Risk Management Forms Banks

							    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
                                                2
   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
                                                    3
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]


                                             9
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).
                                                10
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)
                                                11
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

                                              12
Liquidity Risk & Contractual
Forms

   Profit Sharing Contracts
   Murabaha
   Salam
   Istisna
   Ijarah



                               13
   Resale not permitted
   Resale permitted but non-existent
    market
   Market exists but not active




                                        14
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
                                              15
                       receivables
Analysis and Diagnosis




                         16
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
                                                        17
Examples of Problems with
Commodity Murabaha




                            18
High Proportion of Short-Term Int’l
Murabaha in Total Murabaha,Bank-A (2002)



                             26.3 %




                                           19
High Proportion of Short-Term Int’l
Murabaha inTotal Murabaha (Bank-B)

      2002                 2004




             50.4%                43.7%




                                          20
 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 %


                                                                21
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
                                                      22
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

                                                        23
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

                                                  24
Existing Maturity Structure of Sukuk




                                       25
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




                                                                     26
    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

                                                       27
Conclusions


     What is needed
     What can be done
Thank You