An Alternative Approach to Liquidity Risk Management of Islamic Banks

Muhammed Habib Dolgun, Abbas Mirakhor

• Publisher: De Gruyter Oldenbourg
• Year: 2021
• ISBN:
  9783110580150
• Edition: 1
• Topic: Commerce
• Subtopic: Gestion des risques financiers

Despite noticeable growth in Islamic banking and finance literature in recent years, very few published books in this area deal with supervisory and regulatory issues in Islamic banking – theoretically or empirically – and none with the critical issue of risks involved in liquidity management of Islamic banks. This unique book is the first of its kind in dealing with challenges these financial institutions face in the absence of interest rate mechanism and debt-based financial instruments. The book examines critically issues involve in managing the risk of liquidity management for these types of institutions, including those stemming from Basel requirements. It then offers an alternative regulatory framework more appropriately suited for such banks without compromising safety and security. The book's unique features and innovative dimensions diagnostically differentiate between Islamic banks and conventional banks as related to liquidity management risks. It proposes a risk-sharing regulatory framework that, once implemented, would mitigate risks posed by balance-sheet mismatches. The book aims to assist regulators, supervisors, Islamic finance practitioners, academicians and other relevant stakeholders.

1 Introduction, Objectives and Motivation

1.1 Background and Context of the Book

The recent global financial crisis has brought to the fore the inadequacy of existing institutional frameworks for financial stability, and subsequently called for its strengthening. Following the crisis, financial and monetary authorities, such as central banks, the Bank of International Settlements (BIS), the Financial Stability Board (FSB) and Islamic Financial Services Board (IFSB), consider financial stability to be more important than the prevailing emphasis on financial liberalization or financial engineering. To this end, they have recommended numerous mechanisms, tools and regulatory frameworks for the effective supervision of financial intermediaries, especially global systemically important banks (G-SIBs). Islamic banks are no exception since they are governed by these new developments. While it is not obvious whether the Islamic banks would be affected positively or negatively by these developments, the present developments may crowd out Islamic financial institutions in the long run if they are not properly calibrated in accordance to their needs and requirements.

While the resilience of the Islamic banking system during the recent global financial crisis highlights its potential contributive role to financial stability, particularly in countries with a significant presence of Islamic banks, there remain several concerns. Although there are no G-SIBs in the Islamic banking space, domestic systemically important banks (D-SIBs) that have more than 15% market share could be perceived as “too big to fail” in some countries (IFSB, 2015a).

In addition, the Islamic financial markets in these countries are still in their infancy stage. Thus, they may not be able to withstand challenges and risks stemming from adverse systemic and financial shocks. For sustained real sector financing, the Islamic financial industry requires policy settings and a combination of micro and macroprudential tools in order for build-ups of financial imbalances and vulnerabilities to be addressed and systemic risk mitigated. A key risk factor relating to financial stability that deserves urgent attention is liquidity risk management. It is well recognized that sustainable liquidity risk management is central to the continuous financing and protection against systemic risks for banks. (Some of these risks include herding, unstable capital flows, vulnerable financial structures, and liquidity risks of counterparties, asset managers, market liquidity, business cycle and other market anomalies). In short, it is key to financial stability. This book seeks to evaluate the relation between liquidity risk management and financial stability in Islamic banks by (i) examining at short-term and long-term factors with different models and (ii) by conducting stress testing under several scenarios and (iii) developing an alternative regulatory treatment for liquid instruments.

1.2 Problem Statements

The Islamic banking industry is confronted with several challenges regarding liquidity management. Since an Islamic Financial Institution (IFI) is not allowed to use interest-based financing resources from interbank money markets or other resources (such as using the central bank’s interest-based facilities via open market channels) and is not allowed to transfer its debt, Islamic banks have disadvantages concerning liquidity management compared to conventional banks. It is also a well-known fact that there is a dearth of Shariah-compliant securities or highly liquid Sukuk in many jurisdictions (IFSB, 2012; IFSB, 2015a).

In addition, even if there are several Shariah-compliant Sukuk or securities in some jurisdictions, the secondary markets for these assets are thin or underdeveloped. The absence of Shariah-complaint lender of last resort (LoLR) facilities in many countries places further constraints on the ability of Islamic banks to mitigate liquidity risk (Mohammad, 2015). Having the relevant lender of last resort facility may promote moral hazard amongst these banks¹ and consequently attenuate the efficiency of liquidity management. However, without such facilities, Islamic banks are not able to protect themselves against sudden liquidity changes or increasing stress in market liquidity. These factors and many others can impact the performance, growth, and portfolio management of Islamic banks as well as the confidence of investors. Moreover, the distinctive behavior of Islamic banks concerning asset-liability management, capital adequacy requirement, loan portfolio risk-taking and interbank demand hinder their capacity to undertake a comparable liquidity transformation to their conventional counterparts.

The Basel Committee (BCBS) issued a revised Liquidity Coverage Ratio (LCR) in 2013 to strengthen banks’ liquidity management with the goal of promoting a more resilient banking sector (BIS, 2013). This was followed by the Net Stable Funding Ratio (NSFR) in October 2014.² These requirements were to be enforced by January 2015 and January 2018 respectively. In 2015, with some changes, the IFSB adopted the LCR and the NSFR for Islamic banks (IFSB, 2015). The implementation of the liquidity coverage ratio (LCR) under the new standards may be challenging for Islamic banks. While the LCR and the NSFR are designed to improve banks’ resilience to short-term liquidity shocks by holding High-Quality Liquid Assets (HQLA) as reserve, these requirements compel Islamic banks to keep cash on their books due to a lack of short-term highly liquid and Shariah-compliant financial assets.³ Consequently, the efficiency, resilience, and profitability of Islamic banks can be adversely affected.

Moreover, there are interconnections and interactions between liquidity standards and other standards including capital standards and leverage. The capital adequacy standards, particularly Basel II risk-weight requirements, as well as the capital conservation and countercyclical buffers⁴ further restrict Islamic banks’ liquidity management. Under the risk-weight mechanism, the partnership based investments are treated as high risk-weight due to the presence of counterparty risks.⁵ Accordingly, the current regulatory framework applies higher risk-weights than appropriate to Islamic banking assets.⁶ Like the LCR and NSFR, the mandatory capital conservation and countercyclical buffers force Islamic banks to hold cash. The new regulatory standards will also constrain Islamic banks with high international activity due to its new requirements for total loss absorbing capacity or leverage requirements. Although the Basel III framework allows local authorities to use their discretionary power in granting preferential treatment⁷ to certain assets, most supervisors of Islamic banks have a tendency to mimic the conventional regulatory framework to avoid non-compliance to Basel standards and possible negative assessment by international organizations and international market players. Mechanical application of the recommended methodology of the BIS and the IFSB standards may not be appropriate especially for risk sharing and partnership-based financial instruments.

The risk-sharing based instruments, i.e. Mudarabah and Musharakah contracts are classified as illiquid instruments. The partnership-based business model of these instruments as noted above compel authorities to apply higher risk-weight than mark-up based products under the Basel II capital requirements. As a result, the risk-sharing instruments are not preferred by Islamic banks since they have negative bearings on liquidity management. Although new Islamic financial products have been developed in recent years, e.g. Esham,⁸ GDP-linked Sukuk and commodity-based Sukuk, there has been no attempt to evaluate the regulatory treatment of these instruments with respect to liquidity and capital requirements and standards.

Against these limitations, there seems to be an urgent need to enhance the liquidity management of Islamic banks especially through the adoption of stress testing. Essentially, stress testing is an approximate estimate of how the value of a portfolio changes when there are large changes to some of its risk factors. While stress testing has been a popular tool in assessing the vulnerabilities of a group of institutions or of the financial system, its application to specific risk is limited. Indeed, stressing testing to liquidity risk is even more limited and under-developed, while its application to Islamic banks is virtually absent. For example, the European Banking Authority in its last stress test only assessed liquidity risks related to the cost of funding and not to the size and quality of liquidity buffers. In the US, liquidity stress tests play only a subordinate role to capital stress tests. The BIS working papers (BCBS 2013a; BCBS 2013b) identify gaps in current liquidity stress testing and suggest several areas for developing more robust liquidity stress testing. In light of its importance for liquidity risk management, the liquidity stress testing applicable to Islamic banks needs to be developed as a way to enhance their liquidity risk management.

At present, Shariah-conscious investors are at a disadvantage when it comes to participating in financial services provided by Islamic banks. At...