Fiqh

LIQUIDITY REQUIREMENTS OF ISLAMIC BANKS

IMTIAZ AHMAD PERVEZ

INTRODUCTION

Liquidity is a highly complex phenomenon. It is almost impossible to assume correctly at any time the Quantity Theory link between money stocks and expenditure flows. While ex-post perspective facilitates statistical estimation, ex-ante perspective depends upon the transactors’ wealth-holding and expenditure decisions.

There are basically three concepts of liquidity. The first one of these is maturity. All assets have a certain maturity date, of which money is treated as an asset having zero life to maturity. The closer the assets to maturity, the greater in general is the possibility of realising them before maturity without risk of significant capital loss. Of course, gilt-edged securities with even longer maturity dates are also easily realisable, provided the issuer is prepared to buy or discount without any preconditions at any given time or that these are tradable in an efficient, liquid and well-established secondary market. The second is easiness defined as the ratio of the stock of money balances available (not wealth) to the flow of output. A high ratio would help expansion of output if adequate incentives existed, while a low ratio would tend to inhibit expansion; rather possibly enforce contraction. The third major liquidity concept is the financial strength of a transactor.

To an individual, investment is a present sacrifice for a future benefit. He has to make a rational choice in situations that involve a trade-off between present and future. In addition to securing an income stream over time, his more important choice remains the possibility of transforming his original endowment into other time combinations of consumption.

The periods of time for which depositors opt to forgo the use of their surplus funds do not normally coincide with those over which a bank can put these funds to productive use in financing and investment activities. To optimise the beneficial use of these funds, banks manage maturity transformation. Accordingly, the dates on which depositors want their money back may not necessarily agree with the maturity dates of the bank’s asset portfolio. Because of the uncertainty surrounding their cash flow, banks maintain a ‘fractional reserve’, what is called liquidity, that protects them against the risk of running out of liquid funds.

LIQUIDITY RISK

A considerable portion of the money on deposit with a bank is never withdrawn but is rather rolled over or otherwise reinvested in new accounts. As a result, there remains a considerable volume of funds in the banking system which provide, in aggregate, a deposit base that has certain stability. However, there are a number of competitor institutions vying for these funds and the risk of loss of these funds to other depository institutions is always present. Besides, the following factors increase liquidity risk:

Erosion of confidence in a country’s banking system.

In an open environment, a crisis within the banking system of any country will have an adverse effect on the reputation of any single bank, resulting in withdrawal of cross-border or even internal funds.

Erosion of confidence in an individual bank

The erosion of confidence in a bank can be basically caused by unsound management, negative or even low earnings, mismatch risk (of rate, maturity, currency), operational risk (unsatisfactory client service, regulatory, legal, environmental risks etc.) and reputation risk (losing the support of the client, other banks, regulators etc.).

Lack of diversification of the deposit base

When a bank depends on a limited number of clients or institutions providing funds, it is exposed to a greater chance of volatility in its level of liquidity.

Excessive mismatch of liabilities and assets

Excessive mismatch of deposit maturities with assets may cause the inability of a bank to meet its commitments in a situation when other future cash flow does not materialise at the expected time.

Unattractive return to clients

Islamic banks hope to attract new deposits in addition to retaining the existing deposits not only by providing security but also by generating attractive returns. Failure to provide attractive returns on client funds may result in loss of deposits; hence added liquidity risk.

LIQUIDITY MANAGEMENT

Liquid Assets

A perfect liquid asset is one whose full present value can be raised immediately. In general terms, liquidity refers broadly to the ability to trade instruments quickly at prices that are reasonable in light of the underlying demand/supply conditions through the depth, breadth and resilience of the market at the lowest possible execution cost. The level of liquidity has relevance to the composition of the assets portfolio and the ability to sustain outflows by their shuffling. The traditional liquidity-orientated assets are mainly financial, since maturity dates of loans are not always predictable. These generally comprise the following:

1. Running assets, which banks need to maintain business activities and may include non-financial items such as trade credits in respect of goods sold but still unpaid for.

2. Reserve assets, that facilitate flexibility of response to unforeseen negative changes and include claims on the public sector, such as Treasury Bills etc., and such other marketable securities as may be approved by the regulatory authorities, if and wherever applicable and whose issuer otherwise has the required financial strength.

3. Investment assets, for their yield, such as the whole range of claims in the form of financial paper, bonds etc.

Liquidity Management

There are several arguments about the management of liquidity of a bank.

The Commercial Loan Theory (Real Bills Doctrine) suggests that banks can provide needed liquidity by making only short-term, self-liquidating financing, secured by goods in the process of production (istisna’a or salam) or goods in transit (murabaha). However, the outside factors are not under the control of the bank so that inability of the third party to meet its obligations or any negative development may affect the liquidity position of the bank.

The Shiftability Theory recognises that liquidity could be provided if a certain portion of deposits were used to acquire assets for which a secondary market exists. The bank cannot confine all its activities to marketable instruments alone. Not only their value but also their marketability depends on the financial strength of the issuer, market volatility, liquidity etc. On the other hand, the bank has to undertake other financing operations in the environment in which it operates. Otherwise, it will be seen as being unable or unwilling to fulfil its social responsibilities.

The Anticipated Income Theory is another solution offered for the liquidity problem of banks, under which long-term financing entails repayment by instalments, which in themselves provide liquidity. These expected cash flows, however, are subject to uncertainty.

The Conversion of Funds is an approach under which the bank’s management treats each source of funds individually and matches each source of funds with an asset of similar maturity This is true in the event of restricted mudarabas, but on an overall basis, it is both impossible, cost-intensive and an impractical solution.

The Pool of Funds approach is a portfolio management technique that emphasises safety over short-term profitability. On the basis of a desired level of liquidity, funds are allocated first to primary reserves (cash, deposits with the Central Bank and balances with other financial institutions), secondary reserves (short-term highly liquid securities), and then financing and long-term investments.

There is no objective basis here for estimating the liquid standard of a bank, for the following reasons:

1. Except for restricted mudarabas in which the maturity dates of all assets and liabilities are fully matched, the bank’s sources of funds emanate from a common pool, which is determined by factors beyond the bank’s control.

2. Within the pool of funds, different deposits have different volatility, so that there is no indication of the importance of these differences to overall liquidity.

3. The concentration is on liquidity, not profitability. But ultimately the long-term safety of a bank requires adequate earnings.

4. It ignores the liquidity provided by the financing portfolio, particularly the self-liquidating ones, through the continuous flow of funds from principal and profit repayments.

5. And finally, the Pool of Funds approach disregards the interactive character of assets and liabilities in the generation of liquidity and profit earnings.

Debate for Reserve Requirement

Reserve requirements for banks arise in the following three general ways:

1) Endogenously as part of the operational needs of banks that issue deposit certificates subject to redemption by public or by other financial institutions;

2) As a result of financial market discipline that induces depository financial institutions to compete in providing confidence to depositors about the reliability and liquidity of the institution that holds their deposits; and

3) Exogenously imposed by external political forces, either government directly or regulatory entities such as a Central Bank, that view the reserves as a means of raising government revenue, increasing public welfare by preventing banking panics and the suspension of redeemability, and/or establishing an effective mechanism for executing changes in monetary policy.

Only one hundred percent reserve requirements assure perfect convertibility. Otherwise, fractional reserve ratios imply that if there is a redemption run against a bank, it is unlikely to liquidate sufficient assets in an orderly manner to redeem its liabilities. This aspect of banking establishes the potential for banking panics.

There is also ongoing debate about the relevance of reserve requirements in increasingly sophisticated, efficient financial markets. Some economists envision a deregulated financial system in which banks hold no reserve assets, and instead are a type of open-ended mutual fund in which deposit liabilities are claims against the institution’s assets that are continuously marked to market. This is possible only in a highly competitive, liquid and efficient market. Empirical evidence shows reserve requirements shift demand towards non-bank financial firms which are not subject to reserve requirements. In this situation, the presence of these exempt non-bank financial firms raises questions about the viability of commercial banks that are subject to reserve requirements.

LIQUIDITY REQUIREMENTS OF ISLAMIC BANKS

Islamic Philosophy

As stated above, there are arguments for and against the maintenance of reserve requirements as also its level. Islam has a definitive view on this subject. The deposits in question represent the savings of people whose interests cannot be ignored purely for scientific or empirical reasons. If the maintenance of reserve requirements to a certain standard contributes to the welfare of people, then this is an essential attribute and must be inducted in all the related policy matters of a bank and fully enforced by the regulatory authorities. If the lack of it damages, or may damage, at any time the interests of an individual or society, then such elimination or inadequacy of reserve requirements is not in keeping with the philosophy and spirit of Islam.

The question now arises as to the level of liquidity requirement for an Islamic bank. This depends on the local regulatory laws and the nature of the financial institution as well as of the relevant investment portfolio.

Restricted Mudaraba

Where the investment portfolio represents a restricted mudaraba, in which the term of investment funds matches the corresponding asset maturity date and whose terms and conditions do not allow redemption before the maturity date, a very limited amount of reserve requirement may still be needed to meet calls on compassionate grounds. This is with the sole intention of avoiding undue loss to the investor in the event of emergency. 5 to 10 per cent liquidity would be acceptable. This is so even when trading of the restricted mudarabah certificates is possible in the secondary market. In this case, a part of the cash liquidity may be replaced with redemption arrangements made with certain financial institutions to redeem calls on a limited scale.

Unrestricted Mudaraba

This is a more complex issue, since both the level and the method of measurement of liquidity requirements need to be undertaken. There will obviously be a mismatch of maturity, since 100 per cent matching of assets and liabilities is impossible to achieve. It is expected, however, that a mismatch of rate and currency will be avoided, since hedging in an Islamic environment is a questionable issue and has not been cleared by the religious scholars, although the writer believes that if the interest factor is minimal and the social welfare element is stronger, there should be no harm is allowing currency hedging to cover actual transactions and not for speculative purposes. Social welfare is supreme and this is the core of Islamic philosophy, since almost all the laws and prohibitions are directed toward this end.

Firstly, banks, whether incorporated or branches, must meet local monetary policy and liquidity requirements to remain solvent for which they may resort to the instruments and modes that are Sharia compatible. If such regulatory standards are lower than those required for solvency, then more stringent standards, as evolved at the bank’s head office level, should be implemented.

Secondly, there is the method of measurement of liquidity. It is expected that the process of measurement includes:

(a) Establishing and regularly reviewing a bank’s liquidity policy,

(b) Identifying areas of particular strength and weakness while effecting improvements therein, and

The liquidity policy of an Islamic bank must contain a prudent mix of the following:

1. By holding sufficient immediately available cash or near-liquid assets (qualified by the degree of certainty of the price at which they can be sold).

2. By securing a matching profile of future cash flows (qualified by the risk that borrowers may not be able to repay on the due date).

3. By maintaining a diversified deposit base in terms of maturity and range of counterparties (qualified by the bank’s market standing and general market liquidity).

4. Establishing mutual arrangements with other institutions, the interbank lines and other Sharia compatible financial arrangements.

5. Resorting to high quality Islamically acceptable financial instruments that are marketable in traditional markets.

6. Where possible, joining deposit insurance schemes in a manner acceptable under the Sharia.

Liquidity of a bank can be monitored through a simple maturity ladder based on a cash-flow approach with the net asset of liability position in each time period being added to the position in the next period to give a cumulative position at the end of each time period. In the first maturity band, sight and near-sight liabilities are compared with cash and assets capable of generating cash immediately. There are four further bands: eight days to one month, one to three months, three to six months and six to twelve months. Contingent liabilities are not included in this exercise.

The issue of liquidity instruments is also a complex one for Islamic banks. In fact, no resilient Islamic financial market or financial instrument exists today comparable in quality and strength to the contemporary financial instruments that are today available in the world’s financial markets. In the traditional markets, any type of payoff across the different states of nature can be constructed by combining existing securities, even without the aid of any new securities or any options. This forces even greater pressure on Islamic banks to maintain higher levels of liquidity.

Within these concepts, it is expected that after including the maturity factors of running assets, reserve assets and investment assets, but excluding those relevant to restricted mudarabas, the minimum one-month liquidity level of an Islamic bank should be fifty per cent, of which reserve assets must comprise 30 per cent.

The liquidity levels suggested above are debatable. The arguments for a lower level will hold true whenever there is stability in the system and factors that affect a financial institution’s credibility. However, in the event of any volatility, even 50 per cent may be barely adequate. In the context of the depositors’ interests, more stringent measures are necessary and need to be undertaken by Islamic banks.

Edited By Asma Siddiqi

Institute Of Islamic Banking And Insurance London

Comments

John Doe

23/3/2019

Lorem ipsum dolor sit amet, consectetur adipisicing elit, sed do eiusmod tempor incididunt ut labore et dolore magna aliqua. Ut enim ad minim veniam, quis nostrud exercitation ullamco laboris nisi ut aliquip ex ea commodo consequat.

John Doe

23/3/2019

John Doe

23/3/2019

LIQUIDITY REQUIREMENTS OF ISLAMIC BANKS

Share with a friend

Comments

John Doe

John Doe

John Doe

Comment