Central Bank of U.A.E Abu Dhabi 10 December 2005 Liquidity Management of Islamic Financial Institutions in the UAE Iqbal Khan CEO, HSBC Amanah

Hsb Contents Overview of Issues3 Liquidity Dynamics5 Liquidity Management Today6 Way Forward7 Secondary Market12 Conclusion13

Hsb Maturity mismatchLiquidity surplusLiquidity shortage  Liquid: Islamic Financial Institutions (“IFIs”) are almost 50% more liquid than their conventional counterparts  Low returns: Limited short term investments, and so IFIs earn low returns  Interbank market: IFIs have no real ability to tap short-term funds to meet cashflow requirements  Lender of last resort: Most banking failures are due to liquidity shortages. There is a need for a “lender of last resort”. Well known issue was Ihlas Finans in Turkey  Long term assets: IFIs main investments are long-term, e.g. sukuks and project finance  Short term liabilities: IFIs main funding is from short-term customer deposits  Gap: IFIs have a mismatch risk Overview of Issues

Hsb Liquidity Dynamics in Islamic Financial Institutions  Fastest growing sector: Retail deposits in Islamic banks in UAE grew 29% p.a. between 2001 and 2004, to USD 4.76 billion – nearly twice as much as their conventional counterparts  Where to invest?: IFIs are mainly limited to investing in long-term assets. These generate higher returns, but are also where issuers are looking for financing. For example, structured trade, project finance, infrastructure, Sukuks, funds and equity investments  Maturity gap: If an IFI has invested its 1 month customer deposit in a 5 year sukuk, what happens if the customer withdraws its deposits after 1 month?  Role of central bank: The Central Bank needs to work with IFIs in developing liquidity solutions

Hsb Liquidity Management today  Commodity Murabaha: For the last few years, Islamic Banks have relied mainly on Commodity Murabaha for liquidity management purposes  Issues with commodity Murabaha –Unable to raise liquidity: Banks are unable to raise liquidity through the reverse Commodity Murabaha structure; known as Tawaruq. Not approved by all scholars. However, for some institutions this is the only tool to raise liquidity –Cost of commodity brokerage: The use of an intermediary results in brokerage payout  less competitive product compared to conventional counterpart –Amount of commodity: How much of it do we have? There are doubts if there is sufficient metal to cover the transaction volumes  Interim solution: This product was approved by Scholars as an interim solution until the setup of a comprehensive Islamic money market

Hsb The way forward  New solutions: To address these concerns and diversify the liquidity-management product range, Islamic Financial Institutions are beginning to focus on the development of new solutions. These solutions include –Wakala –Unrestricted Wakala –Short-term Sukuk –Securitisation of Assets  Ideal scenario: IFIs need access to a liquid market of investments with different returns and different maturities  Central bank: Central banks should consider –Encouraging standardisation of structures and documentation. –Offering Islamic interbank securities, e.g. certificates of deposit (CDs), as offered to conventional banks –Investing in, and supporting the liquidity of, a secondary market in long-term Islamic investments, e.g. sukuks

Hsb Wakala & unrestricted Wakala  Recent development: Wakala has been gaining momentum in 2005  Advantages: The Wakala product has several advantages –No commodity: Does not require a physical commodity –No brokerage: No intermediate parties involved  does not attract any brokerage –Access more banks: Allows Islamic Banks to accept liquidity from Islamic as well as conventional banks –Competitive: Priced according to current market benchmarks  Structure: The Wakeel (agent) invests the Muwakils (principal) funds in pre-agreed asset classes for the period of Wakala and the risk of the asset is transferred to the Muwakil. Also stemming from this is the concept of Unrestricted Wakala – this product funds the treasury pool which in turn invests in any of the assets on the balance sheet. Unrestricted Wakalas tend to be more flexible than the plain vanilla Wakala, and are attractive for on-balance sheet risk management  Issues: Banks should refrain from providing explicit guarantees of a minimum return  however, it should be clear to the Muwakil that in case of a loss, the gap would be filled by the bank reserves. This can create legal issues about how to document enforceable payment obligations

Hsb Short-term Sukuks  Issue of liquidity: Due to their medium to long-term tenor and inactive secondary market, Sukuks are not considered as liquid instruments  Create short-term sukuks: However, scholars have authorized banks to “carve-out” these Sukuks in short tenor certificates  this essentially passes the risk and return of the Sukuk to the counterparties for short periods 30 days180 days1 year2 years3 years4 years Currently not available  Central bank promote liquidity: Regulatory authorities can assist by –Encouraging trading –Establishing trading infrastructures It then becomes the initiative of the regulatory and central authorities to encourage the trading of these short-term Sukuks

Hsb Securitisation of Assets (I) - General  Desire for higher returns: Islamic investors, like other investors, seem increasingly willing to give up capital protection (typical of savings accounts and fixed income securities) in order to achieve higher rates of return  Opportunity in physical assets: Investments in physical assets (e.g. real estate, aircraft etc.) offer higher returns but lock-in investors over long periods of time. This creates liquidity issues  Securitisation: To address this point of liquidity, a viable route is that of securitisation where underlying illiquid physical assets are repackaged in securities tradable in the Islamic capital markets. For example, these tradeable securities would represent investments in physical assets generating stable flows of income under Ijara contracts with Islamic compliant lessees  Role of central bank: Possible roles could include –Securitise state assets –Encourage trading

Hsb Securitisation of Assets (II) – Asset Backed Commercial Paper  Short term asset: Asset-backed commercial paper (ABCP) is a well established short term securitised product in conventional markets. Most maturities are 30 to 180 days  US CP market: Statistics for USCP market from US Federal Reserve –387 issuers issued USD 98 billion of CP in Third Quarter 2004 –GE, largest single issuer, has over USD45billion CP outstanding –Total Outstanding of USD 1.4 trillion at 21 Oct 2004  Potential: This product and structure has a great deal of long-term potential  Issues: Lack of underlying Shariah-compliant assets make it difficult to achieve enough volumes to produce this product. In addition there is still a liquidity issue of using short-term securities to finance long-term underlying assets  Role of central bank: Assistance with creating a regular auction process and clearing mechanism

Hsb Possible ABCP structure Originator Sale of asset Lease Purchase of Sukuk asset SPCSPC2 Sale of short-term Sukuk asset Investor Bids for amt. & rate

Hsb Encouragement of a Secondary and Inter-bank Market  Standard framework: The authorities should encourage the develop of a single framework for a formal Islamic Money Market  Assist Islamic finance: The development of such a market would not only promote secondary and inter-bank market activity, but would also allow banks to manage excess liquidity in the short-term  “Level playing field”: At present, the Islamic Banks are subject to the same set of rules and regulations of conventional banks; they have to operate in accordance with the weekly liquidity cycle. –As there is no developed overnight Islamic money market, it is extremely difficult for Islamic Banks to manage there liquidity gaps as efficiently as the conventional banks

Hsb Concluding Remarks  Addressing the liquidity mismatch  Development of new products  Creation of an asset-backed system  Proactively encouraging the setup of a secondary and inter-bank market