1. Salman Syed Ali LIQUIDITY RISK & LIQUIDITY MANAGEMENT in Islamic banks Distance Learning Course: Current Issues in Islamic Finance Lecture 4 March 28, 2006

2. 2 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

3. 3 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

4. 4 Excess of Wet or Dry Liquidity Shortage Assassin of banks Liquidity Surplus Drag on competitiveness

5. 5 Islamic Banks are likely to be more stable They have profit sharing on both the liability side and asset side

6. 6 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

7. 7 While majority of Islamic banks experience excess liquidity Some have also faced liquidity crisis Many different risks culminate in liquidity risk

8. 8 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

9. 9 LIQUIDITY RISK: Definition Risk of Funding [at appropriate maturities and rates] Risk of Liquidating Assets [in time at reasonable prices]

10. 10 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).

11. 11 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)

12. 12 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

13. 13 Liquidity Risk & Contractual Forms Profit Sharing Contracts Murabaha Salam Istisna Ijarah

14. 14 Resale not permitted Resale permitted but non-existent market Market exists but not active

15. 15 Example of LR in Murabaha Primary LRSecondary 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

16. 16 Analysis and Diagnosis

17. 17 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

18. 18 Examples of Problems with Commodity Murabaha

19. 19 High Proportion of Short-Term Int’l Murabaha in Total Murabaha,Bank-A (2002) 26.3 %

20. 20 High Proportion of Short-Term Int’l Murabaha inTotal Murabaha (Bank-B) 20042002 50.4% 43.7%

21. 21 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 %

22. 22 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

23. 23 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

24. 24 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

25. 25 Existing Maturity Structure of Sukuk

26. 26 Sukuk-A Sukuk-B Sukuk-C SPV- 2 Issue Pooled Sukuk of Shorter- Term Investor Long-term Sukuk with different time remaining to maturity Maturity Transformation through Pooled Sukuk Mutual Fund of Sukuk

27. 27 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

28. Conclusions What is needed What can be done

29. Thank You