Liquidity risk and IBIs

Ishrat Hussain
 What’s ahead
• About liquidity risk
– Regulatory LR
– Basel-II LR
– IBIs LR
 What is LR
Unable to fund portfolio of assets at:
– Appropriate maturity
– Appropriate rates
AND
Unable to liquidate a position in:
– Timely manner
– At reasonable prices
 Sources of liquidity risk:
• Nature of banking business
– maturity transformation
– liquidation of assets into cash without loss at time of
needs
– unanticipated recall of depositors
• Macro factors exogenous to IBI
• Internal financing & operational policies
• Shariah compatible contracts, particularly with
conventional financial infrastructure
 Other sources:
• Judgement regarding timing of cash-in and cash out flows
• Change cost of capital/availability of funding
• Abnormal financial conditions
• Assumptions used in predicting cash flows
• Risk activation by:
– Business strategy failure
– Corporate governance failure
– Modeling assumption
• Merger and accusation policy
• Payment/settlement system break down
• Macroeconomic imbalances
• Contractual form
• Shariah restriction on sale of debt
• Financial infrastructure deficiency
LR and Central Bank
 SLR
• The main objectives for maintaining the SLR
ratio are the following:
– to control the expansion of bank credit. By
changing the level of SLR, SBP can increase or
decrease bank credit expansion.
– to ensure the solvency of IBIs.
– to compel the IBIs to invest in government
securities like GIS.
 CRR

• Cash Reserve Requirement is 5% of demand deposits

and a portion of time deposit (<1 year) which IBIs
are required to hold as reserves at SBP.
– At times of serious cash withdrawal, IBIs may resort to this.
– But CRR is a tool to implement MP rather than a
prudential instrument to keep banks liquid in case of
deposits withdrawal.

8
LR due to Shariah in IBIs
 Sources of Liquidity risk in IB

Profit sharing contracts

• Mudaraba and Musharaka
– If each deposit is invested in specific MudMush, no asset-liability mismatch
possible; but it wipes out liquidity insurance possibility for depositors.
• Pool management provides liquidity to banks and reduce variability in deposit rates.
– In the extreme case, depositors want to recall their investment
– the sharing assets are sellable in the market. If their sale fetch lower price
than its market price, than liquidity risk came into being.
– But it is shared between the partners, so liquidity risk to the bank is
reduced.
– Due to low portfolio of MudMush, possibility of liquidity risk due to these
two products is very low.
 Sources of…
Murabaha
• Banks buys commodity for a client and sells it to
on a mark up price to be paid later.
• Mur receivable are debt payable on maturity
they cannot be sold at a price different from the
face value in secondary market.
• This liquidity risk, particularly when avg maturity
of deposits is shorter than avg maturity of
Murabaha contracts.
 Sources of…
• Salam & Istisna
– Advance payment and deferred delivery
– If bank wants to sell the commodity it cannot due
to Shariah restriction, which says ‘do not sell what
is not in your possession’.
 Sources of…
• Ijarah
– Lr arises when the bank has to pay the price of the
asset upfront to acquire the asset before it can lease
it to its customer.
– It depends whether or not the asset is readily resell-
able in the market.
– The risk is less here than Murabaha because asset is
reseelalble and repriceable.
– Lr is even lower in hire-purchase because sale price
is built into the rental instalments
But what to do…?
 Lack of Islamic financial infrastructure
• In the conventional banking system with a well developed interbank
money market, a variety of instruments are available for the banks.
• Access to interbank money markets for short-term borrowings gives
considerable flexibility to banks to adjust their short-term cash flows.
• Existence of secondary markets for financial instruments is also an
important source of liquidity.

• However, this conventional mechanism of liquidity management

including interbank market, secondary market financial instruments
and facilities from the central bank as the lender of last resort are all
based on interest and therefore, not acceptable for Islamic financial
institutions.
 Lack of …
• In addition to the lack of long-term assets to invest in and
get out of, Islamic banks face another serious problem in
balance sheet management:
• Lack of an Islamic inter-bank market on the scale of similar-
sized conventional markets.
• Because Islamic banks, unlike conventional banks, cannot
borrow at interest to meet unexpected withdrawals from
their depositors, it is difficult for them to run mismatched
asset and liability portfolios. And this is aside from the
interest rate risk they run when they invest long at a fixed
rate and have their liabilities frequently repriced
How LR management in IBI is done?
 Liquidity management in Islamic banks
• It is different for full fledge IB and IBD of
conventional banks

• IBD of conventional banks

– Lr management is performed using conventional
hedging instruments and techniques.
– Mixing of risk manag activities of Islamic and
conventional lines of business in main treasury creates
negative externalities for ib and for isl fin system.
 RM practicies in IBIs
• Many Islamic banks place their surplus funds
with conventional banks by means of
Placements, Bai Muajjal Sukuk, and in some
cases Tawarruq. Now OMO in Sukuk
• While such transactions have been deemed to
be Shariah-compliant because of a lack of
alternatives, perhaps this acceptance in itself
has stalled efforts to develop structures.
 Problems, problems, problems
• Islamic banks investing in long-term assets are still
faced with a problem in that most of their deposit
liabilities are very short-term, leading to a massive
liquidity problem.
• Liquidity management tools that are both flexible and
undeniably Shariah-compliant are lacking.
• Although sukuk can be traded, most are held to
maturity. This lack of market liquidity is often seen as
the major constraint to the development of an
integrated Islamic financial system.
 Some crude solutions
• The way banks have most commonly solved this
problem is to have more liquid assets than would
conventional banks, and these are placed with
commodity murabahas/Bai Muajjal Sukuk on the
understanding that they can get liquidity when
required through early cancellations at an explicit or
hidden cost.
• There are a few Islamic liquidity vehicles, but these
are fairly small and could not withstand a several
hundred million dollar injection or withdrawal.
 Need for solution
• There needs to be a market-wide central solution
that allows institutions to park funds between
medium-term to long-term investment sales and
purchases.
• We need a solution that involves high quality and
standardisation, is available for transactions of
substantial size and which gets away from bilateral
murabaha investments by the investor with all the
problems of break clauses, listing and price
transparency.
Some solutions in Pakistan
 Some solutions
• Primary market solutions
– Issuance of sukuk
• Secondary market solutions
– Trading in sukuk through OMO
– Bai Muajjal sukuk trading in IBIs
 STRUCTURE : EXPLANATION
1. SBP will conduct an auction through which Investors will be identified.

2. The Investors will execute the Sukuk Subscription Undertaking in favor of PDSCL
& NHA which will record the commitment of the Investor and appointment of
PDSCL as their agent.

3. PDSCL and NHA will execute Sukuk Issuance Undertaking in favor of the
Investors, whereby PDSCL will undertake to issue the Sukuk to the Investors and
utilize the proceeds to purchase the Assets (Highway land of M3 –motorway
together with constructions & improvements) as an agent of the Investors.
Each Sukuk will represent an undivided ownership in the Assets.

4. PDSCL (as Agent) and GoP (acting through NHA) will enter into a Purchase
Agreement for the purchase of undivided ownership in the Assets at an agreed
Purchase Price (equivalent to the Sukuk issue amount). PDSCL will also be
allowed to purchase additional undivided share in the Assets to cater the GoP’s
future funds requirements upto the value of the Assets. At each such purchase
a document evidencing the transfer of possession to PDSCL from GoP will be
executed.

5. At each purchase of undivided share in the Assets, the beneficial ownership will
be transferred to PDSCL and the registered title will remain with NHA (as
Trustee). NHA will execute a Declaration of Trust in favor of the Investors to the
effect that the NHA is holding the registered title in trust for the Investors.
 STRUCTURE : EXPLANATION
6. Under the Declaration of Trust, NHA will delegate its duties and powers to PDSCL (as delegate
trustee), with the exception of holding the registered title to the Trust Assets.  

7. PDSCL and SBP’s Banking Services Corporation will execute an Agency Agreement whereby
PDSCL will appoint SBP BSC as Paying Agent, Reference Agent and Registrar for the Investors.

8. After each purchase, PDSCL (as Delegate Trustee) will enter into an Ijarah Agreement with
GoP (as Lessee) wherein the Investors’ undivided share in the Asses will be leased to GoP for a
fixed period (3 years), against Lease Rental payments. GoP will be allowed to nominate any of
its affiliates, for e.g. NHA, to use, operate and maintain the Assets as its nominee.

9. PDSCL (as Delegate Trustee) and GoP (as Lessee) will execute a Service Agency Agreement
whereby GoP will be appointed as Service Agent to undertake service of the Assets during the
lease term in consideration for a fee.

10. At maturity or upon an EoD, GoP will undertake to purchase (pursuant to a Purchase
Undertaking) the Sukuk Assets at the Exercise Price (equal to the initial Purchase Price plus
any due and payable amounts by lessee).

11. GoP through a Cost Undertaking will undertake to pay all applicable fees & expenses and
provide indemnities associated with the Sukuk Issuance.
 Sukuk
• But While there have been a number of Islamic sukuk issued
recently, most of the paper is bought to hold rather than trade.
Thus liquidity is a problem both for on-sale and price
determination and marking to market is difficult.
• This is a result of a combination of two factors. There is a
shortage of quality paper issued into the market and also the
view in some quarters that the trading of debt is not Shariah-
compliant.
• In terms of asset/liability management, there is a hedging
problem for institutions that lend long-term at fixed yield
through ijaras and finance through short-term and therefore
variable yield accounts
 Sukuk
• There is also a problem in terms of the lack of
Islamically-compliant short-term liquidity
instruments. Sukuk, even if they are traded
and liquid, are medium to long-term.
• Instead of trading, IBIs prefer to hold Sukuk
 Tawarruq
• Tawarruq is a term used for “buying a commodity
with deferred payment and selling it to a person
other than the buyer for a lower price with
immediate payment”. (Al Mowsoat ul Fiqhiyyah, The
Fiqhi Encyclopedia of Kuwait’s Ministry of Awqaf and
Islamic Affairs)
• AAOIFI Shariah Standard No. 30 defines
“Monetization refers to the process of purchasing a
commodity for a deferred price determined through
Musawamah (bargaining) or Murabahah (Mark up
sale), and selling it to a third party for a spot price so
as to obtain cash”.
 International Islamic Liquidity
Management Corporation
• As a major effort, the International Islamic Liquidity Management
Corporation (IILM) has been established to assist IFIs
• To addresses one of the fundamental problems of Islamic financial
institutions: the provision of adequate liquidity in times of stress as an
international lender-of-last-resort facility
• The IILM is expected to issue high quality, liquid, tradable and low risk
Shari’ah-compliant financial instruments at both the national level and
across borders to enhance the soundness and stability of the Islamic
financial markets.
• The instruments of the IILM will be utilized in liquidity management as
eligible collateral for interbank transactions and central bank financing, or
through trading of IILM instruments (either within the same country or
crossborder) in the secondary market.
LR and Basel-III
Calculation of LR under Basel III
Thank you