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Sunday, 16 August 2009

Unused surplus liquidity a risk factor for Islamic finance

Underutilised surplus liquidity at most Islamic financial institutions (IFIs) has led to weak asset-liability management, increasing liquidity risk, said rating agency Moody's Investors Service.

Issuing a stable rating on most Islamic banks, Moody's said ample liquidity levels, resilient capital bases, high asset returns and relatively low funding costs of Islamic banks add to their strengths.

However, the agency cautioned that future upgrades may be constrained by issues related to their "underutilised excessive liquidity, inadequate corporate governance and weak risk management, particularly in terms of handling of asset liability maturity mismatches".

The risk of underutilised surplus liquidity arises from the scarcity of medium- and long- term funds to reduce the gap between assets and liabilities.

"Currently, IFIs are highly dependent on short-term funds to manage their longer tenure liabilities. The issue has become even more crucial in today's capital market environment because the frequency of asset write-downs is on the rise," said Anouar Hassoune, Vice-President and Senior Credit Officer at Moody's.

Strong liquidity

The liquidity profile of Islamic banks has been strong, said the agency in its report, 'Liquidity leverage trade off for Islamic banks and its impact on their ratings'. The "good liquidity" reduces liquidity risks in the economic downturn.

"Their liquidity profiles have perhaps been one of the most important strength of the IFIs. This provides them with surplus cash to use as shock absorber against possible future shortages pertaining to investment opportunities and payment obligations," said the rating agency.

Owing to their less direct exposure to sub-prime products, Islamic banks are considered a safer option by customers who have been shifting their deposits from conventional banks. "This activity has been recorded in a number of countries, especially in the UAE, Kuwait and Bahrain," said the report.

The excess liquidity has helped Islamic banks increase their deposit volumes. Their deposit base in the third quarter of the last year increased by 34.37 per cent in comparison to the previous year.

"The Islamic banking industry has experienced exponential growth over the 30 years since its inception and we expect Islamic banking assets and assets under management to reach $1 trillion (Dh3.6trn) by 2010. The total assets held by Islamic banks globally amounted to about $840 billion at year-end 2008 and the entire global potential market is worth at least $5trn.

"Islamic banks often rely conservatively on their excessive liquidity base, largely in the form of surplus liquid assets, which has to some extent sheltered them from the global financial meltdown. Nevertheless, they have not fully escaped the effects of the credit crisis and are experiencing the woes of an evolving industry characterised by extremely high growth rates, but also by lagging corporate governance and risk management issues," Moody's noted.

The retail entrenchment, it added, is a good strategic shift, one "suitable for the current environment with wholesale funding restricted and liquidity ratios lower".

In spite of the tough economic climate, most IFIs in the GCC have been able to seek opportunities by using their surplus liquidity to aggressively boost their deposit volumes. They also aim at increasing their market share by growing lending volumes, while maintaining the focus on retail and corporate sectors, the report added.

Key concern

In spite of ample liquidity and their success over the past three decades, most IFIs are grappling with the issues of liquidity, balance sheet management and overall risk management, Moody's pointed out.

Operational models of IFIs are built upon fundamental values that discourage use of disproportionate levels of debt to finance assets, as well as speculative and doubtful investments, which have inhibited the industry in terms of user of leverage. As a result, IFIs funding portfolios are highly concentrated in a few liquid assets and are deficient in terms of a securitised asset base.

The underutilised surplus liquidity has led to weak asset-liability management, which translates into liquidity risk.

Mentioning the impact of the economic challenges, the report said falling asset prices, credit seizures and liquidity crunches have created a tough situation where retail-funded, commercial Islamic banks are better placed than their rivals. They enjoy low leverage and abundant liquidity.

Shariah-compliant investment banks, meanwhile, are wholesale funded with a concentrated deposit base. They are also highly exposed to crucial and illiquid asset classes such as real estate, private equity and venture capital. "Consequently, they have suffered far more, with two of them defaulting recently," said Moody's.

Current assets

Islamic banking is faced with a conundrum. Its institutions maintain a high concentration in short-term assets such as deposits and expensive liquid assets, but at the same time they are exposed to highly profitable but illiquid long-term assets and they have limited access to long-term funding solutions.

"The nature of the Islamic banking model and Shariah-compliant laws applicable to available asset classes means that these banks are persistently faced with a swap between liquidity and profitability."

The report said traditionally IFIs have not been heavily leveraged, neither in terms of credit leverage nor financial leverage. Conservative financial leverage maintenance is primarily due to limited incentives that IFIs have to grow debt-like liabilities as their assets tend to be highly profitable, they set aside extra capital buffers to prepare for expansion and cheap funding is available.

IFIs generally maintain financial leverage of about 5.4x in the GCC. "On the other side of the balance sheet, the average credit leverage of GCC IFIs is close to 55 per cent, which in turn reflects Islamic banks' keenness to keep ample asset liquidity in the event of funding sources becoming unavailable.

"IFIs use cash from deposits and short-term liquidity assets to finance long-term liabilities. These are universal, but they vary greatly among the banks in their composition because of their business characteristics. As a result, the liability makeup affects the IFI funding structures differently."

Moody's said asset-backed transactions could expose Islamic institutions to high credit risk. "In order to mitigate this long-term liability related risk, an IFI should have a vast pool of assets with a maturity range at its disposal to close the asset liability gap."

The strengths of ample liquidity, resilient capital bases are partly offset by the banks' weak asset-liability management and below-par qualitative characteristics such as corporate governance and risk management, which highlight the volatility of this emerging market sector.

"Our view is that the sector's high profitability may not be sustainable and that this will eventually affect ratings, given that the banks' ratings are influenced by restricted asset diversification and inefficient corporate governance structures," said Hassoune.

The inability to efficiently monitor risk, primarily liquidity risk, remains a basic problem with IFIs. "Liquidity management has always been challenging for IFIs, but it is now being exacerbated by the shortcomings of this nascent industry – shortcomings such as a scarcity of liquid instruments, a lack of regulatory consistency and the underdeveloped nature of the Islamic money market."

Even as most of them are expected to survive the impact of declining property prices and rebound with the help of systemic government support and the resurgence of global markets, liquidity-risk-related issues will persist, said Moody's.

Pointing out the different approaches that large and small banks had to the liquidity stress, the analysts said larger Islamic financial institutions – such as Saudi Arabia's Al Rajhi Bank or Kuwait's KFH – prefer to protect their asset liquidity, capitalisation and reputations at the expense of growth and profitability. However, smaller banks are keen to quickly gain market share.

"Such a strategy is apparent in the competitive UAE market. With market liquidity scarce, most banking players have tended to refrain from lending (thus keeping credit leverage at relatively low levels), leaving room for those competitors with ample asset liquidity to use their own balance sheets to capture extra shares of the lending market.

"For instance, Dubai Bank [one of the UAE's smaller Islamic banks] has pursued such tactics. Prior to the crisis, the bank managed to accumulate sizeable asset liquidity on its balance sheet, which it used extensively throughout 2008, resulting in a doubling of its size despite the worsening global credit situation, but at the expense of capitalisation, which declined as financial leverage rose," said the agency.

Asset-backed arrangements

Islamic banks belong to an emerging and conservative industry, so they maintain high levels of liquidity to mitigate the adverse effects of any potential run on deposits.

Overall, less granular deposits or deposit concentrations have been a negative rating factor for the IFIs, said Moody's.

Furthermore, an IFI's balance sheet is based on a "pass-through" mechanism or PLS asset-backed arrangements that allow it to link the returns on its PSIA deposits to asset yields, mitigating its asset-liability mismatch exposure. "This is a risk factor commonly faced by conventional banks.

However, at an Islamic bank, such a risk is more direct and 'mechanical' and is known as 'displaced commercial risk' [DCR], which is defined as the risk of liquidity suddenly drying up as a consequence of massive withdrawals should the IFI's asset yield returns for PSIA-holders be lower than expected or, worse, produce losses. From an operational perspective, this feature creates risks pertaining to premature deposit withdrawals."

Sukuk market

Moody's said the sukuk, or Islamic bond, market is growing but the growth is still insufficient. At the end of 2008, the size of the sukuk market was $106bn, a 10 per cent increase over the previous year's $97bn.

Growth in this segment has led to local debt capital market growth. The popularity of sukuk has contributed to further invention in terms of alternative Islamic assets, with 14 different sukuk structures used so far.

The agency said taking advantage of sukuk was a much-needed solution to the problem of increasing the Islamic banks' funding variety. However, in spite of the enormous success, "the sukuk market is not as deep or liquid as a regular bond market".

"Regardless of growing demand fuelled by banks, corporations and governments in the GCC region, there is a shortage of supply. Additionally, the sukuk market is still stagnant: holders keep their bonds to maturity and there is relatively little secondary market trading," it added.

Innovative solutions

The issue, said Moody's, can be addressed by innovative solutions such as the introduction of a range of Shariah-compliant instruments and the management of asset-liability mismatches, originating from the shortage of long-term funds.

Progress in this field is essential as their underdeveloped funding portfolios are not nearly sufficient to maintain their current performance and allow them to develop into a dominant financial industry, said the rating agency.

(Shveta Pathak/Emirates Business)

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