Monday, March 30, 2009

Islamic banks grapple with liquidity risk profile issues

By Habhajan Singh
Islamic banks are grappling to figure out the actual state of their liquidity risk profiles, an area that has shaken banks in more advanced economies under the current financial market downturn.
Bank Negara Malaysia (BNM) has admitted that local Islamic banks have a challenge before them. It commented on this matter in the Financial Stability and Payment Systems 2008 report released on March 25 with its annual report.
It also noted that the lack of empirical evidence to support behavioural assumptions has posed a challenge for Islamic banks to accurately estimate the extent to which the unique contract features of Islamic financial transactions may affect their liquidity risk profiles.
The key word here is the unique mix of risks due to the different nature of Islamic finance products. Liquidity risk — defined as the failure of a financial institution to meet expected and unexpected cash flow needs as they arise — is inherent within the financial intermediation function assumed by banking institutions and is a central component of the prudential regulation and supervisory framework, the central bank said in the report.
The sound management of liquidity risk is both critical to avert a threat to the solvency of a banking institution, as well as a loss of confidence in the broader financial system which can amplify the systemic nature of liquidity risk, it added. Naturally, the situation is not peculiar to Islamic banks in any one jurisdiction.
Studies on risk management for Islamic banks have acknowledged the presence of the unique mix of risks. In his work entitled 'Risk characteristics of Islamic products: Implications for risk measurement and supervision', Dr V Sundararajan said Islamic financial institutions have to put in place appropriate risk measurements that recognise the specific mix of factors within Islamic financial contracts and the extent of risk sharing embedded in the contracts.
During an Islamic finance conference in Kuala Lumpur in 2007, he said that liquidity risk management of Islamic financial institutions is constrained due to the limited availability of tradable Islamic money market instruments and a weak systemic liquidity infrastructure.
Sundararajan is currently the director and head of financial sector practice at the Washinton based Centennial Group. He was previously the deputy director of the International Monetary Fund's monetary and capital markets department.
In providing an example, BNM pointed out the use of mudharabah contracts. Here, principal amounts are not guaranteed and returns are dependent on the performance of underlying assets. This should, in principle, reduce the funding liquidity risks faced by Islamic banks.
"However, in practice, Islamic banks face a considerable level of competitive pressure on the profit rates of the mudharabah accounts which are being offered.
"The dominance of trade based financing contracts involving assets being held in the form of fixed and illiquid assets or inventories, such as through the murabahah, ijarah, or istisna' contracts, also potentially reduce the balance sheet liquidity," it said in a special report entitled 'Liquidity Risk Supervision and Challenges in Liquidity Risk Management.'
It was one of the several special commentaries in BNM's Financial Stability and Payment Systems Report, which aims to provide an assessment of the risks and challenges faced by the Malaysian financial system.
On the liquidity challenge, the central bank said that it is being addressed 'through ongoing initiatives to better understand the behavioural characteristics of cash flows for different Shariah contracts and their impact on balance sheet liquidity, towards supporting the more effective identification, measurement and management of liquidity risk'.
The development of a wide range of funding options in the Malaysian Islamic Interbank Money Market have also been instrumental in supporting the liquidity needs of Islamic banking institutions, it added.
These include interbank placements based on mudharabah type contracts, selland-buy-back agreements as an alternative to repurchase agreements, and the Islamic derivatives such as the Islamic rate swaps and the Islamic FX forwards.
Providing some figures, the central bank report said total outstanding instruments increased from RM55.2 billion in 2001 to RM211 billion in 2008, while the turnover of securities traded on the Islamic Interbank Money Market increased from RM39.7 billion in 2001 to RM185.2 billion in 2008.
"The growing acceptance of Islamic finance as well as the emergence of more Islamic institutional investors such as takaful operators and Islamic fund managers in recent years have also widened sources for Islamic funding, thus facilitating the diversification of funding strategies for Islamic banks," it said.
During the year, BNM noted that the Islamic finance sector 'continued to record strong performance', with the Islamic banking sector achieving an average annual growth of 20% over an eightyear period.

(This story appeared in The Malaysian Reserve on Mar 30, 2009. The Malaysian Reserve is a daily business/finance newspaper published out of Kuala Lumpur, with a sectoral page on Islamic finance on Mondays, edited by Habhajan Singh)

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