Lecture 6 Liquidity Risk and Management
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Transcript of Lecture 6 Liquidity Risk and Management
8/9/2019 Lecture 6 Liquidity Risk and Management
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LIQUIDITY RISK &LIQUIDITY MANAGEMENT
in Islamic BanksSalman Syed Ali
Current Issues in Islamic Finance Lecture 6
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Lecture Plan Part-I
LIQUIDITY
SHORTAGE (Risk) Sources of risk
Implications for Bankand the System
Current practices of mitigation
Recommendationsand the Future
Part-II
EXCESS LIQUIDITY
(Low ret.) Causes
Implications for Bankand the System
Current practices of itsmanagement
Recommendationsand Future
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Key References Abdul Majid, Abdul Rais. 2003. ³Development Of Liquidity
Management Instruments: Challenges And Opportunities´,paper presented in International Conference on IslamicBanking: Risk Management, Regulation and Supervision,
Jakarta ±Indonesia, Sept 30- to October 3, 2003. Ali, Salman Syed. 2004. ³Islamic Modes of Finance and
Associated Liquidity Risks´ presented in Conference onMonetary Sector in Iran: Structure, Performance andChallenging Issues´, Tehran, February 2004.
Shihadeh, Musa A. 2003. ³Loss Provisioning in Islamic Banks:
Jordan Islamic Bank Case Study´, paper presented inInternational Conference on Islamic Banking: RiskManagement, Regulation and Supervision held in Jakarta-Indonesia. Jointly organized by Bank Indonesia and IRTI,October 2003.
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Dry Climate
Liquidity ShortageAssassin of banks
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Flood Excess Liquidity: A drag on competition
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Stability and Solvency of IBs In theory, Islamic
banks are likely to
be more stable They have profit
sharing on both theliability side and
asset side
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In practice, IslamicBanks have fixed
income assets buthave profit sharing onliability side.
The IBs therefore, arestill more stable than
conventional banks. Solvent
Asset tied finance
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While a majority of Islamic banks haveexcess liquidity
Some Islamic banks have facedliquidity crisis
Many different risks culminate in
liquidity risk
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Liquidity crunch can be a real
problem Example of Financial Crisis in Turkey2000-2001
Islamic financial institutions therefaced sever liquidity problems
One Islamic institution Ihlas Finans
was closed during the crisis
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LIQUIDITY RISK: Definition
Risk of Funding [at appropriatematurities and rates]
Risk of Liquidating Assets [in time atreasonable prices]
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Investment Firm¶s Definition ³liquidity risk includes both the risk of
being unable to fund [its] portfolio of
assets at appropriate maturities andrates and the risk of being unable toliquidate a position in a timely manner
at reasonable prices.´ *
* J.P. Morgan Chase (2000).
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Regulators Definition
³risk to a bank¶s earnings and capitalarising from its inability to timely meetobligations when they come duewithout incurring unacceptable
losses.´*
* Office of the Comptroller (2000)
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Analysis and Diagnosis of
Causes
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LIQUIDITY RISK: Sources 1. Incorrect judgment and complacency 2. Unanticipated change in cost of capital
3. Abnormal behavior of financial markets 4. Range of assumptions used 5. Risk activation by secondary sources 6. Break down of payments system
7. Macroeconomic imbalances 8. Contractual forms 9. Financial Infrastructure deficiency
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Liquidity Risk & Contractual
Forms Profit Sharing Contracts
Murabaha
Salam
Istisna
Ijarah
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Resale not permitted
Resale permitted but non-existentmarket
Market exists but not active
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Example of LR in MurabahaPrimary LR Secondary LR
Receivables are debtcannot be sold Involves buying of commodity then sellingon deferred payment
This brings in many
operational, credit,dispute, and legal risksthat can affectrealization of
receivables
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LR:Current Practices of control Deposit Management
Choice of Mode of Finance
Maturity Matching and Gap Analysis
Mixing of Deposits
Reserves and Provisions
Deposit Insurance Interbank Dealings
Ijarah and Salam Sukuks
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(a) Reserves and Provisions: Provisions
Specific
General
Reserves
Profit EqualizationReserve
Investment RiskReserve
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(b) Problems: Fiqh issue of justice: inter-temporal
/interpersonal transfers
Breaks the link between bank performanceand its reflection in profits
Possibility of manipulation to hide losses
Transfer of resources from shareholders to
investment account holders (displacedcommercial risk)
Loosen the asset and liability tie in IBs.
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(c) Remedies for Transparency: Well defined, consistent and
transparent method of provision and
reserve calculation Improved corporate governance
Reveal ex-ante estimates and ex-post
actual losses Reveal the position and changes in the
PE Reserve and IR Reserve
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Conclusions
What is needed
What can be done
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Conclusions (contd.) Development of liquidity management
instruments
Development of Infrastructureinstitutions (LMC, IIFM)
Rethinking and development of new
structure of Islamic banks (Separatetreatment of Cur. and Inv. accounts)
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Smooth Sailing
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Excess Liquidity
State, Causes andManagement
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Current state of liquidity in IslamicBanks
Excess Liquidity in the Market, resulting in seriousbusiness risk and affects the competitiveness of IFIs due to no return or a very low returns.
In a recent study it was discovered that Islamicfinancial institutions are almost 50% more liquid ascompared to conventional financial institutions.
Out of US$ 13.6 billion total assets of Islamic banksin the study US$ 6.3 billion were found to be inliquid assets.
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Causes of Excess Liquidity
Factors internal to the bank
Factors external to the bank
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Islamic Banks¶ Asset Portfolio
Shirakah
Ijarah
Salam
Istisna¶
Murabaha
Mudharba
IBPortfolio
67%5%
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Islamic Banks¶ Assets Portfolio
67%
6%
5%
7%
15%
murabahah
musharakah
mudarabah
ijara
others
Source: Iqbal Munawar, Ausaf Ahmad and Tariqullah Khan (1998), Challenges Facing Islamic
Banking , Jeddah: IRTI
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Key Issues inLiquidity
Management
Small No. of participants
No Islamic Inter-bank Market
SlowDevelopment
InIslamicfinancialInstruments
Absence of
Islamic Secondarymarket
No Lender of Last
Resort
Different Shari¶ainterpretation
Key Issues in Liquidity Management
Credit for this diagram: IIFM
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Implications for Islamic Banks
Underutilization of financial resources
Lower income and higher cost
Loss of competitiveness
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Current Practices in ManagingExcess Liquidity
Deposit Management
Secured Commodity Murabaha
Mudaraba Sukuk Salam Sukuk
Leasing Sukuk
Musharakah Sukuk
Infrastructure Institutions Liquidity Management Center
IIFM
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Islamic Bank / Investor (Principal)
Broker
µB¶
Broker µA¶
ConventionalBank
(Agent)
Buy
Pay (Spot)
Receive(Sales proceeds at maturity)
Receive funds from Investor (to pay Broker µA¶)
Sell(at a profit & deferred payment)
Settle Investor
(Sales proceeds less Agents fees)
Funds Flow
Commodity Flow
How a Secured Commodity Murabaha Works:
Credit for the diagram: IIFM
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Advantage of SCM
Short-term therefore liquid
Buying and selling in same currency(usually US$) therefore no FX risk
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Problems with SCM
Flow of funds away from Muslim economies
Not contributing in any growth or
development oriented economic activity Limited scope for liquidity management:
since transactions are mostly bilateraltherefore counterparty limits apply
Always back to back murabaha is neededfor maintaining liquidity
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Salam Sukuk (Ex. of Bahrain)
Gov of Bahrain (GoB) undertakes to sell Aluminum (deferred) for advance payment
BMA securitizes it by issuing salam sukuk Individual IBs buy these to park their excess
liquidity
IBs appoint GoB as their agent to receivedelivery of commodity and sell it through itsdistribution channels
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Salam Sukuk (contd.)
Similar to SCM but securitized Advantages:
Cost price need not be declared Lower credit risk to bank due to sovereign
counter-party Lower cost (or higher return) to bank than in
SCM due to securitization Funds utilized in the local economy until very
near to delivery date
Disadvantage: Not trade-able therefore high liquidity risk
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Bahrain Salam Sukuk (contd.)
Countr y
Issuer Type Value Maturity
Bahrain BahrainMonetaryAgency
SukukAl Salam(23issuesup to
April2003)
US$ 625Million(cumulative)*
91 daysfor eachissue
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Structure of Malaysian Sukuk
Credit for this slide: BMA presentation, Feb.,2004
.
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Other sukuk and trade-able securitiesuseful for liquidity management
Gov. Participation Certificates (Sudan)
Central Bank Participation Certificates
(Sudan) Malaysian Global Ijarah Sukuk [US$500M]
First Global Sukuk Malaysia [US$150M]
Qatar Global Ijarah Sukuk [US$700M]
IDB Sukuk [US$400M] Tabreed Global Ijarah Sukuk (Corporate)
[US$150M]
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LM Infrastructure Institutions
OutputCountry
Membership
IIFM
yFacilitation in issuance of sukuk of Bahrain and Malaysia 6 founding members
LMC yPart of IIFM efforts.yFacilitated cross listing of Bahrainand Malaysian sukuk
6 members
IsDB yMother/Umbrella organizationyDevelopment financeyResearch
54 countries
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New Ideas: Good & Bad