Treasury Management in an Islamic Financial Institution

Mohammed TariqAdvisor, President IDB Group

Islamic Development Bank

3 May, 20111

Role of Treasury in an Islamic Financial Institution

Management of liquidity

Resource mobilization

Hedging through profit rate and currency swaps

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Management of liquidity

What is liquidity?

Availability of funds as and when required. Hold cash and securities which can be liquefied

at short notice. Securities or instruments should be such which

have a minimal negative impact on the sale of such securities, hence, minimum price risk.

Ability to deal in reasonable size or quantity depending on an institution’s needs.

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Management of the liquidity

Instruments for Management of Liquidity

o Conventional Finance: Interbank market and other investments e.g. treasury bills, commercial papers, bonds, etc.

o Islamic Finance: Placement of funds under Commodity Murabaha

o How does the Commodity Murabaha work?o Lack of liquidity in such placements.o Reciprocal arrangements through reverse

Murabaha.o Credit risks similar to conventional: lines to be set

up between counter parties. Limits managemento

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Management of the liquidity

o Islamic institutions can deal with conventional banks.

o Other instruments like Sukuk: problems of longer duration, price risk, lack of liquidity, etc.

o Trade finance deals with high quality parties and/or bank guarantee.

o Sukuk holdings to be held as part of investment portfolio of the Treasury to earn higher returns.

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Management of the liquidity

Asset Liability Management (ALM)

o In order to meet disbursement requirements of the institution, placement of funds should ideally match the liability profile.

o Techniques used for matching assets and liability by size as well as maturity.

o Need to have active lines with other financial institutions to raise short-term funds as and when needed.

o Risks involved, if liabilities are much higher than assets: impact of higher or lower interest rates in future, credit risks etc. 6

Management of the liquidity

Role of the Regulators/Central banks

o Lender of last resort roleo Lack of Shariah compatible financial

instruments to intervene in the market for Islamic institutions.

o Treasury bills or other such high quality instruments are not acceptable under Shairah rules.

o Need for regulators to provide shot-term instruments for Islamic financial institutions.

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Resource Mobilization needs

Central to Treasury functions in an Islamic financial institution

o Close involvement of the Treasury with the operational units of the bank to assess short and medium-term business plans and hence resource needs.

o Clear assessment of the cost of funds for different periods to be provided to the business units in order for pricing such products.

o Pricing Methodology for financing.8

Resource Mobilization needs

Instruments for Resource Mobilization

o Short-term: Reverse Murabaha upto 1 year, mostly upto 3 months, Price risk.

o Long-term: o Asset backed Sukuk: Over 51% need to be backed

by tangible assets e.g. lease rentals, eligible Sukuk, equities, etc. Minority, i.e. less than 50% can be debts e.g. Installment Sales, Istisna’ etc

o Availability of acceptable assetso Rollover Commodity Murabaha, upto 3 years, o Issues of fixed vs. floating rateo Asset backed Sukuk tradable, others not so

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Hedging

Profit rate and currency swaps for managing treasury risks

o Objectives and methodologyo For profit rate swap: fixed vs. floating rate and

vice versao Currency swap

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