It is important for Islamic banks to have sufficient funds to deal with its obligations or commitments that may also affect its capability to attract deposits. Like conventional banks, even for Islamic banks, there should be a proper mechanism put in place to match the maturity of assets and liabilities daily while managing with any short-term pressures that may trigger in the course of assuring the assets are fully funded. Unlike conventional banks, Islamic banks in some jurisdictions does not have Islamic short-term liquidity management instruments available in the domestic market as the only available financial instruments are conventional financial instruments tainted with riba. This means that the money market instruments including the interbank market financial instruments and the Central banks acting as lender of last resort in those jurisdictions are typically designed with a loan transaction with interest which is fully prohibited in Islamic finance.

 Liquidity Issues Faced by Islamic Banks

Due to lack of availability of Islamic liquidity management instruments in the domestic market, Islamic banks may face and deal with excess liquidity. This is a situation where the liquid assets of the Islamic banks are either producing a very low return or no return at all threatening the business sustainability of the Islamic banks adversely affecting the competitiveness of the Islamic banks compared to conventional banks. Like conventional banks, Islamic banks are required to follow capital adequacy requirements under Basel norms. For instance, even the Islamic banks under Basel III are supposed to increase the amount of high-quality liquid assets (HQLAs) they hold to ensure that they have the ability to meet the liquidity coverage ratio (LCR). In this regard, the main obstacle which the Islamic banks face is not having enough supply of HQLAs. The undeniable truth is that since the inception of Islamic banking, Islamic liquidity management is a challenge and even today, only limited instruments are available in some selected jurisdictions. The most popular type of investment used by Islamic banks to address the problem of liquidity is commodity Murabahah which is a form of a short-term finance based on Tawarruq. However, the latest practices of the countries prove that there are innovate solutions used in product structuring to manage liquidity.

Differences between Conventional and Islamic Short-Term Liquidity Management Instruments

The main difference between conventional and Islamic short-term Islamic liquidity management instruments is that in Islamic short-term liquidity management instruments, there is no involvement of riba. This means that there is no loan relationship created with interest payment obligation in Islamic short-term liquidity management instruments as there is always an underlying asset or a real economic activity that derives halal profit in the mechanism. To structure an Islamic short-term liquidity management instrument, the shariah contracts are used. For instance, in 2001, the government of Bahrain introduced short-term Al-salam Sukuk to provide investment opportunities for banks and to facilitate monetary policy activity by the Central Bank paving way for Islamic banks to engage in monetary operations. How this Al-salaam Sukuk works is that the government agrees to sell forward to Islamic banks a commodity, typically aluminum in the case of Bahrain, against a spot payment. Instantaneously, the Islamic banks appoint the Bahraini government as their agent to sell the commodity to a third party upon delivery. The price of the future sale determines the return of the Sukuk, and the initial spot payment from the Islamic banks to the Central Bank is considered as the liquidity withdrawal.

 Conclusion

To manage the liquidity of Islamic banks, short term Islamic liquidity management instruments play a vital role. As such, for the sustainable development of Islamic banking, it is imperative to have innovative short-term Islamic liquidity management instruments offered in the domestic market. In this regard, the regulatory authority of Islamic banks could play a vital role to establish a vibrant and resilient Islamic money market parallel to the conventional money market. This is a real challenge faced by the Islamic banking industry of Maldives as well. In 2011, when Maldives Islamic Bank, the only full-fledged Islamic bank was opened in the country, the most critical challenge it faced was to find adequate Islamic liquidity management

instrument in the money market and the capital market and this issue has been highlighted by the Chairman of board of the bank in the bank’s Annual Report 2011 (p.11) as follows:

The bank has gradually deployed the funds towards providing Shariah-compliant financing to its customers under the concept of Istisna’, Murabahah and Ijarah. I wish to highlight, however, that a significant portion of the deposits has to be placed in a nonearning account with the Maldives Monetary Authority due to the absence of Shariah compliant money market and capital market instruments locally to invest in. Finding a viable and acceptable avenue to invest our surplus funds is one of the biggest challenges we face, not only for generating income but also equally important for liquidity management.

Dr. Aishath Muneeza is an Associate Professor at the International Center for Education in Islamic Finance.