Sharia Issues in Liquidity Risk Management

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1 Sharia Issues in Liquidity Risk Management Summer School in Islamic Banking and Finance Durham University July 5 th - 9 th, 2010 Rifki Ismal Durham University

2 Outline Liquidity Risk in Islamic Banking (IB). Characteristics of IB Facing Liquidity Risk. IB Risk Related to Liquidity Risk. Sharia Approaches on Liquidity Risk. Challenges Related to Liquidity Risk Mgt. IFSB Guide on Liquidity Risk Mgt. Depositors, entrepreneurs, Islamic banks involvement in Liquidity Risk Mgt. Sharia Techniques to Mitigate Liquidity Risk. Organizational Approaches. Liquid Instruments. Conclusion.

3 Liquidity Risk in Islamic Banking: Characteristics of Islamic Banks Facing Liquidity Risk

4 Liquidity risk in IB is a reflection of the real economic condition. The probability of liquidity risk is reduced internally throughout the sharia principles and externally through the Islamic financial market mechanism, spurred by regulators. All transactions must link with the real sector activities (assets or projects). Investors (Owners of the Fund) Entrepreneurs Business Activities Islamic Money Market Islamic Bank Government (Regulators) International Partners Other Stakeholders (Takaful, etc) Liquidity Risk Coordination Flow of Islamic fund

5 Islamic banks tie their financing contracts with real assets and this is typically a unique attribute of their operations. As a result, they face commodity risk such as price risk, asset loss, amortization, etc that could all interrupt asset side and end up with asset liability imbalances. Therefore, in Islamic banking, liquidity risk can happen as a result of attaching financing contract with real asset, which is not a typical conventional business transaction. Islamic banks also release their financing to the real projects and the return on deposit is determined based on the output of such projects.

6 Liquidity Risk in Islamic Banking: Islamic Banking Risk Related to Liquidity Risk Management

7 IB is expected to see its liquidity risk from holistic perspective due to current economic condition and interconnection among risks. Financing risk in IB exposes direct loss to asset followed by asset liability mismatch risk and liquidity run risk. Credit risk happens because of the improper performance of the entrepreneurs could cause non optimal investment results. Market risk and commodity risk such as mark up risk, price risk, interest rate risk and foreign exchange risk affect both debt and equity based financings. Business risk, which incorporates rate of return risk, displaced commercial risk, withdrawal risk and treasury risk, also applies in Islamic banking.

8 Liquidity run is caused by (i) asset and liability imbalances; and (ii) uncontrollable factors such as macroeconomic pressures, low trust on banks by investors leading to redemption and, abnormal financial market behavior. FINANCIAL AND BUSINESS RISK Financing Risk Market Risk Operational Risk Asset Liability Mismatch Risk Liquidity Risk Liquidity Run Risk Economic Crisis Lower Trust on Banks Asset Side Liability Side External Shock Sharia Compliance Risk Sharia Compliance Risk Huge & Sudden Demand Certainty Income Default Risk Commodity Risk Asset Value Volatility Under Developed Product Risk Deposit Concentration Risk of Liquidity Followed by Uncertainty Income Depositor Dependence Insolvency Risk Business Life Cycle Risk Gov't Take Over Risk Moral Hazard Risk Rational Depositor Risk Reputation Risk Non Economic Risk Religious Consequences Credit Risk Business Risk Over Capital Commitment Risk Inaccurate Financial Analysis Risk

9 A persistent asset-liability mismatch should be tackled seriously by Islamic banks and banking regulators. On the liability side, it emerges because of the under developed banking products, time deposit concentration, reliance on big investors, rational depositors consequences. On the asset side: if there are disturbances in both certainty and uncertainty financings. For example, Murabahah financing is very sensitive to its long term deferred payment; Ijarah has problems of assets being leased; Bay Salam and Bay Istisna have problems of nondeliverable objects or drop of objects price risk.

10 For example, the incomes from Mudarabah and Musharakah financing depend on business risk such as changes in demand and supply of good, the performance of counter parties, competitiveness of the products, economic/political environment, etc. Sharia offers a trade financing to minimize product risk, commodity risk. Sharia requires the application of profit and loss sharing (PLS) concept to reduce losses in investment based financing when it occurs (Alsayed, 2007:1). Sharia also prohibits non sharia compliant business activities such as gambling, speculation, gharar, riba, etc.

11 Sharia Approaches on Liquidity Risk: Challenges Related to Liquidity Risk Management

12 From the liability side: the characteristics of deposit products (Wadiah demand deposit, Mudarabah saving and time deposits. The returns on a Mudarabah time deposit are uncertain while depositors expect to know it preliminarily and to always have positive and continuous returns on their deposits. The ignorance/unwillingness of depositors to bear any loss on their deposits. In order to maintain the sustainability of the payment on deposit return, Islamic banks are encouraged to retain some of their gross profit namely Profit Equalization Reserves (PER). The domination of short-term deposit tenors. the limited types of Islamic deposit products.

13 From the asset side: there is a requirement to maintain adequate liquidity as standby reserves. The reserves have two modes of reserves, namely reserves requirement stipulated by the central bank and cash reserves/internal liquidity reserves in the bank itself. Another type of liquidity reserve is the placement in the money market instruments (very short-term tenor). Usually, the instruments take form of debt based instruments such as Murabahah inter bank or equity based such as Musharakah and Mudarabah inter bank.

14 Islamic banks tend to allocate funds in the short-term investment tenors (Gafoor, 1995:8). Even, Islamic banks prefer debt based financing to equity based financing. The challenge also appears in the case of entrepreneurs default because they are careless or the asset are lost/broken. Islamic banks in this case are prohibited to charge any accrued income or impose any penalty. The other challenges are lack of easily liquidated long-term investment, immature financial market, etc.

15 Sharia Approaches on Liquidity Risk: IFSB Guide to Liquidity Risk Management

16 IB shall have in place a liquidity management framework taking into account separately and on an overall basis their liquidity exposures in respect of each category of current accounts, unrestricted and restricted investment accounts (Principle 5.1). IB shall assume liquidity risk commensurate with their ability to have sufficient recourse to sharia compliant funds to mitigate such risk (Principle 5.2).

17 Sharia Approaches on Liquidity Risk: Depositors, Entrepreneurs and Islamic Banks Involvement in Liquidity Risk Management

18 Sharia ties depositors to be responsible and aware of liquidity risk. They have to deeply understand the Islamic banking principles, operations and business consequences. They will never do non Islamic business activities such as speculation, seeking return on interest. They are willing to share the risk and responsibility with the bank. Particularly, they are ready to accept the consequence of risk sharing such as: no periodic return in certain types of the banks products, sharing the loss, conduct active monitoring on the bank s condition, etc. Meanwhile, entrepreneurs will never use the funds in the projects which are non Islamic, speculative or do not link with the real business activities.

19 Islamic Banks develop internal sharia approaches to mitigate/prevent liquidity risk problem : Liquidity risk management policy that includes policy related to liability and asset side. It is established by Board of Director and followed up by special task body and continued by senior management in a very technical level. Measuring and monitoring liquidity risk. Islamic bank is obliged to maintain adequate liquidity as its standby reserve and regularly review its limit. Prudential and sharia compliance banking operation that deals with the bank s financing decisions, business partners selection, and possibility of join operation with other Islamic banks.

20 On the liability side. Islamic banks follow three approaches, (a) Adjusting types of deposit products into projects to be financed; (b) Balancing of financing needed and amount to be collected and; (c) Managing maturity date of both deposit products and projects financing. On the asset side. Islamic Banks conduct : (a) Fitting characteristics of deposit and projects financing; (b) Matching the flow of projects return with the due date of PLS payment; (c) Selecting business partners through due diligence; (d) Employing joint financing with other Islamic banks to share the risk and; (e) Monitoring and conducting cooperative business

21 Sharia Techniques to Mitigate Liquidity Risk: Organizational Approaches & Liquid Instruments

22 Organizational approaches set policies of: Regulating redemption time; Mitigating of default in equity financing; Mitigating of default in debt financing, and; Determining parent company internal liquidity agreement. Liquid Instruments as follows: TECHNIQUES TO SOLVE THE PREDICTABLE AND UNPREDICTABLE IRREGULAR DEMAND FOR LIQUIDITY BASED ON SHARIA Solving the Predictable Irregular Demand for Liquidity Selling Short-Term Placements Selling Long-Term Placements for the Short-Term Liquidity for the Short/Long-Term Needs Liquidity Needs - Mudarabah Redeemable CD - Government Securities - Islamic Bankers Acceptance - GII and ILIF - Wakalah instrument - Sukuk - Commodity Murabahah. - Central Bank's Instrument - Islamic Currency Swap - Central Deposit - Private Asset Securitization - Musharakah Certificate Solving the Unpredictable Irregular Demand for Liquidity - Parent Company's lending - Shareholders' lending - Central Bank Emergency Fund for illiquid banks - Government's bail out Borrowing the Short-Term Funds - Borrowing from the Islamic Money Market

23 Conclusion

24 Islamic banking operations have unique characteristics that in some cases need different approaches with respect to liquidity risk. Islamic bank approaches on liquidity risk engage depositors, entrepreneurs and stakeholders in an integrated mechanism. Sharia suggests Islamic banks to have organizational approaches and place/use Islamic financial market to mitigate liquidity risk problem.

25 Thank You

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