Liquidity Risk Management by Syed Salman Ali
Lecture Plan
LIQUIDITY RISK & Part-I SHORTAGE Part-II EXCESS (Low
LIQUIDITY MANAGEMENT (Risk) ret.)
Sources of risk Causes
Implications for Bank Implications for Bank
in Islamic Banks and the System and the System
Current practices of Current practices of its
mitigation management
Salman Syed Ali Recommendations Recommendations
and the Future and Future
1 2
Dry Climate Flood
Excess Liquidity: A drag on competition
Liquidity Shortage
Assassin of banks
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Stability and Solvency of IBs
In theory, Islamic In practice, Islamic
banks are likely to Banks have fixed
income assets but
be more stable
have profit sharing on
They have profit liability side.
sharing on both the The IBs therefore, are
liability side and still more stable than
asset side conventional banks.
{ Solvent
{ Asset tied finance
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1
Liquidity crunch can be a real
problem
While a majority of Islamic banks have Example of Financial Crisis in Turkey
excess liquidity 2000-2001
Some Islamic banks have faced Islamic financial institutions there
liquidity crisis faced sever liquidity problems
Many different risks culminate in One Islamic institution Ihlas Finans
liquidity risk was closed during the crisis
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LIQUIDITY RISK: Definition Investment Firm’s Definition
“liquidity risk includes both the risk of
Risk of Funding [at appropriate being unable to fund [its] portfolio of
maturities and rates] assets at appropriate maturities and
rates and the risk of being unable to
liquidate a position in a timely manner
Risk of Liquidating Assets [in time at at reasonable prices.” *
reasonable prices]
* J.P. Morgan Chase (2000).
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Analysis and Diagnosis of
Regulators Definition Causes
“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)
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2
Liquidity Risk & Contractual
LIQUIDITY RISK: Sources Forms
1. Incorrect judgment and complacency Profit Sharing Contracts
2. Unanticipated change in cost of capital
3. Abnormal behavior of financial markets Murabaha
4. Range of assumptions used Salam
5. Risk activation by secondary sources Istisna
6. Break down of payments system
7. Macroeconomic imbalances Ijarah
8. Contractual forms
9. Financial Infrastructure deficiency
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Example of LR in Murabaha
Resale not permitted Primary LR Secondary LR
Resale permitted but non-existent Receivables are debt Involves buying of
market cannot be sold commodity then selling
Market exists but not active on deferred payment
This brings in many
operational, credit,
dispute, and legal risks
that can affect
realization of
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receivables 16
LR:Current Practices of control (a) Reserves and Provisions:
Deposit Management Provisions
Choice of Mode of Finance { Specific
Maturity Matching and Gap Analysis { General
Mixing of Deposits Reserves
{ Profit Equalization
Reserves and Provisions Reserve
Deposit Insurance { Investment Risk
Interbank Dealings Reserve
Ijarah and Salam Sukuks
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3
(b) Problems: (c) Remedies for Transparency:
Fiqh issue of justice: inter-temporal Well defined, consistent and
/interpersonal transfers transparent method of provision and
Breaks the link between bank performance reserve calculation
and its reflection in profits
Improved corporate governance
Possibility of manipulation to hide losses
Transfer of resources from shareholders to
Reveal ex-ante estimates and ex-post
investment account holders (displaced actual losses
commercial risk) Reveal the position and changes in the
Loosen the asset and liability tie in IBs. PE Reserve and IR Reserve
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Conclusions (contd.)
Conclusions Development of liquidity management
instruments
Development of Infrastructure
What is needed institutions (LMC, IIFM)
What can be done Rethinking and development of new
structure of Islamic banks (Separate
treatment of Cur. and Inv. accounts)
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Smooth Sailing
Excess Liquidity
State, Causes and
Management
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4
Current state of liquidity in Islamic
Banks Causes of Excess Liquidity
Excess Liquidity in the Market, resulting in serious Factors internal to the bank
business risk and affects the competitiveness of
IFIs due to no return or a very low returns. Factors external to the bank
In a recent study it was discovered that Islamic
financial institutions are almost 50% more liquid as
compared to conventional financial institutions.
Out of US$ 13.6 billion total assets of Islamic banks
in the study US$ 6.3 billion were found to be in
liquid assets.
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Islamic Banks’ Assets Portfolio
Islamic Banks’ Asset Portfolio
5%
5%
Mudharba
67%
67% 15%
7%
Shirakah Murabaha
murabahah
musharakah 5%
IB mudarabah
Portfolio ijara
6%
others
Ijarah Istisna’ 67%
Salam
Source: Iqbal Munawar, Ausaf Ahmad and Tariqullah Khan (1998), Challenges Facing Islamic
27 Banking, Jeddah: IRTI 28
Key Issues in Liquidity Management
Implications for Islamic Banks
Small No. of
participants
Underutilization of financial resources
No Lender Slow
of Last
Resort
Development
In
Lower income and higher cost
Islamic
Key Issues in financial Loss of competitiveness
Liquidity Instruments
Different Shari’a Management
interpretation
Absence of
No Islamic Inter- Islamic Secondary
bank Market market
Credit for this diagram: IIFM 29 30
5
Current Practices in Managing
How a Secured Commodity Murabaha Works:
Excess Liquidity
Deposit Management Sell
(at a profit & deferred payment) Buy
Secured Commodity Murabaha Broker
Conventional
Bank
Broker
‘B’ Pay (Spot) ‘A’
Mudaraba Sukuk Receive
(Agent)
(Sales proceeds at maturity)
Salam Sukuk Receive funds from Investor
(to pay Broker ‘A’)
Leasing Sukuk
Musharakah Sukuk Settle Investor
(Sales proceeds less Agents fees)
Infrastructure Institutions
{ Liquidity Management Center Islamic Bank / Investor
Funds Flow
{ IIFM (Principal)
Commodity Flow
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Credit for the diagram: IIFM
Advantage of SCM Problems with SCM
Short-term therefore liquid Flow of funds away from Muslim economies
Buying and selling in same currency Not contributing in any growth or
development oriented economic activity
(usually US$) therefore no FX risk
Limited scope for liquidity management:
since transactions are mostly bilateral
therefore counterparty limits apply
Always back to back murabaha is needed
for maintaining liquidity
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Salam Sukuk (Ex. of Bahrain) Salam Sukuk (contd.)
Gov of Bahrain (GoB) undertakes to sell Similar to SCM but securitized
Aluminum (deferred) for advance payment Advantages:
{ Cost price need not be declared
BMA securitizes it by issuing salam sukuk { Lower credit risk to bank due to sovereign
Individual IBs buy these to park their excess counter-party
liquidity { Lower cost (or higher return) to bank than in
SCM due to securitization
IBs appoint GoB as their agent to receive { Funds utilized in the local economy until very
delivery of commodity and sell it through its near to delivery date
distribution channels Disadvantage:
{ Not trade-able therefore high liquidity risk
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Structure of Malaysian Sukuk
Bahrain Salam Sukuk (contd.)
Countr Issuer Type Value Maturity
y
Bahrain Bahrain Sukuk US$ 625 91 days
Monetary Al Salam Million for each
Agency (23 (cumulat issue
issues ive)*
up to
April
2003)
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Credit for this slide: BMA presentation, Feb., 2004.
New Ideas: Good & Bad
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