Liquidity Management By Islamic Banks

ISLAMI BANK BANGLADESH LIMITED TREASURY & FUND MANAGEMENT DIVISION INTERNATIONAL BANKING WING HEAD OFFICE, DHAKA

M.C Memo:

Date: June 21, 2009

Sub: Fund and Liquidity Management-keeping in view of existing Liquidity Position and Possibility of Short-Term Investment. Liquidity management is an crucial part of asset-liability & risk management framework of the Banking industry, failure to address the issue may lead to dire consequences, including instability of the Bank. It is a process of making properly & timely bridge of Bank’s sources & uses of funds at reasonable cost at all times. For Islamic financial institutions, liquidity management is a big challenge due to limited development of the Islamic money market to raise and deployment of funds to/from the inter-Bank money market (Wholesale market) and Global Market. Whereas the money market is an important component of the liquidity management framework as it is the first avenue to manage liquidity of the Bank. 1. Accessing the liquidity Position of the Bank : a) Maintenance of CRR b) Maintenance of SLR c) Cash Flow cum Balance sheet d) Key management ratios & interpretations: e) Inter-Bank FX & MM position f) IBBL Money Market Position 2. Measuring the risk related to Liquidity of the Bank : a) Risk related to Local Currency Liquidity b) Risk related to Foreign Currency liquidity. 3. Managing the Liquidity risk/Liquidity management

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Sources of funds

BDT (Million)

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Uses of funds

BDT (million)

Net liquidity

Liquidity represents the quality and marketability of the assets and liabilities, in absence of which bank will be exposed to a great deal of risk. Banks liquidity Management is the process of generating funds to meet contractual or relationship obligations at reasonable prices at all times. It includes … •

Ability of bank to meet maturating liability.

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Ability of the bank to attract deposit, meets its commitments

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Ability of matching the maturity of assets & liabilities daily.

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Coping with any short term pressures

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To meet liquidity needs and obligations to ensure the smooth running of business.

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Forecasting cash need and providing for these needs in the most cost-effective way.

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Reduces the adverse situation developing in the Market

Supply and Demand of liquidity:

The following sources of liquidity and supply come together to determine each bank’s net liquidity position at any moment of time. Supplies of liquidity come from • Customers deposit o

Mudaraba Deposits

o Al wadiha deposit

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Demand for Banks liquidity arise from • Customers Deposit withdrawal •

Uses for CRR & SLR

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Investment to Customers

o Sundry deposit

o Bai murabaha

o Bills payable

o Bai Mujjal

o Contingent deposits

o HPSM

(security ,NRD,NRT)

o Musharaka

Revenues from the sale of Non

o Bai us Sarf

deposit services

o Quard – Hasana

Customers Investment/loan

o Mudarabaha

repayments •

o Bai Salam

Sale of Banks asset

o Bai istisna

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From Money Market ( through

o Ijara

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BGIIB). •

Capital & reserve

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Repayment of Non deposit borrowings

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Operating expenses & tax incurred in producing & selling services

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Payment of Dividends

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To Money Market(Through BGIIB)

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Liquidity Risk:

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 liquid a position in a timely manner at reasonable prices. •

Causes of Liquidity Risk: •

Liquidity Shortage:-Total Demand for Liquidity > total supply of liquidity o Implications of liquidity deficit:

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Offering higher rate of profit to deposits

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Shortage of financial resources to invest against commitments

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loss of competitiveness

Liquidity surplus :-Total Supply of liquidity > total demand for Liquidity o Implications of liquidity surplus:

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underutilization of financial resources,

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lower income and higher cost,

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loss of competitiveness

Why face/sources of liquidity problem: •

Maturity mismatch” Bank takes large amount of short term deposit and then make invest in long-term (maturity mismatch).The problem related to maturity mismatch situation is that bank hold an unusually high proportion of liability subject to immediate payment

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Sensitivity to rate change: When rate of profit by other banks on deposits rise/ Change of Profit rate of deposit

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Loss of Public Confidence

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Unanticipated change in cost of capital

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Abnormal behavior of financial Market

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Incorrect judgments and complacency

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Conversion of Non-funded based limit into funded based

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Severe deterioration of assets quality

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Key Issues in liquidity management in Islamic Banking

No lender of Last resort Different shariah interpretation No Islamic Money Market Absence of Islamic secondary market Slow development in Islamic financial instruments Small no. of participants

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Assessing & Managing Liquidity of Islamic Banking •

Sources & uses of funds basis: o Net liquidity/Fund Position: The Banks are to prepare daily position of funds considering total deposits, total Investments, investment in shares & approved securities, Balance with Bangladesh Bank, CRR, SLR, Balance with Sonali Bank as an agent of Bangladesh Bank, Cash in tills, Balance in FC clearing A/cs,, Deposits with others Banks (Short & term Deposit) etc to work out net surplus/shortage of fund on daily basis to assess the liquidity /Investbale funds of the Bank. o

Maturity Profile Mismatch

A key issue that banks need to focus on is the maturity of its assets and liabilities in different tenors. A typical strategy of a bank to generate revenue is to run mismatch, i.e. borrow/takes deposit short term and lend/investment longer term. However, mismatch is accompanied by liquidity risk and excessive longer tenor Investment against shorter-term deposits would put a bank’s balance sheet in a very critical and risky position.

To address this risk and to make sure a bank does not expose itself in excessive mismatch, a bucket-wise (e.g. next day, 2-7 days, 7 days-1 month, 1-3 months, 3-6 months, 6 months-1 year, 1-2 year, 2-3 years, 3-4 years, 4-5 years, over 5 year) maturity profile of the assets and liabilities is prepared to understand mismatch in every bucket. We know that all of the shorter tenor assets and liabilities will not come in or go out of the bank’s balance sheet. As a result, banks prepare a forecasted balance sheet where the assets and liabilities of the nature of current, overdraft etc. are divided into ‘core and non-core’ balances, where core is defined as the portion that is expected to be stable and will stay with the bank; and non-core to be less stable. The distribution of core and non-core is determined through historical trend, customer behavior, statistical forecasts and managerial judgment; the core balance can be put into over 1 year bucket whereas noncore can be in 2-7 days or 3 months bucket.

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Maximum Cumulative Outflow (MCO): The MCO is for Business and measures. Under normal conditions, the day-to-day management of liquidity relies on the effective control of cash flow. Maximum cumulative outflow (MCO) guidelines control the net outflow (inflow from asset maturity minus outflow from liability maturity) over the following periods: overnight, one week and one month. The MCO includes… 

Review funding requirements

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Estimation of retail business

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Realistic Estimation of expected change of assets/liabilities with resulting need to manage the bank’s aggregate cash requirements(Including CRR & SLR)

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Cash flows from settlements of foreign exchange transactions

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Intraday exposures arising from settlements of the daily clearing system.

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The ability to raise cash by selling marketable assets

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Investment and deposit must be forecasted for a given period

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The estimated change of deposit and investment must be calculated

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Computation of bank’s net liquidity funds, surplus or deficit

Undrawn commitments: A bank’s liquidity is very much vulnerable to undrawn commitments by customers. Undrawn commitments may be unutilised by not drawing an sanctioned limits of customers or any investment/loan commitments, which has not been drawn by customers. Customers have the right to ask for these funds at any point in time and the bank is obligated to pay the customer. Thus a ceiling should be set on a bank’s commitments to customers. The undrawn commitment guideline may be established which relates the maximum level of undrawn commitments to the bank’s remaining unused wholesale borrowing capacity. These measures are to ensure that the banks are able to raise funds in order to meet customers’ demands for drawing on lines that they have granted to them. o

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Comparative study of other bank/General market condition o Rate of growth in new deposit o Rate of growth in investment o Specific Bank Crises o General market crises o Over the chosen time frame

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Liquidity ratio indicator: Banks also estimate its liquidity needs based on ratio. •

Investment/Loan Deposit Ratio: Investment/Loan deposit ratio, typically calculated as the ratio of /investment/loans against deposits, is the most common way to see a bank’s liquidity position. In an ideal scenario, loan deposit ratio should not exceed 80%-85% (after keeping required for statutory requirements). However, a bank may decide to invest in inter bank to manage its surplus funds. But excessive Investment/lending (a high Investment/Loan Deposit Ratio) may expose a bank in serious liquidity and interest rate risk as the market liquidity may tighten any time.

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Medium Term Funding Ratio: Banks typically make money by running mismatches, that is, by taking short term and /Investing lending long term. However, short term deposits may go out of the bank upon maturity, whereas a bank cannot call back long term Investment/lending. Thus a bank has to find the right combination for longer term mismatch. Medium term funding ratio is calculated as the ratio of liabilities with a contractual maturity of more than one year to assets with a contractual maturity of more than one year. This ratio is

intended to highlight the extent to which we are dependent on being able to roll over short term deposits in order to fund medium term assets. •

Comparative study of other bank/General market condition o Rate of growth in new deposit o Rate of growth in investment o Specific Bank Crises o General market crises o Over the chosen time frame

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Liquidity measuring & management : signal from Market reaction : o Public Confidence and withdrawal risk o Propaganda against Islamic banking o Stock price behavior o Inability to meet investors commitments against sanctions due to liquidity crunch o Lower rate of profit against deposit o Rate of growth in new deposit

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Deposit management o

In case liquidity shortage :Introduce new (increased) customer rates to encourage deposit accretion and emphasize need to focus on account profitability

o In case of Liquidity surplus : Exploring new opportunities to invest funds •

Choice of right mode of investment to secure investment

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Role of ALCO: ALCO has to take responsibility in managing liquidity position on continuous basis by bringing desired changes in the composition of assets and liabilities.

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Settling different limits : Bank Management set limits to ensure liquidity and these limits should be reviewed: o The cumulative cash flow mismatch(net funding requirements as percentage of total assets) over particulars periods o Liquid assets as a pct of short term liabilities o Limit on investment to deposit ratio (Should be 80-85%

(The AD ratio should be 80%-85%. However, the Loan Deposit ratio of the bank should go upto 110%. The Loan Deposit ratio = Loan/(Deposit+Capital+Funded Reserve) The ratio will be fixed based on the bank’s capital, Bank’s reputation in the market and overall depth of the money market. ) o Limit on investment to capital ratio(single exposure ) o Minimum liquidity provision to be maintained to sustain operation o Counterparty limits for local and foreign bank for local and FC

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Medium Term Funding Ratio (MTF): The MTF of a bank should not be less than 30%. The ideal scenario should be 45%. Given, the overall scenario of current market, it will be suitable to move towards the MTF limit of 45% as we progress.

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Maximum Cumulative Outflow: MCO upto I month bucket should not exceed 20% of the balance sheet assets volumes.

Local Regulatory Compliance?Central Bank Compliance: Banks operating in Bangladesh are required to maintain credit balance with the Central Bank minimum 5% of time and Demand Deposits as CRR and the accounts must not be overdrawn and 5 % as SLR on total deposits or eligible securities like Bangladesh Govt Islamic Investment Bond.

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Regulation

Parameter/Formula

Comprising

Cash reserve

5% of liabilities

Lcy cash at Central Bank

Liquidity reserve

5% of liabilities

Cash in Tills Fcy balance with Central Bank Lcy balance with Central Bank Selected Govt Bonds

Capital Adequacy Banks operating in Bangladesh are required to maintain a minimum capital at 10% of total risk weighted assets.The need to adopt the best international practices, given the globolisation of economies and businesses. As you are aware

of “Basel Committee on Banking Supervision” and the emphasis on maintaining the Capital Adequacy commensurate to exposure or risk on balance sheet. The new “Basel Capital Accord” stipulates that “ Banks must hold capital commensurate with the level of interest rate risk they undertake”. •

Large Exposures

Banks operating in Bangladesh are required to restrict their lending to any large single relationship to 15 %( Funded) & non funded 20% of their capital and with the approval of Central Bank it can be increased to 100% of their capital •

Liquidity Test for Contingencies/Stress liquidity/ The major risk a bank runs is liquidity risk. Under any circumstances a bank has to honor its commitments. As a result, it has to make sure that enough liquidity is available to meet fund requirements in situations like liquidity crisis in the market, policy changes by central bank, a name problem of the bank etc. So, a bank’s balance sheet should have enough liquid assets for meeting contingencies. any crisis situation. Liquid assets can be as follows: • Back up liquidity •

Specific Government Securities.

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Selling Fcy from forex open position limit to generate Lcy liquidity

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Specific FDRs encashment