The implementation of Basel III will result in many Islamic banks having to hold more liquidity in line with their monthly deposit run-offs. There have been important initiatives to provide suitable Shariah compliant liquid instruments, including the path-breaking establishment of the Malaysian Islamic interbank money market.
Individual Islamic banks have also sought their own solutions, with most recently Kuwait Finance House establishing a liquidity house to manage their treasury assets.
A major challenge is to provide treasury facilities in multiple currencies, especially with the decline of the US dollar as the world’s reserve currency. Only a small proportion of Sukuk are now dollar-denominated.
It is even more important is to ensure treasury instruments have Islamic credibility. Merely designating returns as profit rates rather than interest is insufficient, especially if it is unclear how the profit rate is determined.
For treasury bills, returns could be linked to gross domestic product or gross national product growth, resulting in risk sharing between investors and governments. There is much scope for innovative solutions.
RODNEY WILSON
Emeritus Professor, Durham University UK
Islamic banks face two main obstacles when managing the liquidity they need to hold in their treasury.
Firstly, Shariah scholars sometimes disapprove of the instruments used to manage liquidity. For example, in the case of The Investment Dar Company (TID) v Blom Developments Bank (BDB), the bank BDB had placed deposits with TID using Wakalah contracts intended to give BDB a fixed return. TID’s Shariah board initially approved the contracts, but later decided they were not Shariah compliant.
Similarly the main instrument most banks used to manage liquidity is the commodity Murabahah or Tawarruq contract, but the OIC Fiqh Academy ruled in 2009 that the normal form of the contract is not Shariah compliant. Its use has continued in the absence of suitable alternatives.
Secondly, apart from inter-bank deposits structured using Shariah compliant contracts, there are few other instruments available to Islamic banks.
Ideally the sovereign authority where the Islamic bank is located would issue short-term Sukuk, (similar to conventional treasury bills issued by the governments of the US or the UK) for banks to hold in treasury.
The International Islamic Liquidity Management Corporation was set up in October 2010 to fill this gap by issuing high quality short-term Shariah compliant investible instruments, but so far little seems to have happened since its formation was announced.
MOHAMMED AMIN
Islamic finance consultant and former UK head of Islamic finance at PwC
The challenges with treasury requirements in Islamic banks are due to a number of factors. Due to their relatively small balance sheet size and lack of credit ratings they cannot attract large deposits from other banks nor place large deposits with other Islamic banks.
In addition, regulatory requirements play a significant role, in particular in countries where Islamic finance is a relatively new phenomenon. Sukuk, which would be a logical treasury instrument, are often not rated high enough, are relatively short-dated and typically for small amounts, which makes them less attractive.
Finally, instruments such as profit rate swaps are, although increasing, still not generally accepted. The lack of standardization of treasury instruments is an additional hindrance.
DR NATALIE SCHOON
Principal consultant, Formabb
Treasury departments at Islamic banks have several roles:
Managing cash flow — The commodity Murabahah (or Wakalah) market is reasonably well organized, pricing is quite transparent and is suitable for short-term liquidity management. It would be useful for treasurers to have access to slightly more sophisticated products for mid-term liquidity management, such as liquidity funds — these can invest in Sukuk instruments as well as having residual cash elements.
If well managed, these can provide a superior return compared to interbank placements with a more diversified risk profile.
Managing investments — This includes assessing the risk as well as the profitability of the banks’ shorter term investments. Risk associated with interbank placements can be assessed with reference to the relevant credit rating of the banks involved. For investments, assessing risk can be more challenging.
As mentioned above, liquidity funds that have investment criteria (e.g. Sukuk investments should have a minimum rating of ‘AA’) help to assess the risk associated with such funds. The profitability of liquidity flows is easy to assess as they are all priced at interest.
Risk management — Profit rate swaps are quite widely available and pricing can easily be compared to conventional interest rate swaps for transparency (as they are essentially the same product).
Foreign exchange hedging (options, forwards, swaps) again are available in the markets, though the depth of such markets may not be clear at this time.
As with all transactions, especially with treasury deals which tend to occur with more frequency and with a wider number of counterparts, ease of execution of deals is most important. This largely revolves around documentation, which historically has been developed on a bespoke basis depending on the product provider in the markets.
Attempts by the International Islamic Financial Market and the International Swaps and Derivatives Association to streamline this process have been welcome and it is hoped market uptake continues to aid ease of execution.
Linked to this, Shariah approval is again a factor, as it tends to be with most Islamic products. A factor not so much in terms of being sure whether a product is Shariah compliant or not, but a factor in that coordination amongst different scholars and Shariah boards is still an issue in terms of efficiency, especially with regards to negotiation of agreements and cross-border flows.
SAFDAR ALAM
CEO, Siyam Capital