1. Assets-Liabilities Mismatch: Risks and Challenges Sami Al-Suwailem IRTI, IDB Jumada Thani, 1430H – June, 2009

2. Overview Maturity mismatch: ◦ Liabilities are shorter than assets (borrow short and lend long) ◦ Reduces costs (short term interest usually lower) Currency mismatch: ◦ Borrow in a currency and lend in another ◦ Exploits interest rate differentials 2

3. Maturity Transformation Benefits: liquidity—micro level Costs: ◦ Fallacy of composition ◦ Risk of runs ◦ High leverage ◦ Endogenous risk—financial fragility ◦ Systemic risk—macro level International crises “The original sin” 3

4. Endogenous Risk Financial sector is more volatile than real economy Richard Bookstaber (2007): ◦ “The fact that total risk of financial markets has grown in spite of a marked decline in exogenous economic risk is a key symptom of the design flaws within the system” 4

5. Maturity Mismatch vs. Ponzi Schemes Both have serial structure: ◦ Take from B to pay A; from C to pay B; from D to pay C, etc. ◦ Default arises when the chain stops MM is solvent, PS is not Ponzi scheme is a “naked” MM design “Optimal Ponzi design” when government is expected to step in! 5

6. Historical Responses Bank runs Saving & Loans 1980’s Lender of Last Resort, Deposit Insurance, and government bailout Problem: moral hazard 6

7. Shadow Banking System In the past two decades nonbank financial institutions replicated the commercial banking model via money markets Banks also shifted from deposits to money markets Size of the shadow system in 2007 reached $10.5 trillion, while commercial banking system was $10 trillion 7

8. Liquidity Party By end of 2006, investment banks were rolling over 25% of their balance sheets on daily basis Overnight repos = $2.5 trillion “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We‘re still dancing.”  C. Prince, CEO, Citigroup, July 10, 2007 8

9. Asset-Backed Commercial Paper Issuance Monthly MA, $billions Source: Baily et. al., 2008

10. More Risky System Money market is more risky and volatile than deposits Plus, no insurance or LOLR for such institutions “What is truly shocking is that the risks posed by this funding mismatch have gone so unnoticed, for so long.”  Gillian Tett, Financial Times, Sep. 2007 10

11. Global Financial Crisis Triggered by classical run, but in the shadow banking sector The same mechanism of other international crises The system needs to be redesigned 11

12. International Responses BIS: Macro-prudential measures against systemic and liquidity risks FSA: Core funding ratio IMF: Balance-sheet approach for financial assessment CMBS: Mark-to-funding Group of Thirty & WEF: Less short term debt 12

13. Islamic Finance Integration of debt creation with wealth creation Alignment of funding and spending Alignment of assets and liabilities Mismatch may arise incidentally but not deliberately 13

14. Deliberate Mismatching A loan to be paid by another loan, to be paid by another, etc. Each loan is an obligation that bank does not have ability to pay on time—“sale of what you don’t have” Highly risky—gharar “Two sales in one”: Fulfillment of one contract is conditioned on another 14

15. Islamic Model of Intermediation Profit and loss sharing on both sides “Mutual funds banking” “Limited purpose banking” Perfect match and inherent stability 15

16. Islamic Banks in Practice Used to be stable with ample liquidity Recently they are increasingly misaligning their balances Borrow short through reversed tawarruq Lend long through organized tawarruq Islamic banks face the same vulnerabilities of conventional banks 16

17. Diversity Islamic finance promotes diversity: ◦ It is directly linked to the diverse real economy The more finance becomes detached from real economy, the more it becomes homogenous 17

18. Liquidity “Black-hole” A homogenous market fails to meet “law of large numbers” Herd behavior and correlated risk Fallacy of composition: if every one wants to sell, liquidity disappears Diversity is essential for market liquidity 18

19. Role of Regulation Andrew Haldane, BoE (2009): ◦ Deregulation swept away banking segregation and, with it, robustness of the financial network ◦ That is why Glass-Steagall Act is back on the international policy agenda ◦ It may be the wrong or too narrow an answer. But it asks the right question: Can network structure be altered to improve network robustness? 19

20. Firm Boundaries Firms may be segregated based on aligned maturity structures Financial landscape is distributed along maturity horizon This assures stability and diversity No need for Glass-Steagall act 20

21. Conclusion Deliberate mismatching is Islamically questionable and economically dangerous Glass-Steagall Act is outdated and incomprehensive Regulation based on aligned maturities might provide a better approach 21

22. والحمد لله رب العالمين 22