LIQUIDITY MANAGEMENT IN

ISLAMIC BANKING: CHALLENGES

AND OPPORTUNITIES

SUBMITTED BY:
 Contents

1 EXECUTIVE SUMMARY.........................................................................................................................3

2 INTRODUCTION.......................................................................................................................................4

2.1 TREASURY MANAGEMENT.............................................................................................................................4

2.2 WHAT IS LIQUIDITY MANAGEMENT AND ROLE IN TREASURY...............................................................................4
2.3 METHODS OF LIQUIDITY MANAGEMENT IN CONVENTIONAL BANKING....................................................................5
3 LIQUIDITY MANAGEMENT IN ISLAMIC BANKING......................................................................6

3.1 CHALLENGES FACED BY ISLAMIC BANKS IN LIQUIDITY MANAGEMENT................................................................6

3.2 PRESENT DAY ISLAMIC LIQUIDITY MANAGEMENT...........................................................................................7
4 NEW PRODUCTS USED TO MANAGE LIQUIDITY IN ISLAMIC BANKING..............................8

4.1 WAKALA .................................................................................................................................................8

4.2 SHORT TERM SUKUKS.................................................................................................................................9
4.3 SECURITIZATION OF ASSETS........................................................................................................................10
4.4 ISLAMIC INTERBANK MARKETS...................................................................................................................11
4.5 INTERNATIONAL ISLAMIC FINANCIAL MARKET (IIFM)..................................................................................11
5 CONCLUSION..........................................................................................................................................13

6 APPENDIX................................................................................................................................................14

7 REFERENCES..........................................................................................................................................18

7.1 PUBLICATIONS:.........................................................................................................................................18
 1 Executive Summary

One of the very important functions of Treasury management Department in financial

institutions as well as non-financial institutions is effective liquidity management. Funds
should be available as and when they are required and at the same time, cash shouldn’t be
kept idle, and must earn some revenue on it. The focus of this report is on the liquidity
management by the banking sector.

In the conventional banking sector, several methods of liquidity management are

available such as the money market investments, a fully developed interbank market and
the Lender of last resort facility. However, the case with the Islamic Banking Institutions
is very different as they face several challenges in liquidity management and thus also
effective functioning of the treasury department. Their challenges arise due to the fact
that most short term investment instruments are Shariah based and hence non-compliant
with Islamic finance. Most of the investments in Islamic Banks are also short term
customer deposits while the investment instruments are medium to long term like
Sukuks, or illiquid like Commodity Murhabaha.

However with time, Islamic Banks are trying to come up with new techniques of liquidity
management such as Wakala, unrestricted wakala, Short-term Sukuks, Securitization of
Assets. The International Islamic Financial Market has also been set up by the Central
Banks of Malaysia, Indonesia, Bahrain and Sudan which aims to identify the problems
associated with Islamic Financial Institutions like liquidity management, homogenize
Islamic Banking across the world and also provide possible solutions to the problems
faces like creating global markets etc.
 2 Introduction

2.1 Treasury management

Treasury management is concerned with borrowing, investing liquid sources, maintaining

adequate liquidity, managing foreign exchange and interest rate exposures. The
objectives of the treasury function embrace the raising of funds as cheaply as possible,
the investment of liquid funds to earn an adequate return, the control of currency and
interest exposures and ensuring that the firm can meet its liabilities as they fall due.

2.2 What is liquidity management and role in treasury

Liquidity refers to the ability of a firm to meet its immediate demands for cash for loan
disbursements, bill payments, debt repayments etc. It ensures that the demand for funds is
met without additional borrowing. The goal of liquidity Management is to maintain and
effective level of liquidity while balancing the need to earn revenue. Too much cash in
the firm leads to loss of income as idle cash does not incur any revenue but carries a cost
of funds. Too little cash in the firm leads to missed chance of loan disbursements,
delayed bill payments and higher borrowing costs for firm to infuse liquidity again.

Liquidity management covers:

• Cash management
• Short term investment management
• Short term interest rate management

In the case of banks the concept of liquidity risk revolves around the ability of a bank to
maintain sufficient funds to meet its commitments, which may, in turn, be related to its
ability to attract deposits. It is about the ability of matching the maturity of assets and
liabilities daily and coping with any short-term pressures that may arise in the process of
ensuring the assets are fully funded. Bank lending finances investments in relatively
illiquid assets, but it fund its loans with mostly short term liabilities. Thus one of the
main challenges to a bank is ensuring its own liquidity under all reasonable conditions.
The Treasury department must strike a balance and match the sources of funds with the
uses of the funds to maintain adequate liquidity.

2.3 Methods of liquidity management in conventional banking

Money markets are used by the Treasury operations of Central banks, international
banks and corporations to manage their short-term cash requirements and obligations -
so-called liquidity management.

Interbank market: For banks and large corporates, liquidity management is about
getting a fine return on cash which they may need at short notice. They do this by
borrowing and lending between each other - using either money market securities or
deposits and loans - in what is called the interbank market. Just as the interbank market
allows commercial banks to engage in liquidity management, Central Banks too use
money markets to manage their reserves, and in doing so can affect prevailing money
market rates. This is commonly achieved by manipulating the one market segment over
which they have direct control, the Treasury bill market.

Lender of Last Resort Facility: During a liquidity crisis, when no one is ready to give a
loan, the lender of last resort lends credit. Generally the central banks of countries are
lenders of last resorts.
 3 Liquidity management in Islamic banking

3.1 Challenges faced by Islamic Banks in liquidity Management

Islamic banking in the Middle East and the rest of the world is having a growth spurt. In
the last five years, Islamic commercial banks have grown more rapidly than their
conventional equivalents and the investment banking sector has begun to spread its wings
with more confidence. However at the same time several obstacles remain in the banking
sector

Limited development of Islamic interbank market: For Islamic financial institutions,

liquidity management is more unique due to the fact that most available conventional
instruments used for liquidity management are interest based, therefore, not shariah
compatible. It follows, then, that in the absence of shariah compatible short term
instruments, there can only be limited development of the Islamic interbank market.

Lack of Islamic money markets: 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 Shari'ah compliant are lacking. Although Sukuks can be traded, most are held
to maturity. This lack of market liquidity is often seen as one of, if not the, major
constraint to the development of an integrated Islamic financial system. Malaysia is an
exception where they even have overdrafts.

Maturity mismatch: Islamic Financial Institutions are almost 50% more liquid than their
conventional counterparts. The main funding in IFI’s is from short term customer
deposits and the main investments are long to medium term maturity Sukuks (Islamic
Bonds). E.g. If an IFI has invested its 1 month customer deposit in a 5 year Sukuk and if
he wants to withdraw after one month, then it becomes a problem for the bank.
IFI’s earn lower returns: Limited short term investments so Islamic Financial
Institutions earn low returns on intermediate funds.

3.2 Present Day Islamic Liquidity Management

Commodity Murabaha: For the last few years, Islamic Banks have relied mainly on
Commodity Murabaha for liquidity management purposes. It is a form of a short-term
finance based on murabaha contract and generally used for the buying and selling of
commodities in the international market.
Issues with commodity Murabaha

• Unable to raise liquidity: Banks are unable to raise liquidity through the reverse
Commodity Murabaha structure; known as Tawaruq.
• Cost of commodity brokerage: The use of an intermediary results in brokerage payout
and therefore becomes a less competitive product compared to conventional
counterpart
• Amount of commodity: Generally the commodities traded are metals and there are
doubts if there is sufficient metal to cover the transaction volumes.

4 New products used to manage liquidity in Islamic Banking

To address these concerns and diversify the liquidity-management product range, Islamic
Financial Institutions are beginning to focus on the development of new solutions. These
solutions include:

• Wakala, unrestricted wakala

• Short-term Sukuk
• Securitization of Assets

4.1 Wakala

The Wakeel (agent) invests the Muwakils (principal) funds in pre-agreed asset classes for
the period of Wakala and the risk of the asset is transferred to the Muwakil. Also
stemming from this is the concept of Unrestricted Wakala–this product funds the treasury
pool which in turn invests in any of the assets on the balance sheet. Unrestricted Wakalas
tend to be more flexible than the plain vanilla Wakala.
Advantages of using Wakala:

• No commodity: Does not require a physical commodity

• No brokerage: No intermediate parties involved therefore does not attract any
brokerage
• Access more banks: Allows Islamic Banks to accept liquidity from Islamic as well as
conventional banks
• Competitive: Priced according to current market benchmarks

4.2 Short term Sukuks

Sukuks are generally medium term to long term investment instruments and hence are not
considered as mediums for short term investment. Therefore scholars have authorized
banks to “carve-out” short term Sukuks in short tenor certificates. These Sukuks
essentially passes the risk and return of the Sukuk to the counterparties for short periods.

E.g. The Bahrain Monetary Agency has issued a series of new instruments, one of them
being the short-term government bills called Sukuk-al-Salam, having generally a maturity
of 91 days. Aluminium has been designed as the underlying asset of the contract. The
Government of Bahrain will sell aluminium to the buyer. In exchange of the advance
payment that will be paid by the Islamic bank(s) the Government of Bahrain will
undertake to supply a specified amount of aluminium at a future date. At the same time
the Islamic bank(s) will appoint the Government of Bahrain as an agent to market the
quantity of aluminium at the time of delivery through its channels of distribution
However, these sukuks are not tradable instruments.
4.3 Securitization of assets

•Desire for higher returns: Islamic investors, like other investors, seem increasingly
willing to give up capital protection (typical of savings accounts and fixed income
securities) in order to achieve higher rates of return
•Opportunity in physical assets: Investments in physical assets (e.g. real estate, aircraft
etc.) offer higher returns but lock-in investors over long periods of time. This creates
liquidity issues
•Securitization: To address this point of liquidity, a viable route is that of securitization
where underlying illiquid physical assets are repackaged in securities tradable in the
Islamic capital markets.

For example, these tradable securities would represent investments in physical assets
generating stable flows of income under Ijara contracts with Islamic compliant lessees
ABC Islamic Bank of Bahrain has started a securitized fund known as ABC Islamic
Fund. The Fund’s overall objective is to provide shareholders with maximum security,
instant liquidity and realistic and consistent rate of profitability. The fund main
investments are all Shariah compliant and are in ijara, istisna, mudarabah and
murabahah. Shares in fund are valued on a daily basis by reference to the Net Assets
Value (NAV) of the fund’s assets. Thus, if a customer’s shares in the Fund appreciate in
value, the benefit of this appreciation will pass to the customer. However, if a customer’s
shares in the Fund fall in value, ABC Bank guarantees that on the redemption of the
shares the customer will receive an amount equal to the price paid for the shares, thereby
ensuring that the customer cannot be prejudiced by a fall in value of the Fund’s shares. .
The fund concentrates on participating in well secured deals which provide return to
shareholders. It uses conventional money market rates as benchmark to determine the rate
of profitability.

However some issues still remain in securitization as well as there are liquidity issues in
using short term funds to finance long term underlying assets.
4.4 Islamic Interbank Markets

There is a need to develop Islamic Interbank Market wherein the IFI’s can manage their
liquidity. The Central Bank in Malaysia has created an Islamic Interbank market in
Malaysia where purchase and sale of Islamic financial products is done by the market
participants (banks) under the mudarhaba investment scheme.
Under this scheme for instance, a bank participating in the interest free banking scheme
may invest its surplus liquidity funds in another bank. These funds may be invested on
the basis of mudarabah for a period of investment that may vary from overnight to 12
months on an agreed profit sharing ratio.

4.5 International Islamic Financial Market (IIFM)

IIFM is a conglomeration between the Central banks of Malaysia, Bahrain, Indonesia and
Sudan. The Agreement to establish the IIFM was signed in November 2001. The main
objectives that IIFM aims to tackle are the following

(1) To facilitate the establishment of an international financial market based on Shariah’s

rules and principles.
(2) Tackling the issue of liquidity management in Islamic banks
(3) Developing an active, secondary market
(4) creating the environment that will encourage both Islamic and non-Islamic financial
institutions to actively participate in a secondary market and the information of new
traceable instructions.

Hence, IIFM will act towards the harmonization of sharia’a interpretations in the global
financial market and bridge the gap between the different sharia’a interpretations. This
will be achieved through the endorsement of Islamic instruments developed by financial
institution by well-known scholars representing different regions sharia’a schools of
thought. This will allow, for instance, products developed in Malaysia to be accepted in
the Middle East, Indonesia or any other country and vice versa.
IIFM also aims at enhancing the cooperative framework among Islamic financial
institutions globally. It will address the problem of lack of awareness of attractive
investment opportunities in other markets and facilitating the raising of fund and
investment beyond the national borrowing. It will also help in cross listing in different
stocks exchanges of member countries such as that of Labuan (Malaysia) and Bahrain,
for instance.
 5 Conclusion

Studying liquidity management issues is a critical but complex subject. Failure to address
the issue may lead to dire consequences, including banking collapse, and by extension,
the stability of the financial system. In fact, most bank failures are due to difficulties
managing their liquidity problems. This is also the reason why regulators are very
concerned with the liquidity position of financial institutions and current thinking of
regulators centre around the strengthening of liquidity framework.

However the case of Islamic Banks is very unique as they face several challenges in
liquidity management. Although several successful attempts have been made so far to
address the problem of liquidity in Islamic banks, much still needs to be done for an
effective way in solving the liquidity issues in Islamic banks. One of the ways in which
this can be done is by reinforcing cooperation among Muslim countries supportive of
Islamic banking. This is better done through the existing institutions such as the IIFM. At
the same time there is a need of close cooperation between IIFM and Central Banks
especially those of member countries.

If initial initiatives like those mentioned in the report are taken, the demand for Sharia’a
compatible products among all financial intermediaries will grow, thereby creating an
active Islamic capital market that can provide a viable alternative to conventional market.
 6 Appendix

APPENDIX

Ijara:

Unlike capital itself, fixed payments can be determined for assets or rentals. An Ijarah
contract is where the financier buys and leases equipment or other assets to the business
owner for a fee or more often called rental income. The duration of the lease as well as
the fee must be set in advance and mutually agreed. Sometimes there are two contracts
involved in this concept.

Al Wadiah

Islamic banks in Malaysia mostly use Al Wadiah concept to accept deposits from
customers. Under this Islamic scheme of savings and current account, you will enjoy
interest free safekeeping services of your money, as well as a share of any profit that the
bank makes by utilising your deposit. The bank uses an Islamic banking principle that is
known as "Al Wadiah Yad Dhamanah" which means guaranteed custody. This scheme
ensures that Islamic financial institutions acquire deposits under Islamic banking
principles.

The core of this arrangement is that the bank has the authority to use your deposits and
gives a guarantee to return it to you when you need it. You will periodically obtain a
share of the profits earned by the bank when it utilizes your money to invest in its
business ventures. The portion of profit to be shared with you is at the absolute discretion
of the bank. This reward is your alternative to the interest income that you would
otherwise receive from a conventional bank.

Al Mudharabah General Investment Account (AGIA)

An Al Mudharabah GIA account offers you an investment opportunity that operates

under the Islamic banking principle of Al Mudharabah. An Al Mudharabah transaction is
derived from a partnership based on risk and profit sharing. This partnership is a
collaboration between an investor (Rabbul Mal) and an entrepreneur (Mudharib) under
which the former provides funds to the latter for the purpose of investment and profit
sharing.

This is how it works in practice - you, the investor will deposit an amount of money with
the bank, which acts as the entrepreneur. This investment is utilized as business capital by
the bank. In this contract you have no authority to interfere in the management of your
investment. On the other hand, the bank will have the right to manage your investments
as it thinks fit by placing it into businesses that are permissible in Islam and which it
thinks are profitable. Depending on the tenure of your investment, you will be offered a
profit sharing ratio which will form the basis of the agreement made between you and the
bank. On the date that your investments mature, the bank will distribute your share of
accumulated profit into your investment account.

Al Mudharabah Special Investment Account (ASIA)

An Al Mudharabah SIA operates under the same basic principles as an Al Mudharabah

General Investment Account (AGIA). However as the name implies, the SIA is more in
tune with the requirements of the client. In all other respects, the SIA works just as the
GIA does. However, the Bank as the entreprenuer, may specify that the fund from this
special investment shall only be utilized to invest in certain sectors of the economy. The
bank may also specify that a particular SIA fund will only be utilized to fund the
financing of residential properties. The ASIA return therefore will be restricted to the
performance of a particular sector of the economy or a particular financing portfolio.

Al Bai Bithaman Ajil Asset Financing (BBA)

Al Bai Bithaman Ajil means a "deferred payment sale". It is a mode of Islamic financing
used for property, vehicle, as well as financing of other consumer goods. Technically,
this financing facility is based on the activities of buying and selling. The furnitures that
you wish to purchase for example, are bought by the bank and sold to you at an agreed to
price, after the bank and you determine the tenure and the manner of the installments.
The price at which the bank sells you the furniture’s will include the actual cost of the
furnitures and will also incorporate the bank's profit margin. There is no interest charged
and the extra price compensates the bank for its profit. Installments remain fixed over the
period of the contract and no adjustment is made if interest rates fluctuate. The fixed
monthly installments are determined by the selling price, repayment period and the
percentage margin of financing.

Al Istisna' Financing

Al Istisna is by definition an order sale used mainly in financing assets that are under
construction. It allows the Bank to disburse payments according to the stage of
completion. As a financier, the Bank rarely orders the asset for its own use. Once
completed, the asset will be handed over to the customer through a leasing arrangement
(Al Ijarah), a deferred sale arrangement (Al Bai Bithaman Ajil), a cost plus arrangement
(Al Murabaha) or a profit sharing arrangement (Al Mudharabah or Al Musyarakah).
Al Kafalah

Islamic banks use Al Kafalah to issue Bank and Shipping guarantees. Al Kafalah is a
contract made between the Bank and another party whereby the Bank agrees to discharge
the liability of a third party in the case of default by the third party. As a surety, the third
party will give the bank some form of collateral and pay a small fee for the services.

Under the Kafalah Shipping Guarantee, the Bank gives a surety to the owner of the
shipping vessel, to discharge goods to the importer pending receipt of the original bill of
lading.

Under the Kafalah Bank Guarantee, the bank guarantees the company's standing to
facilitate any business endeavours that may require such guarantees.

Al Musyarakah Financing

Al Musharakah a profit and loss sharing partnership. In a Musyarakah financing

arrangement, the Bank and the Customer will both contribute their capital as well as
expertise in a project. Profit and loss will be shared normally based on the capital
contribution.

Al Mudharabah Financing

As in Al Musyarakah financing, Al Mudharabah financing is a form of partnership where

the Bank will provide the capital and the customer will provide the expertise. Both will
agree on a profit sharing ratio. The customer will be solely responsible for running the
business, project or contract without interference from the Bank. All forms of capital loss,
if any, will be borne by the Bank and all forms labor loss, if any, will be borne by the
customer.

Al Murabahah Financing

Al Murabahah financing arrangement is a trust sale financing arrangement. In this

financing arrangement, the customer will first identify the goods to be financed. The bank
will then secure the goods, add the mark up profit, deliver the goods and collect the
payment from the customer - usually in deferred terms. In a Murabaha transaction, the
cost price paid by the Bank must be transparent to the customer. Al Murabaha is widely
used in Islamic Trade Finance arrangements.

Al Wakalah

Al Wakalah means agency, or the delegating of a duty to another party for specific
purposes and under specific conditions. Under this concept, the bank acts as your agent in
completing a particular financial transaction. As your agent, the Bank will be paid a
certain amount of fee for the services it provides.
Bai’ Al-Istisna’ refers to a sale by order of goods/property, which is to be constructed /
manufactured, and delivered at a specified future date.

Bai al salam - Sale of goods where the price is paid in advance of delivery or manufac-
ture.

Sukuk is a shariah compliant bond. In simple words sukuk represents ownership of an

asset. The claim embodied in sukuk is not simply a claim to cash flow but an ownership
claim. This also differentiates sukuk from conventional bonds as the latter proceed over
interest bearing securities, whereas sukuk are basically investment certificates consisting
of ownership claims in a pool of assets.
 7 References

7.1 Publications:

1. International Conference on Islamic Banking: Risk Management, Regulation and

Supervision – 2003 report written by Abdul Rais Abdul Majid (Chief Executive
Officer), International Islamic Financial Market (IIFM)

2. Liquidity Management of Islamic Financial Institutions in the UAE- December

2005 by Iqbal khan, CEO HSBC Amanah

3. Challenges In Managing Liquidity In Islamic Banking Environment- December

2005 by Mohammed Tariq and Salman Syed Ali

4. Islamic Liquidity Management- 8th October 2003 by Warren Edwardes, CEO,

Delphi Risk Management Limited Islamic Funds World 2003

5. Avenues for Investing Liquidity in Islamic Banking Environment – 2005 by Mr.

Ahmed Abbas