June 2009 The International Islamic Rating Agency (IIRA), headquartered in Bahrain and set up two years ago by the Islamic Development Bank (IDB) Islamic Development Bank (IDB) , has warned in its latest research report titled "Liquidity Assessment of Islamic Banks" that "Islamic banks face challenges from declining liquidity in the markets".

This is partly reflected by the fact that many Islamic banks became net borrowers from the interbank market during 2008 from net providers of funds in 2007 indicating increased liquidity needs.

The subprime mortgage crisis, stressed the report, resulted in a loss of confidence among banks. As a consequence, many banks declined to participate in interbank markets. The result was diminished liquidity at a crucial time in the banking system. "Lack of liquidity," explained the report, "means loss of depositor's confidence and the resulting systemic risk which has caused runs on a number of banks. Since the origins of the crisis rest in the diminution of asset values, especially asset backed securities; the nature of Islamic banking with its prohibition on interest has served to protect Islamic banks to some extent. That is not to suggest they are entirely immune from the impact of declining real estate values and restricted real estate lending. However, Islamic banks are less likely than conventional institutions to suffer negative outcomes beyond their capacity to sustain core profitability and capital."

The report was based on the liquidity evaluation of eight banks for the period 2007-2008, which included AlBaraka Islamic Bank, Bahrain, Al-Salam Islamic Bank, Bahrain, Bahrain Islamic Bank, Dubai Islamic Bank, Jordan Islamic Bank, Khaleeji Commercial Bank, Kuwait Finance House Bahrain (KFH) and Meezan Bank Pakistan Ltd. This is a disappointingly small evaluation sample and also pitches together commercial banks with investment banks, which is like evaluating apples with pears, because their business models and product offerings hence the risk and liquidity considerations would differ. Albaraka, Al-Salam and KFH-Bahrain are effectively investment banks while the others are commercial banks. But the balance sheet of Dubai Islamic Bank is by far the largest compared to the others. As such the funding needs and exposure of the latter would far outweigh those of the others.

Nevertheless, the report stressed that at year-end 2007, the Islamic banks under evaluation had a strong liquidity position. They were holding a large amount of liquid assets on their balance sheets -- an average of 47 percent of the balance sheet, reflecting the constraints in deployment of funds imposed by Shariah guidelines.

The most liquid Banks in 2007 were Al-Salam and Khaleeji Commercial Bank which were new start ups in 2007. Excluding these, the average dropped to 32.5 percent of liquid assets in 2007, indicating strong liquidity irrespective of jurisdictions.

IIRA defines liquid assets as cash or cash equivalents, short-term placements to banks or financial institutions and liquid quoted investments such as government paper and quoted Sukuk. Short-term liabilities include deposits and borrowings. The least amount of liquid assets were held by KFH-Bahrain at 9.9 percent and the most liquid was Jordan Islamic Bank at 45 percent. On average, excluding the ratios of the two start up banks, the liquid assets declined to 26 percent of total assets during 2008 from 32.5 percent in 2007. This, explained the report, showed that on average, during 2008 the impact of global crisis on the liquid assets remained limited. This decrease, however, stressed the authors, should be seen in the context of an increase in loans to core funding ratio which indicates that some of the liquid assets were transferred to loans and advances.

Loans to core funding is a measure that captures resource utilization of the bank and is the funds available from customers deployment of resources. Two principal components of core funding are the stable portion of customer deposits and unencumbered capital. As a result of the need to book only Shariah-compliant assets, say the authors, this ratio has historically been low for Islamic Banks representing underutilization of the resources, stressed the report.

This however proved to be an advantage for Islamic banks as the conservative posture of their balance sheet helped them to cope with the repercussions during the crisis situation. Depending on their market, business model and risk positioning a bank often keeps 75-95 percent of its core funds in customer assets. The remainder is kept in liquid assets and investment portfolio in order to provide liquidity and enable the bank to earn a small spread. Most of the banks under evaluation registered a healthy increase in their utilization ratio.

Similarly, the interbank ratio is to assess if the bank is a net taker of funds or a net contributor of funds to interbank market. Man omar 1.1:zy