“There is also the complication that the outstanding stock of Sukuk is not sufficiently large to enable all Islamic financial institutions to meet a liquidity ratio comparable to that mandated under Basel III,” Rasheed M. Al-Maraj, Governor, CBB told the 13th annual AAOIFI-World Bank Conference on Islamic Banking and Finance.
“The markets for Sukuk are not always as liquid as those for conventional government bonds and therefore even if an Islamic financial institution invests in them it might not always be able to find a ready buyer when the need occur,” he added.
The CBB Governor in his speech focused on the relevance of international standards to the Islamic financial industry.
“Basel III requires conventional banks to hold a stock of high quality liquid assets that can be used to meet unexpected deposit outflows. These instruments include highly rated paper issued by sovereigns and by corporates. The regulators of the conventional industry have focused on the issue of liquidity because, pre-crisis, conventional banks increasingly relied on their access to short-term interbank markets to fund relatively long-term assets. Borrowing short to lend long is, of course, fundamental to the business of banking. Even so, there comes a point of which the degree of maturity mismatching is no longer prudent, and we saw with conventional financial institutions that the boundary between prudent and imprudent business conduct had been crossed.
“If we look at the trends in Islamic banking in the years prior to the crisis, we can see that there are important similarities between the practices of Islamic financial institutions and those of conventional ones. Just like conventional institutions, Islamic financial institutions increasingly funded long-term assets with short-term funding. Although the assets and liabilities were structured in a Sharia-compliant manner, the degree of maturity mismatching was just as great as was practiced by conventional institutions. In some cases where the asset involved a long-term development project, the degree of maturity mismatching was significantly greater than that practiced by conventional financial institutions.
“The conventional financial industry received a wake-up call during the crisis concerning the importance of understanding, monitoring and controlling liquidity risks. The Islamic financial industry must recognise that it also needs good liquidity risk management. However, Islamic financial institutions find it difficult to manage their liquidity risk given the relative lack of short-term money market instruments in which they can invest. The CBB has been at the forefront of innovation in assisting Islamic financial institutions to manage their liquidity, but more still needs to be done both by regulators and the industry.
“These are genuine practical difficulties in applying Basel III to Islamic financial institutions. Even so, they should not get in the way of recognizing the important principle that Islamic financial institutions need to take liquidity risk just as seriously as conventional firms need to do. They need to make sure that they keep maturity mismatching to prudent limits. There needs to be a debate about what sort of limits would be prudent. But there is no doubt that limits are needed.
“Another issue that Basel III seeks to address is to ensure that banks have sufficient capital to be able to absorb losses on an on-going basis. Standard setters have focused not only on the amount of capital but also on its quality. In the simplest terms, the financial crisis revealed that too many conventional banks had capital that would only absorb losses if the bank went into liquidation. It was not capable of absorbing losses on an on-going basis. Basel III sets out to ensure that bank capital has a stronger ability to absorb losses before a bank goes into liquidation.
“It has become clear as a result of the financial crisis that the predominant form of bank capital needs to be equity. From an Islamic industry perspective, this has the great advantage that equity is without a doubt Sharia-compliant.