Liquidity Management in Islamic Finance

Sorry for the lack of posting in the last week. I've had a cold that has put me on the sidelines.

What need does the ILMC fill?

The issue of asset-liability maturity mismatch has been a common one in Islamic finance, just as it is in conventional banking. However, in Islamic banking, the maturity mismatch has been accentuated by the lack of short-term, money market instruments that allow for managing excess liquidity and temporary liquidity needs. The solution until now has been interest-free deposits with central banks and bilateral commodity murabaha and wakala agreements where banks place excess liquidity with other banks in need of that liquidity. However, this setup is insufficient for the industry and the flaws of this method was demonstrated in the conventional banking industry in the latest crisis.

In the last crisis, the failure of Lehman Brothers led to a nearly complete freeze in commercial paper markets. Commercial paper is issued with maturities of less than 270 days (to get an exemption from some securities rules in the US). Commercial paper is issued by many corporations, but banks make up a large share of the total issuance. It is also a large portion of the investments held by money market funds. When Lehman collapsed, the purchasers of these securities pulled out of the market, fearing that another large CP issuer's collapse could impose significant losses on them. The market for CP did not return to vibrancy until the US government stepped in to support the market.

In Islamic finance, the current money market alternatives available resemble the commercial paper market (although being far less liquid than commercial paper). A bank with excess liquidity will find a counterparty with a short-term liquidity need and enter into a short-term commodity murabaha or wakala agreement. It will essentially loan its surplus funds to the other institution for a short period and generate a return on the surplus funds. However, these types of bilateral agreements leave the lending bank with exposure to credit risk that the counterparty will fail before it gets its money (with a return) back. In a liquidity crunch like the one following the failure of Lehman, Islamic banks (like the investors in conventional commercial paper) will be far less likely to lend out their surplus liquidity if they feel there is a chance it will be lost.

Because of the counterparty risk involved in these bilateral agreements, the Islamic finance industry is vulnerable to a crisis that could threaten the solvency of Islamic banks. If some banks with liquidity needs cannot find short-term financing through bilateral agreements, they may have to resort to asset sales, which will occur at fire sale prices, and the liquidity needs of the institution could turn into a solvency crisis. The fire sale of assets will deplete the bank's assets compared to its liabilities (which will remain mostly fixed) and for the balance sheet to 'balance', the difference will come out of the bank's capital.

There has not been much in the way of alternatives available to Islamic banks until recently (except on a country-by-country basis--with many countries having no Islamic short-term instruments issued by the government or central bank). The International Islamic Liquidity Management Corporation (ILMC), which was announced recently and will be launched on October 25 in Kuala Lumpur, Malaysia by the Islamic Financial Services Board members (mostly central banks and regulatory bodies).

What will come from the ILMC specifically is not yet clear, but it will be some form of short-term investment and the Malaysian central bank governor Zeti Akhtar Aziz says they will be "short term, and they will be, we expect, highly rated instruments". The fact that ILMC is being established by the central bank members of the IFSB will probably be the factor that makes them highly-rated. The high rating is important for the capital rules under Basel 2 (and soon Basel 3) for how banks classify their holdings of the securities. It is not clear exactly the degree of support the IFSB members will put behind the securities, but having central banks behind the issuer of these securities will also limit the degree to which a future liquidity crisis could lead to Islamic banks losing confidence in the ability of their counterparty (the ILMC) to make good on the obligation to redeem the short-term securities. I keenly await more details on the structure of the ILMC's products as well as details on the degree of explicit support from the IFSB members, but at this stage, it looks like the Islamic finance industry could take a big step forward with the establishment of the ILMC, which could start issuing bills regularly beginning "early next year".

UAE central bank's Islamic CDs

The news about short-term investments for Islamic banks does not end with the ILMC. The UAE central bank announced plans earlier this year for Islamic certificates of deposits (CDs) and new details are being reported on this front as well. Standard Chartered, which sits on the central bank's liquidity management committee, says the UAE central bank will use murabaha for its Islamic CDs. This is mixed news. It is certainly a positive for another country to offer short-term liquidity management tools for its Islamic banks for the reasons I outlined above. However, the use of murabaha for these does little to find a creative solution that does not entrench the industry in more commodity murabaha transactions.

The use of commodity murabaha transactions is common in Islamic finance and is accepted as legitimate by scholars (with some divergence from the OIC and the head of Shari'ah at the IFSB). In the end, it is a case of whether the perfect should be the enemy of the good. The benefits from the availability of short-term liquidity management tools surely outweighs concerns that commodity murabaha is 'too similar' to interest-based loans in the near term. However, the greatest skepticism about the Islamic finance industry is that its products do nothing but replicate conventional interest-based loans with different structures to receive approval.

As much as this criticism is valid--there are some products that do nothing but apply a 'Shari'ah wrapper' to conventional products--it overlooks the fundamental paradox in the prohibition of riba. To paraphrase, trade is like riba, but trade is permitted but riba is prohibited. I am certainly in no position to argue the theological points of the Qur'anic verse I paraphrased; that is, as they say, well above my pay grade (not to mention my qualifications). However, it is important from the level of consumer perception of the Islamic finance industry. At what point does a product which the scholars agree is Shari'ah-compliant become too close to an interest-based product for a consumer to accept it as preferable to an interest-based product.

I don't have an answer to the question and I don't think anyone in the industry does. However, it is a fundamental point for the industry's growth: if 'purity' in perception is the goal, products will likely be too unfamiliar to attract demand from enough people to be profitable (and the costs of those products will be too much higher to elicit much consumer demand). However, if (when) financial engineering is taken to its limit, the distinction between Shari'ah-compliant and conventional products becomes meaningless for enough consumers that the industry will have to compete almost entirely on price alone, which it will be hard pressed to do. Some middle ground is required and I think that some form of cost-benefit analysis can provide a guide and for the murabaha-based Islamic CDs, I think the benefits outweigh the costs and the product will benefit the industry.

Other Items
Reuters reports that according to the Assistant Secretary General of AAOIFI, a regional mandatory Shari'ah body is "years away". This is not surprising, but it is relatively new to have AAOIFI publicly acknowledge it.

I weighed in on my own views on the potential for Islamic finance to lead conventional finance by increasing the role of women in the industry (both conventional and Islamic finance industries are male-dominated). Rushdi Siddiqui adds his take on the issue.