Salman Syed Ali

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Salman Syed Ali

• LIQUIDITY RISK LIQUIDITY MANAGEMENT
• in Islamic banks

Distance Learning Course Current Issues in
Islamic Finance
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Overview

• Baking TheoryWhy 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

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• Banking TheoryWhy 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

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Excess of Wet or Dry
Liquidity Shortage Assassin of banks
Liquidity Surplus Drag on competitiveness
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• Islamic Banks are likely to be more stable
• They have profit sharing on both the liability
  side and asset side

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• 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

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

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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

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LIQUIDITY RISK Definition

• Risk of Funding at appropriate maturities and
  rates
• Risk of Liquidating Assets in time at reasonable
  prices

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Investment Firms 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).
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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)
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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

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Liquidity Risk Contractual Forms

• Profit Sharing Contracts
• Murabaha
• Salam
• Istisna
• Ijarah

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• Resale not permitted
• Resale permitted but non-existent market
• Market exists but not active

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Example of LR in Murabaha
Primary LR Secondary 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
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Analysis and Diagnosis
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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

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Examples of Problems with Commodity Murabaha
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High Proportion of Short-Term Intl Murabaha in
Total Murabaha,Bank-A (2002)
26.3
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High Proportion of Short-Term Intl Murabaha
inTotal Murabaha (Bank-B)
2004
2002
43.7
50.4
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Low Income from Short Term Murabaha (Bank-B)
Income from Short-term Murabaha 15.1
Income from Short-term Murabaha 19
2002
2004
Income from Other Murabaha 84.9
Income from Other Murabaha 81
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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

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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
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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

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Existing Maturity Structure of Sukuk
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Maturity Transformation through Pooled Sukuk
Mutual Fund of Sukuk
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• LMCs 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

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Conclusions

• What is needed
• What can be done

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Thank You