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Salman Syed Ali. LIQUIDITY RISK & LIQUIDITY MANAGEMENT in Islamic banks. 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

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salman syed ali

Salman Syed Ali

LIQUIDITY RISK &LIQUIDITY MANAGEMENT

in Islamic banks

Distance Learning Course: Current Issues in Islamic Finance

overview
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
slide3
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
excess of wet or dry
Excess of Wet or Dry

LiquiditySurplus Drag oncompetitiveness

Liquidity Shortage Assassin of banks

slide5
Islamic Banks are likely to be more stable
  • They have profit sharing on both the liability side and asset side
slide6
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
slide7
While majority of Islamic banks experience excess liquidity
  • Some have also faced liquidity crisis
  • Many different risks culminate in liquidity risk
liquidity crunch can be a real problem
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
liquidity risk definition
LIQUIDITY RISK: Definition
  • Risk of Funding [at appropriate maturities and rates]
  • Risk of Liquidating Assets [in time at reasonable prices]
investment firm s definition
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).

regulators definition
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)

liquidity risk sources
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
liquidity risk contractual forms
Liquidity Risk & Contractual Forms
  • Profit Sharing Contracts
  • Murabaha
  • Salam
  • Istisna
  • Ijarah
slide14
Resale not permitted
  • Resale permitted but non-existent market
  • Market exists but not active
liquidity surplus problem
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
high proportion of short term int l murabaha intotal murabaha bank b
High Proportion of Short-Term Int’l Murabaha inTotal Murabaha (Bank-B)

2002

2004

43.7%

50.4%

low income from short term murabaha bank b
Low Income from Short Term Murabaha (Bank-B)

Income from Short-term Murabaha

19 %

Income from Short-term Murabaha

15.1 %

2002

2004

Income from Other Murabaha 84.9%

Income from Other Murabaha 81 %

approaches to liquidity management
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
liquidity management current practices of ibs
Liquidity Management: Current Practices of IBs
  • To cope with Excess Liquidity
    • Commodity Murabaha
    • Sukuk Ijarah and Salam
    • Stock Markets
  • To manage Liquidity Shortage
    • Reverse Commodity Murabaha
    • Mixing of deposits
    • Various types of reserves for confidence building

Problems and Issues of these practices

new ideas going forward
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
slide26

Long-term Sukuk with different time remaining to maturity

Investor

Sukuk-A

Investor

Issue Pooled Sukuk of Shorter-Term

Sukuk-B

SPV- 2

Investor

Sukuk-C

Investor

Maturity Transformation through Pooled Sukuk

Mutual Fund of Sukuk

slide27
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

conclusions

Conclusions

What is needed

What can be done