Islamic banks across the globe, particularly in the GCC, are sitting on a whole lot of cash. However, aside from Saudi Arabia, many banks in GCC countries such as Kuwait are forced to export their cash as a means to create equilibrium on their balance sheets. NAZNEEN HALIM explores the question of liquidity management in the Middle East.
Perhaps it is both a blessing and a curse that Islamic banks are more liquid than their conventional counterparts in terms of deposits and cold hard cash. In a recent report, it was revealed that Islamic banks are on average 38% more liquid than conventional banks in terms of liquid assets as a percentage of deposits and short-term funds. However, their lower loan-to-deposit ratio indicates that Islamic banks are not generating sufficient financings and loans from their deposit bases; and a generally lower interbank ratio is also evidence of the inability of Islamic banks to deploy their excess liquid assets into loans to other banks, due to an under-developed Islamic interbank money market. In other words, there are currently more Shariah investors who want to place money in Islamic banks than there are instruments that can efficiently transfer the money to the asset side of the bank’s balance sheet.
And despite liquidity management being the crux of any robust financial system, it is ironic that the Islamic finance industry is sorely lacking in this department. “There are no cross-border liquidity products existing today which are truly Shariah compliant. Without liquidity instruments, you cannot have a healthy and systemically safe financial system. Liquidity is indispensable; and it is a significant shackling for the Islamic financial system to not have liquidity instruments that are cross-border in nature. We need cross-border products because financial institutions are globally linked, and the demand for this is enormous,” revealed Hooman Sabeti, a partner at Allen & Overy.
According to a 2009 report by the International Islamic Financial Markets (IIFM) on liquidity management, a typical balance sheet of an Islamic financial institution in the GCC shows a higher asset-to-liability ratio, with more short-term instruments compared to long-term issuances such as Ijarah investments and Mudarabah receivables. Recognizing this, jurisdictions have rolled out short-term Sukuk programs; such as Bahrain’s program started in 2001 via the Central Bank of Bahrain. However, across the board, most Islamic banks have not been successful in addressing the main arena of liquidity management: the very short-term or overnight segments.
Most Islamic banks in the Middle East are currently facing an asset-liability gap, with a shortage of long-dated assets that align with the long-term nature of the investments, and vice versa. An industry player explained: “While the banks’ main investments are long-term such as in Sukuk or project financing, their main funding source is short-term; from customer deposits. The result is a maturity mismatch. With a shortage of longer-dated assets and interbank liquidity, the industry faces the challenge of creating an infrastructure that could support liquidity management strategies and capture the opportunity provided by the Islamic finance sector’s large capital pools. There is now a growing focus across the industry to facilitate greater interaction and linkages among Islamic financial institutions to boost cross-border Islamic liquidity management.”
Standardization woes
In almost every aspect of Islamic finance there is a call for standardization: be it on the regulatory front, Shariah auditing, capital markets or corporate governance. Unsurprisingly therefore, liquidity management is also experiencing calls for consistency. As banks are becoming more globally linked, and Middle East investors are increasingly curious about the emerging markets of Southeast Asia, industry players are beginning to recognize the growing need for standardization in a bid to create a global interbank money market, facilitate investments and allow fluid cross-border transactions.
Even on the domestic front, GCC bankers admit that there is hardly any interbank money market movement to allow for greater investment opportunities and disbursement of the liquidity sitting in their coffers. “Why is it that the legal and regulatory requirements are still unavailable to institutions looking to establish a Shariah compliant platform, while this is so easily done in conventional banking? We need proper planning from the start to enable domestic and cross-border liquidity management. Currently there are no proper instruments to manage internal liquidity. There has to be proper structures put in place; and this needs to be driven by the regulators and private sectors together,” an industry player revealed.
There are currently more than 25 liquidity management instruments available globally, but more than 70% are commodity Murabahah based. “Except in Sudan and Iran where there is no commodity Murabahah, the main instruments for liquidity management are based on this concept,” explained Dr Aznan Hassan, a Shariah scholar and assistant professor at the International Islamic University Malaysia. “Even the recently issued certificate of deposits in the UAE, which are forecasted to attract more than US$2.7 billion in investments, are based on commodity Murabahah. It is easy to utilize commodity Murabahah, but we are also replicating conventional money market instruments, and you cannot liquidate when you want to. Even though some scholars have suggested the use of Bai Al Dayn, there is still some cost incurred,” he added.
A GCC-based investment manager revealed that there is definitely demand for liquidity management products, particularly amongst the Islamic client base. “One of the things they would like to see is an instrument that is flexible and allows them customization to be compliant with their Shariah board, as well as deal documents that can accommodate regulatory issues in the jurisdictions that we serve. Our clients are interested in dealing in highly rated, highly qualified, very strong financial institutions,” he said.
Recognizing the need for standardization in the liquidity management sector, bodies such as the IIFM and IFSB have produced documents intended to offer guidance for regulators and market players alike. The recently drafted IFSB Guideline for Liquidity Risk Management also reveals a pressing need for Islamic banks to get their act together to be able to conform with the Basel III requirement standards. “The IFSB makes a full acknowledgement of the international efforts to make regulatory reforms at a broader level, including the major areas of concern such as capital adequacy and liquidity risk. This set of guiding principles complements various international publications related to liquidity risk management – many of which were revised following the financial crisis – issued by, inter alia, the Basel Committee on Banking Supervision, the Committee for European Banking Supervisors and the International Organization of Securities Commissions.
“Most importantly, the initiative by the Basel Committee to develop two international liquidity standards as part of a global regulatory toolkit is a significant development in this respect. The IFSB is working on the preparation of a separate Guidance Note on quantitative tools for the measurement and monitoring of liquidity risk in Islamic financial institutions, in line with industry practices and other global initiatives; including the Basel III liquidity standards.”
IIFM’s Master Agreement for Treasury Placement also intends to streamline the sector by including solutions based on widely accepted Shariah rulings, to reduce transaction costs and to improve documentation standards and mitigating legal hiccups. The establishment of the International Islamic Liquidity Management Corporation (IILM), by the IFSB in late 2010 also aims to facilitate more efficient and effective global liquidity management solutions for Islamic financial institutions and facilitate greater cross-border investment flows via the issuance of Shariah compliant instruments.
Regulatory power
However, despite the concerted efforts among Islamic banking players and standard-setting bodies, it ultimately comes down to jurisdictional legal issues and regulatory requirements. In most Islamic countries, industry players admit that the engagement of central banks is still minimal, and these institutions mainly engage in monetary policy and do not address liquidity shortages pertaining to the lack of a lender of last resort for the Islamic finance industry.
There is evidently the need for a stronger form of liquidity management agreement between all financial centers; or at least between the Islamic countries and IFSB members; and ultimately the protagonists in this scenario are the regulators and governments. With the right amount of impetus from the industry, there is no doubt that these regulators will begin to take heed.