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Salman Ahmed Shaikh

There are various risks faced by Islamic banks in liquidity management due to the i) absence of an Islamic inter-bank market, ii) lack of Shari’ah compliant alternatives for liquidity management, both at the inter-bank and central bank level, iii) absence of liquid Islamic Sukuk both in short and long term maturities and iv) absence of Islamic discount window at the central bank level for Islamic financial institutions.

In liquidity management, banks often have surplus liquidity as well as a shortage of liquidity. The problem becomes more pressing as there are lesser alternatives for managing liquidity shortage for Islamic banks. An Islamic bank can take investment from any financial institution and invest it in Shari’ah compliant financing assets. However, it cannot invest its surplus liquidity on equity financing basis with conventional banks since they are operating on the basis of interest based loans in all their operations including lending and deposit mobilization.

The nature of liquidity risk is also different in Islamic banks since the instruments and contracts available for Islamic banks in the money market and treasury operations are different for Islamic banks as compared to conventional banks.

Likewise, Islamic banks face greater repercussions if there is a delay in repayment of financial obligations by the clients. Any late payment received in order to maintain financial discipline cannot be taken as income by the Islamic bank. Secondly, the price of asset in Murabaha financing cannot be altered even if the price is not received at maturity. Finally, new debt cannot be created by rescheduling or rolling over loan as it happens in conventional banking.

Islamic banks also have some unique challenges as compared to conventional banks. They do not have access to the central bank as the lender of the last resort in many jurisdictions. Islamic banks also do not invest in Treasury bills in order to meet statutory reserve requirements.

In some jurisdictions, they invest in Sovereign Sukuk and also face greater cash reserve requirements if there is a lack of sovereign Shari’ah compliant instruments available. Thus, Islamic banks have to be more watchful and prudent in their financing operations to mitigate liquidity risk.

Usually, the average maturity of deposits in banks is shorter than average maturity of financing provided. Islamic banks are no exception as they compete in the same market and also need to follow the BASEL requirements.

Liquidity risk management in Islamic banking becomes more difficult due to restriction on sale of debt and absence of alternate instruments for short term liquidity management.

As a result, experts call for more alternative liquidity management instruments which are compliant with Shari’ah together with development of new deposit products, such as special purpose deposits, Bancassurance (bank and insurance) deposits, children deposits, and pilgrimage deposits to expand the deposit base.

In this regard, use of equity financing can ensure pure-pass through returns. Furthermore, securitization of investments with secondary trading can also enable the depositors to liquidate their investment in the secondary market rather than withdrawing deposits which are not replaced by another depositor.

Deposits, especially in Islamic banks are mostly placed in checking accounts. Current accounts are zero-return deposits while investment deposits mobilized in checking account do not on average have higher return. In fact, the returns on Islamic investment deposits are usually lower than conventional.

Hence, if financing is mostly reliant on these low-cost investment deposits and zero-return safekeeping deposits, then cost of funds will be lower as compared to relying on other external sources of funds. 

Rise in benchmark rate may lower liquidity risk and bank may start to rely more on deposits. It is because deposits are less sensitive and elastic to rise in benchmark rate as compared to the financing contracts. Hence, rise in benchmark rate bodes well for the liquidity risk as the bank is able to raise revenues from financing contracts more substantially as compared to the rise on cost of funding from deposits. 

Stringency of capital regulations and credit risk have a negative and significant impact on liquidity risk. Nonetheless, some empirical researches indicate that more solvent banks have better liquidity position with a greater cushion of capital. It may imply that larger banks are able to manage liquidity risk more effectively by leveraging on the trust of depositors and having a relatively more flexible access to interbank market.

For effective liquidity management, Islamic banks shall look to diversify sources of funds. An increase in non-remunerative deposits can reduce the cost of raising funds from the public. Reliance on a few big deposits is risky. It is better to have a widespread deposit base.

Islamic banks also need to reduce the concentration of funding base. It is better to have an efficient liability mix with adequate availability of short term and long term deposits. Maturity matching on both sides of the balance sheet can solve much of the problem systematically. 

In financing operations, all else equal, it is better to rely on financing of marketable assets. It is better to finance those assets on a priority basis that have a secondary market and that are somewhat standardized and widely used in the real sector of the economy.

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