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Home > Capital Markets Viewpoints > The Liquidity Factor

Capital Markets Viewpoints

The Liquidity Factor

by Brandon Davies

Introduction

This article was first published in Quantum magazine.

Shariah banks and financial markets have been affected by the international financial crisis, but, according to a recent International Monetary Fund study, they have proved more resilient and less unstable than their conventional competitors.

This means that they are also well placed to take advantage of any economic upturn, particularly as the Basel III reforms are highlighting structural weaknesses in conventional banks and financial markets and the strengths of shariah finance.

The reforms will also put the two systems of banking on equal terms in the two critical areas of liquidity and capital structures. However, to take full advantage of these opportunities the Islamic sector will also have to adopt other measures, including the development of standardized international products through organizations such as the recently established International Islamic Liquidity Management Corporation (IILM).

The Basel III reforms will have a major impact on capital structure by making conventional banks change from a system dominated by debt capital to one in which equity, supported by contingent capital, is the most important element.

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Shariah Banks, Capital Structures, and Liquidity

At present shariah banks are at a competitive disadvantage. Their capital structures are of necessity dominated by equity because they cannot use debt capital, and this has a materially lower cost than equity. Consequently, a conventional bank will offer equity investors a significantly higher return than an Islamic financial institution with a similar balance sheet. This advantage will be substantially reduced by Basel III, because it will force conventional banks to hold much more equity.

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Contingent Capital

The greater emphasis on contingent capital—a new and not well understood concept—will also benefit Islamic banks. The few contingent capital structures issued so far are dominated by a form of convertible bond (often called CoCos), where the convertibility “option” is not exercised at the discretion of the bondholder but is mandatory, based on “triggers” such as a fall in the bank’s equity-to-asset ratio and/or supervisory intervention in the management of the bank.

Clearly the bond nature of the CoCos makes them unsuitable for shariah banks. But contingent capital as a concept and a product can trace its origins to the insurance industry, and specifically to structures that are based on those of an “indemnity fund.” These can be made shariah-compliant relatively easily, and one already exists with a fatwa issued by Gatehouse Bank’s shariah board.

Such structures are very competitive on cost and feature terms with current CoCos. They hold out the very real prospect of helping to equalize the capital structures of shariah and conventional financial institutions, thereby making Islamic banks relatively far more attractive to investors by leveling the returns on capital.

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Liquidity Requirements under Basel III

The balance between the conventional and Islamic sectors will also be impacted by the changes in liquidity demanded by Basel III. While these liquidity and capital requirements will benefit the Islamic financial sector, there are nonetheless challenges which have to be addressed.

At present, a bank has access to funding liquidity based on its funding structure. If it has plenty of stable retail deposits and medium- to long-term contractual funding through, say, bonds, certificates of deposit, or profit and loss sharing accounts, the bank can use these stable sources to fund its asset base, even in difficult economic circumstances. Shariah banks are by and large well-funded institutions, though with very limited capability to transfer their liquidity across national frontiers. This limits their capacity to create rivals to conventional international banks.

Liquidity can also be raised in the market, enabling a bank to turn its assets into cash either by selling them or by pledging them in order to borrow funds. Market liquidity has grown substantially in recent years, largely due to the growth of so-called “repo” (repurchase) transactions, where banks can pledge assets so that they can receive funds.

Conventional banks have been able to take advantage of this market’s growth to fund new business in areas where they have been less able to attract retail deposits or issue debt securities. In contrast, shariah asset products lack this degree of standardization, sometimes even within national boundaries, and where national markets have developed they have not been able to support international growth.

To address this problem it is necessary to create international product structures which will lead to the creation of common product features and legal contracts on which asset transfers can be based.

In doing so, however, it should be remembered that the short-term nature of repo markets makes them a potentially unstable source of funding. In the recent financial crisis, lenders became unsure of the capability of the underlying assets to be a secure source of repayment for the loans. It should be possible for the Islamic sector to avoid this problem, as transparency and reference to assets with readily observable cash flows are both features of shariah assets.

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Profit and Loss Sharing Accounts

The emphasis of some shariah banks on profit and loss sharing (PLS) accounts as a secure source of funding must, however, be qualified. The nature of the cash “reserves” held against these accounts is likely to be problematic for bank regulators, who in many countries have fought a long battle to eliminate so-called “reserve accounting” in the banking industry. This, they say, is used to smooth profits because international financial reporting standards (IFRS), as implemented, make it virtually impossible to maintain “reserve accounting.”

These factors may make PLS deposits less attractive unless steps are taken to reform their structure to maintain their stability benefit without incurring undesirable treatment from regulators and accountants.

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Retail Funding

The reliance on retail funding also tends to lock shariah banks into their domestic economy. The lack of standardized products internationally, and the often very specific national regulation of shariah banks, means that the often-quoted US$1 trillion of shariah “liquidity” globally is something of a myth. In practice the liquidity is locked into individual national “pools,” and there is only a limited capability to move surplus liquidity to countries which may have investment potential but a shortage of funds.

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Other Issues Related to Liquidity

Basel III also stresses the need for banks to maintain a stock of assets that can easily be turned into cash at reliable values either through markets or, should such markets cease to function, through central bank cash from a “discount window.”

The governments of a number of states where shariah banks are based do issue sukuk which can provide assets that qualify for discount window access, but a number of countries that are important to international banks, including the United States and the European Union member states, do not do so.

Although these countries will accept as bank stock liquidity some assets that are issued by AAA-graded countries and a limited number of international institutions (in the case of the EU countries this is complicated by treaty obligations), there is, even so, almost no sukuk issuance that meets the needs of international banks.

The exception is the sukuk issues by the Islamic Development Bank, which meet the stock liquidity requirements of the UK Financial Services Authority (FSA). However, these issues are not very liquid as banks and investors tend to hold them to maturity.

To address this gap in the market it is necessary to have liquid AAA-government sukuk issued across a range of maturities. This will provide stock liquidity to international shariah banks (and domestic banks in countries where there are no government sukuk).

And, crucially, it will also help to create a zero credit risk profit-rate curve—that is, a profit-rate curve that shows different rates for different tenors of funds. Zero (credit) risk yield curves allow conventional banks to price their own credit, and that of their customers of differing credit risk quality, by reference to such a curve.

Today, the lack of an equivalent to assess the credit standing of those entities to which shariah banks advance funds creates problems of pricing credit risk for shariah banks, and when this is combined with generally illiquid shariah-compliant product markets, the result is that sovereign and corporate sukuk issues trade at what often appear to be illogical prices in relation to their relative credit standing.

Rather than wait for the liquid AAA-sovereign sukuk market to happen, there are initiatives that could be taken by those countries with a strong interest in developing shariah-compliant banking and finance, including the development of a strong role for the IILM. Set up though the actions of Bank Negara governor Tan Sri Dr Zeti Akhtar Aziz and Professor Rifaat Abdel Karim, the secretary general of the Islamic Financial Services Board, the organization’s initial membership of 13 includes Saudi Arabia, Qatar, Luxembourg, and the Islamic Development Bank.

The IILM’s first objective is to issue shariah-compliant financial instruments to facilitate more efficient and effective liquidity management for the shariah banking industry, and, to start with, it will focus on issuing short-term paper in international reserve currencies. This will make a very important contribution to resolving the problems caused by the separate “pools” of liquidity in shariah markets.

There does not yet appear to be any concrete plan to build on the concept of product standardization and the credit quality assurance it creates. But it is possible to envisage that the standard product definition could be created in a way that could at a later date allow the tenor of the product to be extended. Such a move could also make an important contribution to the lack of the necessary stock liquidity instruments to support Basel III compliance by international shariah banks.

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Impact of Basel III

This is a simple illustration of the effect of the Basel III changes to the definition of capital on shariah banks’ and conventional banks’ cost of capital. Under Basel III the majority of junior subordinated bonds (so called Tier 1 and Upper Tier 2 bonds) will cease to qualify as bank capital, and their use must be phased out in stages, beginning in 2013.

Table 1. The situation today

Conventional bank
Equity 25 units RR = 20%
Debt capital 75 units Cost = 10%
Average cost of capital = 12.5%
Shariah bank
Equity 100 units RR = 20%
Average cost of capital = 20%

RR: Required return

Table 2. Tomorrow in a Basel III world

Conventional bank
Equity 75 units RR = 20%
Contingent capital 25 units Cost = 10%
Average cost of capital = 17.5%
Shariah bank
Equity 75 units RR = 20%
Contingent capital 25 units Cost = 10%
Average cost of capital = 17.5%

RR: Required return

Given the immediate reduction in the cost of capital to shariah banks, regulators in countries with shariah banking sectors may consider allowing banks to adopt Basel III at the earliest possible date, while those with equity that exceeds the Basel III requirement could arrange contingent capital and repay equity.

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Contingent Capital: The Shariah-Compliant Structure

The contingent capital structure described here has been developed by FinaXiom Guernsey in cooperation with Gatehouse Bank plc. The structure is asset-based, not asset-backed, and has the following features.

Pre-Draw

  • All assets are kept in cash or in shariah-compliant instruments.

Post-Draw

  • All assets taken into the client are cash or near-cash shariah-compliant.

  • The instruments exchanged are equity or shariah-compliant near-equity products.

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Estimated Increase in Loss-Bearing Capital under Basel III

This estimate for the top 50 banks in Europe, North America, and Asia is based on the following assumptions.

  • Tier 1 data are from the Financial Times banking database for 2009 accounts.

  • No estimate of Tier 2 or replacement capital.

  • The overall Tier 1 capital requirement, comprising not only common equity but also other qualifying financial instruments, will increase from the current minimum of 4% to 6%, with the Swiss now saying 10%!

  • In addition to the minimum capital requirements, banks will be required to hold a capital conservation buffer of 2.5%.

  • The above increases of 2% and 2.5% were taken as percentages of the mean total capital for its sector, and this ratio was applied to the current tier.

  • The type of “loss-bearing” instrument is equity or near-equity in nature.

The total estimated increase for these 50 banks is:

  1. Tier 1: US$513,848 million

  2. Capital buffer: US$642,310 million

  3. Total: US$1,156,158 million

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Shariah-Compliant Liquidity Products

  1. Commodity murabahah. Effectively, this is the trade of an asset between a seller and a purchaser. The seller discloses the original cost price and the additional profit, with the sales price being paid on a deferred basis, which is a very common form of contract for moving liquidity between banks. The International Islamic Financial Market (IIFM) has published a standard document.

  2. Wakalah placement. This involves a deposit-placing bank appointing an agent (wakil) to invest on its behalf. The return, however, must not be guaranteed. It is growing in use as an interbank product and the IIFM is working to create an industry standard.

  3. Sakk/sukuk. A sakk represents an undivided share in an underlying asset of the issuer. The tenor tends to be long term, but sukuk could be issued as short-term instruments and, as such, may well be more universally acceptable than commodity murabahah or wakalah placements.

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Further reading

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