Liquidity Management and Islamic Banks, the need for markets

Think Piece By Prof. Dr. Obiyathulla Ismath Bacha

A recent IMF study which compared Islamic and conventional banks in the GCC (Gulf Cooperation Council) countries made several interesting observations. Of these, two key points were as follows, first, Islamic banks have much more liquidity (liquid assets) on their balance sheets relative to conventional banks. Second, Islamic banks are on average less profitable than conventional banks over the 6 years period of study, when measured by Return on Assets (ROA) or Return on Equity (ROE). Holding liquid assets earns a bank nothing, the fund has to be put to use as customer financing. Not only are potential returns foregone but depositors whose funds it is, will be expecting returns. Thus the lower ROA and ROE of GCC Islamic banks is the direct result of carrying too much liquidity.

That Islamic banks hold too much liquid assets appears to be a global phenomenon. The question that arises is, why is this the case? Banking, whether conventional of Islamic, has an inherent mismatch. Banks take in money as deposits, which can be withdrawn at any time and give out the money as loans with fixed future maturities. This maturity transformation has inbuilt liquidity mismatch. Conventional banking, rather than hold huge amounts of cash to meet liquidity mismatches, has overtime evolved ancillary systems to help in the liquidity management. This is the interbank money market. The money market evolved to meet the liquidity challenges of the banking system but more than merely being a platform for players to borrow and lend among themselves, it has now become a source of price discovery. That is, the determination of short term rates. The short end of the yield curve is derived from activity in the money market. The money market acts as a sponge, contracting and expanding in tandem with banking sector liquidity needs. Well-developed money markets enable banks to minimize the liquid assets they need to hold thereby enabling them to put to use and earn from funds that otherwise would be kept idle, even for short periods. In addition to helping banks with outplacement and enhancing returns, efficient money markets can reduce the cost of funds to banks. In developed capital markets, money market funds are usually the cheapest source of funds for banks. Such reduced costs, enables banks to price their loans competitively.

As money markets evolved, their price discovery function became more important than the liquidity management ability. Taking a macro viewpoint, it is easy to see how important money markets can be to both banking and overall macro-economic efficiency.  It is also easy to see how their absence can be a huge drag on macro-economic efficiency. With the exception of Sudan and Iran, Islamic banks operate within dual banking systems. Islamic banks have products and processes that mimic conventional banks and are expected to be cost competitive with them, yet, with the exception of Malaysia, Islamic banks have no access to money markets. The result is the above IMF finding that Islamic banks have excessive liquid assets and lower profitability.  There is more to this than reduced operational efficiency of banks.

In all countries other than Malaysia, Islamic banks have to manage their liquidity mismatches by way of bilateral arrangements usually with their Central banks or an affiliated agency of the Central bank. Borrowing and lending takes place by buying and selling papers/sukuk. For example, the Islamic bank with surplus funds will buy sukuk from the Central bank and resell it to the Central bank when it needs liquidity. The Islamic bank is a price taker, how the Central bank determines the required yield is unknown, but, there appears to be a high correlation with prevailing interest rates in the conventional banking sector. While such bilateral arrangements solve the liquidity problem of banks, there is no means for price discovery. So, how are loans priced by Islamic banks? Answer, in most cases by using rates similar to those charged in the conventional banking system. It is no surprise therefore that after more than 30 years of Islamic banking, there is no Islamic benchmark rate. This obvious absence is due to a lack of market trading. Without market trading to determine required returns, Islamic banks and Islamic finance more broadly, cannot shake off its reliance on interest rates. Thus, today we have several large global sovereign sukuk outstanding that have their returns benchmarked on LIBOR (London Interbank Offer Rate), which is an interbank money market rate arrived at through trading in London. Shariah scholars have conveniently accepted this practice as “mere benchmarking” or the use of a proxy, but it points to a much larger issue, the superficiality of Islamic banking even after a 30 to 40 years presence. The fact that it has not been able to put down the roots needed to create its own pricing mechanism is testimony to misplaced emphasis. The emphasis on form rather than substance. Continuing on this path is likely to lead to convergence with conventional banking and irrelevance of an Islamic banking system built to mimic.

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