Money Market Instruments in Conventional and Islamic Banks

European International Journal of Science and Humanities

Vol.1 No.3

February 2015

Money Market Instruments in Conventional and Islamic Banks Ola Al-Sayed, PhD Faculty of Economics and Political Sciences, Cairo University, Egypt [email protected] - [email protected]

Abstract The purpose of the study is to analyze the liquidity management performance of Islamic banks by investigating whether the availability of Islamic liquidity instruments is the main factor affects the efficiency of liquidity management in Islamic banks. Findings indicate that there are different factors affect liquidity management in Islamic banks like tangibility of bank assets, leverage, age, economic cycle and the investment behavior of Islamic bank’s depositors and their awareness of Islamic banks' activities, because most of Islamic liquidity instruments are illiquid and non-tradable instruments. Keywords Islamic banking, liquidity management, Islamic money market instruments, and liquidity risk.

(1) Introduction The banking sector is viewed as an important source of financing for many businesses. In order to appraise and weigh up the soundness and reliability of banking industry, the information on the risk and how the fluctuations are managed are important to consider. Among the financial risks liquidity risk of the bank are crucial to consider. Managing the liquidity risk is required to be monitored and managed effectively and cautiously. Liquidity management is part of the larger risk management of the banking sector, whether they are conventional or Islamic. The liquidity risk is the important to management for the conventional as well as the Islamic banks in order to be solvent. Principally, any effort by Islamic banks to construct a sound liquidity management should be arranged across the real business transaction. Because the Islamic banks deals in the real assets for so it deals in within the business cycles, cooperation among the business' partners and good conduct of the stakeholders. This is the core stone of all the Islamic banking operations. Liquidity of any asset means its ease of convertibility into cash or a cash equivalent asset [1]. The risk of liquidity arises from the difficulty of selling an asset quickly without incurring large losses. For a banking and financial firm “liquidity risk includes both the risk of being unable to fund [its] portfolio of assets at appropriate maturities and rates and the risk of being unable to liquidate a position in a timely manner at reasonable prices. Sources of banks’ liquidity risk are either from the asset side or liability side [2]. On asset side, the liquidity risk is related to liquid financial market; smooth transactions, no financial barriers, etc. “this is called market liquidity risk”. While liquidity risk on liability side is the risk that deals with the obligation of a bank to make payments to the third party or simply the solvency of the bank, “This is called funding liquidity risk” [3]. Within the financial system According [4], in the financial system, banks’ liquidity could be classified into two types: funding (or liability) liquidity risk and market (or asset) liquidity risk. While, market-liquidity risk is related to the banks’ inability to easily sell assets at the market price as a result of inadequate market strength. While, funding-liquidity risk associated to the risk whereby the bank is not able to meet efficiently its obligations as they become due. Islamic and conventional Banks face various risks that may affect their performance and operations. In both types of banks, liq'uidity risk is considered to be the most critical. Most banks’ failures, whether they are Islamic or conventional, are due to the difficulties in managing their liquidity needs [5]. Liquidity risk always results from the banks’ typical activities as well as their operational and financing policies, and it may also be the result of any unpleasant economic conditions. Whereas, any conventional bank tries to maximize the return on total assets by investing as much of the cash available. Though, this is challenged by the need to have enough liquidity to meet any mismatch of the term structure (maturity dates) of assets and liabilities.


ISSN: 2420-587X

www.eijsh.org

Islamic banks must additionally comply with the Sharia’h principles, as well as the contractual form of the Islamic securities that are additional sources of liquidity risk. Money in Sharia’h is only measuring tool and does not reproduce; it grows when it is invested in a tangible economic activity, with an estimated rather than predetermined return on investment. Over the years, conventional banks developed large and diversified tools for liquidity management. These instruments refer to “debt” securities, which are short term. Such short-term liquidity instruments mature in a few hours, overnight, a day or longer. In general, liquidity instruments mature in periods ranging from 3 months or less to one year. It is the mission of the Islamic banker to understand the critical need to innovate and produce new solutions and instruments to meet the needs of the Islamic money market. Unfortunately, this is not done most of the time. Many Islamic bankers go to the currently available conventional instruments, classify them to "halal" or "haram" and in some cases try to force an Islamic "dressing" onto them to make them look acceptable. Such "dressings" are labeled by Islamic jurist as heyal (or circumvention), and it has been criticized by most scholars. These does not mean that the use of any conventional financial instruments automatically falls under heyal. Many financial instruments used by conventional bankers can be easily modified to comply with shariah. This paper aims to discuss the concept of liquidity management from Islamic law (Sharia’h) perspective. The result of this study gives an advice to Islamic bankers regarding the most efficient strategies of managing liquidity. The researcher followed logical thinking to test the following hypothesis: “availability of Islamic money market instruments does not necessarily lead to efficient liquidity management in Islamic banks”. Accordingly this study answers the following questions: what are the main factors affecting managing liquidity in Islamic banks?, how would innovative liquidity management instruments enforce efficient liquidity management in Islamic banks? And what is the most efficient strategies that Islamic bankers should apply?. The paper is structured as follows, the next section is an overview of Islamic finance. Section (3) covers the literature review. Section (4) investigates the differences between Islamic and Conventional tools in managing liquidity risk. While section (5) explains the liquidity management instruments based on Sukuk structure. And finally sections (6) and (7) are the conclusion and references. (2) Islamic Finance: An Overview The mid-1970s of the previous century witnessed the emergence of Islamic financial systems or Islamic banks which existed mainly to provide a variety of religiously acceptable financial services to the Muslim communities [6]. Later, the 2008 global financial crisis raised doubts on the proper functioning of conventional “Western” banking, and shed the light on Islamic banking which emphasized risk sharing. Academics and policy makers alike highlighted the advantages of Islamic financial products, which are less skewed towards debt instruments, rely more on equity for greater risk sharing, and limit the mismatch of short-term demand deposits with long-term uncertain loan contracts [7]. These products are very attractive for segments of the population that demand financial services consistent with their religious beliefs. However, only limited academic evidence exists on the functioning of Islamic banks compared to other conventional ones. Beck et.al (2010) discussed Islamic banking products and interpreted them in the context of financial intermediation theory [8]. Comparing conventional and Islamic banks and controlling for other bank and country characteristics, they only found few significant differences in business orientation, efficiency, asset quality, or stability. Cihak and Hesse (2008) assessed the relative financial strength of Islamic banks based on evidence covering individual Islamic and commercial banks in 18 banking systems with a substantial presence of Islamic banking [9]. They concluded that (i) small Islamic banks were financially stronger than small commercial banks; (ii) large commercial banks were financially stronger than large Islamic banks; and (iii) small Islamic banks tended to be financially stronger than large Islamic banks, yet implying challenges of credit risk management in large Islamic banks. Solé (2007) noticed that despite consistent growth of Islamic banks, many supervisory authorities and finance practitioners remained unfamiliar with the process by which these banks were introduced into a conventional system [10]. He shed some light in this area by describing the main phases in the process, and by flagging some challenges faced by countries as Islamic banking developed alongside conventional institutions. Errico and Farahbaksh (1998) discussed the effect of Islamic concepts on the banks’ structure and activities, with special focus on banking supervision issues [11]. Yet, the number of empirical studies evaluating the performance of Islamic banks is considered relatively limited compared to the rising role of these banks. Accordingly, this paper aims to add to the academic literature by comparing the performance of Islamic vs. conventional banks in respect of liquidity risk management. Islamic banking usually refers to the banking activity that complies with the principles of Islamic law, or ‘Shariah’, and its practical application through the development of Islamic economics. In this respect, ‘Shariah’ refers to the Islamic rules


Vol.1 No.3

February 2015

derived from two main sources; the Holy Qur’an and the Sunna, a term which refers to the traditions of the Prophet Muhammad (PBUH). As such, a more correct term for 'Islamic banking' is 'Shariah compliant finance'. Islamic banking and finance can therefore be described as a system through which finance is provided in the form of money in return for either equity or rights to share in future business profits, or in the form of goods and services delivered in return for a commitment to repay their value at a future date [12]. Moreover, Shariah has some core goals; including respect of property rights, support of social and economic justice especially regarding wealth distribution [7]. These goals would be achieved via eliminating interest payments. Shariah treats interest as an act of exploitation and injustice and as such it is inconsistent with Islamic notions of fairness and property rights [6]. Accordingly, it prohibits acceptance of specific interest or fees for loans of money (known as riba, or usury), whether the payment is fixed or floating, as only goods and services are allowed to carry a price. Moreover, Shariah-compliant finance relies on the idea of profit-, loss-, and risk-sharing, on both the liability and asset side. There is always an emphasis on the equitable risk allocation among partners within Shariah-compliant products, whether in the case of musharakah (where both partners provide capital and have the right to manage the project) or mudarabah (where one partner provides the capital and the other works with it). Thus, risk sharing is the guarantee that market forces would determine the productivity of capital rather than fixing it in priori as an ‘‘interest rate’’ [7, 13]. Investment in businesses that provide goods or services contradicting to Islamic principles (e.g. pork or alcohol) is also considered sinful and prohibited (haraam). Besides, Shariah rules prohibit Gharar (speculation or ambiguous contracts or deals) to promote disclosure and discourage uncertainty in contracts [7]. Although these prohibitions have been applied historically in varying degrees in Muslim countries/communities to prevent un Islamic practices, only in the late 20th century a number of Islamic banks were founded to apply these principles to private or semi-private commercial institutions within the Muslim community. In addition to this special function, the banking and financial institutions are expected to contribute to the achievement of the major socio-economic goals of Islam [14]. Conventional interest based finance had become the dominant system during the colonial period (1930s to 1960s), and continued to be so in many Muslim countries even after their independence. This had encouraged Muslim intellectuals and economists to start writing about Islamic economics and financial systems, notably in the Indian Subcontinent and Egypt. The early writings elaborated on the philosophy and the concepts of interest-free finance along with its effects on the socioeconomic welfare of the society. Accordingly, the first models of Islamic finance focused on how a banking system could work without interest, through introducing the concept of risk sharing and partnership [15]. In general, over this early period, Islamic finance witnessed development only on the intellectual or theoretical side, with few and limited trials in the early 1960s of practical realization of a bank-like Islamic financial institution, on a small scale, such as the establishment of an interest-free bank in Karachi and the Mit Ghamr saving-investment bank in Egypt based on sharing profits and avoiding interest. This bank was founded in 1963 and closed down in 1968. Another independent experiment of Islamic finance started in Malaysia in the form of Shariah compliant savings and investments scheme for prospective pilgrims (hujjaj) called Tabung Haji. The experiment was recognized later and transformed to Bank Islam Berhad (BIMB) in 1983 [15, 16]. Then, by the early 1970s, real developments started to emerge with the establishing of the first Islamic banks. The Nasser Social Bank was founded in Egypt in 1971, followed by Dubai Islamic Bank and the Islamic Development Bank in 1975. Afterwards, more Islamic banks were established in Egypt, Jordan, Kuwait, and the Gulf; among which were Kuwait Finance House (KFH) (1977), Faisal Islamic Bank in Cairo (1977), Bahrain Islamic Bank (1979) and Dar Al-Maal Al-Islami (1981). Then the following decade witnessed a rapid expansion in the number of Islamic banks, mainly clustered in the Middle East, South Asia and South East Asia. Besides, some western financial institutions decided to open their own Islamic windows to add innovation and diversity to their operations and to attract deposits from the Middle East and the local Muslim Communities. Among these banks were HSBC, Citibank and ABN AMRO [13, 15]. Islamic finance has grown beyond banking since the 1990s and expanded to the realm of capital markets. Now, Islamic financial industry comprises of Islamic banks, investment funds, asset management companies, house financing companies, and insurance companies. There are to date over 200 Islamic financial institutions in over 70 countries around the world with total asset base in excess of US $ 230 billion [17]. The industry has been growing in double digits since last decade. The value of Shariah compliant assets of commercial banks reached US$ 1.54 trillion in 2012. QISMUT -Qatar, Indonesia, Saudi Arabia, Malaysia, UAE and Turkey- are six countries that commanded 78% of international Islamic banking assets in 2012, with a 5-year compound annual growth rate of 16.4% over the period 2008-2012, and expected to reach 19.7% over 2013-2018. The average return on equity of the 20 leading Islamic banks was 12.6% compared to 15% for comparable conventional peers. However, over the last four years, there had been a noticeable slowdown in the performance of Islamic banks caused by two major developments. First, the continuing economic and political setbacks in some of the frontier Islamic


ISSN: 2420-587X

www.eijsh.org

finance markets; and second, the large scale operational transformation that many of the leading Islamic banks initiated lately, especially concerning customers and technology. These transformations are expected to consume focus and investment, which would eventually affect their pace of growth. (3) Literature Review There are several studies on managing liquidity in Islamic and conventional banks, among them the liquidity risk management is of high concerns. But there is not general agreement in literature about the performance of Islamic banks in managing their liquidity. Existing studies in this area are classified into three groups: the first group includes studies that focus on the importance of the development of Islamic money market instruments. The second group of studies review the empirical studies in some countries with large Islamic banking sector to highlight the different factors affecting the liquidity management in Islamic banks. While the third group of studies assess the liquidity management in Islamic banks through the efficiency of managing their balance sheet. The studies of the first group accept that innovative Islamic money market instruments is the missing stone of managing liquidity efficiently. (Abdul Rahman, 1999) emphasizes on the importance of developing LARIBA money market to strength the liquidity management in Islamic banks [18]. (Hakim, 2007) and (Tag El-Din, 2007) agree with this result. (Ali and Aram, 2002) investigate the importance of Islamic Scholars acceptance for some types of derivative instruments such as options and futures that are not contradictory to Shariah in Iranian economy [19, 20]. (Bacha, 2009) examines the operation of an Islamic Inter-bank Money Market (IIMM), within a dual banking system. The paper argues that even though an Islamic money market operates in an interest-free environment and trades Shariahcompliant instruments, many of the risks associated with conventional money markets, including interest-rate risks are relevant [21]. The empirical evidence, based on Malaysian data, points to Islamic money market profit rates/yields that are highly correlated and move in tandem with conventional money market rates. Therefore, IIMM operating within a dual banking system cannot sterilize itself from interest-rate risks. Then active Islamic money market is a key factor affecting the management of their liquidity. The second group of studies determine several factors other than the Islamic money market instrument that affect the liquidity management in Islamic banks. (Ismal, 2010) used an empirical survey of 408 Indonesian Islamic bank’s depositors and 17 Islamic bankers, the survey was conducted from January to March 2009 [22]. The performance of Islamic banks in managing liquidity has been evaluated depending on the survey' results. Findings of the study determine that the investment behavior of Islamic bank’s depositors and their awareness of Islamic banks' activities such as: Islamic deposit contracts, Islamic banking operations and Shariah principles, are the main factors affecting the liquidity management in Islamic banks. (N. Ahmed, Z. Ahmed and Naqvi, 2011) investigates the determinants of liquidity risk in six Islamic banks in Pakistan from 2006 to 2009, using their financial statements. The study ends that tangibility, leverage and age1 are the main factors affecting liquidity risk [23]. (Ramzan and Zafar, 2014) agrees partially with the results of this study by using a sample of 5 full-fledged Islamic banks and secondary data has been collected from the bank’s annual reports covering the period 2007-2011. It ends that asset size of the bank affects liquidity risk, therefore it can be assumed that strong asset base of Islamic bank contributes towards more strengthen liquidity control [24]. (Sulaiman, Mohamed and Samsudin, 2013) using a dynamic panel data estimation for 17 Islamic banks, this study tried to see how Islamic banking of Malaysia manage their liquidity in response to changes on the basis of several factors. According to the findings of this study, Malaysian Islamic banking liquidity management is formed by Malaysian economic cycle and the level of bank management [25]. While the third group of literatures follows other ground of analysis by examining to what extent the management of Islamic banks financial statements affect their liquidity management. (Antonio, 1999) argued that the sound liquidity risk management (LRM) can be observed at least from analyzing the performance of the balance sheet (asset and liability side) and the LRM policies [26].

1

Tangibility is the ratio of fixed assets to total assets, leverage is ratio of debt to total assets, and age is the difference between establishment and observation year.


Vol.1 No.3

February 2015

(Ismal, 2010) assess liquidity risk management (LRM) practices in 3 Indonesian Islamic banking industry during the period 2000-2007, by constructing the LRM index (100 scale) which is composed of individual index of asset side; liability side; LRM policies; and the overall LRM index. The study ends that efficient liquidity management means managing and forecasting the funding and financing activities of the bank to maintain sufficient reserves to fulfill financial obligations with third party [2]. (4) Islamic and Conventional tools of managing liquidity risk Islamic and conventional banks may use different liquidity management systems trying to achieve the same aim of minimizing this type of risk. Siddiqui (2008) related this to the fact that Islamic banks differ from their conventional counterparts in the modes of financing their use, where Islamic banks have to stick to the Islamic rules “Sharia’h” [15]. (4-1) Conventional Instruments of Managing Liquidity Risk Treasury Bills: Treasury bills are short-term obligations issued by a government and represent one of the most popular money market instruments because of their marketability, safety and short term maturity. They are attractive as investment instruments for a number of reasons: there is no default risk, they are highly liquid and they benefit from a welldeveloped secondary market. Treasury bills are also used to absorb excess cash from the banking sector and help the government to borrow from banks to meet its budgetary shortfall. In many countries, they represent a major instrument to carry out monetary policy. When issued, Treasury bills are sold at a discount to their face value and their yield is a leading indicator of short term interest rate [18]. Certificate of Deposit (CDs): are large-denomination negotiable liabilities issued at a discount by banks to businesses and government units with a fixed maturity and interest rate. Because of their size, these CDs are issued primarily by the largest banks and have a liquid secondary market. By selling a CD, the holder can effectively redeem the deposit before maturity without loss of funds to the bank. Their marketability feature makes CDs attractive to temporary holders of substantial funds and permits banks to tap the money market for quick access to borrowed funds. Interest rates on CDs must be competitive with market rates on comparable money market instruments. Call Money (Inter-Bank) market Call money is a key component of the money market, in which banks primarily participate on a daily basis mainly to wipe out the temporary mismatch in their assets and liabilities. The call money market allows banks to effectively lend or borrow short-term funds from each other. The call money market is influenced by the supply of and demand for overnight funds. In addition, through open market operations, the central bank can directly adjust the amount of funds available in the bank system in order to influence the call money rate and several other short-term interest rates. The inter-bank market is often the center of the call money market where the negotiations between two banks may take place over a communication network or occur through a broker. Once an inter-bank loan transaction is agreed upon, the lending institution can instruct the central bank to debit its reserve account and to credit the borrowing institution’s reserve account by the amount of the loan. `Commercial Paper: consists of short-term notes issued by large and highly rated firms. Typically these notes are of short-term maturity, ranging up to 270 days. Because the firm issues these directly, the interest rate the firm obtains can be significantly below the rate a bank would charge for a direct loan. These papers are not comply with shariah as they are based on the charging of interest. Bankers' Acceptance (BA): These are short term loans granted to importers and exporters by their banks. One way to get a credit commitment from a customer before the goods are delivered is to arrange a Commercial Draft. Typically the firm draws up a Commercial Draft calling for the customer to pay a specific amount by a specified date. The draft is then sent to the customer's bank with the shipping invoice. If immediate payment of the draft is required it is called Sight Draft. If immediate payment is not required it is called Time Draft. When the Draft is presented and accepted by the customer, then it is called a Trade Acceptance and is sent back to the selling firm. The seller can keep the Acceptance or can sell it at a discount to a bank or another institution. If a bank accepts the draft, meaning that the bank is guaranteeing payment, then the draft becomes Bankers' Acceptance BA.


ISSN: 2420-587X

www.eijsh.org

Municipal & Government Loans: These are short term loans to finance municipalities' and government agencies' short term capital needs. (4-2) Liquidity Management Instruments Based on Islamic Contracts Islamic instruments of managing liquidity risk could be classified according to its tradability in the secondary market, there are tradable and non-tradable instruments. When the instruments based on debt, then could not be traded in compliance with the ban Shariah imposes on debt trading, like Murabaha, Istisnaa and Salam certificates. Tradable Instruments a)

Mudaraba certificates, these represent certificates of permanent ownership in a project or company where the holder is not entitled to exercise management control or voting rights. b) Musharaka certificates, these are defined as with the Mudaraba certificates, with the notable exception that the bearer holds management and voting rights. c) Musharaka term finance certificates, these represent certificates that entitle the holder to a temporary ownership of a project or company. The certificates may include or exclude management control and/or voting rights. Non-Tradable Instruments a)

Murabaha and Istisnaa certificates are debt securities arising from standard Istisnaa or Murabaha contracts. The periodic repayment of the debt under these certificates could not be broken up between principal or coupons and the total debt or any portion therefrom could not be traded in compliance with shariah that imposes restrictions on debt trading. The certificates are similar to a zero-coupon security. As a result these securities have limited appeal because of the absence of a secondary market. There is an apparent conflict of opinion on the tradability restriction of these certificates2 b) Salam certificates, these securities arise from Salam contracts which require prepayment for the future delivery of a commodity. The pre-paid funds can represent debt certificates for a commodity. However, the certificates are nontradable for the same reason as the Murabaha and Istisnaa certificates.

(5) Liquidity Management Instruments Based on Sukuk Structures3 Sukuk represent Shariah-compliant securities that are backed by tangible assets. Conceptually, Sukuk are similar to traditional asset-backed securities. The issuing entity should possess a tangible asset (or group of assets). There are various Sukuk certificates that could be used to manage liquidity in Islamic banks. Sukuk structure vary from Murabaha (cost-plus sales), Salam (pre-payment of an asset for future delivery), Ijara (rental/ lease agreement), Istisna (build-to-own property), Mudarbaha and Musharaka (partnerships) [27]. Mudaraba Sukuk certificates are investment Sukuk used to enhance public partnership in capital intensive projects, for example the development of airport, dams and power generation facilities but without participating in the management and the holder does not have the right to vote on the Board of Directors decisions [28]. Musharaka Sukuk certificates are investment Sukuk that represent ownership of Musharaka equity. The Musharaka agreement is a form of joint venture agreement between the issuer and the originator to engage in a Shariah compliant investment activity. These parities enter into a Musharaka (partnership) agreement for a fixed period and agree on profit and loss sharing ratios. The cash returns generated from the Musharaka are paid as profits to the Sukuk investors who participate in management. At the end of fixed Musharaka period (maturity date), the issuer would have bought back the Musharaka shares at pre-agreed prices [29]. Murabaha Sukuk certificates are used to finance a particular commodity or asset for the purpose of resale to the borrower. For example textile mills need cotton to full fill its raw materials needs so it can get it through Murabaha structures.

2

3

In Malaysia, Murabaha and Istisnaa certificates are very popular and are tradable in the domestic bond market (Hakim, 2007).

Depending on the maturity of financial assets, Islamic securities could be structured to act as either “money market” or “capital market” instruments (Tag El-Din 2007)


Vol.1 No.3

February 2015

For that purpose, the corporation like textile mills asked SPV4 to buy particular commodity like cotton at pre-agreed price. The SPV issues Murabaha Sukuk to raise funds (Murabaha capital) required to purchase that commodity from suppliers and sells the same at cost plus profit basis to the borrower. Sukuk holders are entitled for the sale price (cost plus profit) of that commodity which normally paid in installments over a specified period of time [30]. Ijara Sukuk, These are certificates backed by lease agreements of land, buildings or equipment. The underlying lease payments, which determine the return on the Sukuk certificates, can be fixed or variable. The terms of the certificates cannot exceed the term of the underlying leases. Salam Sukuk certificates are used to conduct a forward commodity contract, the price of the commodity or asset is fully paid to the seller by the buyer at spot but delivery will be made at specific future time date. The commodity should be standardized, quality and quantity is well determinable and it is easily available in the market. The future delivery date and place should be clearly mentioned in the contract [31]. Istisna Sukuk certificates are used for the purpose of financing a big and complex capital intensive products or assets. For example the manufacturing of airplane, ships and the development of big infrastructures projects. The SPV raises funds required to pay the sale price. Hybrid Sukuk certificates could be structured by combining the principle of multiple Sukuk structures like Ijara, Mudaraba and Istisna which comprised by a pool of assets. Diversified pool of asset comprised on different structures of Sukuk provided more attractiveness to the investors in the market. Zero-coupon Sukuk certificates, when the backing assets do not yet exist or are not completed at the time of Sukuk issuance, the Sukuk are then similar to Murabaha and Istisnaa certificates. In this case, these Sukuk are similar to zero-coupon bonds [19]. Sukuk certificates could be classified according to its tradability into: tradable and non-tradable Sukuk certificates. Mudaraba and Musharaka Sukuk certificates are tradable, while all other types of Sukuk certificates are non-tradable because they represent debts and the trading of debt is not compliant with Shariah. But non-tradable Islamic certificates affect badly on the size, depth and trading in the Islamic money market. In the regard of finding optimal solutions to the illiquid Islamic instruments, a step forward was taken by the Governors of the Central banks /Monetary Agencies Malaysia, Bahrain, Indonesia, Sudan, and the President of the Islamic Development Bank when they signed the agreement to establish the International Islamic Financial Market (IIFM)5. This non-profit international organization has the objective of developing an active international financial market based on sharia’h rules and principles, solving the liquidity risk management in Islamic banks, and providing an active international secondary market of Islamic financial instruments. The IIFM will enhance cross-border acceptance of Islamic financial instruments “for instance, products developed in Malaysia will be accepted in the Middle East, Indonesia or any other country and vice versa. It will also help in cross listing in different stocks exchanges of member countries such as that Malaysia and Bahrain, for instance. When a critical mass has been achieved, the IIFM will be the “clearing house” of Shariah compliant instruments available for liquidity management [32]. “A major development of the IIFM, is the formation of Liquidity Management Centre (LMC) in Bahrain. The LMC targets to solve the excess liquidity problem of Islamic banks, as “it is expected to facilitate the creation of an inter-bank money market that will allow Islamic Financial Services Institutions ("IFSIs") to effectively manage their asset liability mismatch. Allowing Islamic banks to take positions as providers of funds and users of funds, with LMC as market maker [1]. 4

The special purpose vehicle (SPV) is established as trust in favor of Sukuk holders. Corporations-fund users ask the SPV for the assets it needs for business purpose by providing the feasibility report. The SPV valuates the feasibility report and decide the type of Sukuk to be issued. SPV issues the Sukuk certificates and receives funds from the Sukuk holders. These funds are used to purchasing the assets needed by the corporations. Generated profits are transferred to SPV according to the agreed terms and conditions. Then SPV pays the profits to the Sukuk holders as per their agreed terms and conditions. At maturity date face value of Sukuk is paid, by the corporation, against the asset purchased to the SPV. Finally the SPV pays the face value of Sukuk against the redemption of certificates to the Sukuk holders. 5 Headquartered in Bahrain.


ISSN: 2420-587X

www.eijsh.org

(6) Conclusion Rosly (2005) mentioned short-term liquidity instruments by which traditional banks solve their liquidity risk problem as; Commercial Papers, Certificate of Deposit (CDs), Bankers' Acceptance (BA), repurchase agreements, and inter-bank money deposits. All these instruments are interest-based instruments that are not allowed under Islamic laws [33]. Majid (2003) illustrate that in conventional banks as an additional insurance against liquidity risk a bank could hold a portfolio of marketable securities that can be quickly liquidated in case of need. Moreover, commercial banks can use the central bank as a lender of the last resort, where the relationship works as follows; the lending involves an interest penalty for running out of reserves, while the central bank on the other hand pays interest to commercial banks on the reserves kept with them. On the other hand, Islamic banks cannot take interest on their reserves, and cannot use the central bank as a lender for last resort [32]. Then Islamic banks contradict conventional banks in the way that they don’t allow clean borrowing as they restrict themselves to asset-backed financing. In addition they don’t permit hedging by derivatives. Consequently, such conventional liquidity management tools (The interbank market, secondary market for debt instruments and the central bank) are not permissible for Islamic bank. That was why there was an urgent need for some new Shariah acceptable instruments with derivative like properties, this need led to the establishment of Salam, Istisna, and other innovative liquidity risk management tools that are very close in properties to the forward contracts in conventional banks. This result was documented by (Zararee and Faris, 2014) in their paper that aimed at examining the liquidity efficiency in Islamic Bank. Consequently, more needs to be done, and new innovative diverse shariah complaint instruments need to be pumped into the Islamic interbank financial market in order to provide more flexibility in liquidity management [34]. As a result, this study concern with investigation of the other factors affecting liquidity management in Islamic banks, like tangibility of bank assets, leverage, age, economic cycle and the investment behavior of Islamic bank’s depositors and their awareness of Islamic banks' activities. That represent an advice for Islamic bankers in establishing the most sound liquidity risk management. (7) References: 1.

Ali, S. S. (2004), Islamic Modes of Finance and Associated Liquidity Risks, A paper prepared for “Conference on Monetary Sector in Iran: Structure, Performance and Challenging Issues”, Tehran.

2.

Ismal, R. (2010). Assessment of liquidity management in Islamic banking industry. International Journal of Islamic and Middle Eastern Finance and Management, 3: 147-167.

3.

Fiedler, R. (2000), Liquidity Risk, The professional Handbook of Financial Risk Management, ButterworthHeinemann, London.

4.

Basel Committee on banking Supervision. (2008), Principles for Sound Liquidity management and Supervision. Basel, Switzerland: Bank for International Settlement.

5.

Abdul Majid, A. R. (2005), Developing Liquidity Management Instruments: The Role of International Islamic Banks. In: T. Khan, and D. Muljawan, eds., Islamic Financial Architecture: Risk Management and Financial Stability. Seminar Proceedings No. 46. Jeddah: Islamic Research and Training Institute. pp. 123-156.

6.

Hassan, K., Lewis, M. (2007). Handbook of Islamic Banking. Edward Elgar Publishing, Incorporated. .

7.

Moheildin, M. (2012), “Realizing the Potential of Islamic Finance”, Economic Premise, no. 77, The World Bank, March.

8.

Beck, T., Demirguc-Kunt, A., and Merrouche, O. (2010), Islamic vs. Conventional Banking: Business Model, Efficiency and Stability, World Bank Policy Research Working Paper, no. 5446, October.


Vol.1 No.3

February 2015

9.

Cihak, Martin and Heiko Hesse (2008), Islamic Banks and Financial Stability: An Empirical Analysis, IMF Working Paper, wp/08/16, January.

10.

Sole, J. (2007), “Introducing Islamic Banks into Conventional Banking Systems”, IMF Working Paper, wp/07/175, July.

11.

Errico, L. and , M. (1998), Islamic Banking: Issues in Prudential Regulations and Supervision, IMF Working Paper, wp/98/30, March.

12.

Al-Jarhi, M. A. (2004), “Islamic Banking and Finance: Philosophical Underpinnings”, a paper presented at: conference in Brunei; 5-7 January, Islamic Research and Training Institute and Universiti Brunei Darussalam. .

13.

Khan, M. M. and Bhatti, M. I. (2008), “Islamic Banking and Finance: On its Way to Globalization”, Managerial Finance, 34(10).

14.

Chapra, M. Umer (1985), Towards a just Monetary System, U.K.: The Islamic Foundation.

15.

Sidiqqi, M. N. (2006), “Islamic Banking and Finance in Theory and Practice: A Survey of State of the Art”, Islamic Economics Studies, 13(2), February. .

16.

Syed, Salman and Ausaf Ahmad (2004), “Islamic Banking and Finance: Fundamentals and Contemporary Issues”, Selected papers from conference in Brunei; 5-7 January, Islamic Research and Training Institute and Universiti Brunei Darussalam. .

17.

Otiti, S. A. (2014), “Evolution of Islamic Banking and Finance”, Muslim Public Affairs Center (MPAC), June.

18.

Abdul-Rahman, Y. (1999), Islamic Instruments For Managing Liquidity, International Journal Of Islamic Financial Services, 1(1).

19.

Hakim, S. R. (2007), Islamic Money Market Instruments, In: M. Kabir and Mervyn K. Lewis, eds., Handbook of Islamic Banking, Edward Elgar Publishing, Inc., USA.

20.

Tag-Eldin, S. (2007). Capital and Money Markets of Muslims: The Emerging Experience in Theory and Practice. Kyoto Bulletin of Islamic Area Studies, 1: 54-71.

21.

Bacha, O. I. (2008). The Islamic Inter bank Money Market and a Dual Banking System : The Malaysian Experience. Munich Personal RePEc Archive, 1: 210-226.

22.

Ismal, R. (2010). How Do Islamic Banks Manage Liquidity Risk? An Empirical Survey on the Indonesian Islamic Banking Industry. Kyoto Bulletin of Islamic Area Studies, 3: 54–81.

23.

Ahmed, N., Ahmed, Z., Naqvi, I. H. (2011). Liquidity Risk and Islamic Banks: Evidence from Pakistan. Interdisciplinary Journal of Research in Business, 1: 99- 102.

24.

Ramzan, M., Zafar, M. I. (2014). Liquidity Risk Management in Islamic Banks: A Study of Islamic Banks of Pakistan. Interdisciplinary Journal of Contemporary Research in Business, 5.

25.

Sulaiman, A. A., Mohamad, M. T., Samsudin, M. L. (2013). How Islamic Banks of Malaysia Managing Liquidity? An Emphasis on Confronting Economic Cycles. International Journal of Business and Social Science, 4: 253-263.

26.

Antonio, S. (1999), Sharia Bank for Bankers and Practitioners, 1st ed., Bank Indonesia and Tazkia Institute, Jakarta.

27.

Abdel- Khaleq, A. and Richardson, C. (2007), New Horizons for Islamic Securities: Emerging Trends in Sukuk Offerings, Chicago Journal of International Law, 7(2): 409-425.

28.

Al Zubi, H. and Maghyar, A. (2006), Relative Risk Performance of Islamic Finance: A New Guide to Less Risky Investments, International Journal of Theoretical and Applied Finance, 10 (2): 235-249.


ISSN: 2420-587X

www.eijsh.org

29.

Godlewski, C. J., Ariss, R. T. and Weill, L. (2010), Are Sukuk Really Special? Evidence from Malaysian Stock Exchange.

30.

Al-Sayed, O. (2013), Sukuk risk: analysis and management, European Journal of Applied Social Sciences Research (EJASSR), 1(3), December.

31.

Usmani, M. T. (2002), An Introduction to Islamic Finance, Kluwer Law International, Netherlands.

32.

Majid, A. R. A. 2003. Development of Liquidity Management Instruments:Challenges and Opportunities. International Conference on Islamic Banking: Risk Management, Regulation and Supervision. Jakarta, Indonesia.

33.

Rosly, S. A. (2005). Critical Issues on Islamic Banking and Financial Markets: Islamic Economics, Banking and Finance, Investments, Takaful and Financial Planning. AuthorHouse.

34.

Zararee, A., Faris, J. (2014). The Efficiency of Liquidity Management in Islamic Banks (Conservative vs. Profit), International Journal of Business and Social Science, 5(1): 195-199.