WP# 1433-06

State of Liquidity Management in

Islamic Financial Institutions

Salman Syed Ali










Ramadan I 11, 1433H | July 30, 2012


IRTI Working Paper Series
IRTI Working Paper 1433-06
Title: State of Liquidity Management in Islamic Financial Institutions
Author(s): Salman Syed Ali

Abstract

Liquidity position and liquidity risk of Islamic financial institutions has been changing over time. Using
three measures of liquidity this paper analyses the state of liquidity and the risk management
practices of Islamic banks across countries and regions and compares them with conventional banks.
It calls for creating new instruments and infrastructure for liquidity risk management and proposes
fresh approaches to manage this risk.

______________________________






















Islamic Research and Training Institute
P.O. Box 9201, Jeddah 21413, Kingdom of Saudi Arabia
IRTI Working Paper Series has been created to quickly disseminate the findings of the work in progress
and share ideas on the issues related to theoretical and practical development of Islamic economics and
finance so as to encourage exchange of thoughts. The presentations of papers in this series may not be
fully polished. The papers carry the names of the authors and should be accordingly cited. The views
expressed in these papers are those of the authors and do not necessarily reflect the views of the Islamic
Research and Training Institute or the Islamic Development Bank or those of the members of its Board of
Executive Directors or its member countries.
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State of Liquidity Management in Islamic Financial Institutions

Contents

Executive Summary
1. Introduction
1.1 Definitions of Liquidity and Role of Liquidity Management in Banking Business
1.2 Sources of Liquidity Risk in conventional Banking
1.3 Sources of Liquidity Risk in Islamic Banking
2. Current State of Liquidity in Islamic Bank
2.1 Liquidity in Islamic banks (past, present, and during the crisis)
2.2 Liquidity Comparison with Conventional Banks
3. Liquidity Management Practices
3.1 Liquidity Management in Conventional Banks
3.2 Liquidity Management in Islamic Banks
4. Issues in Liquidity Management
4.1 Issues in Liquidity Management Instruments and Infrastructure
4.2 Changing Business Model of Islamic Banks and the Risks Involved
4.3 Issues in Regulatory Regimes for Liquidity risk Management
4.4 Importance of Principles of Islamic Finance in Liquidity Risk Management
5. Conclusions
Appendices

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Acknowledgements
I would like to acknowledge with thanks the excellent research assistance provided by Br. Hylmun Izhar,
and Br. Mehmet Fehmi Eken. Comments made by many colleagues helped in improving the paper, all
remaining errors are mine. Islamic Banks data from IBIS (Islamic Banks Information System) is also
thankfully acknowledged.

Disclaimer
Views expressed in this paper are those of the author and do not necessarily reflect the views of the
Islamic Research and Training Institute or the Islamic Development Bank.
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Executive Summary

Management of liquidity is quite important to the business of banking. Liquidity risk for a bank
includes both the risk of being unable to fund its financing commitments (on the asset side) and
risk of being unable to meet the demand for withdrawals (on the liability side). Liquidity risk
emanates from the nature of the banking business itself which involves maturity transformation.
This risk also stems from factors that are exogenous to the bank, as well as from the financing
and operational policies that are internal to the banking firm. In case of Islamic banks the nature
of Shar ah-compatible contracts are an additional source of liquidity risk, particularly in the
present environment, when only the conventional financial infrastructure is available which is
not tailored to meet the needs of Islamic financial sector.
The purpose of this paper is to present and explain the dynamic evolution of liquidity and
liquidity risk in Islamic banking institutions and show its current status. This is done through
analyzing (i) liquidity ratios, (ii) deployment ratios and (iii) maturity mismatch over a long time
horizon that includes period before and after the global financial crisis. The paper further
discusses the sources of liquidity risk for Islamic financial institutions in comparison with
conventional banks and summarizes liquidity management practices currently used in Islamic
financial services industry. It shows how the structure of Islamic banking industry is changing
over the time which necessitates greater efforts to liquidity management by the banks
themselves and by the regulatory bodies. Some proposals floated at the international level and
some rules proposed in Basel III for this purpose are also summarized and evaluated in the
appendix.
State of Liquidity
Using the data from about 60 Islamic banks covering 18 countries over a ten year period from
2000 to 2009 (525 observations after excluding the missing values), it was found that the
liquidity situation in Islamic banking industry varies considerably across countries and over the
time but with discernable regional trends. All measures of liquidity indicate that over the past
decade the level of liquidity in Islamic banking has been decreasing while liquidity risk has been
increasing in all geographical regions (GCC, MENA, MENA-excluding-GCC, Africa, South East Asia,
South Asia, and Asia). This risk has further increased after the global financial crisis.
Contrary to the general perception, the liquidity of Islamic banking industry in the GCC is lowest
with highest liquidity risk when measured by liquidity ratio and financing to deposit ratio.
However, the mismatch of maturities in short-term assets and liabilities is the lowest in GCC and
the highest in South East Asia. Post financial crisis, the maturity mismatch has become further
negative in these two regions.
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An important finding is that there has been a major structural change in the maturity profile of
assets and liabilities of Islamic banks between the years 2000 and 2009 from a position of
positive short-term maturity gap to a negative gap. This indicates increased liquidity risk.
In comparison with the conventional banks of the same regions, the Islamic banks, despite a
downward trend in their liquidity ratio, are holding much higher proportion of liquid assets.
Even during the financial crisis the liquidity in Islamic banks was more than twice the liquidity of
conventional banks. This, among other factors, may have helped Islamic banks to ride out of the
crisis. However, financing to deposit ratio of Islamic banks is higher than the conventional banks.
Given the high utilization ratio of deposits, the less developed state of liquidity management
instruments & infrastructure, and non-sellable nature of debt, Islamic banks are exposing
themselves to higher liquidity risk unless they rely on profit sharing investment accounts (PSIA)
and genuinely use risk sharing in their financing as well as funding operations.
State of Liquidity Management Practices
Studies on conventional banks have shown that in a growing and profitable market of money
lending the liquidity risk often becomes a secondary concern. Thus, in the pre-crisis period the
conventional banks were emphasising credit expansion and not as much emphasising risk
management. The global financial crisis had taught many hard lessons; liquidity risk
management has now become single most important concern for the banks.
Liquidity stress is not unknown to fully fledged Islamic banks, subsidiaries of conventional banks
as well as to Islamic banking divisions and Islamic investment banks. During the recent crisis all
these types have faced liquidity shortages of varying degrees and varying durations.
Due to lack of Islamic instruments for liquidity management and less developed infrastructure,
the fully fledged Islamic banks face more difficulties compared to the conventional banks and
the Islamic banking windows of conventional banks. Since the liquidity risk management is
carried out at the group level rather than individual divisions level the risks of the subsidiaries
can be absorbed using conventional hedging tools. This creates negative externalities for Islamic
banks and for the Islamic financial system.
In Islamic banks the responsibility of monitoring liquidity risk is increasingly getting assigned to
Chief Risk Officer. These banks think that less developed money market and money market
instruments are the major constraints in liquidity management. Islamic banks mostly rely on
commodity mur ba ah, interbank placement of funds on mu rabah, wak lah and other
techniques for liquidity risk management.
Issues and Future Steps
The increasing liquidity risk of Islamic banks calls for a review of liquidity management practices
and policies at all levels; i.e., by the individual banks, their regulators, and financial sector policy
makers. The situation also calls for creating appropriate instruments, mechanisms, and
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institutions for efficient liquidity management appropriate for Islamic finance philosophy. The
inter-bank markets exist in those countries where Islamic banks are many. Restrictions on cross-
border movement of capital preclude this market between countries. Banks are also using
commodity mur ba ah to manage liquidity risk. However, with time, commodity mur ba ah
has become a source of funding in it self. This has increased, rather than, decreased the risk.
Another instrument for liquidity management is uk k. Project based uk k are preferable to
commodity mur ba ah as they add economic value and obtain gains from trade. It is thought
that issuance of uk k in larger volume and in many tenors will result in the creation of an
Islamic benchmark rate which can serve as an alternate to LIBOR for pricing of fixed return
assets and inter-bank financing. However, the issuance of more uk k will not necessarily create
a new uk k yield curve if the uk k pricing remains tied to LIBOR.
Proper guidelines need to be developed on liquidity management for Islamic banks. These
guidelines can be principles based in the first stage in order to encourage and develop a
liquidity risk management culture. However, soon in time, some objective measures from the
national level regulators will also be needed based on quantitative measures of liquidity risk and
their enforcement.

Further research is needed to find the drivers of liquidity risk in Islamic banking sector and how
different it is from conventional banking sector. At this juncture it is also important to
emphasise the role of Islamic principles of finance and trade which make risk management
endogenous to the system. Out of the box thinking is needed to come up with solutions.
Researchers and policy makers need not confine their thinking within the present model of
commercial banking and the set-up of the existing financial sector. The approach taken in the
recent amendments to Basel-III is to tweak and fine tune the existing framework which is
politically easy but does not address the fundamental problems which remain at the heart of the
crisis. Islamic finance practitioners, researchers and regulators have to shoulder this
responsibility to make a change in the global financial system.
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1. Introduction
While liquidity surplus is considered a drag on competitiveness, shortage of liquidity is said to be
assassin of banks. Episodes of failure of many conventional banks from the past and the present
provide the testimony to this claim. Therefore, banks and more so their regulators are keen to
keep a vigil on liquidity position of banks and manage this risk. Due to profit sharing nature of
Islamic banks, in theory at least, they are likely to be more stable. However, we observe that
liquidity risks have played a role in bringing financial distress to Islamic banks as well, and some
of them were forced to close.
1
Many different types of risks such as credit risk, operational risk
etc., culminate in the form of liquidity problem for individual banks and the banking sector as a
whole, therefore it, sometimes, becomes difficult to analyze this risk in isolation. The recent
financial crisis has forcefully highlighted the importance of liquidity risk and its management at
micro and systemic levels.
The purpose of this paper is to present and explain the dynamic evolution of liquidity and
liquidity risk in Islamic banking institutions and show its current status. This is done through
analyzing liquidity ratios, deployment ratios and maturity mismatch over a long time horizon
that includes period before and after the global financial crisis. The paper further discusses the
sources of liquidity risk for Islamic financial institutions in comparison with conventional banks
and summarizes liquidity management practices currently used in Islamic financial services
industry. It shows how the structure of Islamic banking industry is changing over the time which
necessitates greater efforts to liquidity management by the banks themselves and by the
regulatory bodies. Some proposals floated at the international level and some rules proposed in
Basel III for liquidity risk management are also summarized and evaluated in the appendix.
1.1 Definitions of Liquidity and Liquidity Risk
Liquidity of an asset is its ease of convertibility into cash or a cash equivalent asset. Liquidity risk
arises from the difficulty of selling an asset quickly without incurring large losses. For a banking
and financial firm liquidity risk includes both the risk of being unable to fund [its] portfolio of
assets at appropriate maturities and rates and the risk of being unable to liquidate a position in
a timely manner at reasonable prices.
2
Sometimes it is defined in terms of maturity mismatch
between assets and liabilities while at others it is defined in terms of asynchronous timing of
cash inflows and cash outflows from the business.
3
The bank regulatory literature defines it as

1 An example is the closure of Ihlas Finans in Turkey in 2001 in the wake of liquidity crisis that had
affected the entire banking sector of the country. Conventional banks faced greater problems than Islamic
banks during that crisis.
2 J.P. Morgan Chase (2000). The text [its] in square brackets is inserted by the author in place of name of
the company JP Morgan Chase.
3 See Merill Lynch (2000).
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risk to a banks earnings and capital arising from its inability to timely meet obligations when
they come due without incurring unacceptable losses.
4

1.2 Sources of Liquidity Risk
Liquidity risk emanates from the nature of banking business, from the macro factors that are
exogenous to the bank, as well as from the financing and operational policies that are internal to
the banking firm. In case of Islamic banks the nature of Shar ah-compatible contracts are an
additional source of liquidity risk, particularly if the conventional financial infrastructure is
maintained.
Banks provide maturity transformation. Taking deposits that are callable on demand or that on
average has shorter maturity than the average maturity of the financing contracts they sell.
While maturity transformation provides liquidity insurance to the depositors, which is valued by
them, it exposes banks to liquidity risk themselves. Since banks specialize in maturity
transformation they take pool deposits and take care to match their cash inflows and outflows
in order to address the liquidity risk they face.
However, maturity mismatch at a given time is not the only source of liquidity risk. The risk of
this kind can arrive from many directions and its pinch depends on various factors. In a nutshell
its sources (i) on assets side depend on the degree of inability of bank to convert its assets into
cash without loss at time of need, and (ii) on liabilities side it emanates from unanticipated recall
of deposits. Using the categorization in Jameson (2001) and adding a few more we can break
them into following behavioural and exogenous sources:
1. Incorrect judgment or complacent attitude of the bank towards timing of its cash in- and
out-flows.
2. Unanticipated change in the cost of capital or availability of funding.
3. Abnormal behaviour of financial markets under stress.
4. Range of assumptions used in predicting cash flows.
5. Risk activation by secondary sources such as:
i. Business strategy failure
ii. Corporate governance failure
iii. Modelling assumptions
iv. Merger and accusations policy
6. Breakdown in payments and settlement system
7. Macroeconomic imbalances

We can add to this list the 8.contractual form, 9. Shar ah restriction on sale of debt, and 10.
financial infrastructure deficiency as additional sources of liquidity risk in the case of Islamic
banks.


4 Office of the Comptroller (2000).
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1.3 Sources of Liquidity Risk Special to Islamic Banks Contractual Forms, Restriction on
Sale of Debt, and Absence of Appropriate Infrastructure
5

The various contractual forms available to Islamic banks can be partitioned into three
categories: (1) Sharing contracts such as mu rabah and mush rakah, (2) trade based contracts
such as mur ba ah, salam, and isti n and (3) service based contracts such as ij rah. Each of
these contracts have various kinds of risk implications including the liquidity risk. The liquidity
risk in these contracts can arise directly from the nature of the contract and also indirectly due
to realization of other kinds of risks (such as credit risk and market risk) at some stage during the
course of the contract. In the following we take each of these contract types and discuss the
direct and indirect liquidity risk associated with it both on the asset side and liability side.
1. Profit Sharing Contracts such as mu rabah and mush rakah does not pose an asset-liability
mismatch problem for the bank if each deposit is invested in a specific project and depositors
can only withdraw on maturity of the project in which their funds are invested.
6
While this
eliminates liquidity risk to the banks it also wipes out the liquidity insurance possibility for the
depositors. It also exposes the depositors to concentrated business risk. It then begs the
question what is the role of bank as financial intermediary, why cant an individual directly
invest in a project of his choice? Economies of scale and scope of the bank in monitoring of the
investment projects are left as the only rationale for investment through banks.
However, there is another rational too. Banks can also work as providers of pooled investment
opportunity to their depositors whereby depositors share in the returns of an investment pool
rather than take concentrated risks in one project. This value added to the depositors in the
form of investment diversification can be another rationale for the existence of Islamic banks.
This arrangement not only smoothes out the variability of returns to depositors but can also
address their liquidity needs to some extent if the investment projects are of various maturity
periods. In order to address the preferences of depositors for stable income stream and liquidity
needs the bank would have to carefully select the projects that have non positive correlation of
returns and whose revenue cycles are negatively synchronized with each other. In the normal
circumstances the bank does not have any liquidity risk emerging from the liability side because
no fixed returns are contractually committed to the depositors.
In the extreme event that the depositors want to recall their investments the sharing assets are
sellable in the market. The liquidity risk for the banks comes into picture if these assets fetch a
price lower than their fair market price. But this loss is shared between the depositors and the
bank in proportion to their capital contributions. Thus the liquidity risk to the bank is reduced by
this proportion.

5 This section borrows heavily from my earlier paper Ali (2004).
6 This assumes that accounting period for calculating returns on deposits is same as the accounting period
for profit calculation on the projects where funds are invested.
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Due to various reasons, mush rakah and mu rabah modes form only a small proportion of the
asset portfolio of Islamic banks in present times. Most of their assets are in trade based modes
or ijara. Therefore we now turn to assess the liquidity risks embedded in such instruments.
2. Mur ba ah: Abstracting away from the operational details, in mur ba ah contract bank buys
commodity for a client and sells it to him on a markup price to be paid later. Since mur ba ah
receivables are debt payable on maturity they cannot be sold at a price different from the face
value in secondary market. This is a source of liquidity risk for the bank, particularly, if average
maturities of deposits are shorter than average maturity of mur ba ah contracts or if the
deposits are sensitive to market returns. We will call the liquidity risk due to non-re-sellable
nature of mur ba ah primary liquidity risk associated with this instrument.
There are other risks in mur ba ah that can also give rise to liquidity risk. Let us call them
secondary liquidity risk associated with this instrument. For example, in a mur ba ah contract
the ordering client has the right to refuse acceptance of the delivery for some reasons. If the
client rejects and refuses to receive the commodity the bank is stuck with it until another buyer
is found. Thus cancellation risk also gives rise to liquidity risk for the bank. Similarly, if the buyer
is unable to pay the due amount on time, which is essentially a credit risk, can also give rise to
liquidity risk for the bank. It is also important to note that like any other sale contract there are
operational risks in the procedure of carrying out mur ba ah contract. Likewise there are legal
and litigation risks if some laws are violated or if a dispute occurs. This can also give rise to
liquidity risk if the payment of price is stopped.
Some ways can be devised to reduce the secondary liquidity risk. For example, banks require the
client to keep his business account with them. They often release funds in instalments which
contribute towards maintaining the banks assets protected and liquid funds at its disposal. Our
main concern here is the primary liquidity risk of mur ba ah finance.
3. Salam: It is an advance payment commodity sales contract where the delivery of the
commodity is deferred.
7
When a bank signs to purchase a commodity on salam and pays out the
price, its receivable is the commodity due at a specified future date that is stipulated in the
contract. In the time of cash needs the bank is unable to exit the salam contract by selling it to a
third party before maturity because of Shar ah restriction of do not sell what is not in your
possession. Thus there cannot be a secondary market for trade in salam contracts. This is a
source of primary or direct liquidity risk associated with this finance.
Secondary or indirect liquidity risk arises in salam contract when some other risk associated with
this contract materializes. For example, the credit risk with this contract is that the seller may
not be able to deliver the commodity on the specified date. If it does happen, then the liquidity
problem of the bank extends beyond the maturity date. Having not received the commodity it
cannot sell it in the market to convert it into a liquid asset. Another example of indirect liquidity

7 Jurists have identified specific conditions for validity of this contract which can be found elsewhere, for
example see Usmani (1998).
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risk is if the commodity is delivered but the quality or quantity or some other attribute of the
purchased commodity is below the required specifications causing a legal dispute. The litigation
risk which was a risk factor before the delivery now becomes a liquidity risk.
A way to mitigate the primary liquidity risk (as well as to avoid the delivery) in salam contract is
to use parallel salam. The idea is to write a separate offsetting salam contract.
8
But the second
salam has to be (i) an independent contract not contingent on the performance of the first
salam contract, and (ii) must be with a third party (i.e., not with the counter party in the first
salam contract or its affiliates).
9
However, as long as the credit risk and the risk of dispute are
there the secondary liquidity risk (or indirect liquidity risk) of salam still remains, and even
increases now because of the two parallel contracts instead of one contract.
4. Isti n : It is a manufacture to order contract for yet to be manufactured good on payment of
an advance price either in full or in instalments. The primary liquidity risk arises in the same way
as in salam contract but to a lesser extent because it is permissible for the bank to provide funds
in instalments or even to defer the whole amount to a future date thus maintaining its liquid
assets. Whereas in salam full upfront payment is necessary.
The secondary liquidity risks of isti n are the same as for salam with two exceptions:
(i) As opposed to salam, an isti n contract can be cancelled unilaterally before the
manufacturer starts manufacturing. Therefore it involves definition and verification
of this event. This feature can contribute to lesser or greater liquidity risk to the
bank depending upon how well the event is defined, the ease of verification by a
third party such as a court, and how much funds have already been advanced by the
bank.
(ii) Time bound delivery is not a must feature of isti n contract, however in current
practice it is not left open ended otherwise it would have been hard to define an
event of default. Thus secondary liquidity risk that is triggered by realization of
credit risk is similar to that found in salam. The only difference being that some
jurists (fuqah ) allow penalty for lateness in delivery on the analogy of
permissibility of such measure in ij rah contracts.
10
This can induce stronger
incentives for timely delivery thus reducing the chances and the duration for which
the contract remains open to liquidity risk after a default as compared to a salam
contract.
5. Ij rah: In an ij rah contract the bank first owns an asset which it leases to its customer. Or the
bank gets a tangible asset on lease from a third party and subleases it to the customer. Liquidity

8 See Khan (1992) and Khan (1995).
9 The first condition is in order to meet the shar ah requirements of: (a) prohibition of contingent sales,
(b) prohibition of sale of a thing that is not in possession. The second condition is in order to meet the
shar ah requirement of prohibition of aeena or buy-back arrangement.
10 Usmani (1998)
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risk comes in an ij rah contract when the bank has to pay the price of the asset upfront to
acquire the asset before it can lease it to its customer. The liquidity risk depends upon whether
or not the asset is readily resell-able in the market. This risk is however less here than in
mur ba ah contract because mur ba ah is not re-sellable and re-price-able. The liquidity risk in
hire-purchase (ij rah muntahi bi tamleek) is even lower because the sale price is built into the
rental instalments. However, the rentals cannot be drawn unless the asset is ready to provide
usufruct to the lessee, therefore liquidity of this contract also depends on the time required to
make the asset useable by the lessee after the agreement.
Above we have discussed the liquidity risk of each individual mode of finance. In reality the
situation is more complicated as the overall liquidity risk depends on the proportion of each of
these contracts in the banks portfolio and the concentration and exposure to individual parties
through them.

2. Current State of Liquidity
To analyze current state of liquidity we have utilized three measures. (1) Liquid Assets to
Total Assets ratio, where the liquid assets are defined as cash and cash equivalents as well as
deposits with other banks. The advantage of this ratio, often called liquidity ratio, is that it gives
a quick picture of proportion of liquidity available within a bank as well as in the banking system
as a whole when aggregated across banks. (2) Financing to Deposit ratio. This is the most
commonly used ratio of liquidity risk. It captures the changing nature of financing demands and
the banks ability to gather the deposits. (3) Maturity Mismatch of Assets and Liabilities,
particularly of short-term nature of less than 3 month period. This captures the liquidity risk
generated by the maturity transformation role of the bank. There are other possible measures
too, such as the ratio of stable deposits to total deposits or the ratio of profit sharing investment
accounts (PSIA) to total deposits, but they are not used due to deficiencies in data.
The data on Islamic banks utilized for this study comes from Islamic Banks Information System
(IBIS) provided by Islamic Research and Training Institute. We utilized data of 61 Islamic banks
from 18 countries and cover the period from 2000 to 2009.
11
The appendix-1 gives the list of
countries and number of banks from each country. The data on conventional banks was
obtained from Bank Scope and the World Bank.
2.1 State of Liquidity in Islamic Banks (past, present and during the crisis)
Liquidity Measure-1: The Liquid Assets to Total Assets Ratio
The Figure-1 shows liquidity ratio data for Islamic banking sector from 18 countries over a
period from 2000 to 2009. This reflects averages of liquidity ratios of Islamic banks within each

11 This means 61 x 10 = 610 data points. However, eliminating the missing values we still have 512 data
points for analysis.
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country for each year. In this sense Figure-1 represent the liquidity ratio of an average
representative Islamic bank in each country. Higher the liquidity ratio, better is the ability of
bank to manage liquidity risk. However, very high liquidity ratio indicates a drag on the earnings
of the bank as more liquid assets generally bring in low or no returns. Thus there is a trade-off
between higher liquidity and return.
Figure-1

Source: Authors calculations using IBIS data.
In general, the countries where Islamic banking is new or where new Islamic banks are coming
into being very fast, we can expect to see erratic movements in the liquidity ratios. This is due to
the fact that the newly established banks have most of their assets in liquid form in the
beginning.
Among the GCC Countries, Kuwait had consistently low liquidity ratio throughout the period.
UAE is the country where liquidity ratio dropped most and remained lowest during the global
crisis. Among all countries, Jordan has the highest liquidity ratio consistently since 2004 followed
by Malaysia. Whereas, the liquidity ratio in Sudan has been consistently showing a downward
trend since 2004 but remained in the middle of the range of all countries in the sample.
The Figure-1 also shows that there is a great deal of variation in liquidity ratios across countries
in each year. However, this figure does not give any information on variability of liquidity among
Islamic banks within a country. This variation among Islamic banks within each country as
measured by the standard deviation of liquidity ratios is high in Bahrain, Jordan, Malaysia,
Pakistan, Saudi Arabia, and Yemen. The variability is found to be low in Bangladesh, Indonesia,
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Kuwait, Qatar, Sudan, Turkey, and UAE.
12
Both the inter- and intra-country variations in liquidity
ratios point to a potential for creation of inter-bank market.
While Figure-1 gives a comprehensive picture to compare across countries. However, there is
information overload in it precluding readers to see any discernable trend and understand the
future direction. Clearer picture emerges when the same information is presented aggregated
by regions. Figure-2 gives the liquidity ratio of average Islamic banks by regions.
13
It clearly
shows that a downward trend in liquidity ratio had started in most regions even before the
global financial crisis. After the crisis this trend further deepened. Only in 2009 after the crisis
the liquidity ratio has started to improve. In the past Islamic banks were characterized to have
high holding of liquid assets. This high liquidity was partially due to lack of avenues for short-
term parking of excess liquidity and partially as a result of risk management strategy as Islamic
banks do not have lender of last resort facility. However, the excess of liquidity is becoming a
matter of past and possibilities of liquidity shortages are building up.
This regional comparison of ratios puts GCC and South East Asia regions on the lower side of
liquidity consistently throughout the ten year period. However, in terms of absolute amounts
(Dollar value) the liquid assets in these regions are multiple times higher than other regions as
the assets of average Islamic banks in these two regions are much high.
Figure-2
Source: Authors calculations using IBIS data.

12 To capture within country variation, the standard deviations of liquidity ratios among the Islamic banks
within each country were calculated for each year. Countries where this standard deviation exceeded 20
within any of the past five years (2005 to 2009) were classified as high variability countries.
13 Average is taken over the liquidity ratios of all individual Islamic banks within a region. It is not total
liquid assets in the region divided by total assets in the region.
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TABLE-1: REGIONAL LIQUIDITY RATIOS
Year GCC MENA MENA
EXCLUDING
GCC
AFRICA EAST ASIA SOUTH
ASIA
ASIA
2000 16.86146 25.29871 31.32532 33.72185 15.65001 25.34142 20.49571
2001 14.2233 26.35404 35.01885 29.34263 16.74299 24.49688 20.61994
2002 15.4576 27.01252 35.26604 30.13395 24.00653 19.87588 21.94121
2003 14.31611 23.86979 30.69384 26.79788 26.72011 16.90559 21.81285
2004 19.42119 26.37737 31.34607 26.03993 20.58021 18.58992 19.58506
2005 18.07303 24.66476 29.37314 23.32841 29.77088 23.84733 26.80911
2006 21.64811 27.0544 30.91604 25.20829 29.52054 17.02539 23.27297
2007 16.99369 23.9035 29.66167 22.01624 24.70429 15.65787 20.18108
2008 14.36213 21.36174 27.19474 20.50475 25.9895 13.97454 19.98202
2009 16.15152 21.7299 28.70287 14.0055 28.04554 18.8833 23.46442
Source: Authors calculations based on IBIS data.

Liquidity Measure-2: Financing to Deposit Ratio
An important measure of liquidity risk is the Financing to Deposit Ratio. It captures the
relationship between changing nature of demand for financing (be it in the form of mur ba ah,
isti n , ij rah or partnership based modes) and the deposit gathering ability of banks to fund
that demand. Higher the ratio, higher is the liquidity risk faced by the bank. Figure-3 shows the
Financing to Deposit Ratio of average Islamic banks in individual countries. In this regard stable
funding, which increases along with demand for financing, is an important factor in managing
the liquidity risk. The Financing to Deposit Ratio has moved differently in many countries but in
most countries this ratio peaked between 2006 and 2009. During this period the growth rate of
financing was higher than the growth rate of deposits in many banks, however, deposits also
increased. The exceptions are the investment banks which rely more on wholesale funding and
little on retail deposits. As a result these banks faced sharp increase in Financing to Deposit
Ratio (i.e., high liquidity risk) during the financial crisis. Islamic investment banks in Bahrain and
Kuwait faced significant distress during 2009.
Table-2 gives the region wise average Financing to Deposit Ratios. The same is shown graphically
in Figure-4. It clearly shows that this ratio was quite high in the GCC and MENA when compared
to other regions. The very high ratio is due to inclusion of investment banks in our sample from
these regions. Figure-5 shows the same ratio for other regions after excluding the GCC and
MENA. It is evident from the data and its plot that the liquidity risk has moderately increased
after the crisis in Asia, East-Asia, South-Asia, and Africa.


| P a g e 10


Figure-3

Source: Authors calculations using IBIS data.


TABLE-2: FINANCING TO DEPOSIT RATIOS BY REGION
Year GCC MENA MENA
EXCLUDING
GCC
AFRICA EAST ASIA SOUTH
ASIA
ASIA
2000 445.19 245.07 78.31 70.51 136.60 107.07 121.83
2001 493.51 262.00 69.07 74.77 106.18 102.47 104.33
2002 870.20 434.80 61.68 82.02 85.43 98.87 92.15
2003 459.55 249.22 73.95 79.40 79.11 98.60 88.85
2004 414.63 246.71 78.80 84.19 88.99 97.29 93.14
2005 483.58 265.76 84.24 89.77 81.07 99.33 90.20
2006 501.15 274.55 85.73 93.15 85.72 95.20 90.46
2007 156.43 118.52 86.93 90.77 98.44 94.23 96.34
2008 140.66 114.59 92.85 90.21 97.68 107.38 102.53
2009 176.84 136.52 86.12 96.40 98.06 113.32 105.69
Source: Authors calculations using IBIS data.



| P a g e 11


Figure-4

Source: Authors calculations using IBIS data.


Figure-5 without GCC

Source: Authors calculations using IBIS data.
| P a g e 12

A growth in deposits equal to the growth in financing is not enough for managing liquidity risk.
Stability and the liquidity of deposits are also important which is not captured in the above
measure. The stability and greater liquidity depends on the diversity of depositor base, on the
contractual terms whether the deposits are profit sharing mu rabah based accounts or fixed
liability mur ba ah and tawarruq based deposits. It also depends on the maturity tenor of the
deposits whether contractually determined or behaviourally set. Many Islamic banks have
strong deposit base, but in some countries the demand for financing is even higher. If this rise in
demand is due to economic growth and development of the country in which Islamic bank is
operating then this is very healthy. However, if this happens due to financial arbitrage
opportunities and speculation then in such environment as competition heats up banks start
relying on wholesale funding and short-term funding to provide longer term financing and
investment. This itself is a source of liquidity and other risks. The paper will provide some
comments on these in a later section. The next section looks at the third measure of liquidity
which is maturity gap in the asset and liabilities.
Liquidity Measure-3: Maturity Gap
The maturity gap tries to measure the congruence of maturity tenors of assets and liabilities of
individual banks and, when aggregated, possibly for the banking sector. High positive or high
negative gaps are sign of potential liquidity problems. For the purpose of analysis of short-term
liquidity position of Islamic banks the focus here is on assets and liabilities gap of up to 3-month
maturity. Using the data for individual banks maturity ladders of assets and liabilities have been
constructed and maturity gap for those banks were calculated in 5 tiers: for up to 3 months, 3 to
6 months, 6 months to 1 year, 1 to 3 years, over 3 years, and unspecified maturity. This section
analyses only the very short term maturity gap i.e. up to 3 months category.
Figure-6 shows the average maturity gap of up to 3 months assets and liabilities of Islamic banks
in three regions: The GCC, MENA, and South East Asia (SEA). It is obtained by averaging the
respective maturity gap of individual Islamic banks in that region. The data is reported for the
years 2000 to 2009.
The Figure-6 reveals that:
With a long history the average maturity gap of up to 3 months assets and liabilities for Islamic
banks have been negative in all regions. Implying that on the average Islamic banks face lack of
short-term assets as compared to the short-term funds they raise.
The SEA region has been consistently showing larger negative maturity gap for short-term assets
and liabilities as compared to the MENA and GCC regions. This implies that the problem of
short-term maturity mismatch is more sever in that region and hence the liquidity management
issues.

| P a g e 13


Figure-6

Source: Authors calculations using IBIS data.

The above are some preliminary observations which will require further investigation because
the sources of asset liability mismatch can be many. Therefore a policy response at the level of
banks and their regulators will crucially depend on those factors.
It can also be noted from Figure-6 that the short-term maturity mismatch in Islamic banking had
been reducing in all regions from 2004 until the advent of the global financial crisis. The liquidity
situation started to deteriorate in the GCC (2007) before the SEA region (2008). However, later
in the year (2009) the short-term maturity mismatch deteriorated much significantly in the SEA
region while it started to taper-off or improve in the GCC and MENA regions respectively.
It may also be noted that the structure of liquidity of Islamic banks have changed significantly
over the years. From an era of liquidity surplus in the beginning of the decade Islamic banks are
now in the era of liquidity shortages. Figure-7 compares the short-term maturity gap during
2001 versus that in 2009 of some Islamic banks. In general, the banks have moved from a
position of positive gap to a negative one or from a negative gap to a more negative one.



| P a g e 14

Figure-7

Source: Authors calculation using IBIS data.

The change in liquidity structure is not confined to 3-month gap only. Rather there has been a
structural shift over the decade with Islamic banks relying more on short-term funding to fund
long term assets, which indeed increases the risks faced by them. To show that the structural
shift has taken place in the funding and financing operations of Islamic banks at all levels of
maturities we took only example of one bank (name left anonymous) and plotted its maturity
gap for all tenors of assets and liabilities from 2000 to 2009. This is shown in Figure-8. It can be
seen from the figure that the structure of the maturity distribution has undergone considerable
change during this period. In fact, it has now the reverse shape in 2009 compared to the year
2000. To facilitate the reader visually see the difference, two different shaped rhombuses are
placed on the data for 2000 and 2009 in Figure-8.




| P a g e 15

Figure-8

Source: Authors calculations using IBIS data.

2.2 Liquidity Comparison with Conventional Banks
For a meaningful comparison of liquidity and liquidity risk of Islamic banks with that of
conventional banks some control over the other very divergent factors between the two types
of banks is necessary. For example, comparing Islamic banks with major international
conventional banks operating at global level will not make sense because of sheer differences in
their size, operations, markets, influence and regulatory environment. To control for these
differences and yet keeping the comparison with well performing conventional banks following
methodology was used. Three large banks (largeness defined in terms of assets), were selected
from each of the seven countries where Islamic banks are actively operating. The seven selected
countries are Bahrain, UAE, Saudi Arabia, Malaysia, Indonesia, Pakistan, and Turkey. Table-3
shows the average liquidity ratio of three largest conventional banks in each of these seven
countries.
Table-3: Liquidity Ratio (percent) Average of three large conventional banks in each country
Year Bahrain UAE Saudi Arabia Malaysia Indonesia Pakistan Turkey GCC
Average
Asia
Average
2006 0.99 6.25 6.26 14.63 2.27 n.a. 8.90 4.50 8.45
2007 1.14 17.70 10.46 17.66 2.62 10.03 8.84 9.77 10.10
2008 1.92 6.37 7.97 14.00 3.37 9.79 9.11 5.42 9.05
Source: Authors calculations using annual reports of conventional banks. In this table the GCC Average is average of Bahrain, UAE
and Saudi Arabia. While in this table the Asia average is average of Malaysia, Indonesia and Pakistan. This definition is slightly
different than that used in the text for GCC and Asia.
| P a g e 16

For the three years from 2006 to 2008 the range of liquidity ratio in conventional banks (average
of three large banks) was between 4.5 percent to about 10 percent in the GCC region. In
comparison to it, the liquidity ratio of average Islamic bank in the same region during that
period varied from 14 to 21 percent.
Similarly, for the Asia region the liquidity ratio in conventional banks varied from 8.5 percent to
10 percent during 2006 to 2008. During the same period the liquidity ratio of Islamic banks
varied from 20 percent to 23 percent.
This comparison clearly shows that Islamic banks in general are holding high proportion of liquid
assets than conventional banks. Even during the financial crisis, which occurred during the
above mentioned period of comparison (2006 to 2008), the liquidity of Islamic banks were more
than twice the liquidity of conventional banks. This, among other factors, helped most Islamic
banks to ride out of the crisis.
The liquidity risk as measured by the Loans to Deposit Ratio in case of conventional banks can be
compared with Financing to Deposits Ratio in case of Islamic banks. Using the same approach as
above we find that Islamic banks have a high deployment ratio than conventional banks. During
2006 and 2008 the ratio of loans to deposits of conventional banks ranged from 88 percent to
97 percent in the GCC region (see Table-4), while for Islamic banks the financing to deposits
ratio was a whooping 140 percent to 156 percent. This implies that Islamic banks in the region
were using non-depository sources of funds. This may be partially the banks own capital and
partially borrowing from wholesale market possibly through commodity mur ba ah, uk k and
private placements. Inclusion of some large Islamic investment banks from the GCC region in our
sample can also account for this high ratio as Investment banks do not rely much on retail
deposit base.
Comparing the Islamic banks with conventional banks in Asia region for the period 2006 to 2008
again shows that Islamic banks do not leave deposits idle. The financing to deposit ratio of
average Islamic bank varied from 90 percent to 96 percent in comparison with 69 percent to 70
percent loans to deposit ratio of average conventional bank.

TABLE-4: Loans to Deposits Ratio (percent) Average of three large conventional banks in each country
Year Bahrain UAE Saudi
Arabia
Malaysia Indonesia Pakistan Turkey GCC
Average
Asia
Average
2006 95.32 99.39 70.61 85.42 51.87 72.03 61.38 88.44 69.77
2007 106.02 104.97 70.31 76.50 52.45 68.13 65.62 93.76 65.69
2008 100.36 114.76 75.90 78.67 54.39 74.00 68.79 97.01 69.02
Source: Authors calculations using annual reports of conventional banks. In this table the GCC Average is average of Bahrain, UAE
and Saudi Arabia. While in this table the Asia average is average of Malaysia, Indonesia and Pakistan. This definition is slightly
different than that used in the text for GCC and Asia.
| P a g e 17

Given the high utilization ratio of deposits, the less developed state of liquidity management
instruments and infrastructure, and non-sellable nature of debt Islamic banks are exposing
themselves to higher liquidity risk unless they rely on profit sharing investment accounts (PSIA)
and genuinely use risk sharing in their financing as well as funding operations.
3. Liquidity Management Practices
3.1 Liquidity Management in Conventional Banks
Liquidity management has always been important for banking. However, in the growing and
profitable market of money lending business the liquidity risk often becomes a secondary
concern for the managers of banks. Aggressive expansion of lending operations that became
possible through securitization of loan portfolios helped the banks to further ignore liquidity risk
and expand the asset portfolio even on thin capital base. The financial crisis that followed has
taught many important lessons to the banks, their regulators and the society in general.
Importance of liquidity risk management is one of these lessons that has forced the banks to
reconsider their practices. Ernst & Young conducted a survey of 62 large banks in 2010 on behalf
of International Institute of Finance and found:
14

92 percent of banks have made changes to their approaches to managing liquidity risk
Liquidity risk management has become single most important area for banks
Primary challenges to liquidity management identified by the survey are:
Systems 87%
Data Quality and Consistency 81%
Regulatory Uncertainty 69%
Banks report that their risk appetite is now linked to business decisions.
The global financial crisis has also placed liquidity risk control high in the agenda of regulators. In
this regard various proposals have been discussed in the literature to monitor and control this
risk for financial stability. Basel Committee on Banking Supervision (BCBS) has come up with new
recommendations for liquidity risk management in BASEL-III. Key among them are two
quantitative measures (i) Liquidity Coverage Ratio and (ii) Net Stable Funding Ratio. The first one
is to ensure that the banks have enough liquid assets to cover for 30 days of net cash out flows.
The second one is to encourage more medium- to long-term funding. The details of these
measures of BASEL-III and other proposals are given in Apendix-1. The liquidity management
tools available to conventional banks and the regulatory support infrastructure available to
them including the lender of last resort facility are well known. Instead of dwelling into these

14 Ernst & Young (2010).
| P a g e 18

well known aspects the paper moves in the next section to liquidity management practices in
Islamic banks.
3.2 Liquidity Management in Islamic Banks
Liquidity stress is not unknown to fully fledged Islamic banks, subsidiaries of conventional banks
as well as to Islamic banking divisions and Islamic investment banks. During the recent crisis all
these types have faced liquidity shortages of varying degrees and varying durations. The severity
of liquidity crunch in some jurisdictions was so high that central banks offered special facilities
or provided temporary blanket guarantees for all accounts, including to Islamic banks. In other
jurisdictions they only provided no more than lip service to Islamic banks.
Generally, the risk management, including the liquidity risk management is carried out at the
group level rather than individual divisions level. This means, in case of Islamic banking
subsidiary of a conventional bank or Islamic banking window of a conventional bank the liquidity
risk management is performed using conventional hedging instruments and techniques. Such
banks do not feel the difficulty that fully fledged Islamic banks face when they try to exercise
liquidity risk management within the bounds of Shar ah in the existing environment. Thus the
mixing of risk management activities of Islamic and conventional lines of business in the former
group of banks creates negative externalities for Islamic banks and for the Islamic financial
system.
Islamic banks are using both asset side liquidity management and liabilities side liquidity
management strategies. Inter-bank placements based on mur ba ah and commodity
mur ba ah are most common instruments. In addition to these, Islamic banks have instituted
(i) Investment risk reserves and (ii) Profit Equalization reserves that help smooth out the
payments to the depositors, hence avoid deposit shifting and control liquidity risk. However,
there are arguments for and against this practice.
Within the Islamic banks the responsibility of monitoring the liquidity does not necessarily
reside with one section but several departments are involved. However, increasingly the Chief
Risk Officer is getting responsible for liquidity risk management in many banks. The other
departments having liquidity risk management responsibilities may include asset-liability-
management units, and treasury department.
Various opinion surveys indicate that the Islamic banks do not think that regulators are less
inclined to support them in liquidity risk management. Rather, they consider the unavailability
of Islamic money market instruments or the less developed state of such money markets as the
major constraint for their liquidity management. This is followed by the constraints imposed by
the legal environment and unavailability of Lender of Last Resort facility to them.
Securitization of own assets is so far relatively less among Islamic banks. Only few large banks
have issued uk k to securitize their own assets for liquidity management. Islamic banks are
| P a g e 19

usually coming in as arranger and facilitator in issuance of uk k of other entities and hold these
certificates for liquidity management purposes.

4. Issues in Liquidity Management of Islamic Banks
The above analysis has shown that the liquidity structure of Islamic banks have been changing
towards lesser level of liquid assets and increasing maturity gap in the short-term assets and
liabilities. These changes have implications for increased liquidity risk faced by Islamic banks.
These developments call for a review of liquidity management practices and policies at all levels;
i.e., by the individual banks, their regulators, and financial sector policy makers. The situation
also calls for creating appropriate instruments, mechanisms, and institutions for efficient
liquidity management appropriate for Islamic finance philosophy. The recent global financial
crisis has also provided an experience of abrupt liquidity shortages to Islamic banks and the
difficulties encountered due to unavailability of suitable infrastructure for providing liquidity to
them. Below we highlight some challenges in liquidity management faced by Islamic banks and
comment on some proposed solutions with a view to provide future direction.
4.1 Issues in Liquidity Management Instruments and Infrastructure
Inter-bank market
Islamic inter-bank markets based on mu rabah placement of funds or on the basis of wak lah
(agency contract) exist but they are less developed. The previous sections have shown that
liquidity ratios across countries vary considerably (see Figure-1). Thus there is a potential to
create cross-border inter-bank placement market to manage liquidity. However, such market
has so far not emerged because there exists restrictions on cross boarder movement of capital
in many countries and the costs of such transactions are high.
Domestic inter-bank market among Islamic banks exists only in those countries where multiple
Islamic banks exist and the variance of liquidity across these banks is high. However, in many
countries Islamic banks are very few and this situation does not allow the possibility of inter-
bank placements among them. Moreover, during any event of macro economic significance the
liquidity positions of Islamic banks start moving in correlated manner, as experienced during the
global financial crisis, then this market virtually disappears. These are some limitations and
constraints on the development of active domestic inter-bank markets.
Commodity mur ba ah
Another solution that has been used, for quite some time now, is the use of commodity
mur ba ah to manage short-term liquidity. Such transactions are carried out by large Islamic
banks through international metals and commodities markets. In some countries such markets
have become also become locally available. A liquidity surplus bank can use commodity
mur ba ah to buy metal from one party in the international commodity market by making spot
| P a g e 20

payment and sell it to another party on deferred payment basis with a marked-up price.
Similarly, temporary liquidity shortage can be made up by buying the commodity on deferred
payment basis on mark-up, and selling it in the spot market at going price to get cash. There are
Shar ah as well as public policy issues in using such methods on system-wide level. Commodity
mur ba ah does not tie the mark-up to economic value addition as commodity bought and sold
is neither intended for consumption nor for further production by the transacting parties. When
practiced on large scale, it breaks the much needed link between the financial and the real
economic sectors.
However, the use of commodity mur ba ah has now transcended from its use for short-term
management of small liquidity gaps to become a funding source or an instrument to raise funds
for the banks. This situation not only creates a dichotomy between the real and financial sectors
but also increases the systemic risk in Islamic banking sector. The matter therefore calls for a
regulatory intervention.
Data on mur ba ah on the liabilities side of the Islamic banks are not available for all banks in
the sample. However, it is possible to create its good proxy by calculating the size of deposits
due to other creditors which include deposits due to banks and other financial institutions that
are mostly mur ba ah and fixed obligation deposits.
15
The Table-5 shows the ratio of deposits
due to other creditors to total assets for average Islamic banks in different regions. The same
is represented in Figure-9 for some selected countries. This ratio has been rising until 2008 and
in many countries it constitutes a substantial portion of total assets (from 15 to 30 percent). This
development calls for regulatory intervention. Commodity mur ba ah should not be used as
fund raising source, but only as liquidity management tool. This also implies only moderate use
of commodity mur ba ah. The regulators should specify upper limit for its use. Benchmarking
for this purpose can be done using bank level data in each jurisdiction and at the global level.

15 In this paper deposits due to other customers is obtained by using the accounting identity: Assets
Equity Customer Deposits = Deposits due to Other Customers.
| P a g e 21

Figure-9



Table-5: DEPOSITS DUE TO OTHER CREDITORS AS PROPORTION OF TOTAL ASSETS (PERCENT)
COUNTRY
AVERAGES
BAHRAIN INDONESIA KUWAIT MALAYSIA QATAR SAUDI
ARABIA
SUDAN UAE
2000 14.90313 11.30308 7.111149 6.442273 14.40714 15.53766 40.78868 7.504963
2001 18.90095 9.167814 9.791766 4.357644 38.16655 12.90474 25.46221 9.625743
2002 20.1303 7.466366 4.004657 3.369744 49.30553 12.32315 24.49502 9.864709
2003 29.4711 7.842027 5.457043 2.786637 43.17153 9.471009 21.7 9.622013
2004 29.8591 5.952651 7.061392 3.923051 38.08775 8.273096 34.08317 10.84074
2005 24.31076 6.586518 9.612413 4.882895 41.81519 6.457849 20.17907 9.119679
2006 19.70334 5.727467 13.95198 12.30084 38.85201 6.720875 19.61846 15.27284
2007 26.36012 4.885499 12.92624 18.20989 45.82013 6.51784 17.87812 13.26485
2008 28.54338 3.570015 9.288876 15.68579 51.88143 8.937748 15.25784 14.31009
2009 28.63433 2.790146 11.5045 15.61897 43.08906 11.18634 16.60054 11.16435
Source: Authors calculations based on IBIS data.
| P a g e 22

uk k
There is also a dearth of market based Shar ah compliant instruments for liquidity management
of Islamic banks. This dearth is both in terms of number of instruments and available volume.
This is not new but has been a long standing situation in Islamic banking. However, some
countries have experimented with creation of various capital market and shorter-term products.
These efforts so far have shown limited success. For example, the Government Investment
Certificates of Sudan and salam based uk k Bahrain. In the former case the limited number of
assets available for securitization was the issue, while in the later case the issuance of uk k was
not for any direct economic activity and that the instrument was not tradable in the secondary
market. These experiences should be carefully evaluated to come up with better and sound
instruments for liquidity management.
It is generally believed that availability of uk k market can help in liquidity management.
However, the shortage of short-term uk k and insufficient volume of uk k in the market are
also considered as main hindrances in liquidity management. It is thought that issuance of uk k
in larger volume and in many tenors will result in the creation of an Islamic benchmark rate
which can serve as an alternate to LIBOR for pricing of fixed return assets and inter-bank
financing. However, the issuance of more uk k will not necessarily create a new uk k yield
curve if the uk k pricing remains tied to LIBOR. In this case the benchmark created will not be
an alternate but only another reflection of LIBOR. To make true uk k yield curve it is
important to increase the number of project specific sovereign uk k, issue them against
diversified economic projects, and price them according to the economic realities of those
projects and economic sectors.
The use of project specific uk k as instruments of liquidity management is indeed superior to
the use of commodity mur ba ah for this purpose because project specific uk k are more tied
to underlying economic activity than commodity mur ba ah.
4.2 Issues in Regulatory Framework for Liquidity Risk Management
Proper guidelines need to be developed on liquidity management for Islamic banks. These
guidelines can be principles based in the first stage in order to encourage and develop a
liquidity risk management culture. However, sooner concrete measures from national level
regulators will also be needed supported by quantitative measures of liquidity risk and their
enforcement.
Liquidity risk is generated from various sources and different risks culminate to it. Therefore, an
approach for overall risk management is needed to contain the liquidity risk. However, the
primary focus of the regulatory efforts for liquidity risk management is to create and meet
certain liquidity ratios, which takes the focus of bank mangers away from the real issue to just
meeting those ratio requirements. Ideal regulatory measures should not only look at risk in
holistic manner but should also account for banks specific characteristics as well as more
| P a g e 23

generalized ratios and measures for liquidity risk management geared towards systemic
stability.
Further research is needed to find the drivers of liquidity risk in Islamic banking sector and how
different it is from conventional banking sector. For example, whether, equity base, asset size,
the proportion of mur ba ah in total assets or liabilities and the size of deposits have any
relation with liquidity risk. To what extent existence of regulatory rules for liquidity risk
management contribute to reduction in liquidity risk? Can a system-wide index of liquidity risk
for Islamic banking be created? All these form important questions for research.
4.3 Importance of Principles of Islamic Finance in Liquidity Risk Management
At this juncture it is also important to emphasise the role of Islamic principles of finance and
trade. These principles such as prohibition of interest, avoidance of gharar; the other simple
principles such as do not sell that you do not own, prohibition of trade of debts etc, make risk
management, including the liquidity risk management, endogenous to the system. Then only
little support is needed from external regulations to discipline the violators.
4.4 Out of the Box Thinking
Out of the box thinking is needed to come up with solutions. Researchers and policy makers
need not confine their thinking within the present model of commercial banking and the set-up
of the existing financial sector. Alternative financial institutional structure can be envisaged in
which banks create a series of deposit pools instead of a common pool. Each deposit pool is for
different maturity and duration and used for investments accordingly. Such arrangement
minimizes liquidity risk for the banks, and provides better justice or fair treatment to the
depositors whose money the banks use. One such proposal is eluded to in Tahir (2006).

5. Conclusions
The business model of Islamic banking is changing over the time and moving in a direction
where it is acquiring more liquidity risk. The three measures of liquidity risk used in this paper
point to this conclusion. A number of factors including competition with conventional banks can
be cited as the reason for this situation. However, such investigation can form the agenda for
another research.
Better approach to risk management is not to treat only the symptoms but to acquire
understanding of the underlying causes where the corrections are needed. This requires risk
management of banks across their business lines, since liquidity risk may be emanating from
some fundamental causes which if corrected will alleviate the problem.
Think and work for systemic changes that will facilitate implementation of Islamic principles of
finance. Many problems of liquidity risk will be address through this approach. Still proper
| P a g e 24

management of liquidity risk and regulatory oversight will remain important. In this regard the
regulations should look at liquidity risk in combination with capital regulations and aggregate
debt of the economy and of the financial sector. These aspects are altogether missing in the
current regulatory thinking.
There were some good proposals put forward by academia and regulators in the aftermath of
the global financial crisis. These were much closer to the principles of Islamic economics and
finance. However, those proposals were not given their due weight in the reform efforts taken
up by the Basel Committee and international forums like G-20. The approach taken is to tweak
and fine tune the existing framework which is politically easy but does not address the
fundamental problems which remain at the heart of the crisis. Islamic finance practitioners,
researchers and regulators have to shoulder this responsibility to make a change in the global
financial system.

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Appendix-1
Basel III on Liquidity Risk
The financial crisis highlighted the lack of sound liquidity risk management at financial
institutions and the need to address systemic liquidity riskthe risk that multiple institutions
may face simultaneous difficulties in rolling over their short-term debts or in obtaining new
short-term funding through widespread dislocations of money and capital markets. IMF Global
Financial Stability Report (GSFR) 2011 takes the view that liquidity risk can materialize in two
basic forms:
Market liquidity risk, which is the risk that a firm will not be able to sell an asset quickly
without materially affecting its price;
16
and
Funding liquidity risk, which is the risk that a firm will not be able to meet expected cash
flow requirements (future and current) by raising funds on short notice.
Under Basel III, individual banks will have to maintain higher and better quality liquid assets and
to better manage their liquidity risk. However, because they target only individual banks, the
Basel III liquidity rules can play only a limited role in addressing systemic liquidity risk concerns.
Larger liquidity buffers at each bank should lower the risk that multiple institutions will
simultaneously face liquidity shortfalls; but the Basel III rules do not address the additional risk
of such simultaneous shortfalls arising out of the interconnectedness of various institutions
across a host of financial markets.
Basel III establishes two liquidity standardsa liquidity coverage ratio (LCR) and a net stable
funding ratio (NSFR) to be introduced after an observation period and further refinements.
Principles for liquidity risk management existed before the crisis, but these rules represent the
first time that quantitative standards for liquidity risk have been set at a global level.
17

The LCR aims to improve a banks ability to withstand a month-long period of liquidity stress as
severe as that seen in the 2007-08 financial crisis. The LCR is defined as the stock of high-
quality liquid assets divided by a measure of a banks net cash outflows over a 30-day time
period. The resulting ratio should be at least 100 percent.
The NSFR aims to encourage more medium and long-term funding of the assets and activities of
the bank, including off-balance sheet exposures as well as capital market activities, and thereby
reduce the extent of maturity mismatch at the bank. In theory, this would lower a banks
probability of liquidity runs and associated default. The ratio is defined as a banks available

16 Market liquidity can also be defined as the difference between the transaction price and the fundamental value of
a security (Brunnermeier and Pedersen, 2009)
17 The latest version of the framework was published in December 2010. An observation period will precede official
implementation of the ratios as a minimum standard. In both cases, any revisions to the factors will be finalized one
and a half years before their implementation, which will be on 1 January 2015 for the LCR and 1 January 2018 for the
NSFR
| P a g e 26

stable funding (ASF) divided by its required stable funding (RSF) and must be greater than 100
percent.
Proposed Measurement Methods of Systemic Liquidity Risk
Three measurement methods, which are complementary to the Basel III liquidity standards, are
proposed and expected to accomplish two goals: (1) measure the extent to which an institution
contributes to systemic liquidity risk; and (2) use this to indirectly price the liquidity assistance
that an institution would receive from a central bank. Proper pricing of this assistance would
help lower the scale of liquidity support warranted by a central bank in times of stress.
The methods are (1) a systemic liquidity risk index (SLRI), that is, a market-based index of
systemic liquidity based on violations of common arbitrage relationships; (2) a systemic risk-
adjusted liquidity (SRL) model, based on a combination of balance sheet and market data and on
options pricing concepts of a financial institution, to calculate the joint probability of
simultaneous liquidity shortfalls and the marginal contribution of a financial institution to
systemic liquidity risk; and (3) a macro stress testing model to gauge the effects of an adverse
macroeconomic or financial environment on the solvency of multiple institutions and in turn on
systemic liquidity risk. Details of the proposed methodologies are depicted in the table below.

| P a g e 27

Main Features of the Proposed Methodologies

Source: IMF Global Financial Stability Report (2011)


| P a g e 28

Appendix - 2
Data Description
Data for Islamic Banks is obtained from Islamic Banks Information System (IBIS) provided by
Islamic Research and Training Institute. The IBIS is available on-line at www.ibisonline.net
We used data from 61 Islamic Banks from 18 countries for the period 2000 to 2009. However,
due to missing values in some years for some banks or because of new banks coming into
existence in some countries the sample has to be adjusted accordingly. Hence it is unbalanced
dynamic sample. Following table shows the distribution of our sample coverage by showing
actual number of Islamic banks covered in each country by each year. In total 524 data points
were used for analysis.
Description of Data: Number of Islamic Banks Covered by Country and Year
Country
2
0
0
0

2
0
0
1

2
0
0
2

2
0
0
3

2
0
0
4

2
0
0
5

2
0
0
6

2
0
0
7

2
0
0
8

2
0
0
9

Total
Data
Points
Algeria 1 1 1 1 1 1 1 1 1 1 10
Bahrain 7 8 9 8 9 11 12 11 11 10 96
Bangladesh 2 2 2 2 2 2 2 2 2 2 20
Egypt 2 2 2 2 2 2 2 2 2 2 20
Indonesia 2 2 2 2 2 2 2 2 2 2 20
Jordan 2 2 2 2 2 2 2 2 2 2 20
Kuwait 2 2 2 2 2 2 2 2 2 2 20
Malaysia 3 3 3 3 3 4 3 3 3 3 31
Pakistan 2 2 2 1 3 3 3 4 4 3 27
Palestine 1 1 1 1 1 1 1 1 1 1 10
Qatar 3 3 3 3 3 3 3 3 3 3 30
Saudi Arabia 2 2 2 2 2 2 2 2 2 2 20
South Africa 1 1 1 1 1 1 1 1 1 1 10
Sudan 5 8 8 10 6 9 10 9 9 7 81
Tunisia 1 1 1 1 1 1 1 1 1 1 10
Turkey 3 3 3 3 3 4 4 4 4 4 35
UAE 3 3 3 3 4 4 4 5 5 5 39
Yemen 2 2 3 3 3 3 2 3 2 2 25
Total Banks 44 48 50 50 50 57 57 58 57 53 524

The full set of data was not available for all variables, as there can be missing observations.
When this occurred the sample is adjusted suitably.
The variables used for this study include: total assets, liquid assets, cash & cash equivalents,
total financing, total deposits, maturity of assets, maturity of liabilities.

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