The Importance of Liquidity Management in Islamic Finance and How Shariah Accommodate Its Implementation

(Nota Ringkasan hasil daripada bab dalam buku "Contemporary Issues in Islamic Finance: Deliberation At The International Shariah Scholars Dialogue 2006" tulisan Dr. Muhammad Syafi’i Antonio)

The Significance of Liquidity  Management

·         Managing liquidity is a fundamental component in the safe and sound management of Islamic bank and financial institutions

·         Sound liquidity management prudently managing assets and liabilities (on and off-balance sheet) to ensure the cash inflows can meet obligations.

·         It is important to have the process of liquidity planning :

o   assesses potential future liquidity needs,

o   considering various possible changes in market, political, regulatory

o   other internal and external factors.

Objective of Liquidity Management

·         Scheming cash outflow commitments (on and off-balance sheet);

·         Avoid excess funding costs; and

·         Fulfill liquidity requirements.

Liquidity Mechanism

Bank and financial institutions raise funds from society to finance their operations.

Islamic Back Liquidity Allocation

·         Primary Reserve:

                                i.            Cash

                              ii.            Current account with central bank

·         Secondary Reserve:

                                i.            Islamic securities

                              ii.            Inter-islamic bank investment

·         Earning assets:

                                i.            murabahah

                              ii.            salam and istisna’

                            iii.            mudarabah and musharakah

                            iv.            ijarah

                              v.            investment participation

·         Non-earning assets:

                                i.            Fixed asset

Source of Funds

·         Funds from internal bank/financial institutions:

                                i.            Paid up capital

                              ii.            Bank reserve

                            iii.            Retained earnings

·         Public funds:

                                i.            Demand deposit

                              ii.            Saving deposit

                            iii.            Time deposit

·         Funds from other sources:

                                i.            Credit liquidity from central bank

                              ii.            Call money (interbank loan)

                            iii.            International bank loan (placement)

                            iv.            Financial market instruments

Balancing Two Sides of Asset-Liability

The bank manager tries to maximize return on assets by investing as much of the cash available; on the other hand, there is a need to have enough liquidity to meet any mismatch of the term structure (maturity dates) of assets and liabilities.

Sources of Liquidity Risk

·         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 payment system

·         Macroeconomic imbalances

·         Contractual forms

·         Financial infrastructures deficiency

Key Issues In Islamic Liquidity Management

·         Under-developed Islamic inter-bank market

·         Slow development in Islamic financial instruments

·         Absence of Islamic secondary market

·         Small number of participants

·         Different Shariah interpretation

·         No ‘lender of last resort’

Islamic Inter-bank market

Most of deposit liabilities of Islamic bank are very short-term in nature while they invested long-term, and Islamic banks cannot borrow at interest to meet unexpected withdrawal from their depositors. Thus, it is difficult for Islamic bank to run mismatched asset and liability portfolios.

Liquidity Problems

·         Liquidity management tools that are flexible and Shariah compliant are limited

·         Although sukuk can be traded, most are held to maturity

·         Many Islamic banks place their surplus funds with western banks through murabahah trading on the London Metal Exchange.

(Note: in handling liquidity problem, often the managers of Islamic financial institutions resort to one or more of the following options:

                                i.            Refuse to take interest-based instrument

                              ii.            Accept interest-based option on the basis of ‘darurah’ and use it for charitable purposes

                            iii.            Rely on some debt-like modes, especially mark-up to ensure a certain degree of liquidity)

Implication for Islamic Banks

·         Under-utilization of financial resources

·         Lower income and higher cost

·         Loss of competitiveness

Liquidity Crunch (Examples)

Can be a serious problem to national banking industry

·         Financial crisis in Indonesia (1997-1998) and Turkey in 2000-2001

o   “Ikhlas Finance” was closed during the crisis

o   More than 70 commercial banks in Indonesia were closed down

Current Practices in Managing Excess Liquidity

·         Short term liquidity instruments

·         Various type of sukuk

·         Secured financing portfolios

·         Infrastructure institutions:

o   Liquidity Management Center

o   International Islamic Financial Market (IIFM)

Short-Term Liquidity Instruments

Inter-bank investment scheme	Mudharabah
Government Investment Certificate	Qard al-Hasan
Wadiah Acceptance	Unconditional Hibah
Al-Rahnu Agreement	Qard Al-Hasan
Various types of Sukuk	Mudharabah Musharakah Ijarah Murabahah Salam Istisna’
Tawarruq-based instrument	Bay’ al-Tawarruq
Central Bank Negotiable Notes	Bay’ Al-Inah
Negotiable Islamic Debt Certificates	Bay’ Al-Inah
Sell and buy back Agreement	Bay’ Al-Inah
Islamic Accepted Bills	Bay’ Al-Inah

Mudharabah Inter-Bank Investment (MII) Scheme

·         MII refers to a mechanism whereby a deficit Islamic bank (investee bank) can obtain investment from a surplus Islamic banking institution (investor bank) based on mudharabah (profit sharing).

·         The period of investment is from overnight to 12 months, while the rate of return is based on the rate of gross profit before distribution for investment of 1 year of the investee bank.

·         Profit sharing ratio is negotiable among both parties.

Central Bank Wadiah Acceptance or Certificate

·         A transaction between the central bank and Islamic banking Institutions

·         It refers to a mechanism whereby the Islamic banking institutions place their surplus fund with the central bank based on the concept of wadiah

·         Under this concept, the acceptor of funds is viewed as the custodian for the funds and there is no obligation on the part of the custodian to pay any return on the account

·         However, if there is any dividend paid by the custodian, it is perceived as hibah (gift)

Secured Commodity Murabahah Scheme

·         Advantages

o   Secured commodity murabahah is short-term in nature, therefore, liquid.

o   The buying and selling transaction is done in the same currency (usually USD), therefore, no foreign exchange risk.

·         Problems

o   Flow of funds away from Muslim economies

o   Not contributing in any growth or development oriented economic activity

o   Limited scope for liquidity management: since transactions are mostly bilateral, therefore, counterparty limits apply.

o   Always ‘back-to-back’ murabahah is needed for maintaining liquidity.

Salam Sukuk

·         Similar to secured commodity murabahah but securitized

·         Advantages

o   Cost prices need not be declared

o   Lower credit risk to bank due to sovereign counterparty

o   Lower cost (or higher return) to bank than in secured commodity murabahah due to securitization

o   Funds utilized in the local economy until very near to delivery date

·         Disadvantage

o   Not tradable therefore high liquidity risk