Islamic Liquidity Management The Malaysian Experience

1. Islamic Liquidity ManagementThe Malaysian Experience Seminar on Islamic Finance: Structure and Instruments 26 – 30 September 2011, Ankara, Turkey

2. Presentation outline • Background of Islamic financial market in Malaysia; • Brief regulatory framework of Malaysian dual banking system; • Interrelationship of conventional and Islamic money market and liquidity; • Islamic liquidity management practices of BNM; • Objective of Islamic liquidity management; • Islamic liquidity management operation and instruments; • Challenges in developing appropriate Sharī`ah-compliant instruments; • Challenges to the current and developing new instruments; • Addressing the challenges.

3. Malaysia dual bankingsystem…comprehensive components of financial institutions to facilitate effective intermediation process… Malaysian Financial System Firewalls against commingling of funds Conventional Banks Islamic banks • Separate: • Capital compliance • Compliance to SRR & single customer limits • Compliance to liquidity framework • Clearing accounts • Membership code in RENTAS* • Cheque clearing system • Statistical reports in Financial Inst. Statistical System on monthly basis Islamic windows* Conventional Money Market Islamic Money Market Conventional Capital Market Islamic Capital Market Insurance Companies Takaful Companies *Islamic windows of conventional banks • For monetary operation purposes, two distinct pools of conventional & Islamic liquidity are managed separately • Monetary instruments applied are different in terms of concept & structure but similar in terms of its effect on liquidity

4. 6 Money Brokers Approved Interbank Institutions (23CBs, 15 IBs, 17 Islamic Banks) Cagamas/ 2 DFIs Market structure: Interbank Players & the Principle Dealers Network • Dealing with Principal Dealers (PD) ensures efficiency • Assists in the collection of bids/offers and confirmation of successful bids/offers; • Promotes a more active secondary trading in the money and capital markets. Principal Dealers 12 CB (Con) 6 Islamic PDs Submission of bids by interbank players BNM BNM & Govt issued paper PrincipalDealer Bids Fully Automated Tendering System Money Tender Bank Negara Malaysia Bids Standing Facility Bilateral Interbank players

5. Financial Market Infrastructure… SYSTEMS SECONDARY MARKET PRIMARY MARKET RENTAS Investors/ Interbank Players Issuers Money Brokers & Principal Dealers ETP FAST IIMM Website Investors/ Interbank Players Investors/ Interbank Players Market Players -55 interbank players with Islamic windows; 17 full-fledged domestic Islamic banks, and 3 foreign Islamic banks Intermediary Channels - 6 money brokers as intermediaries and 18 principal dealers to provide two-way quotations in secondary market Primary and Secondary Market - fully automated system for tendering (FAST), electronic trading platform (ETP) provides near real-time prices, and market information Settlement Mechanism - real-time gross settlement and custodian system for scripless securities trading, reduces settlement risks Legal framework - Islamic banking act, takaful act, DFI, Anti Money laundering act. Operational & Regulatory framework - central bank and securities commission issued various guidelines e.g. repo, money broker, principal dealer and product guideline, Accounting and tax system - adoption of generally accepted accounting principles, easily understood tax regime

6. Monetary policy, liquidity management and role of central bank • Monetary policy aims at achieving sustainable growth in an environment of price stability; • The policy rate is Overnight Policy Rate, currently at 2.75% implemented in the conventional money market; • Objective of monetary operations: • meet the overnight operating target; • reinforce monetary policy intention, and • manage liquidity in the interbank market. • Monetary operations in both conventional and Islamic money markets focus on absorbing surplus liquidity, hence liquidity management operation.

7. Malaysian conventional and Islamic money market • Islamic Money Market • Co-exists and operates in parallel with the conventional money market. • Separate cash and securities clearing accounts under RENTAS (RTGS) platform. • BNM conducts market operations via segregated pools of liquidity. • Act as a short-term intermediary to provide a ready source of investment outlets based on Shariah principles. • Integral to functioning of Islamic system: • Facility for funding and adjusting portfolios over the short term; and • Monetary policy transmission channel. Transmission mechanism in the financial market BNM Government Conventional Money Market Islamic Money Market Deposit/ Profit Rates KLIBOR & Lending Rates Bonds/ Sukuk & Equities Prices Impact towards economy activities

8. Monetary Operating Framework… overnight policy rate guided within a corridor Overnight rate • Overnight rate as the policy rate and also the operating target • Operating band of 50 basis points to minimize extreme volatility • Standing facility available at the ceiling and floor rate • Overnight rate was chosen as the policy rate • high controllability • minimal expectation content • Market determined rates at other tenors. Lending facility Ceiling rate (+25 bps) 50 bps corridor – minimise extreme volatility Policy rate (3.00%) Floor rate (-25 bps) Deposit facility Time Overnight rates to gravitate around policy rate Liquidity is managed using money market tenders and longer-term repo to ensure rates are not persistently too low or too high

9. In ensuring for a smooth and efficient monetary policy transmission, the choice of instrument used by BNM operations is crucial... • Liquidity management operations • influence liquidity via money market and repo tender to achieve operating target • a price taker at all tenors of tenders (other than overnight), thereby allowing market-based pricing • no direct intervention to set market rates • also conduct overnight tender to mop up overnight excess liquidity. • Choice of instruments • degree of controllability on the monetary instrument; • degree of sensitivity or responsiveness of the monetary instrument; and • efficiency of the financial markets • Banking institutions play an important role in monetary policy transmission as a conduit for channels of transmission. • the direct interest rate effect – KLIBOR, BLR and savings rate • domestic asset prices – including bond, stock market and real estate prices

10. Monetary Instruments Various instruments used to absorb liquidity in monetary operations… Common Instruments to both Conventional and Islamic Money Market Statutory Reserve Requirement Outright Sales & Purchases of Securities Conventional Islamic Foreign Currency Swaps Money Market Borrowings Repo & Reverse Repo Up to 1-month Wadiah Acceptance Commodity Murabahah Programme (CMP) Bank Negara Monetary Notes (BNMNs) Up to 3-months Bank Negara Monetary Notes Islamic (BNMN-i) Up to 6-months Sukuk BNM Ijarah Up to 1-year • Frequency of operations: • Daily: Money market borrowings, Wadiah Acceptance, Repo & Reverse Repo, Commodity Murabaha Programme • Twice a week: BNMN & BNMN-i

11. Liquidity is managed twice daily.. term operation in the morning, overnight operation at end of the day Standing Facility BNM’s Operational Intentions for Monetary Policy Implementation Further and final revision of liquidity forecast & overnight operations Possible second round of dealing 0830 0930 1015 1045 1400 1530 1600 1630 1700 1730 1800 Close Securities-driven repo ops (T+1) Forecast liquidity in the banking system for the day Publish liquidity forecast and details of liquidity operations Submission of bid/offers via FAST Revises liquidity forecast after tender operations Liquidity position may change due to exogenous factors Overnight operations via agent banks / overnight tender Residual liquidity position is met by standby facilities FAST: Fully Automated System for Issuance/Tendering • Liquidity forecast is published in FAST 4 times (9.30am, 10.45am, 3.30pm, and 4.00pm) throughout the day to reflect changes in factors that affect liquidity • All monetary operations are conducted electronically via FAST

12. Transparency of operation… liquidity is forecasted and operational intention is disclosed to the market Observe movement of funds • Forecast aggregate liquidity. • Movement of rates will be determined by availability of funds. Decide on monetary tools • Appropriate instruments used to structure the maturity profile, thereby influencing short term liquidity. Disseminate information • Allow market players to structure their liquidity profile.

13. Six Islamic liquidity instrument introduced to-date.. for both Islamic deposit and securities instruments • Choice of instruments • Diversification of the product base – increase the number of instruments available. • Liquidity management purposes (ALM) – Islamic banks are biased towards liquid short-term instruments. • Flexibility to meet market needs and requirement i.e. foreign banks operating in Malaysia. • Shariah compliance issue – consent and approval from Shariah Advisory Council. * Replaced by issuance of BNMN-Murabahah

14. A credit facility extended by BNM to RTGS member for a period of less than one business day. Members may utilize the intraday credit facility by pledging eligible securities in their collateral account. Eligible securities: Securities issued by the government and central bank and any other specified instruments; Other securities with minimum credit rating of A and above. Any intraday credit obtained from BNM will be paid immediately after the intraday credit cut-off time. There is no cost involved other than a very minimal administrative charge. A facility offered to all Islamic interbank institutions to: Obtain overnight liquidity via Sell & Buy-Back Agreement (SBBA) transaction using eligible collateral; or Place overnight liquidity via wadiah deposit. Eligible collateral – Islamic securities issued by government, central bank, quasi-government entities and other specified securities. Margin is applied on collateral and varies between different type of securities. Facility is available on a daily basis, on request by the individual institution from 4pm onwards. No limit to the funding amount, as long as there is sufficient underlying eligible collaterals. Liquidity facilities to support IFI’s liquidity management.. intraday credit facility and standing facility Intraday Credit Facility Standing Facility

15. Current Islamic liquidity instruments.. its challenges and implications Deposit instrument Securities instrument WadiahAcceptance Commodity Murabahah Sukuk BNM Ijarah Bank Negara Monetary Notes-i Challenge & implication • Return to depositors is in the form of hibah. • Hibah is prerogative of custodian and it cannot be contractual, hence return is uncertain. • It does not appeal for longer term placement for liquidity management as return, if any, is uncertain. • Process is tedious and time-consuming – series of trade transaction of underlying assets. • Incur additional cost, relative to wadiah, in the form of commodity brokerage. • Inefficient for use to manage short-term liquidity. • Widely accepted and demanded by investors. • Issuance is limited to the value Ijarah asset; hence it is ineffective to manage massive liquidity. • Due to insufficient issuance to satisfy demand, it leads to buy-and-hold strategy by investors causing lack of secondary trading of the instrument. • Issuance not limited by issuer’s assets; hence the flexibility in managing liquidity. • Issuance incurs additional cost (commodity brokerage).

16. Going forward.. challenges in developing the Islamic liquidity instruments • Needs to have various type of instruments to cater for different issuers and investors' requirements and limitations; • Flexibility in addressing significant liquidity and fund flows; • Financial certainty within the confine of shariah parameters; • Wide acceptance of products by financial market institutions in view of diversity in shariah opinion; • Ensure effectiveness in managing market wide liquidity; • Efficient implementation process with regards to documentation; • Shariah understanding of the structure and business issue. • Efficient infrastructure supporting the development of a new instrument; • Cost-effective supporting infrastructure for efficient transaction. • Market understanding on new structures and sophistication of investors. • Greater use of equity-based Islamic financial instrument, instead of debt-based.

17. Addressing the challenges • Conduct periodical consultation process with Islamic financial market participants; • Obtain feedbacks from market and address all the raised issues; • Have close and early collaboration with shariah and legal practitioners; • Understand the parameters and concerns of shariah and legal; • Have clear communication on business issues and needs; • Support market wide initiative – infrastructure, documentation and education; • Give fullest support, including resources, to market players/association initiative; • Adopt culture of continuous improvement – “Kaizen”

18. Contact details:Azizul Sabri AbdullahE-mail: asabri@bnm.gov.myWebsite: www.bnm.gov.my / iimm.bnm.gov.my / fast.bnm.gov.my

19. Sukuk Bank Negara Malaysia Istithmar (investment) Issue Sukuk Murabahah 1 BNM purchase asset certificate, and sukuk is redeemed 8 • BNM issues sukuk to investors, which proceed is used to purchase: • Ijarah asset, through purchase of asset certificate that represent ownership of asset trust which on issue date contain only Ijarah asset. • Commodity which are sold at profit to BNM to be paid on deferred basis i.e. on maturity date of sukuk. • Investors, through sukuk trustee, will leased the Ijarah to BNM, which rental will be paid and passed to investors as coupon payment. • Upon maturity, BNM will buy back asset certificate from sukuk trustee, effectively redeeming the sukuk from investors. • Asset certificate represent ownership of asset trust that upon maturity will contain Ijarah asset and commodity murabahah debt receivable. Sell asset certificate* 2 Investors Sukuk Trustee Rental payment Asset is leased to BNM 3 4 Cash injection Asset company sell commodities at markup price to be paid on deferred Asset Trustee 6 7 5 Asset trustee purchase commodity BNM sells commodity via agent Vendor B Vendor A * Prior to sukuk issuance, BNM create an asset trust and transfer its Ijarah properties into the trust. An asset trustee is appointed to administer the trust and accordingly it issues an asset certificate to BNM to evidence the ownership of the trust asset. Fund flows at spot date Fund flows at future date Commodity flows Asset flows Sukuk movement

20. Standing Facility Framework Instrument – Sell Buyback Agreement (SBBA) Eligible collaterals – Islamic securities issued by Malaysian Government, Bank Negara Malaysia (central bank), Khazanah, Cagamas (quasi-government entities) and other securities that may be specified by BNM from time to time. Application of margin between government, government-guaranteed and Bank Negara securities in one category and other securities. Access condition – available to all interbank institutions on a daily basis, at their request from 4pm onwards. There is no limit to the amount an interbank institution may borrow or deposit under the standing facilities. However, under the lending facility, the amount borrowed is subject to sufficient underlying eligible collaterals.