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Why Islamic banks are getting riskier

Updated October 15, 2018

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A crisis is brewing in the Islamic banking industry as a major chunk of its liquidity instruments begin maturing in December. ─ File photo
A crisis is brewing in the Islamic banking industry as a major chunk of its liquidity instruments begin maturing in December. ─ File photo

A crisis is brewing in the Islamic banking industry as a major chunk of its liquidity instruments starts maturing this December.

The Islamic banking industry holds approximately 15 per cent of total banking deposits. But when it comes to investments, Islamic banks have a share of only 5pc in the form of liquidity instruments.

Currently, conventional banks have two kinds of liquidity instruments: treasury bills and Pakistan Investment Bonds (PIBs). The tenors of treasury bills are three, six and 12-months while those of PIBs range from three to 30 years. Islamic banks, however, have only one liquidity instrument to invest in: government Ijara Sukuk (GIS), the last auction of which was held in June 2017.

The difference between conventional instruments and GIS is that the former are pure debt securities while the latter has an underlying asset to back it. As of June, the total amount of PIBs and treasury bills held by conventional banks was Rs2.2 trillion and Rs4.8tr, respectively. Islamic banks held GIS worth only Rs368 billion.

The government should allocate more assets for sukuk. If motorways can’t be allocated, unencumbered assets parked elsewhere can be used to back Islamic bonds

Banks keep these liquidity instruments to meet their Statutory Liquidity Requirement (SLR), which is aimed at protecting the institution in the case of a panic run on the bank. Previously, both conventional and Islamic banks were supposed to keep 19pc of their demand and time liabilities in the form of SLR-eligible instruments. But the inventory of Islamic liquidity instruments was depleting. So instead of issuing new instruments, the State Bank of Pakistan (SBP) revised the SLR requirement downward to 14pc for Islamic banks in November 2016. This has actually sent the wrong signals about the industry. Technically, Islamic banks are now riskier than conventional banks as the former keep a smaller percentage of their deposits in SLR-eligible instruments.

Before GIS were launched in September 2008, the SBP had given the SLR-eligible status to a few sukuk issued by public-sector enterprises (PSEs), like Water and Power Development Authority (Wapda) and Pakistan International Airlines (PIA). But such issues came to a halt after the launch of GIS. Initially, the government issued sukuk against motorways (M1, M2 and M3) and Jinnah International Airport. Most sukuk were issued between 2008 and 2013.

Instead of allocating new assets for the Islamic banking industry, the PML-N took the largest motorway asset out of the domestic market and floated international sukuk against it. Its priorities were clear: foreign exchange reserves were the country’s main need while domestic funding could be raised through treasury bills and PIBs. Hence, consideration for the Islamic banking capital market went on the backburner.

However, to avert a liquidity deployment crisis at that time, the SBP issued a circular in October 2015 that allowed the Ministry of Finance to buy the sukuk that were maturing in a month’s time on deferred payment for one year. This deferred payment purchase by the government — also known as bai muajjal — took out the tradability component from the instrument. Nevertheless, it was SLR-eligible.

As of now, Rs320bn worth of Jinnah International Airport sukuk are maturing in three tranches in December, February and March while no other asset is currently in sight. A small asset pertaining to a motorway matured last year, but the government intends to raise dollar funds against it.

In Islamic banking, assets have to be created before liabilities unlike the conventional model. Due to a lack of government-guaranteed SLR-eligible papers, Islamic banks have been forced to finance PSEs at fine rates, raising the risk of non-performing loans. Due to smaller returns on their assets, Islamic banks are finding it difficult to raise deposits at higher rates, resulting in deposit attrition. Also, these institutions don’t have the luxury of an interest rate corridor (available to conventional banks) where banks can place funds at a minimum rate or borrow at a maximum rate from the SBP in dire need. Hence, the axiom that the central bank is the lender of last resort to all banks doesn’t exist for Islamic banks.

These sukuk are a lifeline not just for Islamic banks. Asset management companies also need them for their Islamic mutual funds. Takaful operators also require sukuk for their fund management.

Following measures should be taken to address these problems: the finance ministry should buy sukuk on deferred payment from Islamic banks before maturity and sell them back in the market and then repeat the whole process. Through multiple iterations, Islamic banks will be able to get rid of their excess liquidity.

The ministry should allocate more assets for sukuk. If motorways can’t be allocated, there should be some other unencumbered assets elsewhere parked in different ministries that can be used for sukuk issuance.

There is a misconception in the ministry that the underlying asset has to be an earning one. Assets against which sukuk were issued in the past — motorway or the airport — have all been earning assets. That doesn’t need to be the case. An asset of the Public Development Sector Programme (PDSP) can also be financed through sukuk. For example, post offices have to be established in every corner of the country. They don’t necessarily earn profit, but the government can issue sukuk against such buildings. The government can also fund the construction of dams through Islamic banks by issuing SLR-eligible sukuk.

The government should come up with a short-term alternative to treasury bills for Islamic banks. A possible solution can be a product that allows the government to fund its quarterly purchases of crude oil/furnace oil through the Islamic banking industry by issuing SLR-eligible short-term paper.

A separate desk should be set up in the Ministry of Finance to look after the affairs of the Islamic banking industry. There is a director general for the Debt Management Division, but his job is limited to the issuance of treasury bills and PIBs. Sukuk are overseen sometimes by him or the External Accounts Division.

In the absence of these measures, there is a risk that Islamic financial institutions will fail to meet their statutory liquidity requirement and be forced to supplement it with cash, further eroding their profitability.

The writer is a freelance contributor.

ahmedncel@gmail.com

Published in Dawn, The Business and Finance Weekly, October 15th, 2018