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Rifki Ismal - ASSESSMENT OF LIQUIDITY RISK MANAGEMENT IN ISLAMIC BANKING INDUSTRY

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ASSESSMENT OF LIQUIDITY RISK MANAGEMENT IN ISLAMIC BANKING INDUSTRY

(Case of Indonesia)

Rifki Ismal 1

PhD Student in Islamic Banking and Finance School of Government and International Affairs

Durham University (United Kingdom)

Phone : +44 (0) 7900411659 / Email: [email protected]

ABSTRACTManajemen risiko likuiditas sangat penting bagi bank syariah khususnya terkait dengan keunikan operasional bank syariah. Melalui investigasi kepada tiga bank umum syariah (BUS) nasional, paper ini mengukur praktek manajemen risiko likuiditas bank-bank tersebut dengan membuat indeks manajemen risiko likuiditas. Indeks tersebut mencakup sisi asset dan liability bank syariah termasuk praktek kebijakan manajemen risiko likuiditas yang mereka lakukan. Hasil analisa indeks ini menunjukkan tingkat kriteria “baik” analisa indeks per komponen memberikan gambaran yang beragam.

Keywords: Asset, Liability, Mudarabah, Musharakah, Murabahah

1 The author address: School of Government and International Aff airs, Al Qasimi Building, Elvet Hill Road, Durham University, Durham (DH1 3TU), United Kingdom.

JOURNAL OF ISLAMIC BUSINESS AND ECONOMICS, DESEMBER 2008, Vol. 2 No. 2

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1. INTRODUCTION

1.1 Background

The concept of liquidity in fi nance lies in two areas (a) Liquidity of fi nancial instruments in fi nancial market and; (b) Liquidity related to solvency. The former deals with a liquid fi nancial market and its instruments; smooth transactions, no fi nancial barriers, etc. The later deals with the obligation of a bank to make payments to its third party or the solvency of the bank (Fiedler, 2000:442). This paper analyzes the second concept of liquidity especially focusing on liquidity risk management in banks taking into account Indonesian Islamic banks as a case. By constructing a measurable liquidity risk management index, it tries to value the Indonesian Islamic banking performance on managing liquidity risk.

In practice, one of the ultimate objectives of liquidity risk management is maintaining asset

liability balances. Hence, it manages funding and fi nancing, forecasts of funding requirements and lending of fund not exceptionally maintains suffi cient capacity of the bank to fulfi ll its fi nancial obligations with the third parties. Under global and open economic condition, the task to build proper liquidity risk management becomes very challenging. Particularly for Islamic banking as a new player in banking industry with its unique characteristics, operations and the way of doing business, setting up liquidity risk management mechanism requires extra efforts and special attention. However, dissimilar with conventional banking, liquidity risk in Islamic banking might arise when they fail to conduct proper liquidity management with a balance asset and liability side and fi nancing profi table business to retain their customers.

2. Liquidity Risk Problem in Sharia Perspective

Principally, Islamic banking efforts that aim to provide sound liquidity risk management are conducted throughout

2 From the idea of Dr. Habib Ahmed in his paper, “Assessing Risk Management System”, presented in the 7th Harvard University Forum on Islamic Finance, April 22-23, 2006 (USA).


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real business transactions (Antonio, 1999:46-53). It is because Islamic banking operation is a real and asset based oriented, connecting together business life cycle, cooperation among business partners, and good conduct of the stakeholders. Thus, liquidity risk, if it occurs, comes from disharmony of all parties doing business or unfavorable business condition leading to liquidity problem. It characterizes an Islamic banking industry in dealing with liquidity risk.

Moreover, Islamic banking takes roles as fi nancial intermediaries, supporter and facilitator all together. Even, they position themselves as a trusted body for the investors and business partners by becoming business advisor, consultant and source of knowledge. Then, as they also fully responsible to provide liquidity when demanded by third party, Islamic bank manages it through coordination with its counterparts. Therefore, each one of them should believe and support each other, share the risk and become forbidden to defeat other parties (Qur’an, 26:180-183). Finally, Islamic bank ties its fi nancing contract with

real asset and this is typically another unique attribute of its operation (Kahf, 2000:2). Therefore, in Islamic banking, liquidity risk can happen as a result of attaching fi nancing contract with real asset, which is not a common conventional banking transaction.

3. Construction of Liquidity Risk Management Index

The sound liquidity risk management can be observed from its balance sheet (asset and liability side) and liquidity risk management policies as well. Then, the survey being done explores three aspects in accordance to liquidity risk management: (1) Asset side, (2) Liability side and (3) Liquidity management policy. In asset side, evaluation of liquidity risk management considers Islamic bank’s efforts to monitor the fi nancing; arrange proper fi nancing allocation; tackle fi nancing default and unpleasant economic condition; and handle liquidity distress from asset side.

In liability side, it focuses on bank’s efforts to set appropriate deposit proportion supporting asset side; to


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have good arrangement with depositors on their withdrawal behaviors; to trace potential of liquidity run from rational depositors, etc. Finally, liquidity risk management policies cover corporate eyes on building healthy liquidity management practices. Corporate policies in treating Islamic securities to ratify liquidity demanded, relation with other banks in Islamic money market (PUAS), relation with central bank and government regarding placement of liquidity, etc are some samples elaborated in this area.

As liquidity balancing can be achieved through matching asset and liability side, the 100-point index of liquidity risk management is distributed to asset side, liability side and liquidity risk management policy, applicable for Indonesian case. Assuming Islamic banking policies related to asset side (A) and liability side (B) are equally important, each of them is given 35 points while liquidity risk management policy related to external factor (non operational) (C) is given allocation of 30 points. Hence, total index is accumulation of all or , with A = 35 points, B = 35 points and C = 30 points

such that,

∑ ∑∑= ==

++=n

t

n

tii

n

ti CBAL

1 11 (1)

Further, the index quota in every aspect (A-C) is then separated into some elements also containing index point (s) to detect bank’s actions on mitigating and preventing such risk in detail. All of the questions are as explained briefl y in Appendix I A – C in the last part of the paper. Meanwhile, in the process of constructing the liquidity risk management index, it involves three different styles of questions with their different index points’ treatments.

First of all, yes and no questions (m) and for this, points are given to every single answers marking yes or no. There is always zero point value in every yes/no question. Secondly, multiple choice questions (n) which have points in every single option of their questions. There is no zero point value in this type because each answer is appreciated and given a point (s). Finally, ranking (priority) questions (p). For this style, there is a standard (ideal practices) ranking of answers based on


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sharia perspective (Ismal, 2007: 5-20) in order to gain point (s) and also there is no zero point unless the answer does not match the standard ranking. Then, continuing from equation 1 above,

∑ ∑∑= ==

+=9

1

22

11 t tii

n

ti pmA

(2)

∑ ∑ ∑∑= = ==

++=7

1

14

1

3

11 t t tiii

n

ti pnmB

(3)

∑ ∑ ∑∑= = ==

++=13

1

3

1

12

11 t t tiii

n

ti pnmC

(4)

Upon examining banks X, Y and Z with proposed index calculation above there are three index values for every Islamic bank: (i) index value of its asset (A); (ii) liability (B); and (iii)

LRM policies (C). To evaluate and judge every aspects as well as overall index achievements, four criteria of examination are set: (1) Excellent; (2) Good; (3) Satisfactory and; (4) Poor. The determination of interval value of the index for every criterion just adopts 25% range from 0 (the lowest value) to 100 (the highest value) for overall index and 25% range begins from the highest value for every aspect. Table 2 below writes the complete interval value and all indexes as a whole.

Indonesian Islamic banking industry is graded excellent if its liquidity risk management index lies between 75 – 100; good if 50 – 74; satisfactory if 25 – 49; and poor if below 25. However, grading system and points in every assessment are subjective by the

Table 1. Grading System of Liquidity Risk Management Index


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author. The regulators, banks can come up with their owned value judgment for the result of the assessment.

4. Assessing Indonesian Islamic Banking Industry

Indonesian Islamic banking industry3

has been growing promisingly since the establishment of the fi rst Islamic bank in 1992. People’s awareness to employ Islamic banking spurred by government and Indonesian Moslem Scholars Council (MUI) has made the industry meaningful. Up to end of 2007, there are three Islamic Commercial Banks (BUS) followed by 25 Islamic Banking Unit (UUS) and 114 Islamic Rural Banks (BPRS) integrating 683 offi ces around the country (see Table 1 below).

In its development, Islamic banks have been showing a healthy fi nancial intermediary and prudential banking operation shown by its main banking indicators. For example, Financing to Deposit Ratio (FDR) has been lying between 100%-120% annually since 2001 while in conventional bank it is around 60% and Non Performing Financing (NPF) positions between 2%-4% while conventional records higher position at 8%. Others, like total asset, fi nancing and deposit have been growing annually for more than 60%4 on average . Lately, total asset has been reaching Rp36.53 trillion with total fi nancing of Rp27.9 trillion, well above its total deposit of Rp25.65 trillion.

3 Islamic banking industry consists of Islamic Commercial Banks (BUS), Islamic Banking Unit (UUS) and Islamic Rural Banks (BPRS). Islamic Banking Unit (UUS) is a special sharia banking unit

in conventional bank (windows system or dual banking system) while Islamic Rural Banks (BPRS) names Islamic banks operated in suburb / rural areas.

4 As reported in Bank Indonesia annual report 2006

Table 2. Selected Islamic Banking Indicators


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Despite its achievement above, the share of the industry in the total banking industry is still very small. Total asset caters less than 2% of total banking asset although it grows on average around 60%-80%5 annually . Less competitive, positioning of banks in people’s mind and lack of synergy with other fi nancial institutions are some weakness of the industry (Blue Print, 2005:18-22). Most importantly, some fundamental problems leading to liquidity risk challenge the industry especially depositors’ investment motives; under developed fi nancial market; limited banking instruments; industry’s fragility on macroeconomics issues; etc (Ismal, 2008a: 9-12).

As liquidity risk management is one important factor determining the successfulness of Indonesian Islamic banking industry, there is a need to evaluate and value the practices of liquidity risk management in the industry. The assessment takes three Islamic banks as they dominate the industry with 82% market share,

much higher than UUS or BPRS (Bank Indonesia monthly banking statistics, December 2007). Among others, the benefi t of assessing liquidity risk management practices is to determine the prospects of the industry and to measure the sensitivity of the industry with liquidity risk issue. The construction of liquidity risk management index itself uses information from liquidity risk management survey fi lled by respondents from banking authority and market players. Finally, in order to maintain anonymity the three Islamic banks are named banks X, Y and Z. 4. 1. Liability side

Assessing liquidity risk management from liability side of three Indonesian Islamic banks, it is found that around 50% of their total deposit is a rolled over 1-month deposit owned by non individual (mostly government institutions) which are very cooperative. Although the domination of short-term deposit worries them especially those whose behaviors cannot be predicted

5 Conventional bank’s growth is only about 10% annually.


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(rational depositors) but due to a charge (penalty) granted to liquidating of immature deposit and a requirement for big depositors to give prior notice before withdrawal, Islamic banks can so far sort out any short-term liquidity pressure.

For their future funding arrangement in liability side, some of them plan to design new banking instruments that fi t with depositors demand. The other prefers to attract international investor to invest money in the bank in order to strengthen its capital or realignment tenor of deposit from short-term into long-term deposit. Meanwhile, the purpose of depositors to take their money out of the bank is mostly driven by daily transaction motive and no indication of huge

deposit switching from Islamic bank into conventional bank. Small fraction only happens if interest rate return offered by conventional deposit is up. Nevertheless, these under controlled and predicted withdrawal motives support Islamic banks to manage their liquidity.

Considering the above factors, three Islamic banks face different marks on the liability side index. Bank X gets an excellent grade, Bank Y records a good grade and Bank Z achieves a satisfactory grade as depicted in table 3-5 respectively. Fortunately, none of them falls into poor criterion. And, due to inter related between liability and asset side, these achievements positively contribute to asset side and overall grade of the industry’s

Table 3. Liquidity Risk Management Index for Islamic Bank X


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assessment.

Nevertheless, as only one bank lies in “excellent” grade, it shows that liquidity risk management from liability side is not yet optimal in general. Some ideal liquidity risk practices in this side have to be done to improve the overall industry’s position. Particularly in the future, when the share and contribution of Islamic banks become bigger than what have been nowadays, the need to have an ideal liquidity risk management in liability side is a must. Appendix II A-C informs detail index calculation of every bank in their liability side.

4. 2. Asset side

In asset side, all three banks have done much effort to tackle such risk. First of all, they conduct intensive monitoring and evaluation of the fi nancing. Even, they match fi nancing planning with total available deposit by polling it and advance it based on its maturity date. However, macroeconomics shocks seem their ultimate enemy because Islamic banking operates based on real sector performance as mentioned previously so any unpleasant economic condition might potentially cause direct

impact to the banks. One important impact related to liquidity management in asset side is the increasing of non-performing fi nancing. It also makes banks diffi cult to fi nd profi table and prospective business proposal to be fi nanced.

Whenever liquidity demanded exceed their internal cash reserve, two of them rely on repurchasing of SWBI (Bank Indonesia Wadiah Certifi cate) to Bank Indonesia (BI) and one of them tends to just resell its Islamic securities (such as Islamic money market securities) in secondary market. For the other two, selling Islamic money market securities in secondary market is their second alternatives. Nonetheless, due to infant Islamic money market, depending on them is not their ultimate priority for the case of liquidity run.

Regarding fi nancing real sector projects, they typically still prefer debt-based projects (Murabahah, Salam, Istishna, Ijarah) to equity-based projects (Mudarabah, Musharakah) or service-based projects (Wakalah, Hiwalah, Kafalah). The rest of the fund goes to Islamic securities and SWBI as the zero risk investment instruments.


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For an ideal liquidity risk management practices, banks have to mostly utilize the fund for long-term and profi table projects under equity-based projects.

Unfortunately, for their future liquidity risk management planning, all of them still concentrate of boosting revenue from debt-based fi nancing rather than equity-based fi nancing. Amongst other reasons are due to diffi culties in fi nding profi table business proposal, trusted entrepreneurs and volatile business condition. However, if the industry wants to dominate the national banking industry, they have to be very competitive by offering high deposit return, various banking instruments and professional personnel and one way to reach it is through involvement

in long-term business project under equity-based fi nancing contract.

Upon implementing the above approach in asset side, the three Islamic banks can so far maintain a sustainable fi nancing performance. All of the three gain a “good” grade as explained in table 3-5 respectively. The index result shows a good achievement although it is realized that some improvement should be followed up in order to make it more perfect as explained above. Detailed of the index calculation can be seen in appendix III A-C.

4. 3. Liquidity management policy

This aspect is considerably very essential to determine the successfulness of the comprehensive efforts being done. The banks have

Table 4. Liquidity Risk Management Index for Islamic Bank Y


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been adopting several policies to handle such risk. In terms of managing the appropriate liquidity management, they have division/team dealing with risk management including liquidity risk. Furthermore, they provide the asset and liability balancing by planning every usage of fund, having quantitative model to accurately identify the fund being used, and insuring all deposit with government’s owned insurance deposit (LPS). Some banks set up a communication with big depositors regarding their withdrawal planning.

Because it is a corporate level’s actions, every problem with regard to liquidity risk is processed by risk management team/division before being forwarded to Board of Directors

for the strategic decision. However, for the policies ahead, the banks hope the government to sonly issue sovereign bond (sukuk) as one of ideal Islamic instruments to manage liquidity and will act as a benchmark for all Islamic securities. Keep stabilizing the economic condition and socializing the Islamic banking are their other hopes to be planned by government in cooperation with all industry players.

As a result, the liquidity risk management index in this aspect introduces 2 banks having an excellent grade and 1 bank noting good grade as written table 3-5 above. It is a very remarkable achievement in terms of policy level. Although, some details of actions still have to be taken such as setting up a good communication

Table 5. Liquidity Risk Management Index for Islamic Bank Z


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between banks and their depositors with respect to managing and knowing their liquidity planning and transaction behaviors. None of them are very cooperative with their depositors or business partners while it is one of the core business values of Islamic banking operation and the main different between Islamic banking ways of treating their stakeholders compared with conventional banking one. Detailed of the index calculation and actions being explored in this aspect are explained by appendix IV A-C.

5. Conclusion

Finally, the overall result of the liquidity risk management index comes up with a “good” grade. It clearly explains the recent liquidity risk management mechanism played in the industry. They occupy very short-term anticipative actions with the ultimate purpose to gain high short-term and sustainable

BLIOGRAPHY

Al Qur’an, 2005. Ministry of Religion, Republic of Indonesia, CV. Diponegoro, 10th printed, Bandung.

Antonio, Syaefi , 1999. Sharia Bank for Bankers and Practitioners. Bank Indonesia and Tazkia Institute, 1st Edition, Jakarta.

Kahf, Monzer, 2000. Treatment of Excess Liquidity in the Arab Gambian Islamic Bank”. Available at <URL: http://www.kahf.net/index.html> Access Date Jan, 20th, 2007.

Fiedler, Robert, 2000. Liquidity Risk. The Professional Handbook of Financial Risk Management, Great Britain.

Bank Indonesia, 2006. Annual Report. Indonesian Islamic Banking. Available at: <URL: http://www.bi.go.id.com/ > Access Date: June 3rd, 2007.


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Bank Indonesia, 2002-2007. Monthly Statistics Report. Indonesian Islamic Banking Statistics. Available at: <URL: http://www.bi.go.id.com/ > Access Date: July 10th, 2007.

Ismal, Rifki, 2008a. The Potential of Liquidity Risk in Islamic Banking. Unpublished Academic Paper, Durham University, United Kingdom.

Bank Indonesia, 2005. Blue Print of Indonesian Islamic Banking Development. Publication of Islamic Banking Directorate of Bank Indonesia, revision of 2002’s Blue Print, 2005, 18-22.

Ahmed, Habib, 2006. Assessing Risk Management System: An Application to Islamic Banks. Paper presented at the 7th Harvard University Forum on Islamic Finance, Boston, USA, April 22-23, 2006.

Ismal, Rifki, 2007. Islamic Banking Issues on Liquidity Risk Management. Unpublished Academic Paper, Durham University, United Kingdom.

Ismal, Rifki, 2008b. Analysis of Liquidity Risk Management Practices in Islamic Banking Industry. Unpublished Academic Paper, Durham University, United Kingdom, February, 2008.


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Appendix I A: Liquidity Risk Management (Survey Manual)


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Appendix I B: Liquidity Risk Management (Survey Manual)


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Appendix I C: Liquidity Risk Management (Survey Manual)


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AAppendix II A: Bank X (Survey Result)


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Appendix II B: Bank X (Survey Result)


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Appendix II C: Bank X (Survey Result)


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Appendix III A: Bank Y (Survey Result)


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Appendix III B: Bank Y (Survey Result)


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Appendix III C: Bank Y (Survey Result)


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Appendix IV A: Bank Z (Survey Result)


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Appendix IV B: Bank Z (Survey Result)


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Appendix IV C: Bank Z (Survey Result)


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