Chapter 16
Liquidity Risk
1. INTRODUCTION
Liquidity is defined by the Basel Committee on Banking Supervision (BCBS) as “the ability of a bank to fund increases in assets and meet obligations as they become due, without incurring unacceptable losses.”1 Liquidity risk in banking is thus often defined as “the risk that the bank becomes unable to fund increases in assets and meet its financial obligations as they fall due.” It is also the risk of loss related to premature or inappropriate liquidation of assets, where the asset–liability mix has been poorly managed and value has been wrongly determined (e.g., collateralised debt obligations in U.S. subprime securitisations).
As such, liquidity is derived from both sides of a bank’s balance sheet. Specifically, it comprises:
- The ability to turn bank assets into funds.
- The ability to raise liabilities to fund the bank’s assets.
Regulators are paying a great deal more attention to liquidity risk ratios since the fallout from the financial crisis, evident in changes in new iterations of the Basel Accords. However, their attention is drawn to the systemically risky global banks, and there is a question mark hanging over the appropriateness of the “one size fits all” regulations to measure this risk in smaller, and particularly in Islamic, banks.
2. THE REGULATORY RESPONSE TO LIQUIDITY RISK
Basel II has rightly and often been criticised for its concentration on bank capital and for subsequently paying little attention to bank liquidity and its management.
The new Basel III regulatory proposals attempt to address this deficiency and to improve the liquidity position of banks in three ways:
Islamic banks would as a matter of principle overlay the conventional definitions of risk with avoidance of gharar (uncertainty) and jehala (ignorance) to ensure their Shari’ah compliance. The removal of uncertainty and ignorance from the Shari’ah-compliant business and contracts underlying the asset and liability risk does a great deal to enhance the characteristics of the balance sheet if assiduously applied. The section below suggests that in evaluating liquidity risks of Islamic banks compared to their conventional counterparts, the measurement tools should give greater consideration to certain types of underlying Shari’ah-compliant contracts. It is often stressed, when making the case for dedicated risk measures for Islamic banks, that “risk is agnostic,” and there are no religious implications for risk measurement. This ignores the influence of fiqh al-muamalat (Islamic commercial jurisprudence) applicable to dealings between men on the Islamic economic model. This model encourages Islamic banks to fundamentally understand the business they undertake and to constrain it to dealings in the real economy. This is quite a separate recognition of structure and practice that conventional banks could as easily follow. Indeed, with the increased focus by regulators on the mis-selling of conventional retail banking products and of the “socially useless” nature of some wholesale products, it could be argued that conventional bank regulators are heading in the same direction. The section below on Bank of England Trade Bills is an example of how the conventional market has diverged from the real economy-based approach, and this may be extrapolated across many geographic markets.
3. ASSET LIQUIDITY
The ability to turn assets into cash through liquid markets is a very important aspect of bank liquidity management, and this is one aspect of Shari’ah-compliant banking that often causes concerns for Shari’ah bank treasurers in the management of their banks’ balance sheets. The reverse murabahah and tawarruq solutions based on commodity murabahah transactions (CMTs), which are attracting comment for a variety of reasons, are examples of seeking to increase liquidity in the balance sheet of Islamic banks.
Much has been written since the start of the financial crisis in 2007 of the problems that conventional banks and investors faced as financial asset markets became illiquid as a result of investors and market makers withdrawing from these markets. In practice, there are also much the same problems in some Shari’ah-compliant asset markets, including the sukuk market. Shari’ah-compliant banks in general, however, did not have the same level of problems as conventional banks. On the asset side of their balance sheets this was in part due to the nature of their assets. Whilst much is made of the ability to turn assets into cash funds through markets, assets also possess a degree of natural liquidity through the term of the assets themselves and the process leading to their liquidation. Examples are realisation of the sale of goods upon reaching market, or a fixed asset with a strong natural cash flow servicing it—for example, well-let (i.e., leased or rented) real estate—that can be valued, as compared to general borrowings or contracts based on speculative premises, or, as in subprime mortgages, lacking transparency and thus inherently difficult or impossible to value. A bank that has books of short-dated self-liquidating assets will be more naturally liquid than one that possesses books of long dated assets. Empirical tests tend to illustrate that Islamic banks tend to fall into the former category.
4. TRADE FINANCE ASSETS AS LIQUIDITY
Shari’ah-compliant banks, as a result of adherence to Shari’ah principles, are primarily involved in the finance of the real economy, including the financing of trade in goods and services, which forms a major part of the business of many such banks. Much of this trade finance is short-term in nature, typically between 30 and 90 days, and thus books of such assets provide a steady stream of repayments, which can if not replaced with new business provide a source of liquidity to a bank. More emphasis might be paid to the “self liquidating” nature of these assets and a “merchant bank’s” ability to reconcile the finance to the trading condition of its counterparties and their liquidation against sales. This should also be extrapolated in the distinction between commodity murabahah and genuine murabahah (even in commodities) where the finance (credit) arises from the sale of the specific, identified physical goods, rather than being a pure financial debt, so that the finance may also be secured on the underlying goods throughout their natural transformation cycle. Transparency is further improved in genuine murabahah in commodities by the requirement to price against publically advertised prices and to protect against, for example, deterioration in quality of the underlying goods.
The importance of both funding the real economy and of the funding by banks of short-term (naturally liquid) assets was for a period of about 200 years seen by regulators as of great importance to the stability of both individual banks and the banking system as a whole. Thus, the Bank of England throughout most of the nineteenth and twentieth centuries emphasised the importance of “trade bills” (short-term trade-based debt instruments). This was not fully replaced by a requirement for banks to hold only government bonds until Basel I became the basis for global banking regulation in the late 1980s. Sheikh Saleh Kamel made some progress in promoting liquidity through trade bills rather than commodity murabaha. The proximity of riba (interest) was at the time considered too great; however, a modern study may well back up his original conception.
5. GOVERNMENT BONDS AND LIQUIDITY
The requirement for banks to hold stocks of government bonds as a source of liquidity places heavy reliance on the ability of markets in such assets to stay liquid through having continuous participation of willing issuers and investors as well as market-making institutions. Whilst some markets have these characteristics, it is clear that in the ongoing crisis this is not true for a number of countries, including important euro area countries. Once such markets become illiquid, the dangers of such reliance become very obvious as government bonds are often of very long tenor (UK government bonds have an average life of around 16 years) and thus are naturally very illiquid. The importance attached to government bonds as liquid assets has important implications for Shari’ah-compliant banks in many countries, as very few countries issue sukuk that are sufficiently market-liquid to be used as bank liquidity. This is true in the United Kingdom, where the lack of a sterling sukuk of sufficient quality to be recognised by the Bank of England challenges the five Islamic banks there to meet solvency tests, despite the fact that those banks are all naturally “over-liquid.”
6. ASSET-BASED FINANCINGS AND LIQUIDITY
Shari’ah-compliant banks in all long-term financing structures have a strong reliance on the assets they are funding as a source of financial returns and eventual repayment of the financing. An Islamic bank is charging for the use of the assets it has financed by taking a return based upon their use. In conventional terms these structures are much like project financings and/or securitisations. Such financings are to some extent likely to be subject to extension risk, though the likelihood of default is itself reduced by the flexibility inherent in the structures.
Some securitisation structures fared very badly in the recent financial crisis, most notably those connected to highly geared and/or derivatives-based structures, neither of which are features of Shari’ah-compliant finance structures. In the light of subsequent events, however, many of the more conventional securitisation structures have performed well. Nevertheless, as a result of the bad outcomes, the treatment by regulators of securitisation structures both for capital and liquidity purposes is likely to be disadvantaged against asset-backed structures such as covered bonds.
The development of the Islamic covered bonds market is one of the keys to the development of the Islamic capital markets. Many traditional conventional covered bond structures are unlikely to be Shari’ah compliant, as in many instances these are simply senior debt instruments with security backing provided by what are often substitutable and opaque asset structures, German Pfandbriefen being a case in point. This lack of transparency in structure, asset, and substitution terms is clearly introducing gharar, and the delinking of assets to transparent pricing is also likely to constitute an issue in respect of both equivalence (introducing by default riba al-fadl) and the immediateness of the transaction (which introduces riba al-nasiah). However, in Malaysia, with the close involvement of Cagamas,2 a great deal of quiet progress has been made, and this development demands more participation and study by Islamic banks globally.
There is also a healthy coincidence of needs between the developing markets requirements for Shari’ah-compliant home financing, the suitability of covered bonds, and the natural Shari’ah prohibitions on the kind of structures in securitisation that led to U.S. subprime defaults.
The IFSB Islamic Financial Stability Forum, as well as the G20 Financial Stability Board review particularly, noted the requirement for high quality liquid assets.
7. THE INTERNATIONAL ISLAMIC LIQUIDITY MANAGEMENT CORPORATION (IILM)
The IILM was established on October 25, 2010, largely through the actions of the Islamic Financial Services Board (IFSB) and its then secretary general, Professor Datuk Rifaat Ahmed Abdel Karim. There are 13 initial signatories to the establishment of the IILM though others may join at a later date; 11 of the 13 are central banks, including those of Malaysia, Iran, Turkey, and some Gulf countries, and all 13 signatories are IFSB members.
The IILM was established with the primary objective of issuing Shari’ah-compliant financial instruments to facilitate more efficient and effective liquidity management solutions for the Islamic banking industry. It is expected, initially, to focus on the issue of short-term paper in international reserve currencies.
IILM will issue sukuk in the name of the company itself whilst individual central banks may act as custodians for the assets that underpin the sukuk. Alternatively, the IILM could establish a central custodian agency.
A spokesman for IILM has also stated: “You move the asset to the central bank because that will raise confidence of the buyers of the sukuk.” It is also believed that this would help the issues to obtain top credit ratings that qualify them to be used in banks’ liquidity management.
What may be emerging is a liquidity product with some or all of the following features:
- Underpinned by short-term self-liquidating real trade transactions.
- Backed by real assets, held to the order of the funds provider.
- Asset holder (or holders) to be undoubted.
- Transactions centrally recorded (and registered).
- Active secondary market in the product.
In pursuit of this, the IILM product should have a number of the features and benefits of a central counterparty.
Compared to the central custodian agency alternative, the custodial activities of the individual central banks is potentially, however, a weak point in the structure, to the extent that the diversity of custodians may detract from the benefits of a central counterparty in that:
- Information may be less well coordinated and may not be standardised.
- The contractual rights of creditors may differ if the central banks use their own laws as the law of jurisdiction of the contracts.
In both instances this could detract from what otherwise would be support for one of the more important features of new emerging banking regulation, the requirement of greater transparency in instruments and in markets.
The likely features of the product could create a close parallel with the features of the historic eligible trade bills product and if accepted, as expected, by central banks as liquid instruments may provide a beneficial diversity to bank liquidity and its management.
8. LIABILITIES (DEPOSITS) AS LIQUIDITY
As a result of the problems of illiquid asset markets, regulators have begun to place much more emphasis on banks’ funding liquidity and specifically upon:
- A bank’s retail deposit base as a stable source of funds.
- A bank’s ability to fund long-term by the issuance of senior unsecured debt instruments.
8.1 Stable Deposits
The stability of a bank’s retail deposit base is directly linked to the bank’s size and scope of business in relation to the size of the economy within which it operates. If a bank has a significant share of a country’s retail deposit base, it is highly unlikely to suffer significant defection of its customers to other banks and any attrition is, given the very similar terms and conditions of retail customer accounts in most countries, likely to be matched by customers defecting to it from other banks: the “law of large numbers” applies.
One would normally suggest that a small bank might suffer such defections, as the “law of large numbers” does not apply. Moreover, it is likely to be concentrated geographically and if in a declining area cannot rely upon branches in other areas to grow more rapidly. It is notable that during their development phase, such “national” Islamic banks—for example, Dubai Islamic Bank, Qatar Islamic Bank, Kuwait Finance House (KFH), and others—did not suffer so because of their unique sales proposition (USP) as Shari’ah-compliant banks, which allowed them to attract business across a wide geographic range both within and across economies. Generally, even today these banks have greater protection from defection by virtue of their USP as distinct from their emergence as “large number” players in their local markets. If a bank is also in both retail and corporate markets, moreover, its intra-month deposit base will be more stable as balances tend to move between the retail and corporate sectors of the economy within each month as wages are paid and goods and services purchased by the retail sector. This is a particularly evident trait of the commercial Islamic banks such as KFH.
Shari’ah-compliant banks are, however, more reliant on retail balances than their conventional competitors, and where they are large they do tend to have stable balances, a status that is enhanced by their offering of profit-sharing investment accounts (PSIA—see Section 8.2), which form part of the USP described above.
Apart from PSIA, however, Shari’ah-compliant banks are unable to issue longer-term financing instruments, as they cannot compete with conventional banks in issuing senior debt instruments, which are interest-bearing. In principle, they could issue sukuk to raise longer-term funding, but so far this solution has been little used because of the limitations of sukuk markets, among other reasons.
8.2 Profit-Sharing Investment Accounts
PSIA involve an equitable sharing of profits between the parties involved in a financial transaction. However, the account holder bears the risk of loss in the absence of misconduct and negligence on the part of the bank. In one structure found in the Islamic banking business, known as the two-tier mudarabah, there are three parties—the entrepreneur or the actual user of capital, the bank which serves as a partial user of capital funds and as a financial intermediary, and the depositors (investment account holders) in the bank who are the suppliers of savings or capital funds. There is thus a partnership (mudarabah) between the depositors and the bank, and a similar partnership between the entrepreneur and the bank.
In this structure, the bank does not receive a fixed rate of interest on its outstanding financing. Rather, it shares in the profits of the business owner to whom it has provided the funds. Similarly, those individuals who deposit their funds in a bank will share in the profit but bear any losses related to the investments financed by their funds. Typically, however, Islamic banks provide financing on a variety of bases, such as murabahah, salam and istisna’a (all forms of working capital or project finance), or ijarah (leasing and lease-to-buy), as well as diminishing musharakah (where the bank advances funds to a customer on a partnership basis, but its share is progressively bought out by the customer).
The emphasis of some Shari’ah-compliant banks on PSIA as a secure source of funding must, however, be qualified, as the nature of the reserves (so-called profit-equalisation reserves—PER) held against these accounts that are required by some regulatory authorities is likely to be problematic for both:
- Bank regulators who in many countries have fought a long battle with banks to eliminate so-called reserve accounting in the banking industry, which they accuse of being a method of smoothing bank profits. In fact, PER are used to smooth profit payouts to PSIA, but in the absence of transparency may give a misleading impression of the smoothness or persistence of the underlying profit stream.
- International Financial Reporting Standards (IFRS) which, as implemented, also outlaw the use of “hidden reserves” (i.e., reserves disguised as provisions) to smooth profits, and require transparency in the use of both reserves and provisions.
Both of these factors may make PLS deposits less attractive unless steps are taken to reform their structure. This (and particularly the transparency aspect) is an area to which the IFSB has been drawing attention in its standards for a number of years now, as well as suggesting that from a corporate-governance perspective the nature of the risk reward structure between shareholders and PSIA holders is worthy of more review.3 It is likely that Basel III will underpin their calls for greater transparency in these accounts.
9. ACCOUNTING FOR LIQUIDITY AND FAIR VALUE
Fair-value accounting does not always accurately reflect the business models used by banks and does not result in a close match between bank accounting valuations and the internal performance measures or procedures for management of risk exposures used by different business divisions. This can lead to the liquidity risk described in the beginning, leading to greater risk of failure, and certainly greater risk of loss, if bad asset composition leads to inappropriate disposals. Do the IFRS contribute to that scenario? Under older arrangements, accounting treatments for bank exposures were clearly distinguished along business lines, with “trading book” activities all marked to market, and “banking book” treated entirely on an historical accruals basis. As loans and other credit exposures were being increasingly traded, the lines between banking and trading books were being blurred, suggesting a need for a more consistent treatment between the different business lines. But the mix of valuation procedures introduced by IAS 39 exacerbated profit recognition problems. This continues to cause issues for treatment of, say, sukuk portfolio liquidity.
The application of fair value accounting by IFRS to debt liabilities of conventional banks, resulting in changes in the credit ratings of banks’ debt securities potentially impacting their income, will not affect Shari’ah-compliant banks who do not issue such debt capital instruments.
Achieving a better correspondence between accounting standards and underlying business models is critical for both investor transparency and the comprehensiveness of management information. But is the body (the Accounting and Auditing Organisation for Islamic Financial Institutions, or AAOIFI), which since the mid-1990s has issued financial reporting standards for Islamic banks, equipped to take on the responsibility to adapt and supplement, where necessary, the IFRS for application to Islamic banks position? The area of financial instruments has proved particularly challenging for the International Accounting Standards Board and is likely to be at least equally problematic in the context of Islamic finance. Moreover, international Islamic banks, and indeed any such bank operating in a country that does not accept AAOIFI standards (the ones that do include Bahrain, Qatar, Nigeria, Pakistan, and Sudan) require some other source of financial reporting standards.
10. ISLAMIC BANKS AND THE BASEL III LIQUIDITY MEASURES
The BCBS has proposed two new metrics to be used in liquidity risk management: the liquidity cover ratio (LCR) and the net stable funding ratio (NSFR). Both are proving to be problematic for conventional banks.
The LCR requires banks to hold a stock of high quality liquid assets (HQLA), meaning paper with a high quality credit rating that is at least equal to total net cash outflows over a period of 30 days. Apart from government paper, there are few types of HQLA—and some government papers are far from qualifying. The problem is even more acute for Islamic banks, which cannot hold interest-bearing paper. The establishment of the IILM mentioned above is intended to mitigate this situation.
So far as the NSFR is concerned, available stable funding = equity, sukuk, and liabilities (+ a core percentage of UPSIA, or unrestricted PSIA) expected to be a reliable source of funds over one-year time horizon under conditions of extended stress. As noted above, few Islamic banks have so far issued sukuk to provide longer-term funding. In addition, the trend towards using CMT-based term deposits (typically with maturities of six months or less) in place of UPSIA is likely to aggravate the problem.
The shifting stance of Basel on the composition of the LCR has allowed sufficient flexibility for the position of “Shari’ah-compliant banks” to be considered. Changes are ongoing but in the context of this article the most recent is also the most significant. The Group of Governors and Heads of Supervision (GHOS), the oversight body of the Basel Committee on Banking Supervision, met on 6 January 2013 to consider the Basel Committee’s amendments to the Liquidity Coverage Ratio (LCR) as a minimum standard. The subsequent announcement included important inclusions for Shari’ah-compliant banks.
Basel III High Quality Liquid Assets (HQLA)
The GHOS recognised that: “Shari’ah compliant banks face a religious prohibition on holding certain types of assets, such as interest-bearing debt securities. Even in jurisdictions that have a sufficient supply of HQLA, an insurmountable impediment to the ability of Shari’ah compliant banks to meet the LCR requirement may still exist. In such cases, national supervisors in jurisdictions in which Shari’ah-compliant banks operate have the discretion to define Shari’ah-compliant financial products (such as sukuk) as alternative HQLA applicable to such banks only, subject to such conditions or haircuts that the supervisors may require. It should be noted that the intention of this treatment is not to allow Shari’ah-compliant banks to hold fewer HQLA. The minimum LCR standard, calculated based on alternative HQLA (post-haircut) recognised as HQLA for these banks, should not be lower than the minimum LCR standard applicable to other banks in the jurisdiction concerned. National supervisors applying such treatment for Shari’ah-compliant banks should comply with supervisory monitoring and disclosure obligations.”4
These supervisory and disclosure obligations include:
- A clearly documented supervisory framework
- A disclosure framework
Also in Annex 2 of the release, which includes a complete list of the changes made to the December 2010 release, includes a specific reference to Shari’ah-compliant banks. It is mentioned under Alternative liquid asset (ALA) framework with the bullet point “Development of the alternative treatments and include a fourth option for Shari’ah-compliant banks” and indicates ongoing work in this area.
This recognition of Shari’ah banks compliance issues is very welcome and is an important step towards incorporating Shari’ah banks into the Basel regulatory framework. It is, however, not sufficient for Shari’ah banks to be fully compliant with many jurisdictions liquidity frameworks. There is hope that GHOS will follow up on indications that it will enable “Shari’ah-compliant central banks deposits.”
11. CONCLUSION
I strongly believe that the time is right for engagement with global regulators to ensure that Islamic banks can fit into the global financial system. This would accomplish three goals:
I have argued that in a number of ways, global regulation is moving in a direction that is more compatible with Shari’ah principles. There is clearly a recognition by regulators of these two aspects of international finance:
Such engagement between those representing the interests of Islamic banks and the global regulators will not be without issues for both. It is hoped that the arguments I have outlined above provide an illustration of some of the areas where engagement is most required and may be most contentious. In particular, it is crucial that the handicaps Islamic banks face in managing liquidity risk be addressed by national authorities (so as to provide Shari’ah-compliant substitutes for the conventional interbank markets and lender-of-last-resort facilities, as well as the global regulators in terms of what may count as high quality liquid assets.
There is, however, a more fundamental need for both radical change in global banking regulation and a recognition of this by global regulators. If we are to create a better banking system that is more mindful of the needs of the real economy and of banks’ duty to their customers, then I firmly believe Islamic banking illustrates an approach to banking that, by avoiding speculation and remaining linked to the real economy, provides examples of how complying with these imperatives could be of benefit to all societies.
NOTES
1. BCBS, Principles for Sound Liquidity Risk Management and Supervision, September 2008. The definition of liquidity risk in the Islamic Financial Services Board’s Guiding Principles on Liquidity Risk Management employs a similar wording.
2. Cagamas is a state-sponsored institution that acquires Islamic mortgages from their originators and packages them into pools which it securitises as sukuk—somewhat like Fannie Mae and Freddie Mac in the United States. As Cagamas is a highly rated institution to which the sukuk holders have recourse, the sukuk it issues also benefit from a high rating.
3. See, for example, IFSB-3 Guiding Principles on Corporate Governance for Institutions offering Islamic Financial Services (December 2006) and IFSB-4 Disclosures to Promote Transparency and Market Discipline for Institutions offering Islamic Financial Services (December 2007).
4. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com