Regulations governing liquidity risk in Islamic Banking
This article was first published in Islamic Finance news Volume 16 Issue 48 dated the 4th December 2019
Given the systemic importance and the pivotal role played by banks in a country’s economy, banking regulations are of paramount importance for all stakeholders. Guidelines and regulations enable all banks to maintain stability and monitor their risk. In the context of Islamic Banking, liquidity risk is challenging because of limited availability of Shariah compliant short term liquidity instruments and a shallow markets for these instruments.
While the implementation of regulations is left to each country’s Central Bank, Islamic Financial Stability (IFSB) has set out guidelines, CPIFR (Core Principles for Islamic Finance Regulation), for various aspects of Islamic Banking including liquidity risk. IFSB has endorsed Basel III guidelines and has set out Shariah compliance guidance as required. These serve as references to countries’ regulatory bodies when they set their own regulations. International Monetary Fund (IMF) also goes by these guidelines while assessing the stability of Islamic banks. These guidelines include quantitative ratios and qualitative principles.
CPIFR contains 23 guiding principles for liquidity risk management. The guidelines range from identifying all sources of liquidity risks, modelling behavioural profiles of fund providers to issuance of more Shariah compliant short term instrument and provision of Shariah compliant deposit insurance. Quantitative aspects cover Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) that are to be maintained by the banks to monitor liquidity risk. Both these ratios have to be equal to or greater than 100%.The timeline for implementation is same as that stated in Basel III – LCR could be implemented in phases starting at 60% in 2015 and reaching 100% in January of 2019 and NSFR to be implemented from 1st January 2018.
LCR and NSFR of countries like Saudi Arabia, Kuwait, Qatar are well above the prescribed threshold of 100%. UAE has taken up a phased implementation of these guidelines, where it approves banks on a case to case basis to follow these metrics. It currently uses the Eligible Liquid Assets Ratio (ELAR) as the liquidity risk measure and has prescribed banks to maintain it above 10% (UAE Central Bank Liquidity Regulation 2015). As of December 2018, according to UAE Central Bank data, Islamic banks are comfortably above the benchmark. Bangladesh has implemented these ratios and the values are above 100% as required. LCR of Malaysian banks are above the threshold of 100%. NFSR was in observation period since January 2018 and its implementation has been mandated from 1st July 2020.
Despite IFSB issuing guidelines in 2015, many countries are yet to incorporate these regulations or are currently implementing it in phases. Wider implementation and adherence would enhance soundness of Islamic Banks, especially at a stage when Islamic Banking has been exhibiting growth.