Lecture 6 liquidity_risk_and_management

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LIQUIDITY RISK &
LIQUIDITY MANAGEMENT
in Islamic Banks
Salman 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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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
IB
Portfolio
67%67%5%5%

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Islamic Banks’ Assets Portfolio
67%
6%
5%
7%
15%
murabahah
musharakah
mudarabah
ijara
others
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
Development
In
Islamic
financial
Instruments
Absence of
Islamic Secondary
market
No Lender
of Last
Resort
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)
Broke
r
‘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.)
Countr
y
Issuer Type Value Maturity
Bahrain Bahrain
Monetary
Agency
Sukuk
Al Salam
(23
issues
up to
April
2003)
US$ 625
Million
(cumulat
ive)*
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
Output
Country
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 organization
•Development finance
•Research
54 countries

Lecture 6 liquidity_risk_and_management

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