Novel liquidity instruments need of the hour for Islamic financial institutions
This article was originally published in Islamic Finance News.
Islamic finance is still a relatively small part of the broader financial services industry. Compared to the conventional industry, Islamic finance lacks adequate liquidity instruments as Shariah restrictions limit the number of instruments that could be used for liquidity management. Islamic interbank and money markets also lack the volume and diversification of conventional markets leading to a sectoral disadvantage from the outset.
Review of 2018
Since 2015, there has been a reduction of liquidity in the banking systems in the Middle Eastern region, mainly due to reduced deposit inflows because of low oil prices and a high dependence on deposits from governments and their related entities. This situation has improved in 2018 after oil prices stabilized and governments issued large bonds and injected liquidity locally. However, the dearth of Islamic liquidity management instruments has been a challenge in Islamic banking ever since its inception. The instruments that meet both the industry’s needs and the stakeholders’ expectations are relatively few. The excess liquidity of Islamic banks limit their profitability potential and therefore their long-term viability, it also dampens the effect of monetary policy interventions in the financial markets by central banks.
The onset of Basel III liquidity coverage requirements is likely to exacerbate the problem as Islamic banks will need to maintain high quality short-term liquid assets. As a result, Islamic banks, which are concentrated in the Middle East, hold 8.8% of their assets in cash and equivalents and 9.8% of their assets in placements at other financial institutions. Currently, Islamic banks place liquid funds through short-term instruments such as commodity Murabahah that are non-tradable on secondary markets — Shariah rules prohibit trading on receivables. Moreover, stakeholders typically view these inflexible instruments as artificial replications of interest based transactions. Alternative instruments are gauged against three criteria: whether they are as cost-effective as commodity Murabahah, whether they offer the same or enhanced flexibility and liquidity, and whether they offer sufficient scale to meet the current and anticipated future needs.
Preview of 2019
New strategies to meet the liquidity management needs of Islamic banks and Islamic windows at conventional banks are being developed. These products — including National Bonds’ Sukuk Trading Platform addresses both the operational needs of Islamic banks and preferences of their customers and external stakeholders. In liquidity management, it has the potential to be both flexible and authentic, offering an investment destination for surplus funds or a tool with which financial institutions and central banks can look to as a model for providing liquidity to banks when needed. Islamic banks will shift toward Islamic liquidity management instruments that increase their ability to place more of their surplus liquidity with other banks or with the central bank.
Closer integration may also lead to increasing Sukuk issuance, which could reduce Takaful operators’ exposure to riskier real estate and equities investments or help banks manage their liquidity. Sukuk could also provide investment funds with additional fixed-income revenue, and encourage a shift toward more profit-and-loss sharing instruments. In addition, Islamic banks could start offering Takaful products more systematically if the relevant regulation is in place.
Standalone Islamic banks will have to look to government Islamic T-bills, or other instruments to place most of their surplus liquidity. Some of the remainder will be held on balance sheets as cash in order to manage unexpected shocks because of a smaller set of central bank instruments. A portion of the assets they hold today as cash will be shifted to interbank placements in order to generate yields. However, given the cyclicality of excess liquidity in GCC banks, there will probably be a continued reliance on commodity Murabahah, which amounts to an effective outsourcing of some of the cash management responsibilities at Islamic banks to Islamic windows, which have a deeper set of options and more access to international liquidity management instruments.
Islamic liquidity management instruments are still at their infancy, and the main challenge is in providing liquidity management tools that can compete with conventional ones. Therefore, Islamic financial institutions should invest more in product development. In particular, as Islamic finance grows, the problem of liquidity will grow bigger, as central bank support would become expensive particularly for larger institutions.
Although a variety of approaches have been adopted in different jurisdictions, much work remains to be done to diversify the mix of available options for Islamic banks to manage their short to medium-term liquidity. Further, the divergence in Shariah interpretations across different jurisdictions has so far stifled a truly global approach toward tackling this issue. In this regard, the setting up of organizations providing Shariah standards such as AAOIFI and the IFSB are playing an important role in bridging this gap. Liquidity management continues to remain at the core of the issue that regulators need to address to ensure the healthy growth and development of the Islamic banking sector.