© A. Jobst, 2009

Second Session:Monetary Policy and Liquidity Management

Andreas (Andy) JobstMonetary and Capital Markets Dept.International Monetary Fund (IMF)

Seminar on Islamic FinanceBanca d’Italia

November 11, 2009Rome, Italy

700 19th Street, NW, Washington, DC 20431, USA

E-mail: ajobst@imf.org

Disclaimer: This presentation should not be reported as representing the views of the IMF. The views expressed in this presentation are those of the author and do not necessarily represent those of the IMF or IMF policy.

© A. Jobst, 2009

Window of opportunity for Islamic banking …

Soul-searching in conventional finance:– reduction of complexity simpler financial products– no asymmetric incentive systems– stable growth only if there are redundancies without

leverage otherwise gyrations and no room for error – fundamental reform: no makeshift repairs, structural change

marginalization of leveraged financing

See also • Nassim Taleb, “Ten Principles for a Black Swan-proof World” (FT, April 2009)• Viral Acharya, Thomas Philippon, Matthew Richardson, and Nouriel Roubini, “The

Financial Crisis of 2007–2009: Causes and Remedies” (Geneva Papers, February 2009)

© A. Jobst, 2009

… given the basic precepts of Islamic finance (1) …

• asset-linkage– payments can only be made in association with the temporary or

permanent use of assets and not from the time value of money asset-backing is essential

– align investments in real assets and associated financial claims– prohibition of short-selling and marginalization of the possibility

of leverage (underfunding)

• shared business risk from (entrepreneurial) investment– payoffs from state- or time-contingent profit/loss sharing

arrangements without guarantees, based on direct participation in asset performance

– contractual certainty via clear and transparent investor rights and obligations

© A. Jobst, 2009

… given the basic precepts of Islamic finance (2) …

• identifiable object characteristics (“quantity and quality”) of a bona fide trade and/or certainty about delivery results

– sales must be immediate and absolute without uncertainty (gharar)

– delayed delivery and payment permissible if their commercial value (“diversity of trade”) overrides term contingencies salaf (forward trade)

– any contingency risk limited to pre-defined timing mismatch of delivery or payment

• no trading of the same object between buyer and seller for profit with time delay (bay’ al inah), incl. exchange of money for debt without an underlying asset transfer

• no betting and gambling (maisir), no unilateral (or zero-sum) gains

© A. Jobst, 2009

Overview

• The Balance Sheet and ALM of Islamic Banks• Trade-off between Profitability and Liquidity• Consequences for Liquidity Issues: Solutions

for More Efficient Liquidity Management• Economic, Regulatory and Legal Challenges• Conclusion

© A. Jobst, 2009

Islamic banking is on the rise … • Islamic banking and AUM to exceed US$1 trillion by end-2010

• surplus liquidity to aggressively boost deposit volumes while maintaining focus on retail and corporate sectors, also due to safe haven flows from retail entrenchment

• fragmented and emergent market system as well as excessive liquidity base has sheltered them from credit crisis, but have not escaped unscathed

• retail-funded, commercial banks with low leverage and abundant liquidity wholesale-funded investment banks with concentrated deposit base and highly cyclical exposure

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… but liquidity management is a challenge …

Concept of liquidity lies at the heart of ALM• ability to capture and retain funding to maintain

intermediation margins/ growth, and withstand chance of insolvency (deposit runs)

• capacity to secure alternative funding via selling assets and/or superior financial flexibility

• ALM: balance sheet optimization from cash perspective

© A. Jobst, 2009

… especially if interest rates increase• fixed interest rate on asset side, but floating short-term

liabilities– re-pricing risk on assets (DGAP) and higher funding costs

(DCR) than in conventional banks– potential losses from higher interest rates

Conventional Banks Islamic Banks

Assets Liabilities

Floating income assets

Fixed income liabilities

Assets Liabilities

Fixedincome assets

Profit-sharing liabilities (not fixed)

Risk from lower interest rates Risk from higher interest rates

© A. Jobst, 2009

Balance Sheet of IFIs – Funding Structure• Focus on ample short-term liquidity

– suboptimal term structure transformation due to religious constraints

• Assets: high transaction costs– ample short-term (fixed) assets, such as murabaha, less profitable with

high duration-sensitivity (DGAP>0)– long-term assets entail disproportionate credit risk (which can erode

investment deposits), such as musharaka– natural limits to diversified asset side: underdeveloped inter-bank

money market and dependence on commodities as generic collateral

• Liabilities: uncertain funding liquidity and term risk– principal-guaranteed checking account deposits and savings/term

deposits– “pass-through” mechanism (displaced commercial risk, DCR): investment

deposits and profit-sharing investment accounts (PSIAs) contingent on capital appreciation cash reserve endogenizes mutual cost of deposit protection (self-insurance)

© A. Jobst, 2009

Stylized Balance Sheet

Low credit leverage (liquid credit exposures in asset allocation) and low financial leverage (debt-like liabilities in total funding)

• cash• short-term interbank murabaha• sukuk• other investments (musharaka, murabaha)• credit portfolio• others

• checking accounts (qardh hasan)• short-term murabaha and wakala

(interbank/customers)• long-term syndicated murabaha• sukuk• unrestricted PSIAs• profit equalization reserves

(PERs)• equity

ASSETS LIABILITIES

Shari’ah Compliance

thin interbank market due to prohibitions on debt

investment , derivatives

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Islamic Inter-Bank Market• GCC: no Islamic money market and debt securities account for

less than 5% of capital market– high oil revenues– reliance on bank finance– easy access to equity finance– poor governance standards and infrastructure

• Malaysia: Islamic Inter-bank Money Market (IIMM)– introduced by Bank Negara Malaysia in 1994 – wholesale transactions (Islamic banks and Islamic windows)– but still 2/3 conventional

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Trade-off between Profitability and Liquidityexcessive liquidity syndrome: blessing and curse

Assetsunder-utilized surplus liquidity generating suboptimal revenue and concentrated

nature of asset sideLiabilities

vulnerable funding pattern of long-term assets via short-term PLS and non-PLS deposits and payment of long-term liabilities from deposits and short-term assets

Maturity Mismatch Dilemmahigh concentration of liquid (but expensive) short-term assets and illiquid (but profitable) long-term assets without access to long-term funding and

hedging instruments but high credit risk from asset-linkage

Risk of Liquidity Shortfall recent tendency to lengthen average tenor of credit exposure

© A. Jobst, 2009

Causes of Liquidity Shortage

Causes of Liquidity Shortage

Higher CDR and Funding Volatility:

changes in micro- and macroeconomic

conditions

Asset Linkage: susceptibility to asset price fluctuations and defective asset quality

Religious prohibition of “debt sale” and low interbank liquidity

Reliance on balance sheet assets for liquidity

management

Nascent Short-term Money Market:

no liquid/diverse asset side

Maturity Mismatch: scarce longer term

funding sources

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Consequences of Liquidity Issues

• conduct of monetary policy– different approaches and challenges faced in

applying monetary policy tools• OMOs

• solutions for more efficient liquidity management via securities markets– commodity murabaha, repos, sukuk and

derivatives

© A. Jobst, 2009

Greater Scale of OMO for Short-term Balance Sheet: Duration and Convexity

9.4 Annual interest rate %108.8

Price ($)

10,155.24

10,000

9,847.72

Dollar gain from convexity

Gains from convexity

+$155.24

-$152.28

Duration: slope of line

Greater convexity implies that the price (yield) will …➀ fall (rise) slower (faster) than the yield (price) rises (falls), ➁ rise (fall) faster (slower) than the yield (price) falls (rises).

➀

➁

QE during crisis

Short-term profile of interest-sensitive assets and liabilities

© A. Jobst, 2009

Solutions for More Efficient Liquidity Management (1)

• regulatory dynamics to allow for more efficient investment of excess cash and lower credit risk concentration

• assets – credit leverage– more liquid (and diverse) assets over different

tenors to avoid short-term asset/deposits funding long-term liabilities

• liabilities – financial leverage– more long-term funding sources to balance long-

term exposures to real estate, etc.

© A. Jobst, 2009

Solutions for More Efficient Liquidity Management (2)

Commodity murabaha

Repurchase Agreements

Other sukuk

Short-term ijara sukuk

Derivatives

use of innovative asset classes to complement variety-starved asset section and alleviate ALM concerns

© A. Jobst, 2009

Solutions for More Efficient Liquidity Management (3)

• tawarruq and commodity murabaha most used

Commodity murabaha

Tawarruq

• sale of certain commodity on cost-plus basis

• most used liquidity management instrument

• reverse form of commodity murabaha as cost-plus sale of commodity to customer on installment basis

• customer sells commodity and receives cash

© A. Jobst, 2009

Solutions for More Efficient Liquidity Management (4)

• alternative to auction-based t-bills

• buyback and issuance of sukuk

• same underlying asset

Short-term ijarah sukuk

• securitization of receivables under murabaha contract(s)

• but rejected by most scholars• instead, combination of receivables and fixed assets

• medium-/long-term sukuk only a small portion of the balance sheet illiquid, concentrated, predominantly local issuance

Other sukuk

• repo of tradable Islamic securities

• sale and separate unilateral promise to buy back• alternative: deposit against acquisition of asset and liquidation upon maturity

• not all can be used as collateral for interest-based inter-bank/central bank repos

Repurchase agreements

• scarce, customized and contested

• tendency towards short-term, less costly solutions, such as inefficient back-to-back hedging

Derivatives

© A. Jobst, 2009

• transform bilateral risk-reward sharing between borrowers and lenders into the market-based refinancing of shari’ah-compliant lending or trust-based investment

• investors own the underlying asset(s) via SPV that funds (un)secured payments to investors from direct investment in real, religiously-sanctioned economic activity

• sukuk do not pay interest, but generate returns through commoditization of capital gains

Sukuk: Definition and Market (1)

© A. Jobst, 2009

0

5

10

15

20

0

5

10

15

20Other

Islamic synd. loans

International sukuk

Domestic sukuk

Issuance of Islamic Finance Instruments (In US$ bn.)• moderate issuance in

2008, but number of deals brought to market has steadily increased (139 in 2008 vs. 161 in 2007 over same time)

• sukuk volume dropped to US$17.2bn (50% from US$36.3bn.) in 2008, while structured finance volume dried up with just US$387bn. issued (80%) amid stable EM issuance (US$310bn.)

• issuance 2009Q2 already exceeded total issuance in 2008

Sukuk: Definition and Market (2)

© A. Jobst, 2009

Derivatives in Islamic Finance: Classification

Legacy Derivatives

Explicit Derivatives

Forward2

x (salam, bay mu’ajal,

bay bithaman ajil (BBA), istisna)

x (various commodity

hedges and “wrappers”)

Option

x (wa’d, arbun, al-shart)

x (foreign exchange option contracts)

Swap

x

(tawarruq, al-muqasah)

x (wa’d-based swap,

profit rate swap, cross-currency swap)

Jobst, A. (2009), “Islamic Derivatives,” International Journal of Monetary Economics and Finance, Vol. 2, Nos. 3/4, 254-60.

© A. Jobst, 2009

Profit Rate Swap

Islamic Bank B

Broker/trader

sale of commodity B (every 3 months)

sale of commodity B

purchase of commodity B

Islamic Bank A

purchase of commodity A

sale of commodity A

FIXED LEG

single term murabaha(cost price + fixed profit portion (“cost-plus”))

fixed periodic payments

Supplier Broker/traderSupplier

Floa

ting

Rate

Pa

yer

Fixed RatePayer

2

4

5

1/ This includes full payment and physical settlement each period. This structure was pioneered by Commerce International Merchant Bank (CIMB) of Malaysia in 2005.

3 1 6

sale of commodity A

periodic floating rate payments 1/

FLOATING LEG

reverse murabaha(commodity market price + floating

rate profit portion (over LIBOR))

“Interest Rate Risk”Protection

Most derivatives are customized and costly …

© A. Jobst, 2009

Current Challenges – Market Infrastructure

• traditionally weak reliance on capital market financing critical legal hindrances that impact on the way financial innovation can redress ALM constraints

• organization of trading: contamination via (conventional) market practices

• sukuk– identify reference assets that meet shari’ah requirements– illiquidity in the secondary market and regional fragmentation– origination and servicer risk from narrow asset supply poses

challenges to investor diversification– fair valuation of sukuk and first defaults without body of case law

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• Islamic jurisprudence neither definite nor bound by precedent and no universal recognition and enforceability of rulings– no unified principles on which shari’ah scholars decide on compliance

of new products– no cross-referencing or consolidation of fatwas– regional diversity of secondary sources supporting religious doctrine:

ijtihad (independent analytical reasoning), ijma (consensus) and qiyas (deduction by analogy)

• regulatory standards of shari’ah compliance vary considerably – IFSB Task Force on standard sukuk structures (early in 2008)– International Islamic Financial Market (IIFM)) with ISDA master

agreement– limitations of AAOIFI recommendations

Current Challenges – Regulation and Supervision (1)

© A. Jobst, 2009

Current Challenges – Regulation and Supervision (2)

• legal governance of transactions: commercial law vs. Islamic law (via shari’ah board)– shari’ah compliance by substance or form ? – risk of legal

re-qualification– current ISDA/IIFM derivatives master agreement defines

secular law as forum

© A. Jobst, 2009

Thank you.

© A. Jobst, 2009

• Čihák, Martin and Heiko Hesse, 2008, “Islamic Banks and Financial Stability: An Empirical Analysis,” IMF Working Paper 08/16 (Washington: International Monetary Fund).

• Hesse, Heiko, Jobst, Andreas A., and Juan Solé, 2009, “Market Tension,” Islamic Banking & Finance, Vol. 7, No. 2 (April-May), 24-6.

• ______________, 2008, “Trends and Challenges in Islamic Finance,” World Economics (April-June). • Jobst, Andreas A. and Juan Solé (2009), “The Governance of Derivatives in Islamic Finance,” Journal

of International Business Law and Regulation, Vol. 24, No. 11, 556-65.• Jobst, Andreas A., Peter Kunzel, Paul Mills and Amadou Sy, 2008, “Islamic Bond Issuance – What

Sovereign Debt Managers Need to Know,” International Journal of Islamic & Middle East Finance and Management, Vol. 1, No. 4.

• Jobst, Andreas A., 2009, “Risk Management and Islamic Financial Instruments,” Qatar Finance – The Ultimate Resource (“Qfinance”), Bloomsbury Publishing, London.

• ______________, 2007, “The Economics of Islamic Finance and Securitization,” Journal of Structured Finance, Vol. 13, No. 1 (Spring), 1-22.

• ______________, “A Primer on Structured Finance,” Journal of Derivatives and Hedge Funds, Vol. 13, No. 3, 199-213.

• ______________, “Derivatives in Islamic Finance,” in: Salman, Ali (ed). Islamic Capital Markets – Products, Regulation and Development. Islamic Development Bank, Islamic Research and Training Institute (IRTI), Jeddah.

References