lecture 6 liquidity risk and management

8/9/2019 Lecture 6 Liquidity Risk and Management

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LIQUIDITY RISK &LIQUIDITY MANAGEMENT

in Islamic BanksSalman Syed Ali

Current Issues in Islamic Finance Lecture 6



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Lecture Plan Part-I

LIQUIDITY

SHORTAGE (Risk) Sources of risk

Implications for Bankand the System

Current practices of mitigation

Recommendationsand the Future

Part-II

EXCESS LIQUIDITY

(Low ret.) Causes

Implications for Bankand the System

Current practices of itsmanagement

Recommendationsand Future



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Key References Abdul Majid, Abdul Rais. 2003. ³Development Of Liquidity

Management Instruments: Challenges And Opportunities´,paper presented in International Conference on IslamicBanking: Risk Management, Regulation and Supervision,

Jakarta ±Indonesia, Sept 30- to October 3, 2003. Ali, Salman Syed. 2004. ³Islamic Modes of Finance and

Associated Liquidity Risks´ presented in Conference onMonetary Sector in Iran: Structure, Performance andChallenging Issues´, Tehran, February 2004.

Shihadeh, Musa A. 2003. ³Loss Provisioning in Islamic Banks:

Jordan Islamic Bank Case Study´, paper presented inInternational Conference on Islamic Banking: RiskManagement, Regulation and Supervision held in Jakarta-Indonesia. Jointly organized by Bank Indonesia and IRTI,October 2003.



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Dry Climate

Liquidity ShortageAssassin of banks



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Flood Excess Liquidity: A drag on competition



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Stability and Solvency of IBs In theory, Islamic

banks are likely to

be more stable They have profit

sharing on both theliability side and

asset side



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In practice, IslamicBanks have fixed

income assets buthave profit sharing onliability side.

The IBs therefore, arestill more stable than

conventional banks. Solvent

Asset tied finance



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While a majority of Islamic banks haveexcess liquidity

Some Islamic banks have facedliquidity crisis

Many different risks culminate in

liquidity risk



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Liquidity crunch can be a real

problem Example of Financial Crisis in Turkey2000-2001

Islamic financial institutions therefaced sever liquidity problems

One Islamic institution Ihlas Finans

was closed during the crisis



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LIQUIDITY RISK: Definition

Risk of Funding [at appropriatematurities and rates]

Risk of Liquidating Assets [in time atreasonable prices]



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Investment Firm¶s Definition ³liquidity risk includes both the risk of

being unable to fund [its] portfolio of

assets at appropriate maturities andrates and the risk of being unable toliquidate a position in a timely manner

at reasonable prices.´ *

* J.P. Morgan Chase (2000).



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Regulators Definition

³risk to a bank¶s earnings and capitalarising from its inability to timely meetobligations when they come duewithout incurring unacceptable

losses.´*

* Office of the Comptroller (2000)



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Analysis and Diagnosis of

Causes



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LIQUIDITY RISK: Sources 1. Incorrect judgment and complacency 2. Unanticipated change in cost of capital

3. Abnormal behavior of financial markets 4. Range of assumptions used 5. Risk activation by secondary sources 6. Break down of payments system

7. Macroeconomic imbalances 8. Contractual forms 9. 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-existentmarket

Market exists but not active



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Example of LR in MurabahaPrimary LR Secondary LR

Receivables are debtcannot be sold Involves buying of commodity then sellingon deferred payment

This brings in many

operational, credit,dispute, and legal risksthat can affectrealization of

receivables



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LR:Current Practices of control Deposit Management

Choice of Mode of Finance

Maturity Matching and Gap Analysis

Mixing of Deposits

Reserves and Provisions

Deposit Insurance Interbank Dealings

Ijarah and Salam Sukuks



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(a) Reserves and Provisions: Provisions

Specific

General

Reserves

Profit EqualizationReserve

Investment RiskReserve



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(b) Problems: Fiqh issue of justice: inter-temporal

/interpersonal transfers

Breaks the link between bank performanceand its reflection in profits

Possibility of manipulation to hide losses

Transfer of resources from shareholders to

investment account holders (displacedcommercial risk)

Loosen the asset and liability tie in IBs.



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(c) Remedies for Transparency: Well defined, consistent and

transparent method of provision and

reserve calculation Improved corporate governance

Reveal ex-ante estimates and ex-post

actual losses Reveal the position and changes in the

PE Reserve and IR Reserve



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Conclusions

What is needed

What can be done



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Conclusions (contd.) Development of liquidity management

instruments

Development of Infrastructureinstitutions (LMC, IIFM)

Rethinking and development of new

structure of Islamic banks (Separatetreatment of Cur. and Inv. accounts)



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Smooth Sailing



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Excess Liquidity

State, Causes andManagement



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Current state of liquidity in IslamicBanks

Excess Liquidity in the Market, resulting in seriousbusiness risk and affects the competitiveness of IFIs due to no return or a very low returns.

In a recent study it was discovered that Islamicfinancial institutions are almost 50% more liquid ascompared to conventional financial institutions.

Out of US$ 13.6 billion total assets of Islamic banksin the study US$ 6.3 billion were found to be inliquid assets.



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Causes of Excess Liquidity

Factors internal to the bank

Factors external to the bank



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Islamic Banks¶ Asset Portfolio

Shirakah

Ijarah

Salam

Istisna¶

Murabaha

Mudharba

IBPortfolio

67%5%



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Islamic Banks¶ Assets Portfolio

67%

6%

5%

7%

15%

murabahah

musharakah

mudarabah

ijara

others

Source: Iqbal Munawar, Ausaf Ahmad and Tariqullah Khan (1998), Challenges Facing Islamic

Banking , Jeddah: IRTI



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Key Issues inLiquidity

Management

Small No. of participants

No Islamic Inter-bank Market

SlowDevelopment

InIslamicfinancialInstruments

Absence of

Islamic Secondarymarket

No Lender of Last

Resort

Different Shari¶ainterpretation

Key Issues in Liquidity Management

Credit for this diagram: IIFM



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Implications for Islamic Banks

Underutilization of financial resources

Lower income and higher cost

Loss of competitiveness



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Current Practices in ManagingExcess Liquidity

Deposit Management

Secured Commodity Murabaha

Mudaraba Sukuk Salam Sukuk

Leasing Sukuk

Musharakah Sukuk

Infrastructure Institutions Liquidity Management Center

IIFM



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Islamic Bank / Investor (Principal)

Broker

µB¶

Broker µA¶

ConventionalBank

(Agent)

Buy

Pay (Spot)

Receive(Sales proceeds at maturity)

Receive funds from Investor (to pay Broker µA¶)

Sell(at a profit & deferred payment)

Settle Investor

(Sales proceeds less Agents fees)

Funds Flow

Commodity Flow

How a Secured Commodity Murabaha Works:

Credit for the diagram: IIFM



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Advantage of SCM

Short-term therefore liquid

Buying and selling in same currency(usually US$) therefore no FX risk



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Problems with SCM

Flow of funds away from Muslim economies

Not contributing in any growth or

development oriented economic activity Limited scope for liquidity management:

since transactions are mostly bilateraltherefore counterparty limits apply

Always back to back murabaha is neededfor maintaining liquidity



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Salam Sukuk (Ex. of Bahrain)

Gov of Bahrain (GoB) undertakes to sell Aluminum (deferred) for advance payment

BMA securitizes it by issuing salam sukuk Individual IBs buy these to park their excess

liquidity

IBs appoint GoB as their agent to receivedelivery of commodity and sell it through itsdistribution channels



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Salam Sukuk (contd.)

Similar to SCM but securitized Advantages:

Cost price need not be declared Lower credit risk to bank due to sovereign

counter-party Lower cost (or higher return) to bank than in

SCM due to securitization Funds utilized in the local economy until very

near to delivery date

Disadvantage: Not trade-able therefore high liquidity risk



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Bahrain Salam Sukuk (contd.)

Countr y

Issuer Type Value Maturity

Bahrain BahrainMonetaryAgency

SukukAl Salam(23issuesup to

April2003)

US$ 625Million(cumulative)*

91 daysfor eachissue



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Structure of Malaysian Sukuk

Credit for this slide: BMA presentation, Feb.,2004

.



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Other sukuk and trade-able securitiesuseful 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]



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LM Infrastructure Institutions

OutputCountry

Membership

IIFM

yFacilitation in issuance of sukuk of Bahrain and Malaysia 6 founding members

LMC yPart of IIFM efforts.yFacilitated cross listing of Bahrainand Malaysian sukuk

6 members

IsDB yMother/Umbrella organizationyDevelopment financeyResearch

54 countries



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New Ideas: Good & Bad



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Thank you

lecture 6 liquidity risk and management

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