Base rates are at record lows in Europe with the Bank of England having held its rate at 0.5% for five years now

Tim Evershed

November 26, 2014: A spike in European interest rates could pose a serious challenge to the growth of Islamic finance across the EU.

Base rates of interest are at record lows in Europe with the Bank of England having held its rate at 0.5% for five years now while the European Central Bank recently lowered its base rate from 0.25% to a marginal 0.15%.

These rates have been imposed as an effort to get the UK and Eurozone economies back on track. However, they are expected to rise again in the short to medium term with many expecting the UK base rate to start increasing next spring.

This will pose a threat to the Islamic banking sector in Europe, which cannot charge or pay interest and has never had to compete against a background of rising or high interest rates.

In an interview with International Finance Magazine at the two-day EU Islamic Finance and Banking Summit in London, Dennis Cox, CEO of banking and financial services experts Risk Reward said this could hamper the progress of Islamic banks in Europe.

He said: “One of the issues we face is that Islamic Finance has only really been around since interest rates have been declining. You’ve got to go back to pre-1982 for an interest rate rising environment and Islamic banks just weren’t around then. How do you finance an Islamic bank?

“A lot of the time you have actually got a larger depositor base and it is less geared than the average financial institution. So it is heavily reliant on deposits and at the moment massively liquid, maybe excess liquidity or more than they need.

“But, if you’re a depositor with an Islamic financial institution you’re going to get a very low rate of interest. At the moment, everyone is getting a low rate of interest so it doesn’t matter but how would you feel if interest rates were at 15%?

“Try to predict behaviour in that scenario. Many Islamic customers are also customers of traditional banks. What will they do? Will there be a herd mentality away from us causing a strain on liquidity? The honest answer is: we just don’t know.

“The difficulty for an Islamic bank is they can’t simply bolster their funding base or loan book based on interest rates or massively rising interest rates because that upsets the balance with the sharia boards and takes them too close to being a traditional bank.”

According to Cox, the situation is complicated for Islamic banks, as there is a shortage of suitable hedging and capital instruments available to them.

He said: “We are reliant on one or two, such a sovereign sukuks. We also have the challenge that a lot of the Islamic banks aren’t that large and, in terms of international brand, when they are trying to get reserves and contingency funding lines they just not as well known. If you can only go to an Islamic bank for a contingency funding line, then it is probably going to be a problem. The logic then is to go to a non-Islamic bank because they are the larger ones and they won’t be correlated with your problems but that is flying in the face of everything we are trying to do.”