LIQUIDITY RISK &

LIQUIDITY MANAGEMENT
in Islamic banks

Salman Syed Ali

Distance Learning Course: Current Issues in Islamic Finance

Overview
 Baking Theory—Why banks exist?
 Liquidity Issues in Islamic banks
------------------------------
 Sources of liquidity risk in IBs
 How it is managed and the consequences
------------------------------
 What is being done and further
developments
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 Banking Theory—Why banks exist?
 Banks as providers of liquidity insurance
to depositors and clients
 Rationale for deposit taking and lending
by same institution (bank) Theory of
bank intermediation
 The Nature of Banking Firm Brings in
Liquidity Risk
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Excess of Wet or Dry

Liquidity Surplus Liquidity Shortage

Drag on Assassin of banks
competitiveness 4
 Islamic Banks are
likely to be more
stable
 They have profit
sharing on both the
liability side and
asset side

5
 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.
 Solvent
 Asset tied finance

6
 While majority of Islamic banks
experience excess liquidity
 Some have also faced liquidity crisis
 Many different risks culminate in
liquidity risk

7
Liquidity crunch can be a real
problem
 Example of Financial Crisis in Turkey
2000-2001
 Islamic financial institutions there
faced sever liquidity problems
 One Islamic institution Ihlas Finans
was closed during the crisis

8
LIQUIDITY RISK: Definition

 Risk of Funding [at appropriate

maturities and rates]

 Risk of Liquidating Assets [in time at

reasonable prices]

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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).

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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)

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LIQUIDITY RISK: Sources
 Incorrect judgment and complacency
 Unanticipated change in cost of capital
 Abnormal behavior of financial markets
 Range of assumptions used
 Risk activation by secondary sources
 Break down of payments system
 Macroeconomic imbalances
 Contractual forms
 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-existent
market
 Market exists but not active

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Example of LR in Murabaha

Primary LR Secondary LR
Receivables are debt Involves buying of
cannot be sold commodity then selling
on deferred payment
This brings in many
operational, credit,
dispute, and legal risks
that can affect
realization of
receivables 15
Analysis and Diagnosis

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Liquidity Surplus Problem
 Excess Liquidity is the current norm with
Islamic banks
 Where to park for short-term?
 Use of most Islamic modes requires longer tenor
investment, murabaha leads to illiquidity
(liquidity risk). This induces banks to hold more
liquidity, but this is costly. This leads to very
short-term murabaha low earnings.
 Excess liquidity  Use of commodity murabaha
 Absence of LoLR facility is also a reason
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Examples of Problems with
Commodity Murabaha

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High Proportion of Short-Term Int’l
Murabaha in Total Murabaha,Bank-A (2002)

26.3 %

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High Proportion of Short-Term Int’l
Murabaha inTotal Murabaha (Bank-B)

2002 2004

50.4% 43.7%

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 Low Income from Short Term
Murabaha (Bank-B)

Income from Short- Income from

term Murabaha Short-term
Murabaha
19 %
15.1 %

2002
2004

Income from Other

Income from Other
Murabaha 84.9%
Murabaha 81 %

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Approaches to Liquidity
Management

 Asset Side Liquidity Management

 Liabilities Side Liquidity Management
 Two Sided Approach

 Islamic Banks are mostly using Asset

Approach to liquidity management
 Large size banks use two sided approach
 Approach varies b/w retail and investment
banks
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Liquidity Management: Current
Practices of IBs

 To cope with Excess Liquidity

Problems and
 Commodity Murabaha
Issues of
 Sukuk Ijarah and Salam these
 Stock Markets practices
 To manage Liquidity Shortage
 Reverse Commodity Murabaha
 Mixing of deposits
 Various types of reserves for confidence building

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New Ideas: Going Forward
 Mutual funds
 Mutual fund of sukuk (LMC)
 IBs’ local club for mutual cooperation
 Development of secondary market in
sukuk (issues involved: increasing the
float, shorter term)
 Sequence of Funds instead of Demand
Deposits
 IFSB Guidelines for risk management

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Existing Maturity Structure of Sukuk

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Maturity Transformation through Pooled
Sukuk
Long-term Sukuk with
different time remaining to
maturity Investor

Sukuk-A
Investor
Issue Pooled
Sukuk of Shorter-
Term
Sukuk-B
SPV- 2

Investor
Mutual
Sukuk-C Fund of
Sukuk
Investor

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 LMC’s Short Term Sukuk Program
 Repackages longer instruments into monthly
maturity certificates
 –Guaranteed monthly entry and exit dates
 –Intra-month entry and exit also available (no
penalties)
 –Flexibility of investment amounts
 –Fully secured by underlying Sukuk portfolio
 –Monthly returns

Source for this slide: LMC Presentation

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Conclusions

What is needed
What can be done
Thank You