By Rushdi Siddiqui, Global Head of Islamic Finance at Thomson Reuters
Let me start off with a loaded question, what one word in Islamic finance is as important as Shari’ah, tax, accounting, regulation, and standardisation (STARS)?
Here are some clues:
Islamic finance has institutions called Liquidity Management Center (LMC) in Bahrain, Liquidity Management House (LMH) in Kuwait, and International Islamic Liquidity Management Corporation (IILM) in Malaysia, plus other similar organisations with different names.
The UAE Central Bank has been encouraging commodity Murabaha certificate of deposits (CDs) and expanded to repurchase (repo) offerings to address short-term UAE Islamic bank needs.
The Central Bank of Bahrain (CBB) has been issuing liquidity, addressing Sukuk Al-Salaam, short term, non-tradable securities.
Index providers have created Shari’ah-compliant liquid blue chips, similar to the Dow Jones Islamic Market International Titans 100 Index.
At many of the Islamic finance conferences, there are speakers and sessions dedicated to liquidity management risk along with credit, operational, market, and Shari’ah non-compliant risk.
Thomson Reuters launched the Islamic Inter-bank Benchmark Rate (IIBR), decoupling from LIBOR, an indigenous innovation for Islamic banks to manage their own short term liquidity.
The Islamic Financial Services Board (IFSB) released documents directed towards enhancing reliability and stability in the industry, through The Development of Islamic Money Markets (technical notes), earlier this year.
The Bursa Suq Al-Sila (in Malaysia) is a commodity trading platform, underlying is, say, palm oil, directed towards facilitating Islamic liquidity management.
Well if you haven’t spotted the common thread, in a word it is liquidity and it goes with asset-liability matching. In Islamic finance, there has been a historical mismatch because of the lack of robust short-term money market instruments; primarily reliance on two party bi-lateral commodity Murabaha and Wakala agreements, to manage the liquidity, surplus and deficit of Islamic banks.
The challenges associated with bi-lateral agreements includes counter-party credit risk, meaning that the lending entity may not be able to get its funds back with profit, if the receiving entity goes out of business. Obviously, the situation becomes more pronounced if subjected to external shocks, like the credit crisis in 2008, where liquidity freezes, hence, presenting fire-priced asset sales as the only alternative with the resulting ‘systemic’ risk to the niche industry.
The short-term liquidity challenge has also produced something called ‘leakage,’ where Shari’ah-compliant funds are placed in ‘conventional’ spaces. For example, the CEO of CIMB Islamic Bank, Badlisyah Abdul Ghani, stated during an interview in 2007 that, “there is nothing wrong with commodity Murabaha as a structure … what is not liked is when proceeds … are used for non-Shari’ah purposes … this leakage of Islamic funds is huge … We estimate it is over $1.2 trillion … mostly invested in US Treasuries and non-compliant investment products …
There is continued chatter in the Islamic finance market place about authentic Shari’ah-based solutions, as today’s offering, to address short term liquidity, is about either removing the Haraam elements or placing Islamic ‘wrappers’ on their conventional counter-part products.
However, it must be understood that Islamic finance is an immensely small sub-set (valued at $1.2 trillion) of conventional finance (valued at over $100 trillion) and of course much younger, four decades versus four centuries. And to be fair yes, Islamic finance needs to stop using its infancy as an excuse and to dissociate from the law of necessity, as Islamic finance solutions are gradually surfacing.
Let’s also manage expectations accordingly on what issues Islamic finance can resolve today within this niche industry, before proposing it as a solution for the ills of conventional finance. Today, Islamic finance is more about incomplete product pushing at the national/country level, than providing holistic financial and financing solutions.
For example, conversations are invariably raised on the inefficiencies, such as the inability to achieve economies of scale/size or the lengthy time frame it takes to bring a Sukuk to the market in the GCC, associated with a lack of standardisation, hence, one possible reason that the conventional financial industry has not yet taken IF seriously. Thus, if we do not have a ‘unified’ and efficient approach to addressing some of our major issues like short term liquidity, then it is going to be a challenge for others to accept our advice regarding their concerns.
To grow Islamic finance to $2 trillion and cross-sell beyond its traditional markets, fundamental, not reactive, and foundational, not bi-lateral, approaches are needed and necessary. The thinking of ‘if, it ain’t broke, what you gonna fix,’ is no longer applicable to addressing short term liquidity in Islamic finance.
To get to the end-goal of so called ‘Islamic’ purity, the industry, with guidance from regulators, has to go through interim tolerance parameters that are time consuming to avoid self-destructive destabilisation. Islamic finance has to, at one level, reflect its age and maturity, and not that of the more established conventional finance. In fast tracking solutions, the law of unintended consequences kicks in, where the solution actually creates more problems.
Thus, the alternative approaches in different geographies to, say, liquidity to asset-liability mismatch is the industry recognising a challenge and transparently offering suggestions to find a solution. This reinforces the fact Islamic finance, today, is fragmented and domestic in nature, i.e., pieces in a jigsaw puzzle.
With the recent ‘conventional banking’ scandals over alleged Libor manipulation and money laundering, this openness needs to be both acknowledged and commended!