Presentation on theme: "LIQUIDITY RISK & LIQUIDITY MANAGEMENT"— Presentation transcript:
1 LIQUIDITY RISK & LIQUIDITY MANAGEMENT in Islamic BanksSalman Syed AliCurrent Issues in Islamic Finance Lecture 6
2 Lecture Plan Part-I LIQUIDITY SHORTAGE (Risk) Sources of risk Implications for Bank and the SystemCurrent practices of mitigationRecommendations and the FuturePart-IIEXCESS LIQUIDITY (Low ret.)CausesImplications for Bank and the SystemCurrent practices of its managementRecommendations and Future
3 Key ReferencesAbdul Majid, Abdul Rais “Development Of Liquidity Management Instruments: Challenges And Opportunities”, paper presented in International Conference on Islamic Banking: Risk Management, Regulation and Supervision, Jakarta –Indonesia, Sept 30- to October 3, 2003.Ali, Salman Syed “Islamic Modes of Finance and Associated Liquidity Risks” presented in Conference on Monetary Sector in Iran: Structure, Performance and Challenging Issues”, Tehran, February 2004.Shihadeh, Musa A “Loss Provisioning in Islamic Banks: Jordan Islamic Bank Case Study”, paper presented in International Conference on Islamic Banking: Risk Management, Regulation and Supervision held in Jakarta- Indonesia. Jointly organized by Bank Indonesia and IRTI, October 2003.
6 Stability and Solvency of IBs In theory, Islamic banks are likely to be more stableThey have profit sharing on both the liability side and asset side
7 The IBs therefore, are still more stable than conventional banks. 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
8 While a majority of Islamic banks have excess liquidity Some Islamic banks have faced liquidity crisisMany different risks culminate in liquidity risk
9 Liquidity crunch can be a real problem Example of Financial Crisis in TurkeyIslamic financial institutions there faced sever liquidity problemsOne Islamic institution Ihlas Finans was closed during the crisis
10 LIQUIDITY RISK: Definition Risk of Funding [at appropriate maturities and rates]Risk of Liquidating Assets [in time at reasonable prices]
11 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).
12 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)
14 LIQUIDITY RISK: Sources 1. Incorrect judgment and complacency2. Unanticipated change in cost of capital3. Abnormal behavior of financial markets4. Range of assumptions used5. Risk activation by secondary sources6. Break down of payments system7. Macroeconomic imbalances8. Contractual forms9. Financial Infrastructure deficiency
15 Liquidity Risk & Contractual Forms Profit Sharing ContractsMurabahaSalamIstisnaIjarah
16 Resale not permittedResale permitted but non-existent marketMarket exists but not active
17 Example of LR in Murabaha Primary LRSecondary LRReceivables are debt cannot be soldInvolves buying of commodity then selling on deferred paymentThis brings in many operational, credit, dispute, and legal risks that can affect realization of receivables
18 LR:Current Practices of control Deposit ManagementChoice of Mode of FinanceMaturity Matching and Gap AnalysisMixing of DepositsReserves and ProvisionsDeposit InsuranceInterbank DealingsIjarah and Salam Sukuks
19 (a) Reserves and Provisions: SpecificGeneralReservesProfit Equalization ReserveInvestment Risk Reserve
20 (b) Problems:Fiqh issue of justice: inter-temporal /interpersonal transfersBreaks the link between bank performance and its reflection in profitsPossibility of manipulation to hide lossesTransfer of resources from shareholders to investment account holders (displaced commercial risk)Loosen the asset and liability tie in IBs.
21 (c) Remedies for Transparency: Well defined, consistent and transparent method of provision and reserve calculationImproved corporate governanceReveal ex-ante estimates and ex-post actual lossesReveal the position and changes in the PE Reserve and IR Reserve
22 What is needed What can be done ConclusionsWhat is neededWhat can be done
23 Conclusions (contd.) Development of liquidity management instruments Development of Infrastructure institutions (LMC, IIFM)Rethinking and development of new structure of Islamic banks (Separate treatment of Cur. and Inv. accounts)
25 State, Causes and Management Excess LiquidityState, Causes and Management
26 Current state of liquidity in Islamic Banks Excess Liquidity in the Market, resulting in serious business risk and affects the competitiveness of IFIs due to no return or a very low returns.In a recent study it was discovered that Islamic financial institutions are almost 50% more liquid as compared to conventional financial institutions.Out of US$ 13.6 billion total assets of Islamic banks in the study US$ 6.3 billion were found to be in liquid assets.
27 Causes of Excess Liquidity Factors internal to the bankFactors external to the bank
29 Islamic Banks’ Assets Portfolio Source: Iqbal Munawar, Ausaf Ahmad and Tariqullah Khan (1998), Challenges Facing Islamic Banking, Jeddah: IRTI
30 Key Issues in Liquidity Management Small No. of participantsNo Lenderof LastResortSlowDevelopmentInIslamic financial InstrumentsKey Issues in LiquidityManagementDifferent Shari’a interpretationAbsence of Islamic Secondary marketNo Islamic Inter-bank MarketCredit for this diagram: IIFM
31 Implications for Islamic Banks Underutilization of financial resourcesLower income and higher costLoss of competitiveness
32 Current Practices in Managing Excess Liquidity Deposit ManagementSecured Commodity MurabahaMudaraba SukukSalam SukukLeasing SukukMusharakah SukukInfrastructure InstitutionsLiquidity Management CenterIIFM
33 How a Secured Commodity Murabaha Works: Islamic Bank / Investor(Principal)Broker‘B’‘A’Conventional Bank(Agent)BuyPay (Spot)Receive(Sales proceeds at maturity)Receive funds from Investor(to pay Broker ‘A’)Sell(at a profit & deferred payment)Settle Investor(Sales proceeds less Agents fees)Funds FlowCommodity FlowCredit for the diagram: IIFM
34 Advantage of SCM Short-term therefore liquid Buying and selling in same currency (usually US$) therefore no FX risk
35 Problems with SCM Flow of funds away from Muslim economies Not contributing in any growth or development oriented economic activityLimited scope for liquidity management: since transactions are mostly bilateral therefore counterparty limits applyAlways back to back murabaha is needed for maintaining liquidity
36 Salam Sukuk (Ex. of Bahrain) Gov of Bahrain (GoB) undertakes to sell Aluminum (deferred) for advance paymentBMA securitizes it by issuing salam sukukIndividual IBs buy these to park their excess liquidityIBs appoint GoB as their agent to receive delivery of commodity and sell it through its distribution channels
37 Salam Sukuk (contd.) Similar to SCM but securitized Advantages: Cost price need not be declaredLower credit risk to bank due to sovereign counter-partyLower cost (or higher return) to bank than in SCM due to securitizationFunds utilized in the local economy until very near to delivery dateDisadvantage:Not trade-able therefore high liquidity risk
38 Bahrain Salam Sukuk (contd.) CountryIssuerTypeValueMaturityBahrainBahrain Monetary AgencySukukAl Salam (23 issues up to April 2003)US$ 625 Million (cumulative)*91 days for each issue
39 Structure of Malaysian Sukuk Credit for this slide: BMA presentation, Feb., 2004.
40 Other sukuk and trade-able securities useful for liquidity management Gov. Participation Certificates (Sudan)Central Bank Participation Certificates (Sudan)Malaysian Global Ijarah Sukuk [US$500M]First Global Sukuk Malaysia [US$150M]Qatar Global Ijarah Sukuk [US$700M]IDB Sukuk [US$400M]Tabreed Global Ijarah Sukuk (Corporate) [US$150M]
41 LM Infrastructure Institutions OutputCountry MembershipIIFMFacilitation in issuance of sukuk of Bahrain and Malaysia6 founding membersLMCPart of IIFM efforts.Facilitated cross listing of Bahrain and Malaysian sukuk6 membersIsDBMother/Umbrella organizationDevelopment financeResearch54 countries