Abstract
This paper investigates the most common Islamic-based instruments for managing liquidity. It demonstrates that Islamic financial institutions have limited financial tools for this purpose because they can only use sharia-compliant products, while conventional financial institutions could use interest-based tools. Therefore, common liquidity management tools available to these institutions are Murabaha and Sukuk. However, sukuk is the “must have” liquidity management tool. Nonetheless, this paper suggests that its holders need to consider other short-term financial tools to manage liquidity. Concisely, if they make more effort to identify viable assets for investment, there should be no hindrance for governments, or regulatory bodies, to create other successful liquidity management tools.
Introduction
Liquidity management is a common problem in the financial sector (Onal, 2013). It does not only affect Islamic financial institutions, but conventional financial institutions as well. Albeit a complex process, it is crucial to understand how to manage liquidity issues. The failure to do so may cause serious financial issues, such as the collapse of the financial system, or the collapse of a financial institution (Padmalatha, 2011). In fact, research shows that the failure of many financial institutions and systems partly stem from inefficiencies and incompetence when managing liquidity issues (Duttweiler, 2011). This finding explains why many government agencies (regulators) are concerned about the liquidity of financial institutions. Consequently, mainstream thinking in government focuses on improving the regulatory framework for managing liquidity problems. Based on this background, this paper explores available Islamic-based financial instruments for managing liquidity. The research aim is as follows
Research Aim: To find out existing Islamic instruments for managing liquidity
Experimental Techniques and Methods
This paper is an integrative review of past research studies about Islamic instruments for liquidity management. “Liquidity management” and “Islamic financial institutions” were the keywords in the review. The study used Information from peer-reviewed books, journals and selected websites. Using the coding technique, the information obtained was summarized into groups of information that had the same themes. This process revealed the following findings
Results and Discussion
Liquidity Management Problems
Before exploring the liquidity problems that affect Islamic financial institutions, it is important to understand that liquidity refers to the ease through which financial institutions could exchange one asset for another, without significant losses in value (Abdul-Rahman, 2004). Liquidity problems arise when financial institutions strive to maximise their returns by buying assets and limiting their cash flow (Ismal, 2013). The same problem could occur if the financial institutions do not buy assets and have too much money. Based on both scenarios, financial institutions need to balance their investments and cash flow. Many Islamic financial institutions operate at a 100% reserve requirement (Ismal, 2013). This percentage is self-imposed. The unwillingness of different central banks to extend borrowing privileges to these institutions further exacerbates their liquidity problems because such banks always strive to protect themselves from “runs.” Islamic financial institutions also experience the same problem because of their inability to gain access to government-guaranteed bonds (Ismal, 2013). To explain this issue, Abdul-Rahman (2004) says:
“The opportunity cost of the cash held by Islamic financial institutions, as insurance against a devastating “run,” is the interest rate born on government debt (otherwise known as the seignorage accrued by the government issuing the currency being held by the bank)” (p. 5).
In line with the above findings, Islamic financial institutions often suffer from two problems (compared to conventional financial institutions) (a) their inability to gain access to central reserve funds and (b) the lack of access to government guarantees, which require them to hold on to cash reserves (Abdul-Rahman, 2004). Based on these problems, Islamic financial institutions often have only two options – (a) invest their excess cash flow in financial programs that earn an interest or (b) invest their excess cash flow in financial programs and forego the interest (Riba) accrued. Faced with this dilemma, these institutions often resort to one of the following strategic choices: Refuse to take Interest, take Interest (but only use it for charity purposes), or invest in gold and precious metals (Abdul-Rahman, 2004). These measures outline the current practice that most Islamic financial institutions adopt to cater for the losses they experience through ineffective liquidity management processes. While some of the measures proposed in this article may fail to pass off as “generally agreed” sharia-compliant strategies for managing liquidity, confusion in the interpretation of sharia laws make it possible for their continued application (Abdul-Rahman, 2004). According to Bacha and Mirakhor (2013), such strategies pave the way for existing financial institutions to follow sharia laws (in future) without compromising their competitiveness in the financial market.
History of Islam-Based Liquidity Management Tools
Generally, Islamic financial institutions have higher liquidity levels than conventional financial institutions. For example, Majid and Rais (2003) say financial institutions in the Middle East have a 50% higher liquidity level compared to conventional financial institutions. This is why financial institutions in the Middle East have more than $6 billion in liquid assets (out of $13.6 billion) (Majid & Rais, 2003). Such high liquidity levels mean that this money generates very few returns, or no returns at all (Majid & Rais, 2003). This situation is problematic because it means that Islamic financial institutions are going to be less competitive than conventional financial institutions.
Traditionally, Islamic financial institutions have used commodity murabahah to manage their liquidity issues (Schoon, 2010). However, because this tool had a limited space to invest short-term funds, it created inefficiencies in liquidity management (Majid & Rais, 2003). This problem forced many Islamic financial institutions to seek alternative instruments for managing liquidity issues (Majid & Rais, 2003). Consequently, Islamic financial institutions started using new liquidity management tools such as the sukuk to manage liquidity (Ariff, Iqbal, & Mohamad, 2012). At the same time, Muslim scholars were exploiting other alternative financial instruments for managing liquidity (International Monetary Fund, 2010). Their research mainly focused on seeking new tools that improved the inter-bank market (International Monetary Fund, 2010). The International Islamic Financial Market has supported the efforts of these Muslim scholars to find alternative financial tools for managing liquidity (Hunt-Ahmed, 2013). This institution has helped to build the legal and institutional infrastructure for research. The International Islamic finance market has also assumed the function of developing an active secondary market for researching the appropriate financial instruments for managing liquidity issues (Hunt-Ahmed, 2013). However, the proposed financial management tools have to consider the uniqueness of Islamic financial transactions
Uniqueness of Islamic Financial Institutions
Islamic financial institutions manage their liquidity differently from conventional financial institutions because the latter mainly uses interest-based financial instruments, while the former do not (Hunt-Ahmed, 2013). Islamic financial institutions cannot use interest-based financial tools to manage their liquidity because such instruments are not sharia-compliant (Majid & Rais, 2003). Sharia-compliance is at the centre of the operations of all Islamic financial institutions because without it, there would be no significant development of the Islamic interbank money market (Hunt-Ahmed, 2013). Nonetheless, similar to conventional financial institutions, Islamic banks have to manage their liquidity problems well to make sure they do not affect the smooth running of their operations (Majid & Rais, 2003). The same is true for their conventional counterparts.
The quest by Islamic banks to avoid using interest-based tools (riba) and relying on sharia-based tools to manage their liquidity, presents unique challenges for these institutions (Elasrag, 2014). Conventional banking institutions do not share this problem because they thrive in a well-developed interbank market that avails a wide array of financial tools for managing liquidity (Majid & Rais, 2003). Broadly, having access to the inter-bank money market is beneficial to conventional and Islamic financial institutions alike because it gives them access to short-term funds for correcting their liquidity positions (Majid & Rais, 2003). Secondary financial markets also pose similar benefits to these financial institutions. However, the unique nature of the operations of an Islamic financial institution limits its options to using asset-based financial instruments for managing liquidity (Elasrag, 2014). Therefore, the debt (bond) capital market is more useful to such institutions compared to other money markets. However, here lies the challenge because the bond market does not specifically cater to the operational needs of Islamic financial institutions. Indeed, the unique operational issues of Islamic financial institutions make them suffer liquidity problems. For example, Elasrag (2014) singles out the small number of participants, the slow development of Islamic financial instruments, the lack of acceptable interbank money market, and the absence of a liquid Islamic secondary market as the main causes of liquidity problems for Islamic financial institutions. Similarly, the lack of a lender of last resort for Islamic financial institutions and different interpretations of sharia laws also contribute to the liquidity problems of Islamic financial institutions. The diagram below summarises these operational issues
Islam-Based Liquidity Management Tools
Murabaha
Murabaha is a popular financial tool used by Islamic financial banks to manage their liquidity (Schoon, 2010). It is a contract for selling commodities in the financial market. This financial tool works by paying a 100% purchase price for a commodity and selling the same commodity to a third party for a specific sum of money that includes the cost and profit of the commodity (Schoon, 2010). The sale could accommodate a deferred payment that matures after six or 12 months. Two issues are critical in such transactions – an agreement on margins and ownership. Ownership may vary across the seller, buyer, or a third party who emerges when a seller resells the commodity in the secondary Murabaha market (Khan, 2013).
Islamic financial institutions use Murabaha to solve short-term liquidity issues. For example, some Middle East countries, such as the UAE and Saudi Arabia, have used it to purchased commodities from foreign markets (Majid & Rais, 2003). Particularly, these countries have used it to purchase precious metals in London as a measure for improving the liquidity positions of their local financial institutions (Majid & Rais, 2003). Malaysian financial institutions have also used this financial instrument, but instead of trading oil or precious stones (as Middle East Countries do); it trades crude palm oil (Majid & Rais, 2003). Ordinarily, Muslim scholars define these transactions as Tawarruq (Majid & Rais, 2003). In 2005, the Central bank of Malaysia officially endorsed such transactions as authentic tools for managing liquidity issues (Majid & Rais, 2003).
Although Murabaha is popular among many Islamic states, it suffers from market risks, counterparty credit risks, liquidity risks, and operational risks (Schoon, 2010). Other risks include rate of return risks and counterparty credit risks (Khan, 2013). Without delving much into the details surrounding these risks, most of them emerge from the multiple ownership transactions that emerge when trading commodities among different people (Khan, 2013). However, these risks are not the main deterrents for financial institutions to manage liquidity because the sharia permissibility of the financial tool mostly instils fear among Islamic financial institutions by prompting them to believe they contravene sharia principles when they make a profit margin from the resale of commodities (Elasrag, 2014). However, this conflict exists because of different sharia law interpretations.
ABC Islamic Fund
The ABC Islamic fund strives to improve the security and profitability of shareholder investments by managing liquidity. To do so, the fund allows financial institutions to take part in different financial transactions, such as Ijara and Murabahah (Majid & Rais, 2003). For example, through the Ijara system, Islamic banks could invest their excess money in another bank that subscribes to the same system. Using this investment model “Shares in funds are valued daily, based on accruals, by reference to the Net Assets Value (NAV) of the fund’s assets and bought and sold by customers at the Net Asset Value of the preceding business day” (Majid & Rais, 2003, p. 8). Based on this model, shareholders gain from an increase in investment value. The ABC Islamic fund system also protects customers if their investments do not yield a return because they receive their initial capital when their investments mature. This mechanism protects customers from prejudice that would occur if the values of their shares decrease (Majid & Rais, 2003). The ABC fund also allows financial institutions to adjust their liquidity positions by giving them a platform to participate in lucrative deals if they want. Such transactions happen through an irrevocable agreement between ABC and participating institutions that allow the latter to buy, or sell, shares for their investors. Although ABC could do so, it only participates in deals that would be lucrative to the shareholders (Majid & Rais, 2003). To know which investments would be most profitable, ABC uses conventional money market rates as an indicator of profitability.
Sukuk Al-Salam
Sukuk is the most commonly used financial tool in Islamic finance. Its proponents introduced it to increase the depth and breadth of available liquidity management tools (Ariff et al., 2012). A key part of this liquidity management tool is government bonds that often mature after about three months (Ariff et al., 2012). In this arrangement, financial institutions often prefer to use aluminium as the underlying trading asset. For example, the Bahrain monetary agency often sells aluminium to participating financial institutions in exchange for an advance payment (Ariff et al., 2012). When the participating institution wants to change its liquidity position, it appoints the agency as the seller for the aluminium.
Sukuk’s dominance should persist for long. Its recent issuance outside the precincts of Islamic finance (notably in the United Kingdom and Hong Kong) shows that Islamic finance is growing (Majid & Rais, 2003). However, the traditional problems associated with such investment tools persist because few investors hold it to maturity. Even fewer investors choose to trade with it (Majid & Rais, 2003). This challenge has made it difficult to properly price Sukuk products. It has also made it difficult to provide sufficient liquidity to participating institutions. Usually, these two problems exacerbate each other, thereby creating a bigger liquidity problem in the Islamic financial sector. Substantial interests by some non-Islamic financial institutions to use sukuk further exacerbate this problem because their participation makes it more competitive for Islamic financial institutions to gain access (Ariff et al., 2012). The relative paucity of its supply has also created fear among Islamic financial institutions that prefer to hold on to their sukuk products because they fear that they would not get others (Ariff et al., 2012). Consequently, the sukuk secondary market is mostly inactive. Investors also rarely see it as a liquid market.
Private Debts
Private debt is a financial instrument used by conventional and Islamic financial institutions to correct their liquidity positions. Non-Islamic financial institutions use it to manage liquidity because it is not interest-based (Majid & Rais, 2003). Some Islamic states have a well-developed private debt market than others do. For example, Malaysian Islamic financial institutions benefit from a well-developed private debt security market. In the early 2000s, the private debt market was more active than the bond market (Majid & Rais, 2003). This figure means that the private debt market was more vibrant than the bond market. Nonetheless, issuers of private bonds do so under different structures (some of which are contentious). For example, some Muslim scholars have expressed their concern with the structural composition of debt securities (Von-Pock, 2007).
Equity-Based Financial Instruments
Equity-based financial instruments are unpopular liquidity management tools among Islamic financial institutions. However, some countries use them as the dominant liquidity management tools. For example, Sudan often issues Musharakah certificates to their local financial institutions to manage liquidity (Majid & Rais, 2003). The government issues this financial instrument as part of its ownership of local commercial banks. The Ministry of Finance also issues Musharakah-based instruments as part of the government’s ownership of joint venture institutions, to manage liquidity (Majid & Rais, 2003). The Islamic Monetary Fund Staff often joins in this arrangement and helps to regulate and manage liquidity (Majid & Rais, 2003). Therefore, it is beneficial to some institutions when managing liquidity.
Other Financial Instruments for Managing Liquidity
Based on the limitations of existing tools for liquidity management, few Islamic financial institutions have properly managed their liquidity issues (Ariff et al., 2012). Consequently, governments and regional financial institutions have come up with selective, but innovative, interventions for managing liquidity. For example, several central banks and monetary authorities have created regional (international) financial bodies to provide short-term financial and sharia-compliant products to Islamic financial institutions. The International Islamic Liquidity Management Corporation is one such institution. It has helped to improve liquidity management across international borders. However, most of its interventions are regional, or constrained to only a few countries. For example, Bahrain introduced the Salam program to create local solutions for managing liquidity issues. It stands out as the most preferred liquidity management tool in the country and provides short-term liquidity to participating institutions. It differs from other types of financial tools because it premises on assets, as opposed to debt (Mohammed, 2014). For example, many Islamic-based institutions in Bahrain have used it to solve their short-term liquidity issues by trading oil products. In such arrangements, the government invites financial institutions to buy oil, or oil-based products, as a tool for solving liquidity issues. The transaction ends when the institutions sell these oil-based products after a fixed period (say two months). This is a Salam agreement. This arrangement does not only solve the short-term liquidity problems of participating financial institutions; it also boosts the secondary commodity market for other institutions that would want to participate. Although this tool is popular and has been in use for a long time, experts believe there is room for improvement (Mohammed, 2014). For example, its lack of diversity and redundancy has hampered its efficiency (Mohammed, 2014). Its limited supply also makes it difficult for financial institutions to exploit it. However, considering this program has many subscribers, similar programs (modelled on the Salam) should have relatively low risks. This view aligns with the views of Khan and Porzio (2010) who say Muslim scholars cannot continually rely on sovereign issuers to solve the liquidity challenges that Islamic financial institutions experience. Instead, they need to take proactive measures to shape their destinies. Replicating the structure of the Bahrain Salam program would allow prospective institutions to share the program’s success (Bacha & Mirakhor, 2013). In line with this recommendation, Cosgrave (2014) says, “Sharia-compliant hedging products have become increasingly popular and the structures used here can be transferred into new products such as structured investments that generate returns that may hinge on the performance of certain indices or other assets” (p. 27). Muslim scholars should also be more innovative when creating new market-based liquidity tools by exploiting the existing frameworks that support the same initiative.
Besides Bahrain, the Malaysian government also introduced alternative financial tools to help local financial institutions adjust their liquidity levels. To do so, it introduced the Islamic Monetary Agency, which strived to sell Islamic financial instruments as a tool for managing liquidity. Relative to this role, Majid & Rais (2003) say, “The Islamic financial instruments that are currently being traded in the IIMM because of Bai al Dayn, are the Green banker’s acceptances, Islamic accepted bills, Islamic mortgage bonds and Islamic private debt securities.” (p. 10). To adjust their liquidity levels, participating financial institutions could sell government investment issues on an Islamic foundation. Participating financial institutions could also buy the same securities from the central bank. The Malaysian bank also offers private debt securities to participating financial institutions (Majid & Rais, 2003).
Recommendations
This paper has already shown different types of liquidity management tools used by Islamic financial institutions. Although these instruments help to manage most of the liquidity issues that affect these institutions, they have many shortcomings. For example, they do not contribute to the creation of a secondary Islamic finance market, over-rely on short-term investments, have different sharia interpretations, and have no universal acceptance (Majid & Rais, 2003). Based on this challenge, Muslim scholars have proposed different Islamic-based financial alternatives for managing liquidity (Von-Pock, 2007). For example, they have proposed several alternatives to improve conventional interbank markets. They include
Mutual Financing and Inter-bank Cooperative Arrangements
Similar to conventional banking institutions, Islamic banks should have mutual financing arrangements that allow them to share losses and profits (Von-Pock, 2007). This arrangement would be useful to banks that require many resources to operate. Such an arrangement would also allow banks to use their surplus funds wisely by catering to the resource needs of other banks and balancing their asset and liability portfolios (Von-Pock, 2007). Muslim scholars also propose that Islamic banking institutions should have an inter-bank cooperative arrangement for reciprocal accommodation of all parties involved (Von-Pock, 2007). The only rule for this proposal is that the net use of this facility should be zero. So far, several Islamic states have heeded to this call and developed a common interbank market for liquidity management. For example, the Central Bank and Monetary Agencies of Malaysia, Indonesia and Sudan have come up with unique recommendations for building an infrastructure of liquidity management for local financial institutions (Majid & Rais, 2003). Other Islamic states, such as Brunei Darussalam and Bahrain (in partnership with Islamic financial institutions, such as the Islamic Development Bank), have also supported the same initiative (Majid & Rais, 2003).
Regulatory Interventions
Besides adopting structural adjustments to improve the efficiency of the Islamic money market, there should be more innovative initiatives by Islamic states to regulate the financial market. The Islamic Financial Board Taskforce has supported this initiative by encouraging central banks to support liquidity management (Stimpfle, 2011). It outlines unique steps that central banks should follow to meet this objective. For example, the taskforce says, the most important issue (here) is to “Design Islamic money markets and Islamic government-financing instruments harbouring relatively low risks that are simply designed, regularly issued, widely held and accepted and supported by a robust payment and settlement system” (Onal, 2013, p. 311). Secondly, it proposes the development of an Islamic government security market (Onal, 2013). There are several ways to do so. For example, governments could include Islamic financial instruments to the structure of public debt issuance programs. Alternatively, they could include Islamic financial instruments to improve market-based monetary operations (Onal, 2013). This step would allow central banks to manage liquidity issues urgently. Another recommendation is to create an efficient Islamic financial market. Governments could also supervise, or guide, Islamic financial institutions that struggle to find innovative ways to manage their liquidity issues. These measures could improve the liquidity management efforts of Islamic financial institutions.
Designing Islamic Short-term Liquidity Instruments
The International Islamic Financial market has taken significant steps to improve the number of options available to Islamic financial institutions, to manage liquidity. For example, it has spearheaded the “collaterisation” of Murabaha transactions as a step towards meeting this goal (Cosgrave, 2014). Similarly, it has spearheaded this process to provide a sharia-compliant alternative to conventional repo transactions. Experts consider this push as an excellent step towards standardising Islamic finance documents (Elasrag, 2014). This step alone shows that Islamic finance continues to develop and mature. It also shows that Muslim scholars are taking proactive steps towards filling the gaps that exist in using sharia-compliant products to manage liquidity (Cosgrave, 2014). Nonetheless, there is a lot of more work that these professionals need to do to improve the current state of Islamic financial products. Particularly, they must build on existing financial foundations to create more innovative products for Islamic finance.
Conclusion
This paper shows that Islamic financial institutions have few instruments for managing liquidity. However, based on the insights highlighted in this paper, Islamic financial institutions mainly rely on the sukuk product as the main financial instrument for liquidity management. The inefficiencies attributed to alternative financial instruments emphasise the need for Islamic financial institutions to come up with alternative short-term, medium-term, and long-term investment options for managing their liquidity; otherwise, they would have to seek conventional financing options if they want to correct their liquidity positions. The quest to look for sharia-compliant products magnifies this problem. Based on this challenge, some Islamic states have assumed local initiatives to provide the much-needed financial instruments of liquidity management. This is why this paper has included a category of “other” financial instruments for liquidity management. In this category, this paper mentioned the Bahrain government’s Salam program as a short-term liquidity tool for its local financial institutions to manage liquidity. Malaysia also has a similar program. However, the uniqueness of these “private” programs highlights a similarly unique problem of Islamic-based liquidity management – the lack of a common acceptance of liquidity management tools. Nonetheless, albeit significant challenges undermine the efficiency of existing liquidity management tools available for Islamic financial institutions, the 2007/2008 global economic crisis shifted global attention to seek alternative financial systems, such as the Islamic financial system. This is why there has been significant growth in this sector, since 2008. However, it would be difficult to exploit this potential if there are literature gaps in this area of study. Therefore, there needs to be more effort among Muslim scholars to fill this literature gap.
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