International Islamic Liquidity Management Corporation An Overview of Liquidity Management Issues for Institutions Offering Islamic Financial Services March 9 th, 2016/ Jumada Al- Awwal 29, 1437 IRTI Eminent Scholar Lecture Series, Jeddah, Saudi Arabia Professor Datuk Rifaat Ahmed Abdel Karim Chief Executive Officer, International Islamic Liquidity Management Corporation
What is Liquidity? From an economic theory perspective and in the broadest terms, liquidity relates to the ability of an economic agent to exchange his or her existing wealth for goods and services for other assets A more market oriented definition is twofold: (1) Unhindered flows amongst agents of the financial system, with a particular focus on the flows among central banks, commercial banks and markets; and (2) The ability of entities and consumers to realise these flows. -European Central Bank, 2009 2
Liquidity Risk: Funding Liquidity & Market Liquidity Liquidity risk is the potential loss to an institution arising from its inability either to meet its obligations or to fund increases in assets as they fall due without incurring unacceptable costs or losses Liquidity risk can be categorised into: Funding liquidity risk the risk that an institution will not be able to meet efficiently both expected and unexpected current and future cash flow and collateral needs without affecting either daily operations or the financial condition of the institution Market liquidity risk the risk that an institution cannot easily offset or eliminate a position at the market price because of inadequate market depth or market disruption 3
How Liquidity Affects Average Consumers Banks have very illiquid assets (loans) and, generally, obligations to repay their depositors in full at any moment. If all of the depositors at a bank withdraw their funds at the same time, the bank will have to sell their asset at a discount, and they will not have enough funds to pay all of their depositors. If all depositors keep their money in the bank, most banks will be able to repay all of their depositors with a return (interest in conventional banks). Thus, the payoff to any individual depositor depends on what other depositors decide to do. 4
How Liquidity Effects Consumers (Con t.) - Bank Runs The phenomenon in which all depositors compete to withdraw their funds at the same time is called a bank run or a bank panic. This phenomenon is worsen by asymmetrical information between the depositors, the bank and the market. Panic is contagious. Since banks lend money to each other, a bank run at one bank may lead to beliefs that the resulting bankruptcy will affect the loan quality of other assets. Banks play a large role in the financial intermediation system. A collapse in the banking system will disrupt financing. 5
Central Banks - Ultimate Liquidity Management Tool The damage from a banking panic is so severe that central banks often step in during a crisis and provide almost unlimited liquidity. An emergency source of liquidity is the lender of last resort. Central banks are the natural lender of last resort as they can create seemingly infinite liquidity through their control of the money supply. This provides confidence in the banking system. However, a lender of last resort may encourage depositors to ignore the excessive risk taking of their banks, encouraging banks to take excessive risks and other moral hazards. 6
Conventional Strategies for Liquidity Management Borrowed Liability Strategy: Maintain lines of credit to make up for temporary cash short-falls. But in an liquidity crisis, these lines of credit can be insufficient (e.g., Global Financial Crisis). In addition, accessing money market requires some prior planning and potentially lines of credit. Sources of funds: Financing through the Interbank market Issuing large CD s to money market mutual funds or large depositors. (Brokered deposits) Borrowing, financing or liquidity arrangements from central bank. 7
When You Think of Liquidity Management, Think of. BASEL III 8
Basel III Liquidity Ratio Requirements Two proposed liquidity ratios: short term liquidity cover ratio ( LCR ) longer-term net stable funding ratio ( NSFR ) Liquidity cover ratio high quality liquid assets (HQLA) to cover net cash outflows over 30 day period builds on traditional internal methodologies used by banks to assess exposure to contingent liability events LCR = stock of high quality liquid assets divided by total net cash outflows for next 30 days 9
Basel III Liquidity Ratio Requirements (Con t) Net stable funding ratio (NSFR): designed to promote resilience over a period of one year builds on net liquid asset and cash capital methodologies used by internationally active banks available stable funding ( ASF ) must be at least equal to required stable funding ( RSF ) 10
Liquidity Management Concerns for IFIs According to the IFSB Stability Report 2015, the lack of liquidity management tools is a continuing concern. The financing-to-deposit ratios of most [Islamic] banks remained under 90%, and the short-term asset liability ratio was on average (with significant deviations of individual banks) about 80% of the liabilities payable within 90 days. The improvement of the liquidity position was partially due to new regulatory initiatives enacted by countries in an effort to comply with the Basel III framework. The Basel III capital and liquidity framework is still an issue in particular, Sharīʿah-compliant HQLA. 11
Liquidity Risk Management for IFIs IFSB Guidelines IFSB issued new guidelines on liquidity management expounding on the Basel III liquidity framework for IFIs in April 2015. The guidance note GN-6 aims to complement global liquidity standards such as the liquidity coverage ratio and net stable funding ratio, as well as other developments on liquidity risk management, for the Islamic financial services industry. 12
Liquidity Management in Islamic Financial Institutions (IFIs) IFIs need financial instruments that have certain characteristics to manage their liquidity that: Enable the institution to gain a return on their capital, while ensuring compliance with Shari ah rules and principles; Meet local statutory or regulatory requirements, while also satisfying internal liquidity management requirements; Are easily tradable; Meet Basel III requirements, particularly the so-called Liquidity Coverage Ratio ; Would be broadly accepted by Shari ah Committees of IFIs; and Have a high credit rating. 13
Overview of Issues of Liquidity For IFIs Liquidity surplus Liquid: Islamic Financial Institutions ( IFIs ) are widely believed to be more (cash) liquid than their conventional counterparts Low returns: Limited short term liquid instruments (e.g., Interbank Money Market placements, commodity murabaha), and so IFIs earn low returns Liquidity shortage Interbank market: IFIs have no real ability to tap short-term funds to meet cashflow requirements Secondary Market: Not enough opportunities, inclination or liquidity for secondary market Lender of last resort: Most banking failures are due to insufficient eligible instruments for a lender of last resort. Maturity mismatch Long term assets: IFIs main investments are long-term, e.g. Sukūk and project financing Short term liabilities: IFIs main funding is from short-term customer deposits Gap: IFIs have a mismatch risk 14
Liquidity Surplus? Still a Liquidity Management Problem Excess Liquidity is the current norm with Islamic banks Where to park for short-term? Most Islamic modes require longer tenor investment. Long term Murabahah leads to illiquidity (liquidity risk). This induces banks to hold more liquidity, but this is costly. Short term Murabahah leads to low earnings. For Excess liquidity, they use commodity murabahah (which is a cost-plus salebased form of financing) 15
Short-Term Islamic financial instruments currently available Instruments Maturity Currency Tradability Rating Central bank: instruments and short-term Sukūk (mostly in commodity murabaha form) 3 months 1 year Local Limited Unrated/ Central Bank rated Commodity murabaha 1 week- 6 months Any No Counterparty Interbank mudharabah overnight 1 month Any No Counterparty Interbank wakalah 1-3 months Any No Counterparty Islamic repo (not widely available) Overnight 1 month Local No Unrated 16
National Regulators Approaches to Islamic Financial Instruments for Liquidity Management 17
Scenario for Liquidity Management of IFIs in Crisis 18
Scenario for Liquidity Management of IFIs in Liquidity Surplus 19
Recent Liquidity Management Efforts by Regulators (Middle East) Liquidity initiatives in Bahrain and the UAE have been deemed positive for both markets. In 2015, Fitch noted that the April 2015 launch of one-week Shari ah compliant contracts with the Central Bank of Bahrain (CBB) will benefit domestic Islamic banks because they broaden the range of options available for short-term liquidity management. The Central Bank of the UAE has also extended the range of instruments it accepts as collateral for accessing liquidity to include Shariah compliant securities, which will similarly help the UAE s Islamic banks that often hold these securities, says Fitch. Bahrain and UAE-based Islamic banks have so far held excess liquidity either in cash or monthly offerings of central bank Sukūk, with maturities between three and six months. This placed them at a disadvantage to conventional banks, which have a wide range of interest-earning liquidity management options available. CBB also launched a new Shariah compliant Wakalah liquidity management instrument aimed at absorbing excess liquidity of the local Islamic retail banks and placing it with the Central Bank. Encouraging foreign investors to purchase its Sukūk, the CBB last June invited investors to subscribe to the Sukūk through the primary market by giving orders to registered brokers at the Bahrain Bourse, which will enable them to trade it in the secondary market once listed. 20
When You Think of Liquidity Management Tools for the IFSI, Think of the IILM Sukūk BASEL III Amal 21
History Central banks have been concerned for some time about the lack of adequate Shari'ah-compliant money market instruments for liquidity management and the underdevelopment of Islamic money markets generally. Together, with the other international organisations, they decided to establish the International Islamic Liquidity Management Corporation (IILM). Confidential 22
The International Islamic Liquidity Management Corporation The IILM is an international institution established in October 2010, current shareholders comprise nine central banks and one multilateral institution Kuwait Turkey Qatar Luxembourg Saudi Arabia IDB Malaysia Nigeria UAE Indonesia Mauritius The IILM mandate is to address liquidity management challenges faced by Islamic financial institutions Confidential 23
The International Islamic Liquidity Management (IILM) Short-Term Sukūk The first Shari ah-compliant, US Dollar denominated short-term financial instrument. Widely accepted by Shari ah Committees of IFIs around the world. Tradable, as the assets of its portfolio are at least 51% tangible. This is an application of the position of the Islamic Fiqh Council. The IILM Sukūk have received a number of favorable regulatory treatments from the IILM s member central banks that would certainly enhance the demand for these Sukūk. Backed by Sovereign assets. 24
Disclaimer This material has been prepared by the International Islamic Liquidity Management Corporation ( IILM ) for discussion purposes only. It is preliminary and indicative only. This material is not a promise of any particular terms for the IILM s issuance programme and it is not a research report and is not intended as such. The information contained herein speaks only as of the particular date or dates included in the accompanying slides. The IILM does not undertake an obligation to, and disclaims any duty to update any of the information provided. Certain information contained herein, which is subject to change at any time without notice, has been obtained from sources believed to be reliable but has not been independently verified therefore we do not represent that it is accurate, complete and/or up to date, and it should not be relied on as such. Opinions expressed are our current opinions as of the date appearing on this material only and only represent the views of the author and not those of the IILM, unless otherwise expressly noted. No representation or warranty, either express or implied, is made that the information contained herein is appropriate for use in all locations, or that any products, investments and/or services discussed herein are available or appropriate for sale or use in any jurisdiction, or by any investors. Any opinions expressed in these materials are subject to change without notice and may differ or be contrary to opinions expressed by other business areas of the IILM as a result of using different assumptions and criteria. Neither the IILM nor any of its member, nor any of their directors, employees, contractors, subcontractors or agents, accepts any liability for any loss or damage arising out of the use of any part of this material. Non-Reliance and Risk Disclosure: This material should not be construed as an as a solicitation or an offer to buy or sell any securities or related financial instruments or products in any jurisdiction where such an offer or solicitation would be illegal. We are not soliciting any specific action based on this material. It does not constitute a recommendation or take into account the particular investment objectives, financial conditions, or needs of individual clients. Before acting on this material, you should consider whether it is suitable for your particular circumstances and seek professional advice. The price and value of the investments referred to in this material and the income from them may go down as well as up, and investors may realize losses on any investments. Past performance is not a guide to future performance. Future returns are not guaranteed. We do not provide tax, accounting, or legal advice and all investors are advised to consult with their tax, accounting, or legal advisers regarding any potential investment. Not a Fiduciary: Nothing in this material will result in the IILM becoming a fiduciary or advisor with respect to any person. To the extent this material is provided to any other recipient, this material is provided solely on the basis that the recipient has the capability to independently evaluate investment risk and is exercising independent judgment in evaluating investment decisions in that its investment decisions will be based on its own independent assessment of the opportunities and risks presented by a potential investment, market factors and other investment considerations. Information Not for Further Dissemination: This material is for distribution only under such circumstances as may be permitted by applicable law. This material is not for distribution to any person or in any jurisdiction in which such distribution would be prohibited. To the extent this material contains any pricing information from the IILM, such pricing information is proprietary and/or confidential and is provided solely for the internal use of the intended recipient(s). You are notified that any unauthorised use, dissemination, distribution or copying of this material or its contents, including pricing information, in whole or in part, is strictly prohibited. Further, unless prohibited by local law, any use, review or acceptance of this information is subject to and manifests your agreement with the IILM to use such information only in accordance with the terms set forth above. The IILM has caused its proprietary information to be delivered to you in reliance upon such agreement. Reproduction and Re-Distribution: No part of this material may be (i) copied, photocopied, duplicated, reproduced, amended, modified, adapted, transmitted in any form, or translated in any form by any means or (ii) redistributed without our prior written consent. The IILM accepts no liability whatsoever for the actions of third parties in this respect. Copyright 2016 The International Islamic Liquidity Management Corporation. All rights reserved. 25