PARIS: Regulatory proposals for a liquidity coverage ratio for Islamic financial institutions could help to address some of the industry’s long-standing weaknesses, particularly the lack of high quality liquid assets (HQLA), Standard & Poor’s Ratings Services in a report titled Basel III Requirements Could Strengthen Islamic Banks’ Liquidity Management, said.
In October 2014, the Islamic Finance Services Board (IFSB), an international standard-setting body of regulatory and supervisory agencies that aims to ensure the soundness and stability of the Islamic finance industry, published guidance on quantitative measures for liquidity management in institutions offering Islamic financial services. This note (IFSB-GN-6) set three main characteristics of high quality liquid assets (HQLA): low correlation with risky assets, an active and sizable market, and low volatility. The guidance also specifies how Islamic banks should implement the liquidity coverage ratio (LCR) and the net stable funding ratio related to Basel III, as well as the timeline for implementation.
Most Islamic bank liquidity management instruments currently consist of low-profitability assets, such as cash and central bank deposits. Sukuk are primarily offered as over-the-counter instruments and only a limited amount of them are listed on developed and liquid exchanges.
However, the report says the implementation of Basel III and its new liquidity coverage ratio could increase offerings of liquidity management instruments.
“We think that sukuk issuers will likely list more of their sukuk on exchanges and that some regulators will start to accept sukuk as collateral for liquidity provisions,” Standard & Poor’s credit analyst Mohamed Damak.
“We expect high credit quality and local currency sukuk offerings will increase because these instruments are part of the Level 1 HQLA definition in the IFSB GN-6.”
Sovereigns, central banks, multilateral lending institutions, and specialized institutions—such as the International Islamic Liquidity Management Corporation (IILM)—could play a role in further fostering the supply of Islamic liquidity management instruments, the report says. The demand for these instruments and their current scarcity are also likely to push their yields downward and align them more with the yields of similar conventional instruments.
Islamic banks’ profitability might benefit slightly from increased sukuk issuance, but not enough to lead to higher ratings. “For this reason, we do not expect any rating impact from this development alone. Still, we see increased new liquidity rules as being to the overall benefit of Islamic banks and a step in the right direction,” Damak, said.