Salman Syed AliLIQUIDITY RISK & LIQUIDITY MANAGEMENTin Islamic banksDistance Learning Course: Current Issues in Islamic Finance

*OverviewBaking TheoryWhy banks exist?Liquidity Issues in Islamic banks------------------------------Sources of liquidity risk in IBsHow it is managed and the consequences------------------------------What is being done and further developments

*Banking TheoryWhy banks exist?Banks as providers of liquidity insurance to depositors and clientsRationale for deposit taking and lending by same institution (bank) Theory of bank intermediationThe Nature of Banking Firm Brings in Liquidity Risk

*Excess of Wet or DryLiquidity Shortage Assassin of banksLiquidity Surplus Drag on competitiveness

*Islamic Banks are likely to be more stableThey have profit sharing on both the liability side and asset side

*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.SolventAsset tied finance

*While majority of Islamic banks experience excess liquiditySome have also faced liquidity crisisMany different risks culminate in liquidity risk

*Liquidity crunch can be a real problemExample of Financial Crisis in Turkey 2000-2001Islamic financial institutions there faced sever liquidity problemsOne Islamic institution Ihlas Finans was closed during the crisis

*LIQUIDITY RISK: Definition

Risk of Funding [at appropriate maturities and rates]

Risk of Liquidating Assets [in time at reasonable prices]

*Investment Firms Definitionliquidity 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).

*Regulators Definition

risk to a banks earnings and capital arising from its inability to timely meet obligations when they come due without incurring unacceptable losses.* * Office of the Comptroller (2000)

*LIQUIDITY RISK: SourcesIncorrect judgment and complacencyUnanticipated change in cost of capitalAbnormal behavior of financial marketsRange of assumptions usedRisk activation by secondary sourcesBreak down of payments systemMacroeconomic imbalancesContractual formsFinancial Infrastructure deficiency

*Liquidity Risk & Contractual FormsProfit Sharing ContractsMurabahaSalamIstisnaIjarah

*Resale not permittedResale permitted but non-existent marketMarket exists but not active

*Example of LR in Murabaha

Primary LRSecondary LRReceivables are debt cannot be soldInvolves buying of commodity then selling on deferred payment This brings in many operational, credit, dispute, and legal risks that can affect realization of receivables

*Analysis and Diagnosis

*Liquidity Surplus ProblemExcess Liquidity is the current norm with Islamic banksWhere 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 murabahaAbsence of LoLR facility is also a reason

*Examples of Problems with Commodity Murabaha

*High Proportion of Short-Term Intl Murabaha in Total Murabaha,Bank-A (2002)26.3 %

*High Proportion of Short-Term Intl Murabaha inTotal Murabaha (Bank-B)2004200250.4%43.7%

*Low Income from Short Term Murabaha (Bank-B)Income from Other Murabaha 81 %Income from Short-term Murabaha15.1 %Income from Other Murabaha 84.9%20022004Income from Short-term Murabaha19 %

*Approaches to Liquidity ManagementAsset Side Liquidity ManagementLiabilities Side Liquidity ManagementTwo Sided Approach

Islamic Banks are mostly using Asset Approach to liquidity managementLarge size banks use two sided approachApproach varies b/w retail and investment banks

*Liquidity Management: Current Practices of IBsTo cope with Excess LiquidityCommodity MurabahaSukuk Ijarah and SalamStock MarketsTo manage Liquidity ShortageReverse Commodity MurabahaMixing of depositsVarious types of reserves for confidence buildingProblems and Issues of these practices

*New Ideas: Going ForwardMutual fundsMutual fund of sukuk (LMC)IBs local club for mutual cooperationDevelopment of secondary market in sukuk (issues involved: increasing the float, shorter term)Sequence of Funds instead of Demand DepositsIFSB Guidelines for risk management

*Existing Maturity Structure of Sukuk

*Maturity Transformation through Pooled SukukMutual Fund of Sukuk

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LMCs Short Term Sukuk ProgramRepackages longer instruments into monthly maturity certificatesGuaranteed monthly entry and exit datesIntra-month entry and exit also available (no penalties)Flexibility of investment amountsFully secured by underlying Sukuk portfolioMonthly returns

Source for this slide: LMC Presentation

ConclusionsWhat is neededWhat can be done

Thank You

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