Salman Syed Ali

LIQUIDITY RISK &LIQUIDITY MANAGEMENTin Islamic banks

Distance Learning Course: Current Issues in Islamic FinanceLecture 4

March 28, 2006

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Overview

Baking Theory—Why banks exist? Liquidity Issues in Islamic banks

------------------------------ Sources of liquidity risk in IBs How it is managed and the consequences

------------------------------ What is being done and further

developments

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Banking Theory—Why banks exist? Banks as providers of liquidity insurance

to depositors and clients Rationale for deposit taking and lending

by same institution (bank) Theory of bank intermediation

The Nature of Banking Firm Brings in Liquidity Risk

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Excess of Wet or Dry

Liquidity Shortage Assassin of banks

Liquidity Surplus Drag on competitiveness

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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 majority of Islamic banks experience excess liquidity

Some have also 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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LIQUIDITY RISK: Sources

Incorrect judgment and complacency Unanticipated change in cost of capital Abnormal behavior of financial markets Range of assumptions used Risk activation by secondary sources Break down of payments system Macroeconomic imbalances Contractual forms 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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Analysis and Diagnosis

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Liquidity Surplus Problem

Excess Liquidity is the current norm with Islamic banks Where to park for short-term? Use of most Islamic modes requires longer tenor

investment, murabaha leads to illiquidity (liquidity risk). This induces banks to hold more liquidity, but this is costly. This leads to very short-term murabaha low earnings.

Excess liquidity Use of commodity murabaha Absence of LoLR facility is also a reason

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Examples of Problems with Commodity Murabaha

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High Proportion of Short-Term Int’l Murabaha in Total Murabaha,Bank-A (2002)

26.3 %

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High Proportion of Short-Term Int’l Murabaha inTotal Murabaha (Bank-B)

20042002

50.4% 43.7%

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Low Income from Short Term Murabaha (Bank-B)

Income from Other Murabaha 81 %

Income from Short-term Murabaha

15.1 %

Income from Other Murabaha 84.9%

2002 2004

Income from Short-term Murabaha

19 %

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Approaches to Liquidity Management

Asset Side Liquidity Management Liabilities Side Liquidity Management Two Sided Approach

Islamic Banks are mostly using Asset Approach to liquidity management

Large size banks use two sided approach Approach varies b/w retail and investment

banks

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Liquidity Management: Current Practices of IBs

To cope with Excess Liquidity Commodity Murabaha Sukuk Ijarah and Salam Stock Markets

To manage Liquidity Shortage Reverse Commodity Murabaha Mixing of deposits Various types of reserves for confidence building

Problems and Issues of these practices

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New Ideas: Going Forward

Mutual funds Mutual fund of sukuk (LMC) IBs’ local club for mutual cooperation Development of secondary market in

sukuk (issues involved: increasing the float, shorter term)

Sequence of Funds instead of Demand Deposits

IFSB Guidelines for risk management

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Existing Maturity Structure of Sukuk

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Sukuk-A

Sukuk-B

Sukuk-C

SPV- 2

Issue Pooled Sukuk of Shorter-Term

Investor

Investor

Investor

Investor

Long-term Sukuk with different time remaining to maturity

Maturity Transformation through Pooled Sukuk

Mutual Fund of Sukuk

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LMC’s Short Term Sukuk Program Repackages longer instruments into monthly

maturity certificates –Guaranteed monthly entry and exit dates –Intra-month entry and exit also available (no

penalties) –Flexibility of investment amounts –Fully secured by underlying Sukuk portfolio –Monthly returns

Source for this slide: LMC Presentation

Conclusions

What is neededWhat can be done

Thank You