Liquidity Risk
Download as PPTX, PDF3 likes3,559 views
This document discusses liquidity risk in Islamic finance. It defines liquidity risk as a bank's potential inability to meet short-term financial demands due to difficulties liquidating assets. For Islamic banks, liquidity risk is critical as they cannot borrow funds through interest or sell debt assets. The document identifies two types of liquidity risk - funding liquidity, which is the inability to raise funds for business growth, and market liquidity, which is the inability to liquidate assets quickly. It also discusses causes of liquidity risk for Islamic banks like limited Sharia-compliant money markets and differences in Islamic legal interpretations. The document recommends mitigation strategies like risk dispersal and a diversified portfolio, and notes IFSB guiding principles
Liquidity Risk
- 2. Liquidity Risk Content Liquidity Risk in Islamic Banks Type of Liquidity Risk Importance of Accounting for Liquidity Risk Causes of Islamic Banking in Liquidity Risk Mitigation of Liquidity Risk IFSB Guiding Principles on Liquidity Risk Learning Outcome • To explain what is Liquidity Risk in conventional means and Islamic means • To identify the differences between Islamic Liquidity Risk and Conventional Liquidity Risk • To identify the causes of Liquidity Risk • To know how to mitigate the Liquidity Risk 2
- 3. Introduction Refers to bank’s potential inability to liquidate positions quickly and sufficiently Bank may have sufficient asset but no quick demands thus cannot be liquidated Relates to bank’s ability to honour its; obligations in meeting demands from depositors for withdrawal of their deposits ability to find replacement sources of funds to continue supporting its business growth The quality of liquid assets is determined by how fast assets can be liquidated Their realised value (sometimes assets are valued at heavy discounts during distressed situations) 3
- 4. Definition There are 2 definition: Probability of loss arising from a situation where: (1) there will not be enough cash and/or cash equivalents to meet the needs of depositors and borrowers, (2) sale of illiquid assets will yield less than their fair value, or (3) illiquid assets will not be sold at the desired time due to lack of buyers. Liquidity risk is the risk that a company or bank may be unable to meet short term financial demands. This usually occurs due to the inability to convert a security or hard asset to cash without a loss of capital and/or income in the process. 4
- 5. Liquidity Risk in Islamic Banks As mentioned above, liquidity risk arises from either difficulties in obtaining cash at reasonable cost from borrowings or sale of assets. The liquidity risk arising from both sources is critical for Islamic banks. As interest based loans are prohibited by Shariah, Islamic banks cannot borrow funds to meet liquidity requirement in case of need. Furthermore, Shariah does not allow the sale of debt, other than its face value. Thus, to raise funds by selling debt-based assets is not an option for Islamic financial institutions. 5
- 6. How Does It Work? Liquidity risk generally arises when a business or individual with immediate cash needs, holds a valuable asset that it can not trade or sell at market value due to a lack of buyers, or due to an inefficient market where it is difficult to bring buyers and sellers together. 6
- 7. For Example: Consider a RM500,000 home with no buyers. The home obviously has value, but due to market conditions at the time, there may be no interested buyers. In better economic times when market conditions improve and demand increases, the house may sell for well above that price. However, due to the home owner’s need of cash to meet near term financial demands, the owner may be unable to wait and have no other choice but to sell the house in an illiquid market at a significant loss. Hence, the liquidity risk of holding this asset. 7
- 8. Type of Liquidity Risk 2 types of Liquidity risk: Funding liquidity Market liquidity risk Refers to bank’s inability to raise liquidity but differs in terms of the purpose of raising liquidity. 8
- 9. 1 . Funding Liquidity Inability of bank to meet its funding requirements for business growth common bank’s funding resources; Customers deposits from individuals, corporate entities Bank’s own capital e.g from issuance of sukuk. Shareholders inject of capital; but it is an expensive funding cost since capital requires return on equity Unavailability of fund causes liquidity risk which hinders bank’s ability to grow 9
- 10. 2. Market Liquidity Risk Refers to the bank’s potential inability to liquidate quickly and sufficiently for financial obligations such as depositors’ withdrawal. Banks may have sufficient asset but no quick demand for such asset thus can not be liquidated within specified timeframe. Or asset can be liquidated but at a high discounted rate thus the liquidated fund is insufficient. During situations of no new deposits, banks have to ensure available funds – if the bank has sukuk financing, it need to dispose the sukuk to meet the withdrawals. 10
- 11. History of Liquidity Risk History has shown that liquidity risk is one of the major causes of bank bankruptcy. The bankruptcy of Long Term Capital Management in America 1997, the Indonesian banking crisis of 1997, the bankruptcy of Northern Rock bank is the UK in 2007 and the case of Century Bank in Indonesia in 2008 were all triggered by liquidity risk. 11
- 12. Importance of Accounting for Liquidity Risk Purchasers and owners of long term assets must take into account the saleability of assets when considering their own short term cash needs. Assets that are difficult to sell in an illiquid market carry a liquidity risk since they can not be easily converted to cash at a time of need. Liquidity risk may lower the value of certain assets or businesses due to the increased potential of capital loss. Liquidity risk is also ever present. It can happen at any time. 12
- 13. Islamic vs Conventional Islamic Instruments of Islamic Banks are Shariah Compliant compared to Conv Banks Free of Riba, Gharar and Maysir Conventional On the other hand, conventional banks are more focused on gaining profit in any means necessary. This includes means of Riba, Gharar and Maysir. 13
- 14. Causes of Islamic Banking in Liquidity Risk Limited accessibility of the Sharia compatible money market and intra-band market. Slow development of financial instrument which avert Islamic banks of raising funds from market when needed The fact that most available conventional instruments used for liquidity management are interest-based; therefore, they are not Sharia compliant 14
- 15. Small number of Islamic banks, as they emerged quite recently and are very young compared to their competitors. Different interpretations of Sharia teaching is a critical source of liquidity risk. For example, the contract of bay’ al- dayn (sale of debt) is allowed in Malaysia, while in other countries, it may not be allowed to be used. 15
- 16. Mitigation of Liquidity Risk Dispersal of risk = Responsibility of liquidity risk is assumed by both the bank and the investors. Understanding your time horizon (eg, ForEx) Diversified portfolio = Investments that you can sell right away, such as bonds, as well as long-term investments that are not liquid, such as CDs. Keep enough of your assets liquid to cover your short-term obligations 16
- 17. IFSB Guiding Principles on Liquidity Risk 1. IFI should have a sound and comprehensive liquidity risk management framework to maintain sufficient liquidity to meet its daily funding needs and cover any deviations. BOD should establish level of liquidity risk to be tolerated BOD should establish, approve and review from time to time the liquidity risk management strategy 2. IFI should have appropriate governance process to identify, measure, monitor, report and control liquidity risk in compliance with Shariah rules. Should specify roles an responsibilities of senior management, Shariah supervisory board, the business units 17
- 18. IFI should be able to identify sources of primary and secondary risks that can lead to liquidity risk e.g. the diminishing number of deposits or depositors. The management framework should be integrated within firm-wide, taking into account the market risk, liquidity risk, operational risk, credit risk. IFI should ensure that it has a well-diversified funding base that fits with its nature of business If the institution is a part of conventional bank, the management should prepare a strategy. Policy and procedure suitable for Islamic operations 18
- 19. Mahyuddin Khalid End of Chapter 19