LECTURE 12 �Treasury Management

Islamic Bank Management

FEB UI

Wahyu JATMIKO, PhD I Ronald Rulindo, PhD

wahyujatmiko@ui.ac.id | w.jatmiko09@gmail.com I rulindoku@gmail.com

May 2022

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Liquidity Risk

Wahyu Jatmiko | Treasury Management

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Concept of Liquidity and Risks

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• Liquidity ‘is easier to recognize than to define’
• ‘the ease with which value can be realized from assets’
• ‘the ease with which an asset can be exchanged for money without loss of value’
• also implies ‘availability of cash’
• Financial intermediation—liquidity transformation
• short-term liabilities transformed into long-term assets—can potentially create liquidity problems
• More and more dependence on market to get liquidity through tradable securities
• Liquidity risk: potential loss to a bank arising from its inability to ‘meet obligations as they come due because of insufficient liquid asset, an inability to liquidate assets or to obtain adequate funding (IFC)’

Quality of Assets and Liquidity Risks

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• Liquidity is a valuable feature and priced accordingly
• Assets (loans) originated by a bank affects its balance sheet only
• Default reduces its value of assets
• Is illiquid if cannot be securitized and sold
• Securities—financial assets originated by others
• Change in market conditions of securities can lead to lowering of their quality and value
• Value of securities held by a bank can go down (due to mark-to-market)—can sell securities only at lower prices
• Market changes in prices has the potential to create system wide liquidity crisis

Liquidity & Insolvency—Example

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A + E > L [105k > 95k]—the firm is solvent

Assume the following withdrawals:

1. Depositors withdraw 5000, will be able to pay from cash
2. Depositors withdraw 10,000, will be able to pay from cash and deposits from bank
3. Depositors withdraw 15,000, will be able to pay from cash, deposits and selling bonds.

What if the bank cannot sell bonds?

Sources of Liquidity Risks

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• Liability side
• Large withdrawals of deposits
• Uncertainty about renewable inter-bank loans
• Assets side
• Uncertainty of loan repayments
• Uncertainty about the loan sizes (new requests or renewal of old loans)
• Uncertainty about liquidity of financial assets held
• Off-balance sheet
• Contingent claims and commitments (including guarantees, credit lines, positions taken on derivatives markets, etc.).

Liquidity Risk Assessment

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Liquidity Risk Measures

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• Can be measured as ‘stocks’ or ‘flows’
• Stock approach—uses balance sheet items
• Short-term debt obligations vs. liquid assets or asset that can be liquidated or used to obtain loans
• Long term funding ratio used for measuring long term liquidity positions

Liquidity Measures—Flow Approach

Wahyu Jatmiko | Treasury Management

• Maturity Ladder—compares a bank’s future cash inflows and outflows over different maturity time bands
• Shows the liquidity mis-match or gaps
• Net Funding Requirement for each time band
• Cumulative Funding Requirement for the over the overall timeframe

Maturity Ladder-Example

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Liquidity Risks

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Liquidity risks categorized into two major types

• Funding liquidity risks:
• Unable to use credit worthiness to obtain external funding
• the risk that a firm will not be able to meet its expected and unexpected current and future cash flow and collateral needs from external sources without affecting its operations or financial condition
• Market liquidity risks:
• the risk that a firm cannot easily offset or eliminate a position at the market price because of inadequate market depth or market disruption

Liquidity Infrastructure

Wahyu Jatmiko | Treasury Management

Elements of Liquidity Infrastructure for a sound and competitive financial sector includes:

• Business laws (securities, capital markets, bankruptcy, etc.)
• Secure and efficient payment system
• Well functioning money markets
• Timely and accurate information disclosure and transparency
• Public safety nets (LLOR)

Mitigating Funding Liquidity Risks

Wahyu Jatmiko | Treasury Management

• The bank can borrow funds
• Inter-bank markets
• Money-markets
• Borrowing would require a good quality collateral
• Most FIs would not provide funds to banks in trouble
• Issue short-term debt securities to raise funds from markets (including repos)
• Securitize assets and raise funds over longer terms
• Lender of the last resort (from the central bank)

Market Liquidity

Wahyu Jatmiko | Treasury Management

• Dimensions of market liquidity
• Market depth: ability to carry out large market transaction without affecting the price too much
• Tightness: small gap between bid and offer prices
• Immediacy: the speed at which transactions can be carried out
• Resilience: speed at which prices of underlying prices revert to former levels after a shock
• A market is liquid if
• Market infrastructure is efficient (low transactions cost and narrow bid-ask spreads)
• Large number of buyers and sellers
• Assets transacted are transparent (prices reflect the characteristics of the security)

Lender of the Last Resort (LLOR)

Wahyu Jatmiko | Treasury Management

• If everything fails, the bank can go to the central bank for liquidity support—LLOR
• The crisis has shown the central bank can also play the role of ‘Market-maker of the last resort’
• Buy illiquid assets through open market operations at discounted prices
• Use illiquid assets as collateral to provide financing

Liquidity Risk Management

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Who Should Manage Liquidity Risks?

Wahyu Jatmiko | Treasury Management

• Arguments for Regulating Liquidity
• Market failure
• No incentives for banks to hold liquid assets (as they do not earn income on liquid assets)
• Liquidity crisis are low probability events
• Liquidity can bring about stability (a public good)—banks with higher liquidity can withstand larger shocks
• Protect the depositors (from bank failures)
• Distribution of responsibility to manage liquidity risks between banks and regulator?

Basel Framework

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• Basel II did not have anything on liquidity risks
• Liquidity risks were a key feature of the GFC
• Along with capital adequacy standards (for mitigating credit, market and operational risks), Basel III incorporates standards for liquidity risk
• Liquidity Ratios
• Liquidity Coverage Ratio (LCR)
• Net Stable Funding Ratio (NSFR)

Liquidity Coverage Ratio (LCR)

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Net Stable Funding Ratio (NSFR)

Wahyu Jatmiko | Treasury Management

Liquidity Risk Management in Islamic Finance

Wahyu Jatmiko | Treasury Management

Liquidity Issues for Islamic Banks

Wahyu Jatmiko | Treasury Management

Funding Liquidity Risks

• The bank cannot borrow funds on interest
• Inter-bank markets/Money-markets
• Issue short-term debt securities to raise funds from markets (including repos)
• Islamic repos?
• Lender of the last resort (from the central bank)
• Need for Shari’ah compliant financing

Liquidity Issues for Islamic Banks

Wahyu Jatmiko | Treasury Management

Market Liquidity Risks

• Debt securities cannot be sold at discount
• Securitize assets and raise funds over longer terms
• Possible if securities are asset-backed
• Sukuk markets in most countries are weak and lack depth

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The government has a role to create market infrastructures for Islamic securities

Liquidity Issues for Islamic Banks

Wahyu Jatmiko | Treasury Management

FSB-12 (2012): GUIDING PRINCIPLES ON LIQUIDITY RISK MANAGEMENT FOR INSTITUTIONS OFFERING ISLAMIC FINANCIAL SERVICES [EXCLUDING ISLAMIC INSURANCE (TAKĀFUL) INSTITUTIONS AND ISLAMIC COLLECTIVE INVESTMENT SCHEMES]

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Elements of Liquidity Infrastructure for a sound and competitive IF sector includes:

• Business laws (securities, capital markets, bankruptcy, etc.)
• Secure and efficient payment system
• Well functioning Islamic money markets
• Timely and accurate information disclosure and transparency
• Public safety nets (LLOR)
• Shari’ah governance framework

Islamic Liquidity—Global Initiatives

Wahyu Jatmiko | Treasury Management

• International Islamic Financial Markets (IIFM)
• Established in 2002 in Bahrain
• Global standard setting body for Islamic capital and money market instruments
• Liquidity Management Centre (LMC)
• Established in 2002 in Bahrain
• To help Islamic financial institutions manage their liquidity mismatch through money-markets and short and medium term liquid investments
• International Islamic Liquidity Management Corp. (IILM)
• Established in 2010 in Malaysia
• To create and issue short-term Shari’ah-compliant financial instruments to facilitate effective cross-border Islamic liquidity management

Islamic Liquidity Management Shari’ah Compliant Initiatives

Wahyu Jatmiko | Treasury Management

• Malaysia
• Islamic Interbank Money Market (IIMM): mudarabah based interbank market
• Bursa Suq al-Sila: Commodity trading platform
• Indonesia
• Domestic Interbank Shari’ah Financial Market: Mudarabah based Interbank Investment Certificate
• Bank Indonesia Certificate
• Bahrain
• Short-term salam and ijarah sukuk
• UAE
• Islamic certificates of deposits: commodity Murabahah based certificates
• IIFM
• Islamic Repos

Islamic Liquidity Management Shari’ah Based Initiative

Wahyu Jatmiko | Treasury Management

Central Bank of Sudan encouraged the development of ‘alliance groups’ (takaful structure)

• Established an investment portfolio to manage the excess and shortage of liquidity among group members
• Investment portfolio managed by separate entity fund
• Entity’s pool of assets highly liquid assets including sukuk, current deposits and cash
• Members get dividends annually

LOLR Facilities for IBs

Wahyu Jatmiko | Treasury Management

• Most of the LOLR facilities are interest-based

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Source: IFSB Stability Report 2013

SLOLR Facilities Structures

Wahyu Jatmiko | Treasury Management

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Source: IFSB Stability Report 2013

Thank you

Wahyu JATMIKO, PhD

wahyujatmiko@ui.ac.id

w.jatmiko09@gmail.com