Islamic banking – managing liquidity risk

Yesterday saw the opening of the UK’s first Islamic bank. In this article Abdul Jabbar Karimi explores one specific risk issue which such banks face.

The value of cash as a strategic asset is now fully recognised by company boards and the analyst community, bringing effective liquidity management to the top of the agenda at many multinationals. This fact, combined with increasing opportunities in previously challenging markets, makes it worthwhile for the treasurer to re-assess the possibilities for liquidity management in all geographies where the company operates.

In a conventional banking system, the treasury has to manage the bank’s cash flow to maximise the profit generating potential of the front lines, and to protect the balance sheet and P&L statement from erosion due to market risk. To achieve this all current and future cash flows are to be identified and priced at market levels. The excess liquidity is to be managed through mainly four ways;
(1) Lending the surplus in the inter-bank network,
(2) Invest in government securities,
(3) Lend to corporate customers,
(4) Keep the excess funds at 0 percent return. The first three ways involve interest and Islamic Banks cannot utilise these options.

From a liquidity management perspective, Islamic banking have to come a long way. Today, many more multinational companies (MNCs) are exploring the potential to optimise their liquidity across the globe and are making useful improvements in the management of their day-to-day liquidity problems.

The obstacles for Islamic banking
Liquidity risk encompasses risks arising out of gaps in applications and available resources, mismatching of tenors of sources, and application of funds, not meeting prudential liquidity requirements, lack of access to the market etc.

For this, the conventional bank’s treasuries used to place the excess funds overnight in money market but the Islamic banks cannot do this because of Shariah constraints.

Surplus liquidity with Islamic banks cannot be easily transferred to conventional banks since the Islamic banks do not accept interest, however there is room for exchange of surplus funds among the Islamic banks on a Mudarabah / Musharakah basis. The greater the number of Islamic banks and wider their activities, the greater will be the scope of cooperation in this field.

In general, to manage liquidity effectively, you need visibility of your cash positions, good forecasting, a way to concentrate your funds, and the ability to negotiate FX and get it done before cut-off times. The challenges, with liquidity management in Islamic Banks, are not just regulatory ones.

It may currently be difficult to manage the excess liquidity but it will soon be possible. In recent times a Bahrain based organization IIFM – International Islamic Financial Market (IIFM) has been established by Islamic Development Bank (IDB)– Saudi Arabia, Bahrain Monetary Agency (BMA), Bank Indonesia-Indonesia, Bank of Sudan-Sudan, Bank Negara Malaysia –Malaysia, Ministry of Finance –Brunei Darussalam. IIFM is trying to make a liquidity management structure for Islamic banks / divisions available through its network.

Investments will be made in equity or mutual funds and in any Shariah compliant Islamic product available in the market at that particular time or to invest the excess funds with other Islamic banks. An ‘Islamic Collective Investment Scheme’ can then be introduced to collectively manage the problem of excess liquidity. This follows the example already set by some of the Islamic banks in Bahrain. Examples are Al Amin Bank and ABC Islamic Bank.

Bank Negara Malaysia has developed the Shariah-compatible inter-bank investment facility to address the issue of access through ‘lender of last resort’ (LOLR) to good extent. Islamic financial institutions may obtain short-term funds from one another on the basis of PLS arrangements. Operations in central bank and government paper, once developed, would greatly facilitate the use of LOLR arrangements. [1]

An Islamic financial market if established, will help to accomplish the mission and overcome the problem of liquidity management by participating through the respective Islamic modes.

[1] IMF, V. Sundararajan & Luca Errrico, working paper: ‘Islamic Financial Institutions & Products in the Global Financial System….

Author: Abdul Jabbar Karimi, Islamic Banking Division, Metropolitan Bank Ltd. Karachi-Pakistan karimi_aj@metrobank.com.pk

•Date: 23rd Sept 2004 •Region: UK/Various •Type: Article •Topic: Financial sector
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