Liquidity Management in Institutions Offering Islamic Financial Services

Having good liquidity management is a key prerequisite for sustaining financial stability and helping to alleviate any liquidity shortage. As Islamic finance is moving to being part of the global interconnected financial system, financial markets across jurisdictions become more connected and economies become interlinked. Simply, joining up the dots is becoming more important. The lack of a global Islamic interbank market and liquidity management scheme has, according to some Islamic bankers, hampered the systemic development of the Islamic finance industry.

After the consequences of the global financial crisis, a renewed effort has been made to come up with a mechanism that is global, effective and efficient, as well as Shariah compliant. Regulators, industry organisations and market players have all stressed the urgent need for a global Islamic interbank market and a liquidity management scheme.

Figure 1: Drivers for a Global Islamic Interbank Market and Liquidity Management Scheme

Source: Deloitte

Challenges and Issues

Liquidity management lies at the heart of confidence in Islamic financial institutions. Customers must be confident they can withdraw their deposit when they wish. If the ability of the bank to pay out on demand is questioned, all its business may be lost overnight.

The importance of liquidity transcends the individual institution, since a liquidity shortfall within any institution may invoke systemic repercussions, causing harm to the whole financial stability of a country.

A globally accepted Shariah-compliant liquidity management scheme is vital for the development of the industry. Creating such a scheme is challenging due to differing interpretations of Shariah rulings on financial matters across jurisdictions, which have led to differing methods of structuring or packaging financial instruments and the non-validity or non-recognition of some contracts or terms of practice in certain jurisdictions.

The process of harmonisation and standardisation of transactions across and within borders must be comprehensive. Shariah differences need to be resolved and a common design agreed among central banks. Consensus in fatwas, or legal pronouncements, may be overcome by the centralisation of Shariah rulings in a central Islamic authority such as the Islamic Fiqh Academy of the Organisation of the Islamic Conference. Furthermore, research entities such as the Islamic Research and Training Institute (IRTI) and International Shariah Research Academy for Islamic Finance (ISRA) can collaborate. Ijtihad – to make a legal decision independent of traditional schools of thought – can also be the final option.

A Robust Cross-border Liquidity Market and Infrastructure

Without adequate cross-border liquidity market and infrastructure, Islamic banking institutions suffer poor cash management, arising from the lack of a comprehensive Islamic interbank market with highly rated short-term tradable instruments.

Without access to such a market, it is difficult for these institutions to manage their short-term liquidity needs, requiring them to maintain a larger amount of liquidity compared to their conventional counterparts. In Malaysia, such markets exist and have been key to facilitating liquidity management.

Co-ordinated effort across jurisdictions is required to promote a harmonised approach in designing and developing Islamic money market instruments to contribute to the development of regionally and internationally integrated Islamic money markets. However, priority should be given to the creation of domestic Islamic money markets, based on the agreed general framework and guidelines. This could then lay the basis for creating regional and sub-regional markets for Islamic money market instruments.

Adequate Availability of Liquid Short-term Financial Instruments

The availability of Shariah-compliant money market instruments is limited and varies considerably among countries. Instruments such as commodity murabahah interbank placement of funds under various profit sharing arrangements, and Islamic mutual funds, are the most commonly used instruments by institutions offering Islamic financial services (IIFS) in many jurisdictions.

The reliance on central banks for liquidity management is still low, as most short-term financing from central banks has not been adapted to comply with Shariah rules and principles. Central banks should focus on encouraging the development and design of tradable Shariah-compliant instruments which:

  • Carry low risk and can set a benchmark for other instruments.
  • Can be issued in adequate volume and on a regular schedule to meet the needs of monetary policy, government financing and the portfolio needs of investors.
Figure 2: Robust Global Standards of Documentation, Product, Process and Accounting

Source: Deloitte

Standardisation of documentation, product, process and accounting is needed to promote a consistent and efficient regulatory framework that will ensure unimpeded Islamic financial intermediation, as well as liquidity management. The different standard used among jurisdictions is the main impediment. Global standardisation is needed urgently so that an IIFS in one jurisdiction can transact easily with other jurisdictions.

Uniformity in Legal, Regulatory and Tax Framework

Legal frameworks for public debt and financing arrangements often do not explicitly allow for the design and issuance of Islamic financial instruments. Appropriate modifications to the law could facilitate Islamic money market development. A globally accepted legal, regulatory and tax framework would allow IIFS transactions to be easily conducted across jurisdictions.

Areas of concern in the legal, regulatory and tax framework are the trust laws, the banking and securities laws, the public debt laws, appropriate adjustments in the tax regime as well as tax incentives or tax neutrality to facilitate the operation of Islamic money and capital markets.

An Integrated Payment and Settlement System

The final challenge is to have an integrated and sophisticated payment and settlement system. Certain features within the existing payment and settlement system will require adaptations in order to ensure that payment transactions can be made within Shariah rules.

In particular, adaptations are required in the types of collateral, the loss sharing arrangements, the interbank lending arrangements, and the availability of central bank lender of last resort facilities to support settlements by the IIFS.

The current ongoing global financial and economic crisis has highlighted the weaknesses of the global financial regulatory and supervisory framework. Co-operation between regulators across jurisdictions is important in addressing potential systemic risks that have extended beyond the national and regional boundaries.

Active liquidity management by IIFS can be encouraged through supervisory guidance on liquidity risk management. And the use of government finance instruments can be integrated into the liquidity monitoring and liquidity risk management framework.

Making it a Reality

The Islamic Financial Services Board (IFSB), the Islamic Development Bank (IDB) and IRTI have developed eight building blocks to strengthen the Islamic financial infrastructure. They target the stability and dynamism of the Islamic financial system through solid infrastructure components and strengthening key institutions.

Addressing these building blocks is vital in ensuring development of a robust and resilient Islamic financial system, as all these eight areas are interconnected. Stability and contribution towards growth and development can be preserved if we adhere to these building blocks.

Liquidity is the lifeblood of any business, and we must make sure that we get there as quickly and as efficiently as possible. We have to ensure that we are able to provide adequate education programmes at all levels in order to educate people, encourage intelligent debate and discussion, and raise the status of the industry, knowledge, information, and quality of debate. Finally, we need to change perceptions. There are still many negative perceptions about Islam and Islamic finance. We need to address this in a non-confrontational way, by engaging in debate.

Combined with sufficient cross-border liquidity tools and infrastructure, liquidity management will be able to progress. At the end of the day, a little persistence can go a long way.

Emerging Practices, Initiatives and Trends

The types of instruments used for managing liquidity vary among jurisdictions, and also differ among IIFS. Here are some examples of initiatives being taken to develop platforms and benchmarks:

Southeast Asia

  • The Islamic Interbank Money Market (IIMM): Introduced in January 1994 to provide an off-the-shelf source of Shariah-based short-term investment outlets. Instruments include mudarabah interbank investment, government investment issue and Islamic treasury bills.
  • Bursa Suq Al-Sila: The world’s first Shariah-compliant commodity trading platform of Bursa Malaysia. A fully electronic international multi-currency and multi-commodity trading platform.
  • Domestic Interbank Shariah Financial Market: Launched by the Central Bank of Indonesia in 2000 using the mudarabah interbank investment certificate. Internationally it is accommodated in the International Islamic Financial Market (IIFM).
  • Bank Indonesia Wadiah Certificates (SWBI): Issued by the central bank for IIFS to place their excess liquidity. The SWBI bonus is lower than the IIMM and murabahah time deposit.
  • Short-term rolling of sukuk al-salam and ijarah has been in place since 2001 and 2005 respectively. This short-term sakk is complemented by regular issuance of medium to long-term sukuk al-ijarah.

Gulf Co-operation Council (GCC)

  • Special deposit facilities are available only for conventional banks as these are not Shariah-compliant. IIFS rely on noninterest-bearing excess reserves held in their current accounts with Central Bank of Bahrain (CBB). IIFS also have access to a range of ijarah and sukuk al-salam.
Dubai/United Arab Emirates (UAE)
  • ‘The Gate’ (global commodity finance in Dubai) acts as an electronic Islamic interbank platform project for short-term liquidity management. It is a global marketplace development for financial institutions to resolve treasury imbalances. The system is based on the Islamic benchmark for interbank transactions.
  • The UAE central bank in May 2010 announced a plan to launch new liquidity facilities through the issuance of Islamic certificates of deposit (CDs), with maturities of one week up to one year. The new Islamic CDs are based on the commodity murabahah concept and will be offered in daily auctions.

This excerpt is taken from a full paper published on the IFSB website. Daud Vicary presented this paper at the 2nd Islamic Financial Stability Forum in conjunction with 17th Meeting of Council of the IFSB on 14 December 2010 in Jeddah, Saudi Arabia.


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