR Qatar Money Market Rate Standing Facility

QCBRR QCB Repo or Repurchase Rate

RFR Risk-Free Rate

RSA Regulatory and Supervisory Authorities

SOFR Secured Overnight Financing Rate

SONIA Sterling Overnight Index Average

SAIBID Saudi Arabian Interbank Bid Rate

SAIBOR Saudi Arabian Interbank Offered Rate

TLREF Turkish Lira Overnight Reference Rate

TR LIBOR Turkish Lira Interbank Bid Rate

TONAR Tokyo Overnight Average Rate

iii
Abstract
The transition away from LIBOR to RFRs triggered several financial and regulatory
issues for RSAs in jurisdictions offering Islamic financial services. During the early
stage of the transition phase, RSAs have put in place several policy measures to
mitigate the adverse effect of LIBOR`s abolishment and foster Islamic banks`
resilience. This study, therefore, opts for a qualitative approach based on a survey
questionnaire to gather inputs on challenges related to (i) LIBOR`s use and
application across jurisdictions offering Islamic financial services, (ii) exposures
and fallbacks, (iii) RFRs use and application across jurisdictions, (iv) major
transitioning financial risks, (v) regulatory and supervisory challenges, and (vi) the
additional roles that the IFSB can play during the transition phase. Responses
were collected from 69 participants, mainly 11 RSAs and 64 Islamic banking
institutions from various jurisdictions. In response to the raised issues,
respondents provided sets of policy measures and actions taken to maintain a
smooth transition process. After examining participants` feedback thematically
and comprehensively, relevant results are provided. First, a lack of significant
market disruptions is found, proving the magnitude of regulators` efforts to ensure
a smooth transition to RFRs. Results show that IIFS have low exposure to LIBOR
as it was being used for foreign currency-denominated transactions, whereas local
reference rates were utilized for domestic transactions. Second, the study
illustrates various policy measures that have been adopted by RSAs across
jurisdictions enabling IIFS to mitigate major transitioning risks, as well as
regulatory and supervisory challenges that have been triggered when transitioning
from LIBOR to RFRs. Third, the study highlights additional challenges that
regulators and standard setters interested in Islamic finance can address to
strengthen the resilience of the Islamic banking sector.

Keywords: LIBOR, RFRs, Islamic banks` stability, Regulations

JEL Classifications: F65, G21, G28

iv
Table of Contents

ABOUT THE ISLAMIC FINANCIAL SERVICES BOARD (IFSB) ......................................... i

ABBREVIATIONS ................................................................................................................. ii
Abstract ............................................................................................................................... iv

SECTION 1: INTRODUCTION .............................................................................................. 5

1.1 Background .................................................................................................................... 5
1.2 Objectives....................................................................................................................... 4
1.3 Scope of the Paper ........................................................................................................ 4
1.4 Methodological Assumptions and Limitations ........................................................... 5
1.5 Structure of the Paper ................................................................................................... 5
SECTION 2: LITERATURE REVIEW ................................................................................... 6
SECTION 3: RESEARCH METHODOLOGY AND DATA.................................................... 9
3.1 Research Methodology ................................................................................................. 9
3.2 Data ............................................................................................................................... 11
SECTION 4: RESULTS ....................................................................................................... 11
4.1 General Background ................................................................................................... 11
4.2 Exposures and Fallbacks on LIBOR .......................................................................... 16
4.3 Policy Measures on Major Transitioning Risks ........................................................ 21
4.4 Policy Measures on Regulatory and Supervisory Challenges ............................... 23
4.5 Additional Roles of the IFSB ...................................................................................... 25
SECTION 5: POLICY IMPLICATIONS AND CONCLUSION ............................................ 26
5.1 Policy Implications ...................................................................................................... 26
5.2 Conclusion ................................................................................................................... 28
References ......................................................................................................................... 30

v
SECTION 1: INTRODUCTION

1.1 Background
The London Inter-Bank Offered Rates (LIBOR) have been used for several decades
as a global benchmark for interest rates benchmark, underpinning derivatives,
loans/financings, bonds, and other financial products. The London Inter-Bank Offered
Rates (LIBOR) measure the interest rates that large banks offer when lending to each
other on an unsecured basis in the London short-term money market. It represents the
average of submissions from a panel of banks and is published by ICE Benchmark
Administration (IBA), which is regulated by the Financial Conduct Authority (FCA).

LIBOR has been used in the financial world as a reference rate that underpins more
than USD 400 trillion of financial contracts, derivatives, bonds, loans, and other
exposures worldwide. It was calculated for five currencies (USD, GBP, EUR, CHF, and
JPY) and seven tenors in respect of each currency (Overnight/Spot Next, One Week,
One Month, Two Months, Three Months, Six Months, and 12 Months).

LIBOR has been calculated as of 11.00 every London business day and is normally
published by ICE Benchmark Administration (IBA) at 11.55 London time. It represents
a trimmed arithmetic mean that excludes the highest and lowest quartile of
submissions. Trimmed mean is a method of averaging, which eliminates a small
specified percentage of the largest and smallest values before calculating the mean.
Each panel bank’s submission carries an equal weight, subject to the trimming.

The IBA has constituted a designated panel of global banks for each currency and
tenor pair. For example, 16 major banks, including Bank of America, Barclays,
Citibank, Deutsche Bank, JPMorgan Chase, and UBS constitute the panel for U.S.
dollar LIBOR. Only those banks that have a significant role in the London market are
considered eligible for membership on the ICE LIBOR panel, and the selection process
is held annually. Although LIBOR has been used for several decades as a global
benchmark, it showed several weaknesses, which became more apparent with the
global financial crisis of 2007-08 (BCBS, 2020). In 2017, the FCA and the Bank of
England’s Financial Policy Committee (FPC) noted that it had become increasingly
apparent that the absence of active underlying markets and the scarcity of term
unsecured deposit transactions raised serious questions about the future sustainability
of the LIBOR benchmarks.

5
A review set up by the British government identified several issues which include (i) its
subjective nature in which a shortage of transaction data meant that submissions were
largely based upon expert judgement rather than actual transactions; (ii) both banks
and individuals within them had incentives to manipulate the rates, and there had been
significant manipulation over a period of years; and (iii) there were major weaknesses
in governance, which at that time lay with the British Bankers Association. This led to
a set of immediate reforms in governance, regulation, and calculation, but also to
international efforts coordinated by the Financial Stability Board (FSB) to reform
benchmark rates1.

The FSB and other standard-setters set the objective of transitioning away from LIBOR
to more robust benchmarks, and a large amount of detailed work was undertaken. In
early 2020, the market turmoil during the COVID-19 pandemic added impetus to the
transition. The limited number of market transactions underpinning LIBOR decreased
even further, meaning that these rates were almost entirely based on expert
judgement.2

The Financial Stability Board3, therefore, has admitted that continuing the reliance of
global financial markets on LIBOR poses clear risks to global financial stability, and in
October 2020 it published a global transition map away from LIBOR4. On 5 March
2021, IBA and the FCA formally confirmed the dates that panel bank submissions for
all LIBOR settings will cease, after which representative LIBOR rates will no longer be
available.

The majority of LIBOR panels will cease at the end of this year, with several key US
dollar (USD) settings continuing until the end of June 2023,5 to support the rundown of
legacy contracts only. The extended dates for the USD LIBOR tenors may enable
legacy USD LIBOR contracts to mature before LIBOR experiences disruptions

1See FSB, (2022), LIBOR and other benchmarks - Financial Stability Board (fsb.org)
2 See Bank of England (2020), Interim Financial Stability Report, May. Available at
https://www.bankofengland.co.uk/-/media/boe/files/financial-stability-report/2020/may-2020.pdf
3 See FSB (2021a) `Transition away from LIBOR requires significant commitment and sustained effort

from both financial and non-financial institutions across many LIBOR and non-LIBOR jurisdictions`.
https://www.fsb.org/2021/06/global-transition-roadmap-for-libor-2/
4 See FSB (2021b) Global Transition Roadmap for LIBOR - Financial Stability Board (fsb.org)
5 See FCA (Financial Conduct Authority) (2021) ‘FCA Announcement on Future Cessation and Loss of

Representativeness of the LIBOR Benchmarks’, 5 March:

https://www.fca.org.uk/publication/documents/future-cessation-loss-representativeness-libor-
benchmarks.pdf

6
because the transition of these contracts to alternative reference rates will be
challenging.6

With timelines for the cessation of LIBOR panels confirmed, there should be no
remaining doubts as to the urgency of the need to transition away from LIBOR by the
end of 2021 (FSB, 2021c). The FSB encouraged authorities to set globally consistent
expectations and milestones that firms will rapidly cease the new use of LIBOR,
regardless of where those trades are booked or in which currency they are
denominated. Market participants were urged to cease new use of LIBOR in all
currencies as soon as practicable7, respecting national working group timelines and
supervisory guidance where applicable, and in any case no later than the end of 20218.

Consequently, continued reliance of global financial markets on LIBOR benchmarks,

particularly the most widely used USD LIBOR settings, might pose risks to financial
stability, market integrity, and investor protection. It also creates various consumer
protection, litigation, and reputational risks (IOSCO, 2021). Regulators, therefore, have
been urging market participants to replace LIBOR with recommended Risk-Free rates
(RFRs) which tend to be backward-looking overnight reference rates compared to
LIBOR which is forward-looking9.

Interestingly, the issue of backward-looking is becoming uncommon with the

introduction of CME Term SOFR rates. This benchmark rate is a daily set of forward-
looking rates, calculated and published for 1-month, 3-month, 6-month, and 12-month
tenors. Each CME Term SOFR Reference Rates tenor will start on (and include) the
second US Government Securities Business Day following the publication day and
span the corresponding tenor (e.g., 1-month, 3-month, 6-month, 12-month) in
accordance with modified following day-count conventions10.

The CME Term SOFR Reference Rates calculation method enables determining a
possible path of overnight rates that is consistent with the observable averages implied

6 See BOG (2020), ‘Statement on LIBOR Transition’, 30 November, Board of Governors of the Federal
Reserve System, Federal Deposit Insurance Corporation, and Office of the Comptroller of the Currency:
https://www.federalreserve.gov/newsevents/pressreleases/files/bcreg20201130a1.pdf
7 IOSCO (2021), The Board of International Organization of Securities Commissions, Statement on

Benchmarks Transition.
8 FSB (2021c): Progress Report to the G20 on LIBOR Transition and Remaining issues, The Financial

Stability Board
https://www.fsb.org/2021/07/fsb-urges-action-to-complete-the-transition-away-from-libor-by-
end2021/#:~:text=In%20June%202021%2C%20the%20FSB,is%20chaired%20by%20Randal%20K.
9 AAOIFI (2021) Research on Alternative Reference Rate, Benchmark Rate for Islamic Finance in post

LIBOR scenario
10 CME (2022), `CME Term SOFR Reference Rates Benchmark Methodology`, CME Group Benchmark

Administration Limited. Available at https://www.cmegroup.com/market-data/files/cme-term-sofr-

reference-rates-benchmark-methodology.pdf

7
by SOFR based derivative contracts. Intuitively, averages over standard tenors can be
directly created once the path of overnight rates is determined. The publication of CME
Term SOFR reference rates occur on the next business day following the business day
during which future data sampling takes place. Term SOFR reference rates are
computed based on a reference period that begins two Business Days (T+2) after the
publication date settlement.

Although several changes have been done at the global level, regulators and market
players have considered rigorous policy measures to cope with the new benchmark
reforms to ensure a smooth transition process11. Considered as a part of the global
financial sphere, Islamic financial institutions (IIFS) are somehow exposed to LIBOR,
whereas their exposure is less likely to be significant compared to their conventional
counterpart. This implies that RSAs in jurisdictions offering Islamic financial services
are also concerned about the LIBOR transition because it might have an impact on the
resilience and stability of the Islamic finance sector. Global and national regulators in
jurisdictions offering Islamic financial services have been monitoring the progress on
the LIBOR transition closely and coordinating on supervisory issues. This included
collaboration on implementing cross-industry solutions and active dialogue between
large Islamic financial institutions and various stakeholders (FSB, 2021c). To this
extent, this working paper aims to identify the various policy measures adopted in
jurisdictions offering Islamic financial services when transitioning away from LIBOR.

1.2 Objectives
Although this research paper aims to complement other IFSB`s efforts to facilitate a
smooth transition away from LIBOR, the study embarks on three objectives:

a. To identify the risks and challenges that occurred during the early stage of the
transition phase;
b. To ascertain early policy responses in mitigating the adverse effects of LIBOR
transitioning related risks on the resilience of the Islamic banking sector,
c. To determine the IFSB`s additional roles towards a smooth transitioning
process;

11For an in-depth understanding of LIBOR`s cessation background and alternative rates utilisation in
jurisdictions offering IIFS , See IFSI, Stability Report (2022),
https://www.ifsb.org/download.php?id=6571&lang=English&pg=/sec03.php

8
1.3 Scope of the Paper

This working paper gathers inputs from RSAs and IIFS on the various actions and
policy measures that have been adopted to mitigate the adverse effects of transitioning
away from LIBOR on the Islamic banking industry. More precisely, it aims to identify
the early policy responses and measures that have been taken against various risks,
from financial, regulatory and supervisory point of view. The outcome of this study shall
help regulators and policy makers to have an in-depth understanding of the actions
taken by various RSAs and their respective market players, to ensure the resilience of
the Islamic banking sector.

1.4 Methodological Assumptions and Limitations

When transitioning away from LIBOR, various risks were triggered from financial and
regulatory perspectives, subject to IIFS exposure to LIBOR tough legacy contracts in
particular. Using a qualitative methodology, a survey questionnaire is circulated to
regulators and market players (IIFS) in jurisdictions offering Islamic financial services.
The survey incorporates open-ended questions to seek for respondents` feedback on
various issues and challenges such as: (i) LIBOR`s use and application across
jurisdictions offering Islamic financial services, (ii) exposures and fallbacks, (iii) RFRs
use and application across jurisdictions, (iv) major transitioning financial risks, (v)
regulatory and supervisory challenges, and (vi) the additional roles that the IFSB can
play during the transition phase.

Once the issues are identified, specific policy measures are gathered from RSAs and
IIFS with regards to each issue, then analysed on a thematic approach across
jurisdictions. Although this study aims at giving a holistic examination of the adopted
early policy measures across jurisdictions, it does not include a comparative
assessment on alternative risk-free rates adopted across RSAs in jurisdictions offering
Islamic financial services in anticipation of LIBOR cessation. This could be the subject
of future IFSB`s undertakings when necessary to provide an in-depth understanding
of the main practices in terms of RFRs` implementation. The idea could also be
extended to cover any differences in terms of RFRs utilization and regulatory and
supervisory aspects between Islamic banks and their conventional counterparts,
leading to a clearer understanding of the recent development worldwide.

9
1.5 Structure of the Paper

This paper comprises five sections. Section 2 provides a literature review. Section 3
describes the methodology and data characteristics. Section 4 discusses the results.
Section 5 provides a review of the policy implications, as well as a conclusion.

SECTION 2: LITERATURE REVIEW

Since the establishment of the Islamic finance industry, practitioners and researchers
have been seeking for shari`ah compliant alternative rates (IRTI, 2020). The Islamic
finance industry has continued the adoption of conventional benchmarks due to the
lack of a reliable Islamic interbank benchmark. In revanche, several interesting models
have been proposed. For instance, macroeconomic models have been suggested to
develop the Islamic benchmark rate (Hasan and Aznan, 2020; IRITI, 2020). The
proposed models, considered the expected economic growth as a proxy to capture
economic development across jurisdictions offering Islamic financial services.
Intuitively, this will make the development of an Islamic benchmark rate more realistic,
while Islamic finance is strongly related to the real economy. In addition, another group
of researchers12 introduced the capital asset pricing model (CAPM)13, whereas the
study by Majeed (2014) suggested the use of equity indices as pricing benchmarks.

The rates of return-based on budgetary surplus was proposed by Choudhry and

Mirakhor (1997) and Sari et al., (2017), whereas Mannan (1982) suggested the
accounting price of capital to be employed when calculating the benchmark rates. Last
but not least, the studies by Mirakhor (1996) and Ali and Azmi (2014) suggested
Tobin`s Q to be considered as a cost of capital in an interest-free economy, where
price return-based measures can be computed for a shorter frequency with daily
closing tick by tick data.

Although the aforementioned studies provide relevant suggestions about the

development of Islamic benchmark rates, RSAs offered to IIFS the possibility to opt for
an appropriate benchmark rate that is in line with international standards as long as it
is shari`ah compliant. The lack of standardisation and the raise of uncertainty during
the early stage of the transition period urged RSAs and market players to shed some

12 See Omar et al (2010) and Zangeneh and Salam (1993), for the theoretical understanding of adopting
the CAPM model to construct an Islamic interbank benchmark
13 See the studies by Sharpe, (1964) and Ross, (1976), for the theoretical understanding of the capital

asset pricing model and the Arbitrage Pricing theory, respectively.

10
lights on the potential issues related to transitioning from LIBOR to RFRs subject to
their exposure. In this regard, the recent study by IIFM14 proposed directives and
recommendations to mitigate the potential risks related to transitioning from LIBOR
(IIFM, 2021).

Strictly speaking, the transition from LIBOR to RFRs might trigger some challenges for
Islamic Banking transactions15. Although LIBOR is a forward-looking rate, enabling
banks to calculate the interest at the start of the contract, shifting to RFRs (given the
rates are overnight) might be challenging for Islamic banks due to their backward-
looking nature16. Overnight rates must be compounded in arrears over the actual
interest period; thus, the borrower will not be able to know for certain the interest
payment amount until shortly before the end of the period17. The backward-looking of
RFRs represents a lack of complete certainty on the products` terms, leading to
excessive (gharar) uncertainty18.

Similarly, a smooth transition from LIBOR to RFRs requires efforts to discontinue

LIBOR in legacy contracts (FSB, 2021c). Thus, the transition from LIBOR to RFRs on
Islamic Banking transactions may trigger issues19 related to a number of areas besides
the Shari`ah risk related to (gharar) such as pricing, accounting, liquidity risk,
operational risk, credit risk, market risk, supervisory and regulatory risks (including
legacy contracts and documentation) (IIFM, 2021, Clyde and CO, 2021).

In terms of pricing, the LIBOR includes the bank`s credit risk. It also incorporates a
liquidity premium contingent on the relevant terms (Clyde and CO, 2021). The RFR,
being overnight rates based on actual transactions, does not include these elements.
This means that an RFR could be a lower rate than LIBOR, which may leave a pricing

14 IFN (2021a), IIFM introduces Islamic solutions for risk-free rate benchmark as LIBOR phases out,
https://www.islamicfinancenews.com/daily-cover-story-iifm-introduces-islamic-solutions-for-risk-free-rate-
benchmark-as-libor-phases-out.html
15 Watson Farley and Williams (2021), LIBOR Transition, Implications for Islamic Finance,

https://www.wfw.com/articles/libor-transition-implications-for-islamic-finance/
16 Dentons (2021), LIBOR transition and Islamic finance in the GCC – accelerating the transition

https://www.dentons.com/en/insights/articles/2021/august/17/libor-transition-and-islamic-finance-in-the-
gcc
17 DLA Piper (2020): The demise of LIBOR: Is it an issue for Islamic banking?
https://www.dlapiper.com/en/us/insights/publications/2020/04/finance-and-markets-global-insight-issue-
18/the-demise-of-libor-is-it-an-issue-for-islamic-banking/
18Clifford Chance, (2020), Transitioning from LIBOR: Implications for Islamic Finance,
https://www.cliffordchance.com/content/dam/cliffordchance/briefings/2020/07/transitioning-from-libor-
implications-for-islamic-finance.pdf
19 IFN (2021b), LIBOR Transition: Challenges for Islamic Banks,
https://www.islamicfinancenews.com/libor-transition-challenges-for-islamic-banks.html

11
gap (Clyde and CO, 2021). As a result, various financial risks such as market risk and
liquidity risk might be triggered.

Accounting challenges may also arise due to the following issues: (i) relevance of
modification in financial assets and financial liabilities concept as defined in generally
accepted accounting principles; (ii) treatment of rental or profit amount in executory
contracts (where performance remains outstanding) and their related accounting; (iii)
treatment of profit amount in equity or quasi-equity type contracts; and (iv) treatment
of agency fee where it is based on variable benchmark rate such as LIBOR (IIFM,
2021). In addition, Internal controls need to be updated along with accounting and
financial processes. This includes debt compliance, inputs used in valuation models,
and potential income tax consequences20.

From supervisory and regulatory perspectives, RSAs should consider the appropriate
RFR to be chosen, and how to incorporate it into the financing agreement (Clyde and
CO, 2021). Failing to establish a comprehensive framework, therefore, may engender
internal issues leading to reputational and operational risks.

Based on the aforementioned insights, introducing a new benchmark needs to

consider all potential issues that may arise in relation to various stakeholders including
customers, bankers, regulators, and supervisors to ensure transparency and
compliance. Intuitively, RSAs in jurisdictions offering Islamic financial services should
focus on the various implications of transitioning from LIBOR to RFRs to maintain
confidence among stakeholders as well as the soundness of the Islamic financial
sector.

Interestingly, the IFSB conducted a questionnaire survey analysis to collect inputs from
RSAs in jurisdictions offering Islamic financial services regarding the potential
challenges that Islamic financial institutions may face during the transition period (IIFS,
Stability Report 2022). The survey was responded to between November and
December 2021, by 24 RSAs representing 21 countries in Asia, Africa, and the Middle
east regions. In addition to RSAs, the IsDB has been incorporated in the study due to
its efforts and initiatives in fulfilling economic sustainability and financial stability in
member countries.

20Mark D. Mishler (2020), End of LIBOR: How all industries, not just banks, can prepare, Journal of
Accountancy: https://www.journalofaccountancy.com/issues/2020/aug/end-of-libor-how-to-prepare.html

12
Several issues (potential risks) that may arise due to the transitioning from LIBOR to
alternative RFRs have been highlighted. It was found that profitability calculation and
market risk are most likely to arise when transitioning from LIBOR to RFRs as stated
by 63.16% and 57.89% of the respondents. Furthermore, 52.63% of the respondents
revealed that operational and regulatory risks may arise due to the transition process,
whereas 47.37% of the respondents admitted that the transition process may trigger
liquidity risk as well as shari`ah risks. In addition, the survey`s results showed that
36.84% of the respondents revealed that credit risk is most likely to arise when
replacing the LIBOR with RFRs, whereas the accounting and reputational issues may
be triggered along the process as mentioned by 26.32%. Finally, the presence of
governance risk was identified by 21.09% of the respondents.

As an attempt to mitigate the aforementioned potential transitioning risks, RSAs in

jurisdictions offering Islamic financial services considered various preliminary
measurements such as: (i) issuing circulars to the banks to set plans, (ii) setting internal
goals and deadlines for the transition from LIBOR, and (iii) implementing permanent
reviews through specialized work teams to determine the extent of commitment and
progress. Furthermore, the survey questionnaire provided relevant inputs on the
Alternative Rate(s) that RSAs have adopted during the transition period. RSAs have
been working on developing alternative rate(s) under consideration as part of their
transitional arrangements on LIBOR`s abolishment. The outcome of the survey
provides relevant inputs on RSAs potential alternative rates under consideration. Most
RSAs considered the overnight reference rates in addition to international rates such
as SOFR, SONIA, €STR, and TONAR to ease financial transactions during the
transition period.

Admitting that the previous IFSB`s assessment attempted to identify the potential
challenges related to LIBOR`s abolishment as preliminary actions/measures utilized
by regulators (IIFS, Stability Report 2022), this research paper focuses on identifying
the implemented policy measures related to various challenges that RSAs have faced
when transitioning away from LIBOR. The outcome of this analysis enables us to
assess how RSAs and market players in jurisdictions offering Islamic financial services
have mitigated the adverse impact of LIBOR discontinuation, depending on their
Islamic financial institutions` exposure.

13
SECTION 3: RESEARCH METHODOLOGY AND DATA

3.1 Research Methodology

This research paper opts for a qualitative methodology to gather inputs from RSAs and
market players (Islamic banks) on the various policy measure that have been taken to
mitigate the challenges related to LIBOR abolishment. The data used in this study is
collected via questionnaire survey distributed online. The survey was responded to
between March and April 2022 by 75 participants representing 11 RSAs and 64 IIFS
from countries in Asia, Africa and Middle-East regions (See section 3.2 for further
details).

The survey comprised mainly closed-ended questions with codes to indicate options a
respondent might wish to select. In some other instances, open-ended questions were
also included for the respondents to freely express their opinion on related matters
beyond the options provided. Owing to the exploratory nature of the research, data
elicited from respondents were subjected to descriptive data analysis only, mainly
based on simple percentages and frequency to show relative importance.21

The survey questionnaire includes questions related to (i) LIBOR`s use and application
across jurisdictions offering Islamic financial services, (ii) exposures and fallbacks, (iii)
RFRs use and application across jurisdictions, (iv) major transitioning financial risks,
(v) regulatory and supervisory challenges, and (vi) the additional roles that the IFSB
can play during the transition phase. The survey is developed based on the outcomes
of previous IFSB`s assessments of the transition phase (IIFS, Stability Report 2022),
as well as the Financial Stability Board`s recent publication on supervisory issues
associated with benchmark transition (FSB, 2020; 2021a, 2021b, 2021c).

The first part of the survey aims to collect inputs on LIBOR`s application across
jurisdictions offering IIFS. The second part instigates Islamic financial institutions`
exposure to LIBOR and specific fallbacks considered to avoid any adverse effect of
LIBOR legacy contracts on the stability of Islamic financial institutions. The third part
focuses on RFRs use and application across jurisdictions. The fourth and the fifth parts
attempt to gather inputs on the various policy measures that RSAs have adopted
subject to the occurrence of major transitioning financial challenges and regulatory and
supervisory issues, respectively. Finally, the sixth part highlights the additional roles of
the IFSB in providing guidance and recommendations to RSAs in jurisdictions offering

21The analysis is based on pooled data which may conceal jurisdictional or institutional peculiarities. This
concern is addressed in some instances in this paper in cases where such a peculiarity is considered
material and relevant information is available.

14
Islamic financial services to ensure resilience and stability during the transition phase.
In a nutshell, this study aims to provide relevant insights on the recent development
made by RSAs in jurisdictions offering Islamic financial services in terms of policy
measures to mitigate the adverse effect of the transition phase from financial,
regulatory and supervisory perspectives.

3.2 Data
This research paper aims at identifying the early responses to LIBOR discontinuation
in jurisdictions offering Islamic financial services using a survey questionnaire. The
sample is composed by 75 mainly 11 RSAs and 64 IIFS (full-fledged Islamic banks and
windows) from systemically important jurisdictions as illustrated in Table 1. The
cooperation of the respondents was sought especially in terms of ensuring that the
responding officer was the person with the relevant responsibility to do so and that the
permission of relevant superiors or authorities was obtained where necessary. The
responses provided by an institution are assumed to reflect its perspectives on the
issues raised.

Table 1 List of Variables

Countries RSAs Number of IIFS

Bahrain Central Bank of Bahrain 3 IIFS
Indonesia Financial Services Authorities (OJK) 3 IIFS
Indonesia
Kuwait Central Bank of Kuwait (CBK) 5 IIFS
Malaysia Bank Negara Malaysia 18 IIFS
Mauritius Central Bank of Mauritius NA
Nigeria NA 4 IIFS
Oman Central Bank of Oman 7 IIFS
Pakistan State Bank of Pakistan 18 IIFS
Philippines Bangko Sentral ng Pilipinas
Qatar Qatar Central Bank 4 IIFS
Saudi Arabia Saudi Arabia Central Bank (SAMA) NA
Turkey Banking Regulation and Supervisory NA
Agency (BRSA)
United Arab Emirates NA 2 IIFS

15
SECTION 4: RESULTS
4.1 General Background
LIBOR has been used disproportionally by various financial institutions across
jurisdictions (See Figure 1). All RSAs indicate that conventional banks have been using
LIBOR as a benchmark for financial transactions, whereas 72% of RSAs revealed that
LIBOR has been utilised for government and regulation matters.

Figure 1: LIBOR`s Utilisation by Financial Institution

Islamic banks
81.82%

Islamic non banks

Government/ 45.45% (Takaful, Securities
Regulators
companies)
72.73%

Conventional non-
banks 72.73%
Conventional banks
(Insurrance,
Securities… 100.00%

Source: IFSB Survey

The survey results also indicate that LIBOR has been adopted by conventional non-
bank institutions as stated by 72% of the RSAs. Finally, Islamic banks and Islamic non-
banks institutions have used LIBOR for financial transactions as mentioned by 81%
and 45% of RSAs, respectively. For a better understanding of the use of LIBOR across
the selected jurisdictions relevant insights are provided in Figure 2.

Figure 2 shows that before its abolishment, the majority of the respondents admitted
the use of LIBOR as one of the components in formulating Islamic banks` financing
rate, as well as a benchmark in the domestic financial market rate formulation.
Although, RSAs have been opting for LIBOR when formulating the price of Islamic
securities rate and Islamic banks financing rate equally, results indicate that market
players (IIFS) were more into using LIBOR as one of the components of financing rate,
which is mostly attributed to the size of the Islamic banking sector compared to ICM
(IFSI Stability Report, 2021).

16
Figure 2: LIBOR`s application by instrument across the selected Jurisdictions

26.67%
Others 21.88%
54.55%

One of components in 54.67%

56.25%
Islamic banks’ financing rate 45.45%

One of components in formulating 26.67%

25.00%
the price of Islamic securities (Sukuk, etc) 36.36%

Benchmark in the domestic 42.67%

financial market rate (money market, capital 42.19%
market, ) 45.45%

One of components in 29.33%

29.69%
the policy rate formulation 27.27%

Total Respondents IIFS RSAs

Source: IFSB Survey

Results also indicate that LIBOR has been used as (i) one of the components in policy
rate formulation, (ii) a component in formulating the price of Islamic securities, and (iii)
for other purposes as indicated by 26% of the respondents. More precisely, it is found
that LIBOR was mostly employed in some specific financial operations, such as a
benchmark for (i) USD denominated financial market rate, (ii) foreign currency
investment Portfolio, deposits and advances and pricing provisions and extension of
external funds. Other local reference rates, however, have been used for domestic
transactions, which is reflected in Figure 3.

Figure 3: Application of Domestic Rates by IIFS across the selected jurisdictions

Not Applicable
9%

No
11%

Yes
No
Not Applicable

Yes
80%

Source: IFSB Survey

17
Figure 3 shows that the majority of Islamic banks in our sample indicate the use of
domestic rates in their financial transaction. Based on the survey results, several
domestic rates have been provided by RSAs. For instance, The Central Bank of
Bahrain is utilizing the Bahraini Dinar Interbank Offer Rate (BHIROR) as a benchmark.
The Banking Regulation and Supervision Agency Turkey (BSRA) revealed that IIFS
are applying their participation rates. Furthermore, Borsa Istanbul has started
publishing TLREFK Turkish Lira Overnight Participation Reference Rate for Islamic
banks22, meaning that different products such as securities, derivatives, loans,
deposits, and issued bonds are priced concerning TLREF by the Turkish banking
sector.

Islamic banks in Indonesia are mostly applying the Bank Indonesia 7 Day Reverse
Repo Rate for lending and deposit facility between banks and the central bank,
whereas the Overnight index Average (IndoNIA) for overnight financial transactions.
Jakarta Interbank Offered Rate (JIBOR), however, is mainly used for financial
transactions with periods more than overnight.

The Malaysian domestic industry is transitioning towards RFR by the adoption of

MYOR-i (introduced in 2022). It is calculated as the volume-weighted average rate of
return on Shari’ah-compliant unsecured overnight MYR interbank placements. Further
on MYOR-i.23 KLIBOR (introduced in 1987) which is a submission-based reference
rate, similar to LIBOR, has been phased out for tenures 2M and 12M, and the
remaining tenures will be reviewed in 2H 2022. Moreover, banks are also using the
cost of funds (COF), which is an internal rate determined by banks for the pricing of
deposits and financing.

The Central Bank of Oman (CBO) has advised banks to put in place a suitable process
to identify and use appropriate Alternative Reference Rates based on respective
currency. CBO also indicated that most Islamic banks add a premium on published
Weighted Average Interest Rates on Deposits published by CBO every month, for
consumer/corporate transactions. Some other Islamic banks link their financing to their
bank’s published monthly expected deposit rate, which is locally called “card rate” or
“on-shelf rate”.

22 See Borsa Istanbul for further details on TLREFK adoption

https://borsaistanbul.com/en/sayfa/7956/tlrefk-data
23
https://www.bnm.gov.my/documents/20124/938039/pd-myor-i.pdf

18
In a nutshell, Islamic banks in Oman are using the domestic rate to price the interbank
money market transaction in OMR like Wakalah or Repo, Corporate loans in OMR and
customer deposits in OMR. These rates vary from OMIBOR, CBO Repo rate and
current market deposit rates. The rates are either declared on official channels like
CBO page on Bloomberg and Reuters or communicated directly between the local
banks.

QCB interest rate framework embraces three policy rates namely, QCB Deposit Rate
(QCBDR), QCB Lending Rate (QCBLR), and QCB Repurchase Rate (QCB Repo or
QCBRR). QCBDR and QCBLR are the interest rates announced by QCB on overnight
deposit and loan transactions between QCB and local banks through the Qatar Money
Market Rate Standing Facility (QMR), respectively. The QCBLR is the key rate used
by QCB to convey signals to the market revealing adjustments to its monetary policy
stance. The QMR facility is a double-featured monetary instrument encompassing two
standing facilities, lending, and deposits. All commercial banks operating in Qatar can
request access to the QMR facility where all transactions are executed electronically
through the QMR system. Both facilities of the QMR are of various maturities ranging
from 1 day (overnight) to 30 days with the primary objective of influencing the money
market rates. Interest rates are fixed over the course of the day but (positively) vary
with maturity over the 30 monetary-policy-day intervals and are computed daily, based
on QCBDR for deposit transactions and QCBLR for loan transactions. Deposit and
loan transactions per bank per day are subject to ceilings set by QCB.

The Saudi Central Bank asserted that the alternative rates differ depending on the
currency of the transaction, whereas IIFS are currently using Saudi Arabian benchmark
rates such us SAIBOR and SAIBID. Emirati Islamic banks are also utilizing the
Emirates Interbank Offered Rate (EIBOR) for 1M, 3M, 6M, 12M tenors for denominated
financial transactions wherever applicable.

The state bank of Pakistan indicated the use of the Karachi Interbank Offer Rate
(KIBOR) for PKR-denominated transactions. KIBOR is mainly utilized for
financing/Asset and Sukuk investments. KIOBR rates are applied for 3 months to 1
year depending upon the tenor of the facility. The rates are revised on a periodical
basis concerning the KIBOR applied.

Bank of Mauritius asserted that financial institutions were free to choose their
benchmark rates in the following denominated currencies. For instance, Fed funds rate

19
or Secured Overnight Financing Rate (SOFR) is mostly used for USD, whereas the
European Overnight Index Average (EONIA) is employed for transactions with
European countries. Last but not least, the Sterling Overnight Index Average (SONIA)
is utilized for GBP-denominated transactions. Finally, Islamic banks in Nigeria adopt
CBN monetary policy rate to benchmark the pricing of financial transactions besides
the Nigeria Interbank Offered Rate (NIBOR) plus Cost of Fund plus Risk Premium.
More precisely, Islamic banks in Nigeria do not have significant exposure to LIBOR-
linked contracts because local contracts are based on markup to the Central Bank of
Nigeria (CBN) monetary policy rate (MPR). The most notable exception to this is the
pricing of foreign trade lines, Foreign Direct Investments (FDIs), and Foreign Portfolio
Investments (FPIs), in which case, counterparties are more comfortable with
internationally acceptable and agreeable benchmarks like the LIBOR.

The Central Bank of Kuwait (CBK) has adopted the Profit Rate which is based on the
Central Bank of Kuwait discount rate plus Margin. For the local currency, the Kuwait
Interbank Offered Rate was not abolished because it is well monitored by the CBK and
it does not have any Governance issues. With regards to LIBOR abolishment,
however, the CBK did not interfere in specifying a certain rate but encouraged banks
to decide, based on their internal policy.

4.2 Exposures and Fallbacks on LIBOR

In terms of total exposure to LIBOR, Figure 4 shows that the majority of the
respondents admitted to having low exposure to LIBOR. Respondents` feedback
revealed that few Islamic financial institutions only had insignificant numbers of
agreements based on LIBOR rates for funds they have provided externally or funds
they have extended to other financial institutions. Most of the banks (especially, Islamic
retail banks) do not have significant exposure to LIBOR-linked contacts. A large number
of Islamic banks used either rates that are fixed or domestic rates. In contrast, the usage of
LIBOR was noted mainly for foreign currency (mainly USD) floating rate instruments. Only 35%
of the respondents expressed their non-exposure to LIBOR, whereas moderate and
high exposures were found for 11% and 4% of the respondents, respectively

20
Figure 4: Total Exposure to LIBOR

34.67%
No Exposure 37.50%
18.18%

54.67%
Low 50.00%
81.82%

10.67%
Moderate 12.50%
0.00%

4.00%
High 4.69%
0.00%

0.00%
Very High 0.00%
0.00%

Total Respondents IIFS RSAs

Source: IFSB Survey

Note: The magnitudes of exposure levels (No exposure, Low exposure, Moderate exposure and high
exposure) capture the rate/values of LIBOR-based transactions compared to the total balance sheet
exposure. Overall, exposure to LIBOR has not exceeded 10% of total IIFS balance sheet exposure.
Admitting that Islamic banks assets/size varies from one jurisdiction to another, what is considered low
exposure for certain countries might be highly significant for others and vice versa. Most IIFS transactions
are denominated in local currency, whereas LIBOR is only used for certain international transactions
denominated in foreign currency, which explains the significantly low exposure to LIBOR across various
jurisdictions.

To mitigate the adverse effect of IIFS and RSAs` exposure to LIBOR, Figure 5
illustrates strategies undertaken by IIFS to phase out LIBOR and transition towards
RFR, with the majority of the respondents indicating the utilization of fallback language.

Figure 5: Fallbacks on total Exposure to LIBOR

33.33%
Total Respondents 22.67%
44.00%

34.38%
IIFS 23.44%
42.19%

27.27%
RSAs 18.18%
54.55%

Not Applicable NO YES

Source: IFSB Survey

21
RSAs have urged financial institutions (including IIFS) to identify fallback options
available to them as part of existing documentation, as well as initiating consultations
with respective counterparty, in case such fallback clauses are not specifically
documented as per the financial agreements, to find and agree on another suitable
option. IIFS have been advised to incorporate fallback clauses in all financial contracts
that reference LIBOR, by referring to market standards prescribed by accredited
agencies such as ISDA in collaboration with IIFM, or fallback language proposed by
the US Alternative Reference Rates Committee (ARRC). In the same context, market
players have been exploring different approaches like using secured overnight SOFR
or Term SOFR as benchmarks. LIBOR and SOFR are different rates and thus the
transition requires a credit adjustment spread to make the rate levels more
comparable. As known, LIBOR is produced in various tenors and SOFR is an overnight
rate. Another critical difference between LIBOR and SOFR is that LIBOR is based on
unsecured transactions and is intended to include the price of bank credit risk. SOFR,
on the other hand, is a near risk-free rate that does not include any bank credit
component, as the transactions underpinning SOFR are fully secured by U.S.
Treasuries. To address these issues, International Swaps and Derivatives Association
(ISDA) sought market participants’ views on several approaches to determining Credit
adjustment spread. Thus, a significant majority across different types of market
participants preferred the ‘historical mean/median approach,’ which is based on the 5-
year historical median difference between USD LIBOR and SOFR, for the Credit
adjustment spread.

Results also show that 23% of the respondents revealed that fallbacks were either
considered on an instrument-by-instrument basis or already embedded in existing
contracts before the LIBOR abolishment decision took place. Finally, 33% of the
respondents affirmed the non-applicability of fallbacks due to the lack of exposure to
LIBOR.

With regards to LIBOR`s tough legacy contracts, Figure 6 reveals that the majority of
the respondents affirmed the lack of exposure/low exposure in their jurisdiction,
whereas it tends to be moderate and manageable for 9% of the total respondents. This
indicates that Shari’ah-compliant LIBOR exposure represents a very small portion of
total LIBOR exposure in the derivative market. Furthermore, the overall balance sheet
exposure is small relative to the total balance sheet, implying that IIFS`s exposures
have minimal legacy contracts.

22
Figure 6: Exposure to LIBOR`s tough legacy contracts

42.67%
No Exposure 43.75%
36.36%

45.33%
Low 42.19%
63.64%

9.33%
Moderate 10.94%
0.00%

1.33%
High 1.56%
0.00%

1.33%
Very High 1.56%
0.00%

Total Respondents IIFS RSAs

Source: IFSB Survey

Note: The magnitudes of exposure levels (No exposure, Low exposure, Moderate exposure and high
exposure) capture the rate/values of LIBOR-based transactions compared to the total balance sheet
exposure. Overall, exposure to LIBOR has not exceeded 10% of total IIFS balance sheet exposure.
Admitting that Islamic banks assets/size varies from one jurisdiction to another, what is considered low
exposure for certain countries might be highly significant for others and vice versa. Most IIFS transactions
are denominated in local currency, whereas LIBOR is only used for certain international transactions
denominated in foreign currency, which explains the significantly low exposure to LIBOR across various
jurisdictions.

In revanche, high exposure to tough legacy contracts has been indicated by less than
2% of the respondents. This is attributed to the fact that few IIFS have investment and
repo transactions based on LIBOR; in addition to Sukuk investment/issuance (both
asset and liability respectively) that are dependent on US swap rates (which is based
on LIBOR) plus a credit spread. Overall, IIFS`s exposure is significantly low, as
expressed by their respective RSAs, meaning that the stability of the Islamic banking
sector is less likely to be harmed when transitioning from LIBOR to RFRs. Due to the
minimal exposure of the Islamic banking sector to LIBOR`s tough legacy contracts,
Figure 7 shows that the majority of the respondents, comprising RSAs and IIFS have
not used specific fallbacks on LIBOR`s tough legacy contracts.

23
Figure 7: Fallbacks on LIBOR`s tough legacy contracts

45.45%
42.19% 41.33%

36.36%

30.67% 29.69%
28.13% 28.00%

18.18%

YES NO Not Applicable

RSAs IIFS Total Respondents

Source: IFSB Survey

In contrast, general fallbacks have been considered instead of specific ones. General
fallback language was included in the documentation of legacy contracts. The fallback
clauses incorporated in the financing documents indicates that Banks are entitled to
change the reference rate at any time, subject to compliance with Shariah.
Furthermore, IIFS have allowed for customer discussion and negotiation in use of new
rates and adjustment spread to be used, subject to market convention.

Only, 31% of the respondents have adopted specific fallbacks to LIBOR tough legacy
contracts. Indeed, IIFS have conducted consultations with their respective legal
councils to introduce fallback language when addressing existing and new contracts
related to shariah-compliant products. Furthermore, active negotiations with customers
have been undertaken to ensure the local regulatory timeline and Shariah
requirements are met. In addition to the incorporation of the US Alternative Reference
Rates Committee (ARRC), provisions have incorporated fallback languages that are in
line with ISDA standards which for Islamic/shariah terms means the execution of the
ISDA-IIFM language on a bilateral basis for corporate and investment banking.
Intuitively, customers can choose to fallback to either the cost of fund (COF) or SOFR
or any other reliable alternative Risk-Free Rate (RFR). Interestingly, Term SOFR is a
forward-looking rate based on transactions in the large and growing SOFR derivatives
markets, including SOFR futures and SOFR overnight index swaps (OIS) transactions.
To ensure a smooth transition from LIBOR to RFRs, respondents provide additional
feedback with regards to the dynamic assessment that has been undertaken along the

24
process when applicable. Figure 8 illustrates that the majority of the respondents have
considered a dynamic assessment.

Figure 8: Dynamic assessment of the transition period

50.00%
46.67% 45.45%

34.38% 33.33%

27.27% 27.27%

20.00%
15.63%

YES NO Not Applicable

RSAs IIFS Total Respondents

Source: IFSB Survey

The dynamic assessment enables IIFS to identify their exposures to LIBOR to

complete the remediation to non-USD LIBOR exposures. Furthermore, assessments
were performed to ascertain whether the change in contractual terms meet the
requirements of the practical expedient and does not result in derecognition or
modification of financial instruments and discontinuation of hedge accounting, which
may have profit and loss implication.

The dynamic assessment has been adopted by IIFS based on RSAs instruction and
supervision to ensure the stability of the Islamic banking sector during the transition
period. Several working groups were formed across jurisdictions to assess the impact
of transition and discuss common challenges. IIFS were required to submit quantitative
and qualitative reports to their respective RSAs to monitor the transition process. More
precisely, each bank was required to assess the impact in terms of total gross
exposures of contracts referencing LIBOR on their respective balance sheet (asset
and liability side) and derivatives and submit information on their exposures. Overall,
respondents indicate that there were no major financial stability risks resulting from the
LIBOR transformation. The fallbacks to LIBOR exposure have been adopted for
Islamic and conventional banks equally, implying that Islamic banks` specific policy
measures have not been employed by the majority of RSAs and IIFS (See Figure 9).

25
Figure 9: Islamic Banks Specific Policy Measures
YES
9%
Not Applicable
27%

NO
64%

YES NO Not Applicable

Source: IFSB Survey

According to Figure 9, Islamic banks` specific policy measures have only been adopted
by 9% of RSAs. The policy measures attempted at providing clarity to the industry on
the Shariah issues related to RFRs, such as the use of backward-looking compounded
setting in-arrears (CSIA) method to derive the RFR term rate for Islamic financing
facility.

4.3 Policy Measures on Major Transitioning Risks

Figure 10 shows the major risks that the Islamic banking industry might face when
shifting from LIBOR to RFRs. The majority of the respondents admitted that profitability
and pricing calculation have occurred when replacing LIBOR with RFRs the rise of
profitability and pricing calculation issues have trigged various risks such as credit risk,
market risk, liquidity risk, accounting risk, operational risk, reputational risks. Pricing
calculation has a strong impact on banks` operations as IIFS provides financings to
various sectors. Mispricing, therefore, might be explained in terms mismatch between
the cost of financing and earned profit, leading to unexpected losses from the bank`s
side. The lack of accuracy and consistency in terms of pricing engenders an
accounting issue as current values might not necessarily reflect the current economic
conditions. Following the changes in pricing, operational issues occur due to the
compatibility issues between various systems of financial institutions.

In terms of market risk, IIFS assets and liabilities are subject to market conditions,
meaning that pricing calculation is a fundamental key element to predict future trends

26
and mitigate excessive volatility using appropriate mitigation techniques. The lack of
proper pricing, therefore, might result in biased expectations, leading to unappropriated
investment decisions. In this regard, the occurrence of both risks or one of them may
trigger liquidity risk as the bank might be unable to handle short- and long-term
obligations in distress situation due to insufficient funds raised, or mismatch related to
the generated income/profit, leading to solvency issues. Intuitively, insolvency will hurt
banks` reputation as they were not able to ensure their resilience when facing severe
economic conditions or global operational changes.

Figure 10: Major Transitioning Risks

22.67%
Reputational Risk 21.88%
27.27%

45.33%
Shari`ah Risk 45.31%
45.45%

38.67%
Operational Risk 39.06%
36.36%

29.33%
Accounting Issues 32.81%
9.09%

16.00%
Liquidity Risk 14.06%
27.27%

30.67%
Market Risk 29.69%
36.36%

14.67%
Credit risk 14.06%
18.18%

50.67%
Profitability calculation 53.13%
36.36%

Total Respondents IIFS RSAs

Source: IFSB Survey

To mitigate these issues, IIFS were instructed to develop integrated systems before
offering RFRs. More precisely, systems were upgraded to ensure correct profit
calculation and accounting, besides the identification of financial exposures and define
accounting tax approaches. Amendments to the pricing methodology have been
considered to address credit and tenure risk premium. For instance, credit adjustment
spread has been used for all transactions and adjustment in pricing. Then, IIFS were
requested to initiate awareness, training, and education programmes for LIBOR
transition within the organisation and, specifically for customers to ensure transparency
in terms of decision-making.

27
The majority of the respondents also highlighted the Shariah compliance risk arising
from the uncertainty (gharar) posed by the use of backward-looking compounded
setting in-arrears (CSIA) method in deriving the term rate to calculate the installment
payment for Islamic financing facility at each payment interval. Uncertainty (gharar)
from the adoption of average RFR or backward-looking term rate at the point of
payment has been mitigated via proper determination and disclosure of the ceiling
price and formula to derive the periodic payment amount to the customer at the
inception of the contract.

Shariah compliance risk could also be related to the lack of customer consent in
transitioning to the alternative benchmark rate following LIBOR cessation. Therefore,
IIFS needed to determine the appropriateness of invoking the deemed consent
mechanism to signify customers’ consent. Intuitively, IIFS indicated that Shariah risk
was mitigated by following IIFM standard structures, in addition to the utilization of the
term SOFR which is a forward-looking rate for Islamic transactions.

4.4 Policy Measures on Supervisory and Regulatory Challenges

When transitioning from LIBOR to RFRs, RSAs and IIFS have faced several
challenges from regulatory and supervisory perspectives. Figure 11, therefore,
illustrates the main issues raised by the respondents. Then, detailed explanations are
provided about the actions taken and the adopted policy measures to ensure a smooth
transition process.

Figure 11 indicates that various issues have been triggered when transitioning from
LIBOR to RFRs such as (i) the lack of clarity on the readiness of market infrastructure
to accommodate RFRs; (ii) the lack of engagement with the relevant authorities to
identify legislative solutions when necessary; and (iii) the existence of constraints in
supervisory capacity and resources.

28
Figure 11: Supervisory and Regulatory Challenges

10.67%
Constraints in supervisory capacity and resources 12.50%
0.00%

Lack of engagement with the relevant authorities to 14.67%

identify legislative solutions, when necessary, to 17.19%
mitigate the exposure 0.00%

Cross border issues (Differing supervisory 21.33%

21.88%
expectations on transition across jurisdictions)
18.18%

Lack of follow-up of relevant regional and international 17.33%

developments to ensure an understanding of market 18.75%
developments. 9.09%

Lack of IIFS` engagement in terms of developing plans 21.33%

and set internal goals and deadlines for the transition 20.31%
from LIBORs. 27.27%

26.67%
Lack of understanding on the use of RFRs 28.13%
18.18%

Lack of communication among stakeholders 24.00%

25.00%
(RSAs, Islamic financial Institutions and clients)
18.18%

Lack of clarity on the 29.33%

28.13%
readiness of market infrastructure
36.36%

Total Respondents IIFS RSAs

Source: IFSB Survey

To mitigate these challenges, RSAs have issued requirements for banks to report their
readiness and provide regular updates on implementation of banks’ plan. Strictly
speaking, committees and working Groups have been formed to monitor, manage and
implement the affected infrastructure. IIFS were required to conduct internal meetings
with relevant stakeholders to set up working committee, develop alternative fallback
provisions, and assess transition risks and challenges. In addition, direct engagement
sessions were held to understand the selected bank’s LIBOR transition preparedness/
readiness overall and any challenges in meeting their requirements. IIFS, therefore,
were required to furnish their respective RSAs with updates on their transition plans.
Their inputs were useful for identifying regulatory and legal issues to consider the
appropriate solutions when necessary and ensuring a smooth transition process.

Results also show that issues related to RFRs understanding and communication
among stakeholders have also been raised by respondents. RSAs therefore, have
guided banks and urged them to initiate awareness, training and educational

29
programmes for LIBOR transition within the organisation and, specifically for
customers. Guidelines have been circulated to urge the industry to engage
clients/counterparties for the transition. This has helped IIFS to become proactive in
their engagement with clients/counterparties. Similarly, regular communication has
been put in place, between banks and RSAs on the progress of LBOR.

In the same context, respondents also highlighted the occurrence of cross-border

issues due to different supervisory expectations across jurisdictions. Although most
LIBOR-based transactions are international in nature, there was always a risk of cross-
border legal and regulatory issues. To this extent, detailed guidance to banks has been
put in place to mitigate measures. IIFS has been actively engaging with standard-
setting bodies and market players to provide industry-wide feedback to streamline
supervisory expectations. External consultants have also been hired in some
jurisdictions to provide advice on the LIBOR transition implementation. Last but not
least, the lack of follow-up of relevant regional and international developments has
been highlighted because, during the early stage of the transition, preparations were
still under development and pending finalisations. This implies that following up on
global developments was very challenging. Interestingly, closer to the end of 2021,
things become clearer to catch up on preparedness and readiness.

4. 5 Additional Roles of the IFSB

The IFSB as an International standard-setting body interested in Islamic finance kept
guiding RSAs and market players to ensure the stability of the Islamic banking sector
during the transition process. Based on the survey results, respondents highlighted
relevant additional roles that the IFSB can play to foster the resilience of the Islamic
banking sector. Given that the IFSB has access to LIBOR-related information on its
members, respondents indicated that it is strongly needed to provide an assessment
that gives an overall picture of the transition, impact, and mitigation to Islamic finance
globally, and where possible to also provide any differences with the conventional
counterparts. The assessment may include (i) conducting a comparative assessment
on alternative risk-free rates adopted by member countries in anticipation of LIBOR
cessation and (ii) engaging members to document challenges and solutions during the
transition for the outcome to be shared among members. Intuitively, this will help the
IFSB and other market-based institutions in promoting and introducing standardised
approaches for the adoption of various pricing methodologies replacing LIBOR to
ensure the smooth functioning of the Islamic markets.

30
Respondents also raised the need for a set of guidelines or principles on the key
components of a sound and effective shariah governance on Islamic products that use
RFR as benchmark. This will help clarify the supervisory roles on awareness and
understanding of LIBOR transition and RFRs in Islamic banking. In addition to that,
organizing and facilitating training for the Islamic financial services industry, especially
on related issues will be appropriate to strengthen the regulatory and supervisory
actions during the transition period. Last but not least, participants expressed the need
for clarification about contractual obligations in absence of fallback language
provisions such as clarifying the use of SOFR rates` applicability on different tenors
reflecting credit and liquidity premiums.

Based on the aforementioned participants` feedback, the IFSB shall keep supporting
the industry by providing guidance and standards addressing the emerging issues
related to the Islamic banking sector. Being represented in the AAOIFI alternative
benchmark rate`s working group, the IFSB is actively engaging with various
stakeholders to develop a governance document that addresses the issues that have
been raised in this working paper. Further actions will be taken along the process
individually and in collaboration with international standard setters interested in Islamic
finance when necessary.

SECTION 5: POLICY IMPLICATIONS AND CONCLUSION

5.1 Policy Implications
The transition process has been well managed as IIFS has not experienced any
significant instability issues related to transitioning away from LIBOR due to IIFS`s low
exposure to LIBOR, which is in line with (FSB, 2022). This indicates that LIBOR was
being used by sovereigns and IIFS for international transactions denominated in
foreign currency, whereas local reference rates were applicable for domestic
transactions. In terms of LIBOR`s legacy contracts, most IIFS have conducted a
dynamic assessment of their exposure based on the directives of their respective
RSAs. Then, general and specific fallback languages have been included in contracts
and legal documents to ensure a smooth transition process and protect the interest of
all parties.

In terms of major transitioning risks, the majority of RSAs and IIFS have witnessed the
presence of profitability and pricing calculation challenges, leading to an increase of
four major risks namely, credit risk, market risk, liquidity risk and accounting risk. To

31
mitigate these risks, major amendments to the pricing methodology have been
considered such as the use of credit adjustment spread for all transactions.
Furthermore, systems were upgrade to ensure correct profit calculation and disclosure
requirements.

Shari`ah risk was considered the second major issue when transitioning from LIBOR
due to RFRs` backward-looking. This risk was mainly mitigated by following IIFM
standard Structures, in addition to the utilization of the term SOFR, which is a forward-
looking rate for Islamic transactions. Although the Shariah compliance risk might be
linked to the lack of customer consent in transitioning to RFRs, a deemed consent
mechanism has been incorporated to ensure customers` consent. Admitting that
operational and reputational risks have also occurred during the transition period,
specific awareness programs have been initiated within financial institutions and for
customers to ensure transparency.

From a supervisory and regulatory point of view, several challenges have been
highlighted when transitioning from LIBOR to RFRs such as:
(i) The lack of clarity on the readiness of market infrastructure to
accommodate RFRs
(ii) The lack of understanding of the use of RFRs
(iii) The lack of communication among stakeholders
(iv) The lack of IIFS engagement in terms of developing plans and set internal
goals have been highlighted
(v) Cross-border issues due to different supervisory expectations across
jurisdictions
(vi) lack of follow-up of relevant regional and international developments to
ensure an understanding of the market and;
(vii) The lack of engagement with the relevant authorities to identify legislative
solutions when necessary has been raised
To this extent, committees and working Groups have been formed to monitor, and
manage the various challenges that IIFS have faced. Guidelines have been issued to
IIFS for disclosure and timeline preparation, in addition to the circulation of specific
directives to initiate awareness and training programmes. Interestingly, these steps
were useful for identifying the appropriate solutions for regulatory and supervisory
issues when transitioning from LIBOR to RFRs.
From the IFSB perspective, transitioning away from LIBOR represents operational
challenges rather that regulatory issues. RSAs efforts to catch-up with the change in

32
reference rates has been so far successfully as the Islamic banking industry remained
stable during the transition period. In contrast, additional efforts can be made to foster
the resilience of the Islamic banking sector such as, (i) providing a set of guidelines or
principles on the key components of a sound and effective shariah governance on
Islamic products that use RFR as a benchmark; and (ii) conducting a comparative
assessment on alternative risk-free rates utilized by member countries.

From an Islamic banking point of view, there is a need to focus on the peculiarity of the
contractual terms in their various extant products to ensure Sharīʿah-compliance while
it presents additional transitional complexities relative to the conventional banks (IIFS,
Stability Report, 2022). More precisely, the Shari`ah-compliance implies that parties
agree in advance to a pre-agreed rental rate in an ijārah transaction or to a pre-agreed
cost and mark-up in a murābahah transaction is at variance with the backward-looking
rates used in the RFR where the amount payable is only determinable a few days
before the payment due date. While there are ongoing efforts to come up with an
acceptable Islamic RFR, in the interim, the effect on Islamic finance might be the
relative complexity of offering a Shari`ah-compliant floating rate structure, as well as
limitations in engaging in dual financing together with a conventional financing
institution (IIFS, Stability Report, 2022). To this extent, further clarification needs to be
provided about the use of RFRs in Islamic banking. These steps can enable the IFSB
and other stakeholders to introduce standardized approaches about the
implementation of the pricing methodologies replacing LIBOR for smooth functioning
of the Islamic banking sector.

5.2 Conclusion
This study aims at determining the early policy responses of RSAs and IIFS when
transitioning from LIBOR to RFRs in jurisdictions where Islamic financial services is
provided. A survey questionnaire is constructed to gather inputs on (i) LIBOR`s use
and application across jurisdictions offering Islamic financial services, (ii) exposures
and fallbacks, (iii) RFRs use and application across jurisdictions, (iv) major
transitioning financial risks, (v) regulatory and supervisory challenges, and (vi) the
additional roles that the IFSB can play during the transition phase.

Results show that the exposure of RSAs and IIFS to LIBOR was significantly low, which
explains the lack of significant market disruptions upon the cessation of LIBOR. This
is due to the fact LIBOR was mainly used for international transactions, whereas local
rates were applicable for domestic transactions. During the transition period, several
financial and regulatory challenges have been triggered, followed by immediate

33
regulators and market players` actions to mitigate them. The main policy measures
include (i) the incorporation of fallback languages for tough legacy contracts, (ii)
systems` updates for profit calculation, financial information disclosure, and financial
risks assessment, (iii) the introduction of Term SOFR to avoid shari`ah issues as it is
considered a forward-looking, (iv) incorporating a consent` mechanism to get
customers` consent when shifting from LIBOR to RFRs. Additional measures have
been implemented to initiate awareness, and capacity building leading to a better
understanding of the new RFRs` application for bankers and customers respectively.

The various policy responses adopted by RSAs and IIFS actions showed their
effectiveness in ensuring a smooth transition from LIBOR, which explain the resilience
of the Islamic banking sector during the transition phase. Based on the survey`s
outcomes, The IFSB shall continue supporting the industry by providing guidance and
standards addressing the emerging issues related to the Islamic banking sector. Being
represented in the AAOIFI alternative benchmark rate`s working group, the IFSB is
actively engaging with various stakeholders to develop a governance document that
addresses the issues that have been raised in this working paper. Further actions will
be taken along the process individually and in collaboration with international standard-
setting bodies interested in Islamic finance.

34
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