Dubai: The implementation of Basel III and its new liquidity coverage ratio (LCR) could increase offerings of liquidity management instruments and could help address some of the industry’s long-standing weaknesses, particularly the lack of high quality liquid assets (HQLA), said Mohammad Damak, a credit analyst with Standard & Poor’s.
In October 2014, the Islamic Finance Services Board (IFSB), an international standard-setting body of regulatory and supervisory agencies published guidance on 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 sizeable market, and low volatility.
This guidance for Islamic financial institutions also specifies how Islamic banks should implement the LCR and the net stable funding ratio related to Basel III, as well as the timeline for implementation.
“The introduction of a liquidity coverage ratio might help to address some of the industry’s long-standing weaknesses, particularly the lack of HQLA,” said Damak.
Most Islamic Bank liquidity management instruments 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.
S & P analysts expect that the implementation of Basel III and its new LCR will increase offerings of liquidity management instruments while issuers are likely to list more of their sukuk on exchanges and that some regulators will start to accept sukuk as collateral for liquidity provisions. In a recent move the UAE Central Bank started accepting a wide range of sukuk as collateral for banks to access its special lending facility from April 1.
Play a role
“We expect high credit quality and local currency sukuk offerings to increase because these instruments are part of the Level 1 HQLA definition of the IFSB. And we believe sovereigns, central banks, multilateral lending institutions (MLIs), and specialised institutions — such as the International Islamic Liquidity Management Corporation (IILM) — could play a role in further fostering the supply of Islamic liquidity management instruments,” said Damak.
Besides cash and deposits with central banks, HQLA include sukuk that highly rated sovereigns, central banks, MLIs, and public sector enterprises issue in local and foreign currencies. They can also include other instruments with specific haircuts on their values and subject to an overall limit in the HQLA mix. However, there is a significant lack of Sharia-compliant HQLA, which may push banks to rely primarily on cash and central bank placements as their main liquidity management tools.
The IFSB Quantitative Impact Study (QIS) — based on a sample of 32 banks in seven countries — found that most participating banks complied with the LCR requirement through their cash and central bank reserve holdings and reported a very strong average LCR of 241 per cent. “We believe that the adoption of Basel III will create an opportunity for the industry to improve the lack availability of Sharia-compliant HQLA. Sovereigns, central banks, MLIs, and other specialised institutions will have a role to play through increasing their issuance of sukuk. In our view, some central banks may start to accept sukuk to back short- to medium-term liquidity facility access,” said Damak.
