Market review following recent banking system stress
The failure of two mid-sized lenders in the US, Silicon Valley Bank (SVB) and Signature Bank, as well as the financial problem faced by European banking giant, Credit Suisse Group, in March 2023 and the rescue of First Republic Bank bought over by JP Morgan in April 2023 triggered a sell off of US regional banks shares and have shocked financial market participants all around the world and introduced a new sense of caution about global financial stability and growth prospects.
Financial conditions tightened after the stress episodes in the banking sector weighed heavily on bank stocks and funding spreads. In the days after SVB’s failure, stock market volatility surged, credit spreads widened, and strains were apparent in interbank funding markets. These moves have partly retracted in subsequent weeks, although interbank funding spreads remain wide and volatile.
As reflected in the Bloomberg US Treasury Liquidity Index, significantly higher interest rates and heightened uncertainties surrounding inflation and economic output prospects have made the US Treasury liquidity worse. Bid-ask spreads in the US Treasury markets also widened as traders have demanded larger liquidity premiums to trade US Treasury.
US authorities immediately launched emergency measures on the 12th March to shore up confidence in the banking system. Two-thirds of the quantitative tightening done by the Federal Reserve (Fed) since a year ago to fight inflation have now been erased in less than two weeks. The Fed also made additional funding available through a new Bank Term Funding Program, which offer loans of up to one year to depository institutions, backed by Treasuries and other assets. As of mid-March 2023, US banks took around US$150 billion from the discount window facility and US$11.9 billion in loans from the Fed’s newly created Bank Term Lending Program. The discount window jump crashed through the prior record of US$112 billion in the fall of 2008, during the most acute phase of the financial crisis.
To protect depositors, a US government corporation that oversees the banking industry, the Federal Deposit Insurance Corporation, took over First Republic Bank initially and invited several lenders to buy First Republic, with JPMorgan Chase ultimately sealing the deal on the 13th April 2023.
In addition to these market uncertainties volatilities, the OPEC and its allies, mainly Russia (OPEC+), surprisingly announced oil production cuts from May until the end of 2023. Oil prices have surged around 6% after the oil cut announcement.
Furthermore, the US government’s efforts to raise the US$31.4 trillion debt ceiling has also sent fears that the deadline to raise the borrowing limit may come sooner than expected. As a consequence, the insurance cost against a US default hit a fresh high in early May as lawmakers wrangle over raising the debt ceiling. One-year US government credit default swap traded at 177bps on 1st May 2023, reaching highest levels since 2008.
The fallout from the recent banking crisis is increasing the probability of recession for the US economy in 2023 amid relatively high global uncertainties. However, the latest US inflation and job market data from mid-April sparked some optimism from market participants which could lead to a soft-landing scenario instead of a recession. Market uncertainty remains high, and it is quite difficult to predict the impact of the Fed’s monetary policy on the real economy. Nonetheless, the base line scenario expected by market experts is that the Fed will need to cut its benchmark rate before the year end.
Middle East’s economic prospects
Amid high global uncertainties with some countries expected to experience a recession, the Middle East stands out as a global outlier. In 2022, the good performance of the Middle Eastern economy was a result of the highly effective response the region offered to the pandemic, which set the foundation for the subsequent rapid recovery in economic activities.
Thereafter, the outlook further improved as surging energy prices triggered a transfer of wealth and purchasing power from energy-consuming markets to regional producer nations. Fiscal pressures have materially eased higher energy receipts, non-oil revenue strategies as well as spending rationalization measures.
This has been reflected in a favorable rating environment observed only in the Middle East with the upgrade of sovereigns and government-related entities (ie Saudi Arabia, Qatar, Oman). Additionally, some Middle Eastern countries have benefited from strong liquidity supported from high oil prices in 2022 (2022: US$100/barrel; 2023F US$85/barrel as per Fitch Ratings forecast) which remains higher than the fiscal breakeven observed in the GCC and will continue to remain high after cuts announced by OPEC+ members.
Market impact on IILM Sukuk performance
The track record and robustness of the IILM Sukuk program have been seen from its significant qualitative and quantitative expansion so far, with a total cumulative issuance of US$92.95 billion through 210 short-term high quality Islamic instruments since its inaugural Sukuk issuance in 2013. Other notable achievements include the IILM diversifying the supply of Shariah compliant instruments with regular monthly issuances of multiple tenors (one-, three-, six- and 12-month) to address the demand; securing high short-term credit ratings from Fitch (‘F1’) and S&P (‘A-1’); introducing a pricing discovery process in 2020 through competitive bidding auctions on Bloomberg, allowing higher transparency and market efficiency for participants; and setting an active global secondary market activity with US$2.2 billion traded in 2022.
Since the beginning of the year until May, the total US dollar Sukuk volume issued stood at US$17 billion. The 15 IILM Sukuk issued amounted to US$4.35 billion and represented 26% of the total volume of US dollar Sukuk issued globally.
The performance of IILM Sukuk in the secondary market has been continuously improving over the years. The total value of traded IILM Sukuk surged by 43% to US$2.23 billion in 2022, compared with US$1.55 billion traded in 2021. This improvement in the secondary market reflects the growing acceptance of IILM Sukuk in the market, not only because of their high asset quality but also due to a constant high tangibility ratio (79%) and wider investor distribution over the last 10 years.
IILM’s performance since Fed monetary policies
From March 2022 to March 2023, the Federal Open Market Committee raised its key interest rate by 475 basis points in its pursuit to curtail inflation, bringing the Fed funds rate to 4.75% to 5%. In this tightening environment, the IILM has been performing well, as the spreads paid over the US LIBOR rates have tightened, touching negative spreads across all tenors for the first time in April and May auctions including reaching a double-digit negative spread for six-month in the third consecutive month supported by a higher investor appetite. As witnessed in the recent auctions, a lot of bids were received from new and returning investors as reflected by the average bid-to-cover ratio of 210% in the first five months of 2023 vs 147% during the same period of last year.
The overall blended weighted average spread above US LIBOR rates stands at a negative spread, -6.9bps year-to-date (YTD) in 2023 vs ~14bps in 2022 over the same period due to the tight pricing across all tenors.
In line with the uptick in global benchmark rates due to the continued tightening monetary policy by the Fed, the IILM yield curve relatively flattened in 2023 YTD. The one-month tenor profit rate continues its upward trend in line with the rising benchmark rates as well as higher interbank rates triggered by the banking sector stress. Meanwhile, the profit rate for the longer end is moving lower resulting from deteriorating global economic prospects.
Further restrictive stance from the Fed and banking sector distress could lead to higher IILM cost of funding. On the other side, the rising yield environment would continue to enhance the investor base of the IILM by attracting investors mainly from the Middle East and Asia with yield pick-up appetite. There is a significant increase from Türkiye as its buyer distribution portion reached 31% YTD in 2023 on the secondary market and 12% on the primary market while Malaysia’s allocation has dropped. Islamic investors remain the main recipients of the IILM Sukuk over time.
Key challenges within the Islamic liquidity management space
In line with the IILM’s goal to promote the stability of the Islamic finance industry by facilitating cross-border liquidity management, several challenges have been identified including the relatively small number of Islamic Investors globally, a limited demand for Shariah compliant instruments from conventional investors, the limited availability of short-term liquidity instruments in local and non-US dollar currencies, a lack of medium-term Shariah compliant instruments (one to five-year tenors) in the market (despite some issuances this year ie the two-year Saudi National Bank Sukuk and three-year Egypt Sukuk), as well as the need to develop a deep and active Islamic repo market with the use of Sukuk, and limited green project availability as the underlying of green Sukuk issuances.
The IILM also identified that the lack of standardization in the treatment of high-quality liquid assets of the few available short-term instruments and the buy-and-hold strategy for long-term Sukuk also impede secondary market trading. Addressing these challenges is crucial for Islamic financial institutions to manage their liquidity more effectively and efficiently.