Liquidity management and the lack of a global Islamic interbank money market are perhaps two of the biggest challenges for the future development of the global Islamic finance industry. These challenges apply both in Muslim and non-Muslim markets.
While regulators, industry organizations and market players have repeatedly stressed the urgent need for a global Islamic interbank market and a liquidity management scheme, the sector has not moved much forward in this respect, instead relying on tried and tested and potentially contentious commodity Murabaha contracts placed through the London Metal Exchange (LME).
Speaking in London at a conference on the “Emerging Financial Stability Framework” organized by the Kuala Lumpur-based Islamic Financial Services Board (IFSB), the Jeddah-based Islamic Development Bank (IDB) and its research arm, the Islamic Research and Training Institute (IRTI) in early July 2009, Professor Rifaat Abdel Karim, the Secretary General of IFSB, once again reiterated, “We need to expedite the development of a systemic liquidity infrastructure for the Islamic financial services industry, as this constitutes one of the key prerequisites for sustaining financial stability. We need to step up our efforts to foster the development of liquid sovereign Sukuk markets, Islamic interbank money markets and more efficient tradable Shariah-compliant financial instruments.” Bank Negara Malaysia, the central bank, together with the Securities Commission and Bursa Malaysia and industry players, launched the Commodity Murabaha House (CMH), which will act as a liquidity management scheme for Islamic bank’s overnight and short-term deposits in Malaysia, based on using crude palm oil as the underlying commodity traded for investment. In June this year, the CMH launched a Palm Oil Murabaha which allows Islamic financial institutions and other institutions to create transactions using Palm Oil contracts. A taskforce set up last year by the Islamic Development Bank and the IFSB has identified a number of building blocks for the Islamic finance sector development and for sustained stability architecture. These blocks address the issues of liquidity infrastructure, prudential standards, financial safety net mechanisms, procedures for crisis management and resolution, cross sectoral policy cooperation and macro-prudential surveillance. But to what extent do the aspirations of the Islamic finance industry match the actual practice or regulators, market players and stakeholders? According to professor Volker Nienhaus, president of Marburg University in Germany and a seasoned analyst of the Islamic banking industry, as far as support of market players by central banks and regulators in terms of developing a liquidity infrastructure, there is indeed a huge discrepancy between ideals and practice. This is largely due to the immaturity of Islamic finance markets.
Similarly, stressed Nienhaus, there is a mismatch between the need for a liquidity management infrastructure and monetary policy in many markets. The lack of a flexible and Shariah-compliant money markets and underdeveloped secondary markets for use of long-term Sukuk for short-term liquidity management has meant that Islamic financial institutions are widely using “second-best” instruments such as compensating deposits and Tawarruq. Nienhaus proposes the design of private and public Islamic money markets and government financing instruments with low risk, regular issues and wide holding features. These instruments could be used for monetary policy purposes and for reserve requirements for Islamic banks.
In terms of risk management, capital adequacy and corporate governance, there are several IFSB standards and exposure drafts available, but they are not yet generally applied because these are published on the basis of voluntary adoption. Nienhaus also rues the lack of a Lender of Last Resort in Islamic finance and inadequate deposit insurance schemes with only Malaysia and Turkey having Shariah-compliant deposit insurance schemes based on Takaful.
In terms of crisis prevention and early warning systems, Nienhaus warned that the Islamic finance sector does not have any macro-prudential surveillance and financial stability analysis. This is partly because these should be supra-national and supra-governmental.
Islamic banks can use commodity Murabaha as a liquidity management scheme for overnight and short-term deposits. The latest model to emerge is a scheme based on the Bai Salam (forward sale) contract and proposed at the recent IFSB “Emerging Financial Stability Framework” conference by Sami Al-Suwaillam, Deputy Director of IRTI. According to Dr Al-Suwaillam, the objectives for an alternative liquidity management scheme must be “optimal fund management; minimum transaction costs; and flexible short-to-medium-to- longer-term funds and borrowing.”
He suggests that using the Bai Salam contract to lend money and to collect assets and commodities may be a more efficient and cost-effective liquidity management system, although he acknowledges that a problem could be the price risk for future delivery of the commodity or asset. But this could be mitigated by a fund to protect value through a dynamic asset allocation strategy. “The Bai Salam could be traded on the basis of a parallel Bai Salam, where the buyer has recourse to the Islamic banks and the new owner has recourse to the counterparty if the party does not deliver the commodity or asset. The bank would be issuing a new Bai Salam contract with identical terms to the original Bai Salam. The Bank effectively takes the credit risk,” he explained.
Market players such as Badlisyah Abdul Ghani, CEO of CIMB Islamic Bank, however, stresses that it may be better for each market to develop its own Islamic liquidity management scheme, before the industry contemplates establishing a global Islamic interbank system.
