Issues in Islamic liquidity
From Jakarta to Jeddah, there are about 300 Islamic banks and other financial institutions now operating in some 40 countries, with the value of Islamic banking internationally estimated at approaching US$500bn. By Warren Edwardes, CEO of Delphi Risk Management.
Islamic banking is clearly a rapidly accelerating market. But does this fast moving juggernaut have adequate brakes and headlights in terms of sound asset/liability and liquidity management tools in the event of a downturn? The Islamic financial market is flush with liquidity and issue after issue of sukuk have recently been launched, but paradoxically, there is a potentially destabilising and dangerous lack of liquidity in the global Islamic financial market.
"Islamic banking in the Middle East is having a growth spurt. In the last five years, Islamic commercial banks have grown more rapidly than their conventional equivalents and the fledgling investment banking sector has begun to spread its wings with more confidence. At the same time, bankers complain that old obstacles remain – a lack of consensus between banks about what is or is not Islamic, a shortage of longer-dated assets and inter-bank liquidity, and the absence of an Islamic capital market. However, there are some signs that tentative moves are being made to address these shortcomings." These words were published in the Middle East Economic Digest on December 19 1997, more than nine years ago!
There is still an asset/liability gap management problem for Islamic banks at the very short end in that there is a dearth of instruments. The Liquidity Management Centre and the International Islamic Financial Market in Bahrain and others have done some excellent work and new Islamic liquid instruments such as the sukuk issued by Malaysia, Bahrain, the IDB and more recently by several corporates are coming on stream on a regular basis. Malaysia, of course, has had such instruments in its domestic market for some time. There have been great strides made, but much more work needs to be done.
Without an efficient capital market to operate within, Islamic banking finance will not continue to grow meaningfully. The market requires liquidity and price transparency to enhance a secondary market. It is all very well having entire issues oversubscribed, but there has to be an exit route to demonstrate liquidity. And this lack of truly liquid assets has paradoxically increased the demand for liquid instruments.
Solid state of liquidity
It may seem obvious, but it is not always taken into account that liquidity is about more than having a particular financial instrument listed in Luxembourg or some other exchange. Just because it is listed does not mean that someone is out there ready to buy it at the very moment that you wish to sell it.
Liquidity also requires more than being negotiable with a secondary market or the availability of proceeds on demand. Just because someone guarantees to buy back a bond from you, does that make it liquid? What's the bid/offer price spread? Are there only sellers and no buyers? Ultimate liquidity means having access to a determinate amount of cash – when you need it. This can be either through the asset side or the liability side of the bank or financial institution.
On the asset side, the preservation of capital on demand is important. That means that the asset must have undoubted quality with minimal credit risk. And it must be seen to have that quality behind it and be free from price risk. I have come across so many instruments where the issuer or the broker guarantees to make a market in the paper and buy it back on demand. Such a guarantee is worthless. What's the point of a guaranteed repurchase if the price or price mechanism is not part of the guarantee?
The spate of sukuk issued over the past year are a most welcome development, but sound asset/liability management still requires a highly rated overnight instrument with stable value.
Co-operation is key
Many Islamic banks place their surplus funds with conventional banks by means of bilateral murabaha transactions based on commodities or metals quite unconnected with the underlying business of the financed party under the murabaha. This is a huge market perhaps dominating all other Islamic transactions.
While such transactions have been deemed to be Shariah-compliant because of a lack of alternatives, perhaps this acceptance in itself has stalled efforts to develop structures in which the murabahas are created to finance the underlying business of those requiring financing and in which the murabahas themselves are structured on the businesses' genuine trading goods and services.
Islamic banks investing in long-term assets are still faced with a problem in that most of their deposit liabilities are very short-term, leading to a massive liquidity problem. Liquidity management tools that are both flexible and undeniably Shariah-compliant are lacking. Although sukuk can be traded, most are held to maturity. This lack of market liquidity is often seen as the major constraint to the development of an integrated Islamic financial system. Malaysia, where they even have overdrafts, is an exception.
It is inevitable that competition between various conventional banks and Islamic ones has led to segmentation and prevented a really substantial market being developed that would lead to an upwardly spiralling virtuous vortex of liquidity. For things to change, there will need to be more co-operation among Islamic banks and between them and their conventional counterparties.
Minding the balance sheet
In addition to the lack of long-term assets to invest in and get out of, Islamic banks face another serious problem in balance sheet management: the lack of an Islamic inter-bank market on the scale of similar-sized conventional markets. Because Islamic banks, unlike conventional banks, cannot borrow at interest to meet unexpected withdrawals from their depositors, it is difficult for them to run mismatched asset and liability portfolios. And this is aside from the interest rate risk they run when they invest long at a fixed rate and have their liabilities frequently repriced.
The way banks have most commonly solved this problem is to have more liquid assets than would conventional banks, and these are placed with commodity murabahas on the understanding that they can get liquidity when required through early cancellations at an explicit or hidden cost. These are done through agency agreements or break clauses. But a facility for early cancellation does not come without cost, explicit or otherwise. There are a few Islamic liquidity vehicles, but these are fairly small and could not withstand a several hundred million dollar injection or withdrawal.
There needs to be a market-wide central solution that allows institutions to park funds between medium-term to long-term investment sales and purchases. We need a solution that involves high quality and standardisation, is available for transactions of substantial size and which gets away from bilateral murabaha investments by the investor with all the problems of break clauses, listing and price transparency.
Sound asset/liability management requires a quality/liquidity pyramid of investments. Globally, the most highly liquid instrument is the US dollar note. While earnings are nil, there is quality and price stability in terms of the US dollar. Beyond that, one has a variety of highly liquid investments and funds, starting with government-issued Triple A rated interest-bearing or discounted instruments, and all haram. But so far, no short-term halal Triple A instruments.
On a governmental level, most countries' reserves are invested in part in risk-free and low-risk instruments: highly-rated government and other securities or gold. And even in the Islamic world, most countries appear to hold reserves haram-wise given the absence of appropriate halal alternatives. So institutions currently have no choice but to investment in haram securities. But even when a highly rated Islamic market is created, investors will have the invidious choice between halal investments and inevitably higher-yielding haram investments to allow for the added layer of Shariah compliance and financial engineering.
There are also fiduciary requirements for banks and trustees to invest in low-risk/price-stable assets on behalf of clients. And on banks' own behalf, a quality parking vehicle for cash is essential. Triple A does have an advantage in that it is pretty much homogeneous. Furthermore, with Basel II approaching the horizon, this has capital adequacy benefits.
In any event, sound risk-management principles are of increasing importance to banks worldwide. Of course, one would not suggest that entire portfolios consist of Triple A assets. Such assets should be but the foundation stone of an inverse risk and liquidity pyramid containing a portfolio of lesser assets.
An Islamic investor fund could construct its own equivalent Double A or Single A balanced portfolio using its own combination of Triple A, Double A, Single A and down to Single B assets without paying an external fund manager to financially engineer these basic building blocks to suit individual requirements.
One can interpolate between investments to intermediate risk profiles, but one cannot extrapolate to produce an instrument of Triple A rating. The investment trade-off is always between the rate of return on the one hand and risk and liquidity/duration on the other. And this truism includes the Islamic, ethical and every other market. Various medium-term building blocks are being put in place through the LMC's spate of government and corporate sukuk. But there remains the essential Triple A building block to the Islamic financial market.
While there have been a number of Islamic sukuk issued recently, most of the paper is bought to hold rather than trade. Thus liquidity is a problem both for on-sale and price determination and marking to market is difficult. This is a result of a combination of two factors. There is a shortage of quality paper issued into the market and also the view in some quarters that the trading of debt is not Shariah-compliant.
In terms of asset/liability management, there is a hedging problem for institutions that lend long-term at fixed yield through ijaras and finance through short-term and therefore variable yield accounts. There is thus a pressing need for Islamic derivatives to address this gap problem. But most derivatives are deemed to be haram on the grounds of being gharrar. Perhaps financial takaful (insurance) would be a better banner to address this problem.
There is also a problem in terms of the lack of Islamically-compliant short-term liquidity instruments. Sukuk, even if they are traded and liquid, are medium to long-term. They are thus not price stable. And recent trends have led to an increase in short-term cash holdings by Middle East banks, but the lack of suitable instruments creates a liquidity trap. There needs to be a truly global-sized liquid inter-bank market where institutions can park their liquidity reserves.