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LIQUIDITY RISK &LIQUIDITY MANAGEMENT

in Islamic BanksSalman Syed Ali

Current Issues in Islamic Finance Lecture 6

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Lecture Plan

Part-I LIQUIDITY

SHORTAGE (Risk) Sources of risk Implications for Bank

and the System Current practices of

mitigation Recommendations

and the Future

Part-II EXCESS LIQUIDITY

(Low ret.) Causes Implications for Bank

and the System Current practices of its

management Recommendations

and Future

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Key References

Abdul Majid, Abdul Rais. 2003. “Development Of Liquidity Management Instruments: Challenges And Opportunities”, paper presented in International Conference on Islamic Banking: Risk Management, Regulation and Supervision, Jakarta –Indonesia, Sept 30- to October 3, 2003.

Ali, Salman Syed. 2004. “Islamic Modes of Finance and Associated Liquidity Risks” presented in Conference on Monetary Sector in Iran: Structure, Performance and Challenging Issues”, Tehran, February 2004.

Shihadeh, Musa A. 2003. “Loss Provisioning in Islamic Banks: Jordan Islamic Bank Case Study”, paper presented in International Conference on Islamic Banking: Risk Management, Regulation and Supervision held in Jakarta- Indonesia. Jointly organized by Bank Indonesia and IRTI, October 2003.

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Dry Climate

Liquidity Shortage Assassin of banks

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Flood

Excess Liquidity: A drag on competition

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Stability and Solvency of IBs

In theory, Islamic banks are likely to be more stable

They have profit sharing on both the liability side and asset side

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In practice, Islamic Banks have fixed income assets but have profit sharing on liability side.

The IBs therefore, are still more stable than conventional banks. Solvent Asset tied finance

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While a majority of Islamic banks have excess liquidity

Some Islamic banks have faced liquidity crisis

Many different risks culminate in liquidity risk

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Liquidity crunch can be a real problem

Example of Financial Crisis in Turkey 2000-2001

Islamic financial institutions there faced sever liquidity problems

One Islamic institution Ihlas Finans was closed during the crisis

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LIQUIDITY RISK: Definition

Risk of Funding [at appropriate maturities and rates]

Risk of Liquidating Assets [in time at reasonable prices]

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Investment Firm’s Definition

“liquidity risk includes both the risk of being unable to fund [its] portfolio of assets at appropriate maturities and rates and the risk of being unable to liquidate a position in a timely manner at reasonable prices.” *

* J.P. Morgan Chase (2000).

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Regulators Definition

“risk to a bank’s earnings and capital arising from its inability to timely meet obligations when they come due without incurring unacceptable losses.”*

* Office of the Comptroller (2000)

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Analysis and Diagnosis of Causes

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LIQUIDITY RISK: Sources

1. Incorrect judgment and complacency 2. Unanticipated change in cost of capital 3. Abnormal behavior of financial markets 4. Range of assumptions used 5. Risk activation by secondary sources 6. Break down of payments system 7. Macroeconomic imbalances 8. Contractual forms 9. Financial Infrastructure deficiency

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Liquidity Risk & Contractual Forms

Profit Sharing Contracts Murabaha Salam Istisna Ijarah

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Resale not permitted Resale permitted but non-existent

market Market exists but not active

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Example of LR in Murabaha

Primary LR Secondary LR

Receivables are debt cannot be sold

Involves buying of commodity then selling on deferred payment

This brings in many operational, credit, dispute, and legal risks that can affect realization of receivables

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LR:Current Practices of control

Deposit Management Choice of Mode of Finance Maturity Matching and Gap Analysis Mixing of Deposits Reserves and Provisions Deposit Insurance Interbank Dealings Ijarah and Salam Sukuks

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(a) Reserves and Provisions:

Provisions Specific General

Reserves Profit Equalization

Reserve Investment Risk

Reserve

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(b) Problems:

Fiqh issue of justice: inter-temporal /interpersonal transfers

Breaks the link between bank performance and its reflection in profits

Possibility of manipulation to hide losses Transfer of resources from shareholders to

investment account holders (displaced commercial risk)

Loosen the asset and liability tie in IBs.

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(c) Remedies for Transparency:

Well defined, consistent and transparent method of provision and reserve calculation

Improved corporate governance Reveal ex-ante estimates and ex-post

actual losses Reveal the position and changes in the

PE Reserve and IR Reserve

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Conclusions

What is needed

What can be done

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Conclusions (contd.)

Development of liquidity management instruments

Development of Infrastructure institutions (LMC, IIFM)

Rethinking and development of new structure of Islamic banks (Separate treatment of Cur. and Inv. accounts)

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Smooth Sailing

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Excess Liquidity

State, Causes and Management

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Current state of liquidity in Islamic Banks

Excess Liquidity in the Market, resulting in serious business risk and affects the competitiveness of

IFIs due to no return or a very low returns.

In a recent study it was discovered that Islamic financial institutions are almost 50% more liquid as

compared to conventional financial institutions.

Out of US$ 13.6 billion total assets of Islamic banks in the study US$ 6.3 billion were found to be in

liquid assets.

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Causes of Excess Liquidity

Factors internal to the bank Factors external to the bank

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Islamic Banks’ Asset Portfolio

Shirakah

Ijarah

Salam

Istisna’

Murabaha

Mudharba

IBPortfolio

67%67%5%5%

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Islamic Banks’ Assets Portfolio

67%

6%

5%

7%

15%

murabahah

musharakahmudarabah

ijaraothers

Source: Iqbal Munawar, Ausaf Ahmad and Tariqullah Khan (1998), Challenges Facing Islamic Banking, Jeddah: IRTI

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Key Issues in Liquidity

Management

Small No. of participants

No Islamic Inter-bank Market

Slow DevelopmentInIslamic financial Instruments

Absence of Islamic Secondary market

No Lenderof LastResort

Different Shari’a interpretation

Key Issues in Liquidity Management

Credit for this diagram: IIFM

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Implications for Islamic Banks

Underutilization of financial resources Lower income and higher cost Loss of competitiveness

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Current Practices in Managing Excess Liquidity

Deposit Management Secured Commodity Murabaha Mudaraba Sukuk Salam Sukuk Leasing Sukuk Musharakah Sukuk Infrastructure Institutions

Liquidity Management Center IIFM

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Islamic Bank / Investor(Principal)

Broker

‘B’

Broker‘A’

Conventional Bank

(Agent)

Buy

Pay (Spot)

Receive (Sales proceeds at maturity)

Receive funds from Investor(to pay Broker ‘A’)

Sell (at a profit & deferred payment)

Settle Investor(Sales proceeds less Agents fees)

Funds Flow

Commodity Flow

How a Secured Commodity Murabaha Works:

Credit for the diagram: IIFM

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Advantage of SCM

Short-term therefore liquid Buying and selling in same currency

(usually US$) therefore no FX risk

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Problems with SCM

Flow of funds away from Muslim economies Not contributing in any growth or

development oriented economic activity Limited scope for liquidity management:

since transactions are mostly bilateral therefore counterparty limits apply

Always back to back murabaha is needed for maintaining liquidity

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Salam Sukuk (Ex. of Bahrain)

Gov of Bahrain (GoB) undertakes to sell Aluminum (deferred) for advance payment

BMA securitizes it by issuing salam sukuk Individual IBs buy these to park their excess

liquidity IBs appoint GoB as their agent to receive

delivery of commodity and sell it through its distribution channels

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Salam Sukuk (contd.)

Similar to SCM but securitized Advantages:

Cost price need not be declared Lower credit risk to bank due to sovereign

counter-party Lower cost (or higher return) to bank than in

SCM due to securitization Funds utilized in the local economy until very

near to delivery date Disadvantage:

Not trade-able therefore high liquidity risk

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Bahrain Salam Sukuk (contd.)

Country

Issuer Type Value Maturity

Bahrain Bahrain Monetary Agency

SukukAl Salam (23 issues up to April 2003)

US$ 625 Million (cumulative)*

91 days for each issue

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Structure of Malaysian Sukuk

Credit for this slide: BMA presentation, Feb., 2004.

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Other sukuk and trade-able securities useful for liquidity management

Gov. Participation Certificates (Sudan) Central Bank Participation Certificates

(Sudan) Malaysian Global Ijarah Sukuk [US$500M] First Global Sukuk Malaysia [US$150M] Qatar Global Ijarah Sukuk [US$700M] IDB Sukuk [US$400M] Tabreed Global Ijarah Sukuk (Corporate)

[US$150M]

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LM Infrastructure Institutions

OutputCountry

Membership

IIFM

Facilitation in issuance of sukuk of Bahrain and Malaysia 6 founding members

LMC Part of IIFM efforts.Facilitated cross listing of Bahrain and Malaysian sukuk

6 members

IsDB Mother/Umbrella organizationDevelopment financeResearch

54 countries

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New Ideas: Good & Bad

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Thank you