Conventional financial institutions find it hard to manage liquidity in volatile times, especially when their confidence to lend to each other is at a low end. During the global financial crisis two years ago, the liquidity contraction in certain structured products and interbank markets led to funding strains for banks and forced central banks to intervene and inject the needed liquidity into markets.
Since they were generally more liquid than their conventional counterparts, a number of Islamic financial institutions were spared much grief during the global liquidity crunch. But the liquidity seizure did not spare Islamic finance and impaired the ability of a few high-profile corporates and Islamic financial institutions to meet their obligations. Several of these were forced to scramble for more expensive liquidity.
The crisis served as a wake-up call for Islamic finance – in the same way it was an eye-opener for the conventional finance industry – and helped to highlight the importance of liquidity to the banking sector.
Overcoming constraints
The case of Dubai World which had issued sukuk to raise equity for its ambitious and often outlandish property project in Dubai is one telling example. If a global financial crunch happens again, there is no telling how tough it would be for corporates and financial institutions. If liquidity is considered to be the ability to fund increases in assets and meet obligations as they come due, then the implied assumption is that such obligations will be met at a reasonable cost. For this reason, liquidity management is an everyday reality that Islamic financial institutions contend with.
In view of the dearth of Shariah-compliant instruments where available liquid assets can be parked to generate stronger returns, it is arguably tougher for Islamic financial institutions to manage liquidity than for conventional banks.
In addition, there is often a maturity mismatch in terms of their assets and liabilities: they have locked most of the funds in long-term investments such as sukuk, project finance and real estate, while most of their liabilities are of a short-term nature, because most of their funding comes from short-term deposits.
Islamic finance experts are working to address these types of constraints. Shariah’s prohibition of riba, the lending of money at interest means that the scope for liquidity management has long been limited. International products in the money markets may be off limits to Islamic banks since those instruments rely on the payment or receipt of interest rates. It has not helped that only a few countries have active interbank markets in Islamic instruments. Malaysia is one exception and it boasts an active interbank market for Islamic negotiable instruments of deposits, negotiable Islamic debt certificates as well as mudaraba and wakala interbank placements.
Islamic bankers acknowledge that the dearth of Shariah-compliant short-term liquidity management instruments is a challenge for Islamic financial institutions and that they hope to see the entry of more liquidity management products in the market. This is the reason why the creation of a corporation set up by central banks and financial institutions in the Islamic world to help Islamic banks and other asset managers better manage liquidity has been described by bankers and ministers as “a major breakthrough” in the history of Islamic finance.
Filling a gap
The various players (including Bank Negara Malaysia) signed the articles of agreement setting up the corporation on October 25, during the Global Islamic Finance Forum (GIFF) conference, which attracted over 1,500 delegates to Kuala Lumpur. The following day Malaysia chaired the first board meeting of the International Islamic Liquidity Management Corporation (IILM), set up by central banks and financial institutions in the Islamic world to help Islamic banks and other asset managers better manage liquidity. Bank Negara Malaysia governor, Tan Sri Zeti Akhtar Aziz, says the entity will enable effective liquidity management for both Islamic financial institutions and managers of Islamic portfolios.
The goal of the corporation, according to Zeti, is to bring together regulators and key banking participants so they can establish a mechanism that will help reduce risk for a slew of Islamic institutions, especially during volatile periods. Earlier proposals have urged for the widespread adoption of Islamic repo agreements to ensure sufficient liquidity when institutions need it.
As the global financial crisis two years ago demonstrated, Islamic finance is not insulated from problems facing conventional banks.
While Islamic banks have been somewhat resilient to the global financial crisis, the supply shortage of Islamic instruments has nevertheless affected the effective management of liquidity within Islamic banks. KFH Research believes that IILM will fill this gap by providing the Islamic markets with new and innovative products that will allow Islamic financial institutions to better manage liquidity and risk.
Bankers say IILM could help asset managers better manage their portfolios with a cross-border flavour. Several stock exchanges already list Islamic funds, including ETFs, on their board. During the conference, Shariah scholars and other experts urged the industry to focus less on real estate and focus more on infrastructural development to enhance the development of the industry.
The evolution of the Islamic finance industry continues apace with more countries expected to issue sukuk in the near future. Participants at the Islamic conference say Thailand, Korea and even Australia could issue sovereign sukuk.
Dheerasak Suwannayos, president of the state-run Islamic Bank of Thailand, tells The Asset that the Thai sovereign sukuk can tentatively reach the market in June next year with the guidelines from the finance ministry expected to be issued in the fourth quarter this year.
Baljeet Kaur Grewal, managing director and vice-chairman of Kuwait Finance House and Research, told delegates on October 25, the first day of the conference, that global sukuk issuance could reach US$30 billion this year compared to US$24.7 billion in 2009, on the back of the recovery in global economic activity.
Clamouring for greater coordination
Francis Yeoh, managing director of YTL Corporation, says Islamic finance provides a golden opportunity for countries in the region such as Malaysia and Indonesia to enhance their prospects for growth by investing in each other’s infrastructure.
KFH Research says a number of jurisdictions have already come up with their own liquidity management tools, but industry players have clamoured for a more coordinated approach. This is required if the industry is to develop further and remain competitive.
In this regard, adds the research house, IILM has a concrete collaboration commitment by 12 regulatory authorities to establish a mechanism for more efficient management of liquidity across borders. The proposed short-term papers will be structured in such a way that they are easily accepted by investors and therefore intensely traded. “These efforts will serve to contribute towards the continued resilience of the global Islamic financial system.” The establishment of IILM is expected to enable Islamic banks and asset managers to be better equipped to face any liquidity crisis and thus support the systemic development of the Islamic finance industry.
It had been noticed that industry participants use a limited number of products to assist with management of short-term liquidity.
Baljeet says the IILM’s new products, due to be launched early next year, will be designed to directly assist asset managers in their task to maintain their institutions’ balance sheets and provide avenues to invest excess liquidity in short-term Shariah-compliant instruments.
The Islamic financial institutions will therefore be able to reduce liquidity risk by better matching their short-term liabilities with short-term assets. “With the development of Islamic finance spreading throughout the world and into non-Muslim jurisdictions, the need for liquidity management tools has deepened,” according to Baljeet.
She explains that in a conventional setting, institutions offering Islamic financial services are faced with a much greater challenge. For example, there are no liquid assets which Islamic banks in the UK can hold because there is no basis for the placement of short-term assets with the Bank of England on a Shariah-compliant basis. Without an efficient inter-bank market and the support from central banks, market forces have driven Islamic banks towards an increasingly sophisticated replication of conventional banking techniques. There is obviously a trade-off between efficiency and distinctiveness of Islamic finance, asserts Baljeet. Given the conceptual preference for profit and loss or risk sharing, much more fresh thinking and radical innovations are needed in order to engineer efficient instruments for participatory financing.
More short-term push
Islamic institutions today are heavily dependent on a small number of liquidity management instruments. Among the most commonly used is commodity murabaha with a tawarruq structure which acts as an inter-bank lending mechanism similar to the conventional lending arrangements. Such structures have faced troubles on a global scale with not all jurisdictions fully subscribing to the products. Baljeet feels that in order to develop cross-border liquidity it is important to get the structure right. One of the major challenges is to identify suitable assets that can be the basis for the underlying transactions and that are tradeable on a cross-border basis with full recourse to the law of the land.
The push towards more short-term instruments is merely one part of the initiative to enhance liquidity management. As the Bank of International Settlement (BIS) writes in a report on liquidity management at conventional banks, global financial market developments have transformed the nature of liquidity risks in recent years and the challenges facing financial institutions have grown in complexity.
It cites, among others, how the funding needs of banks have shifted towards greater reliance on the capital market, which is a more volatile source of funding than traditional retail deposits.
It notes too that the complexity of financial instruments has increased and that this had led to heightened demand for collateral and additional pressure on prospective liquidity from margin calls.
The increased cross-border business means that events in one market can quickly affect another, BIS notes. More banks face greater challenges in their intra-day liquidity management in relation to both their own activities and the activities of their customers. According to BIS, such challenges have been compounded by recent changes in the design of payment and settlement systems, which have become increasingly real-time in nature.
This article was published in the DEcember 2010 issue of The Asset magazine
The Asset website is at http://www.theasset.com
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