LIQUIDITY RISK &
LIQUIDITY MANAGEMENT
in Islamic banks
Salman Syed Ali
Distance Learning Course: Current Issues in Islamic Finance
Overview
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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
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Banking Theory—Why banks exist?
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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
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Excess of Wet or Dry
Liquidity Surplus
Drag on
competitiveness
Liquidity Shortage
Assassin of banks
4
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Islamic Banks are
likely to be more
stable
They have profit
sharing on both the
liability side and
asset side
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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.
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Solvent
Asset tied finance
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While majority of Islamic banks
experience excess liquidity
Some have also faced liquidity crisis
Many different risks culminate in
liquidity risk
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Liquidity crunch can be a real
problem
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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
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LIQUIDITY RISK: Definition
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Risk of Funding [at appropriate
maturities and rates]
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Risk of Liquidating Assets [in time at
reasonable prices]
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Investment Firm’s Definition
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“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).
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Regulators Definition
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“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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LIQUIDITY RISK: Sources
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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
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Liquidity Risk & Contractual
Forms
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Profit Sharing Contracts
Murabaha
Salam
Istisna
Ijarah
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Resale not permitted
Resale permitted but non-existent
market
Market exists but not active
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Example of LR in Murabaha
Primary LR
Secondary LR
Receivables are debt
cannot be sold
Involves buying of
commodity then selling
on deferred payment
This brings in many
operational, credit,
dispute, and legal risks
that can affect
realization of
receivables
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Analysis and Diagnosis
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Liquidity Surplus Problem
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Excess Liquidity is the current norm with
Islamic banks
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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
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Examples of Problems with
Commodity Murabaha
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High Proportion of Short-Term Int’l
Murabaha in Total Murabaha,Bank-A (2002)
26.3 %
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High Proportion of Short-Term Int’l
Murabaha inTotal Murabaha (Bank-B)
2002
2004
50.4%
43.7%
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Low Income from Short Term
Murabaha (Bank-B)
Income from Shortterm Murabaha
Income from
Short-term
Murabaha
19 %
15.1 %
2002
2004
Income from Other
Murabaha 81 %
Income from Other
Murabaha 84.9%
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Approaches to Liquidity
Management
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Asset Side Liquidity Management
Liabilities Side Liquidity Management
Two Sided Approach
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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
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Liquidity Management: Current
Practices of IBs
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To cope with Excess Liquidity
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Commodity Murabaha
Sukuk Ijarah and Salam
Stock Markets
Problems and
Issues of
these
practices
To manage Liquidity Shortage
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Reverse Commodity Murabaha
Mixing of deposits
Various types of reserves for confidence building
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New Ideas: Going Forward
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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
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Existing Maturity Structure of Sukuk
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Maturity Transformation through Pooled
Sukuk
Long-term Sukuk with different
time remaining to maturity
Investor
Sukuk-A
Investor
Issue Pooled
Sukuk of ShorterTerm
Sukuk-B
Sukuk-C
SPV- 2
Mutual
Fund of
Sukuk
Investor
Investor
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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
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Conclusions
What is needed
What can be done
Thank You