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© A. Jobst, 2009 Second Session: Monetary Policy and Liquidity Management Andreas (Andy) Jobst Monetary and Capital Markets Dept. International Monetary Fund (IMF) Seminar on Islamic Finance Banca d’Italia November 11, 2009 Rome, Italy 700 19 th Street, NW, Washington, DC 20431, USA E-mail: firstname.lastname@example.org Disclaimer: This presentation should not be reported as representing the views of the IMF. The views expressed in this presentation are those of the author and do not necessarily represent those of the IMF or IMF policy.
© A. Jobst, 2009 Window of opportunity for Islamic banking … Soul-searching in conventional finance: –reduction of complexity simpler financial products –no asymmetric incentive systems –stable growth only if there are redundancies without leverage otherwise gyrations and no room for error –fundamental reform: no makeshift repairs, structural change marginalization of leveraged financing See also Nassim Taleb, “Ten Principles for a Black Swan-proof World” (FT, April 2009) Viral Acharya, Thomas Philippon, Matthew Richardson, and Nouriel Roubini, “The Financial Crisis of 2007–2009: Causes and Remedies” (Geneva Papers, February 2009)
© A. Jobst, 2009 … given the basic precepts of Islamic finance (1) … asset-linkage –payments can only be made in association with the temporary or permanent use of assets and not from the time value of money asset-backing is essential –align investments in real assets and associated financial claims –prohibition of short-selling and marginalization of the possibility of leverage (underfunding) shared business risk from (entrepreneurial) investment –payoffs from state- or time-contingent profit/loss sharing arrangements without guarantees, based on direct participation in asset performance –contractual certainty via clear and transparent investor rights and obligations
© A. Jobst, 2009 … given the basic precepts of Islamic finance (2) … identifiable object characteristics (“quantity and quality”) of a bona fide trade and/or certainty about delivery results –sales must be immediate and absolute without uncertainty (gharar) –delayed delivery and payment permissible if their commercial value (“diversity of trade”) overrides term contingencies salaf (forward trade) –any contingency risk limited to pre-defined timing mismatch of delivery or payment no trading of the same object between buyer and seller for profit with time delay (bay’ al inah), incl. exchange of money for debt without an underlying asset transfer no betting and gambling (maisir), no unilateral (or zero-sum) gains
© A. Jobst, 2009 Overview The Balance Sheet and ALM of Islamic Banks Trade-off between Profitability and Liquidity Consequences for Liquidity Issues: Solutions for More Efficient Liquidity Management Economic, Regulatory and Legal Challenges Conclusion
© A. Jobst, 2009 Islamic banking is on the rise … Islamic banking and AUM to exceed US$1 trillion by end-2010 surplus liquidity to aggressively boost deposit volumes while maintaining focus on retail and corporate sectors, also due to safe haven flows from retail entrenchment fragmented and emergent market system as well as excessive liquidity base has sheltered them from credit crisis, but have not escaped unscathed retail-funded, commercial banks with low leverage and abundant liquidity wholesale-funded investment banks with concentrated deposit base and highly cyclical exposure
© A. Jobst, 2009 … but liquidity management is a challenge … Concept of liquidity lies at the heart of ALM ability to capture and retain funding to maintain intermediation margins/ growth, and withstand chance of insolvency (deposit runs) capacity to secure alternative funding via selling assets and/or superior financial flexibility ALM: balance sheet optimization from cash perspective
© A. Jobst, 2009 … especially if interest rates increase fixed interest rate on asset side, but floating short-term liabilities –re-pricing risk on assets (DGAP) and higher funding costs (DCR) than in conventional banks –potential losses from higher interest rates Conventional BanksIslamic Banks AssetsLiabilities Floating income assets Fixed income liabilities AssetsLiabilities Fixed income assets Profit-sharing liabilities (not fixed) Risk from lower interest ratesRisk from higher interest rates
© A. Jobst, 2009 Balance Sheet of IFIs – Funding Structure Focus on ample short-term liquidity –suboptimal term structure transformation due to religious constraints Assets: high transaction costs –ample short-term (fixed) assets, such as murabaha, less profitable with high duration-sensitivity (DGAP>0) –long-term assets entail disproportionate credit risk (which can erode investment deposits), such as musharaka –natural limits to diversified asset side: underdeveloped inter-bank money market and dependence on commodities as generic collateral Liabilities: uncertain funding liquidity and term risk –principal-guaranteed checking account deposits and savings/term deposits –“pass-through” mechanism (displaced commercial risk, DCR): investment deposits and profit-sharing investment accounts (PSIAs) contingent on capital appreciation cash reserve endogenizes mutual cost of deposit protection (self-insurance)
© A. Jobst, 2009 Stylized Balance Sheet Low credit leverage (liquid credit exposures in asset allocation) and low financial leverage (debt-like liabilities in total funding) cash short-term interbank murabaha sukuk other investments (musharaka, murabaha) credit portfolio others checking accounts (qardh hasan) short-term murabaha and wakala (interbank/customers) long-term syndicated murabaha sukuk unrestricted PSIAs profit equalization reserves (PERs) equity ASSETSLIABILITIES Shari’ah Compliance thin interbank market due to prohibitions on debt investment, derivatives
© A. Jobst, 2009 Islamic Inter-Bank Market GCC: no Islamic money market and debt securities account for less than 5% of capital market –high oil revenues –reliance on bank finance –easy access to equity finance –poor governance standards and infrastructure Malaysia: Islamic Inter-bank Money Market (IIMM) –introduced by Bank Negara Malaysia in 1994 –wholesale transactions (Islamic banks and Islamic windows) –but still 2/3 conventional
© A. Jobst, 2009 Trade-off between Profitability and Liquidity excessive liquidity syndrome: blessing and curse Assets under-utilized surplus liquidity generating suboptimal revenue and concentrated nature of asset side Liabilities vulnerable funding pattern of long-term assets via short-term PLS and non-PLS deposits and payment of long-term liabilities from deposits and short-term assets Maturity Mismatch Dilemma high concentration of liquid (but expensive) short-term assets and illiquid (but profitable) long-term assets without access to long-term funding and hedging instruments but high credit risk from asset-linkage Risk of Liquidity Shortfall recent tendency to lengthen average tenor of credit exposure
© A. Jobst, 2009 Causes of Liquidity Shortage Causes of Liquidity Shortage Higher CDR and Funding Volatility: changes in micro- and macroeconomic conditions Asset Linkage: susceptibility to asset price fluctuations and defective asset quality Religious prohibition of “debt sale” and low interbank liquidity Reliance on balance sheet assets for liquidity management Nascent Short-term Money Market: no liquid/diverse asset side Maturity Mismatch: scarce longer term funding sources
© A. Jobst, 2009 Consequences of Liquidity Issues conduct of monetary policy –different approaches and challenges faced in applying monetary policy tools OMOs solutions for more efficient liquidity management via securities markets –commodity murabaha, repos, sukuk and derivatives
© A. Jobst, 2009 Greater Scale of OMO for Short-term Balance Sheet: Duration and Convexity 9.4Annual interest rate % 10 8.8 Price ($) 10,155.24 10,000 9,847.72 Dollar gain from convexity Gains from convexity +$155.24 -$152.28 Duration: slope of line Greater convexity implies that the price (yield) will … ➀ fall (rise) slower (faster) than the yield (price) rises (falls), ➁ rise (fall) faster (slower) than the yield (price) falls (rises). ➀ ➁ QE during crisis Short-term profile of interest-sensitive assets and liabilities
© A. Jobst, 2009 Solutions for More Efficient Liquidity Management (1) regulatory dynamics to allow for more efficient investment of excess cash and lower credit risk concentration assets – credit leverage –more liquid (and diverse) assets over different tenors to avoid short-term asset/deposits funding long-term liabilities liabilities – financial leverage –more long-term funding sources to balance long- term exposures to real estate, etc.
© A. Jobst, 2009 Solutions for More Efficient Liquidity Management (2) Commodity murabaha Repurchase Agreements Other sukuk Short-term ijara sukuk Derivatives use of innovative asset classes to complement variety-starved asset section and alleviate ALM concerns
© A. Jobst, 2009 Solutions for More Efficient Liquidity Management (3) tawarruq and commodity murabaha most used Commodity murabaha Tawarruq sale of certain commodity on cost-plus basis most used liquidity management instrument reverse form of commodity murabaha as cost-plus sale of commodity to customer on installment basis customer sells commodity and receives cash
© A. Jobst, 2009 Solutions for More Efficient Liquidity Management (4) alternative to auction-based t-bills buyback and issuance of sukuk same underlying asset Short-term ijarah sukuk securitization of receivables under murabaha contract(s) but rejected by most scholars instead, combination of receivables and fixed assets medium-/long-term sukuk only a small portion of the balance sheet illiquid, concentrated, predominantly local issuance Other sukuk repo of tradable Islamic securities sale and separate unilateral promise to buy back alternative: deposit against acquisition of asset and liquidation upon maturity not all can be used as collateral for interest- based inter- bank/central bank repos Repurchase agreements scarce, customized and contested tendency towards short-term, less costly solutions, such as inefficient back- to-back hedging Derivatives
© A. Jobst, 2009 transform bilateral risk-reward sharing between borrowers and lenders into the market-based refinancing of shari’ah- compliant lending or trust-based investment investors own the underlying asset(s) via SPV that funds (un)secured payments to investors from direct investment in real, religiously-sanctioned economic activity sukuk do not pay interest, but generate returns through commoditization of capital gains Sukuk: Definition and Market (1)
© A. Jobst, 2009 moderate issuance in 2008, but number of deals brought to market has steadily increased (139 in 2008 vs. 161 in 2007 over same time) sukuk volume dropped to US$17.2bn ( 50% from US$36.3bn.) in 2008, while structured finance volume dried up with just US$387bn. issued ( 80%) amid stable EM issuance (US$310bn.) issuance 2009Q2 already exceeded total issuance in 2008 Sukuk: Definition and Market (2)
© A. Jobst, 2009 Derivatives in Islamic Finance: Classification Jobst, A. (2009), “Islamic Derivatives,” International Journal of Monetary Economics and Finance, Vol. 2, Nos. 3/4, 254-60.
© A. Jobst, 2009 Profit Rate Swap Islamic Bank B Broker/ trader sale of commodity B (every 3 months) sale of commodity B purchase of commodity B Islamic Bank A purchase of commodity A sale of commodity A FIXED LEG single term murabaha (cost price + fixed profit portion (“cost-plus”)) fixed periodic payments Supplier Broker/ trader Supplier Floating Rate Payer Fixed Rate Payer 2 4 5 1/ This includes full payment and physical settlement each period. This structure was pioneered by Commerce International Merchant Bank (CIMB) of Malaysia in 2005. 316 sale of commodity A periodic floating rate payments 1/ FLOATING LEG reverse murabaha (commodity market price + floating rate profit portion (over LIBOR)) “Interest Rate Risk” Protection Most derivatives are customized and costly …
© A. Jobst, 2009 Current Challenges – Market Infrastructure traditionally weak reliance on capital market financing critical legal hindrances that impact on the way financial innovation can redress ALM constraints organization of trading: contamination via (conventional) market practices sukuk –identify reference assets that meet shari’ah requirements –illiquidity in the secondary market and regional fragmentation –origination and servicer risk from narrow asset supply poses challenges to investor diversification –fair valuation of sukuk and first defaults without body of case law
© A. Jobst, 2009 Islamic jurisprudence neither definite nor bound by precedent and no universal recognition and enforceability of rulings –no unified principles on which shari’ah scholars decide on compliance of new products –no cross-referencing or consolidation of fatwas –regional diversity of secondary sources supporting religious doctrine: ijtihad (independent analytical reasoning), ijma (consensus) and qiyas (deduction by analogy) regulatory standards of shari’ah compliance vary considerably –IFSB Task Force on standard sukuk structures (early in 2008) –International Islamic Financial Market (IIFM)) with ISDA master agreement –limitations of AAOIFI recommendations Current Challenges – Regulation and Supervision (1)
© A. Jobst, 2009 Current Challenges – Regulation and Supervision (2) legal governance of transactions: commercial law vs. Islamic law (via shari’ah board) –shari’ah compliance by substance or form ? – risk of legal re-qualification –current ISDA/IIFM derivatives master agreement defines secular law as forum
© A. Jobst, 2009 Thank you.
© A. Jobst, 2009 Čihák, Martin and Heiko Hesse, 2008, “Islamic Banks and Financial Stability: An Empirical Analysis,” IMF Working Paper 08/16 (Washington: International Monetary Fund). Hesse, Heiko, Jobst, Andreas A., and Juan Solé, 2009, “Market Tension,” Islamic Banking & Finance, Vol. 7, No. 2 (April-May), 24-6. ______________, 2008, “Trends and Challenges in Islamic Finance,” World Economics (April-June). Jobst, Andreas A. and Juan Solé (2009), “The Governance of Derivatives in Islamic Finance,” Journal of International Business Law and Regulation, Vol. 24, No. 11, 556-65. Jobst, Andreas A., Peter Kunzel, Paul Mills and Amadou Sy, 2008, “Islamic Bond Issuance – What Sovereign Debt Managers Need to Know,” International Journal of Islamic & Middle East Finance and Management, Vol. 1, No. 4. Jobst, Andreas A., 2009, “Risk Management and Islamic Financial Instruments,” Qatar Finance – The Ultimate Resource (“Qfinance”), Bloomsbury Publishing, London. ______________, 2007, “The Economics of Islamic Finance and Securitization,” Journal of Structured Finance, Vol. 13, No. 1 (Spring), 1-22. ______________, “A Primer on Structured Finance,” Journal of Derivatives and Hedge Funds, Vol. 13, No. 3, 199-213. ______________, “Derivatives in Islamic Finance,” in: Salman, Ali (ed). Islamic Capital Markets – Products, Regulation and Development. Islamic Development Bank, Islamic Research and Training Institute (IRTI), Jeddah. References
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