JEDDAH — Regulatory proposals for a liquidity coverage ratio for Islamic financial institutions could help address some of the industry's long-standing weaknesses, particularly the lack of high quality liquid assets (HQLA), Standard & Poor's Ratings Services said Tuesday in a report “Basel III Requirements Could Strengthen Islamic Banks' Liquidity Management”. In October 2014, the Islamic Finance Services Board (IFSB), an international standard-setting body of regulatory and supervisory agencies that aims to ensure the soundness and stability of the Islamic finance industry, published guidance on quantitative measures for liquidity management in institutions offering Islamic financial services. This note set three main characteristics of high quality liquid assets (HQLA): low correlation with risky assets, an active and sizable market, and low volatility. The guidance also specifies how Islamic banks should implement the liquidity coverage ratio (LCR) and the net stable funding ratio related to Basel III, as well as the timeline for implementation. Most Islamic bank liquidity management instruments currently 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. However, the report said the implementation of Basel III and its new liquidity coverage ratio could increase offerings of liquidity management instruments. "We think that sukuk issuers will likely list more of their sukuk on exchanges and that some regulators will start to accept sukuk as collateral for liquidity provisions," said Standard & Poor's credit analyst Mohamed Damak. "We expect high credit quality and local currency sukuk offerings will increase because these instruments are part of the Level 1 HQLA definition in the note." Sovereigns, central banks, multilateral lending institutions, and specialized institutions—such as the International Islamic Liquidity Management Corporation (IILM)—could play a role in further fostering the supply of Islamic liquidity management instruments, the report says. The demand for these instruments and their current scarcity are also likely to push their yields downward and align them more with the yields of similar conventional instruments. Islamic banks' profitability might benefit slightly from increased sukuk issuance, but not enough to lead to higher ratings. "For this reason, we do not expect any rating impact from this development alone. Still, we see increased new liquidity rules as being to the overall benefit of Islamic banks and a step in the right direction," said Damak. Under Standard & Poor's policies, only a Rating Committee can determine a Credit Rating Action (including a Credit Rating change, affirmation or withdrawal, Rating Outlook change, or CreditWatch action). This commentary and its subject matter have not been the subject of Rating Committee action and should not be interpreted as a change to, or affirmation of, a Credit Rating or Rating Outlook. Besides cash and deposits with central banks, HQLA include sukuk that highly rated sovereigns, central banks, multilaterals, 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 Shariah-compliant HQLA, which may push banks to rely primarily on cash and central bank placements as their main liquidity management tools. Indeed, 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%. “We believe that the adoption of Basel III will create an opportunity for the industry to improve the lack availability of Shariah-compliant HQLA and that sovereigns, central banks, MLIs, and other specialized 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.” The recent change in the rules of the United Arab Emirates Central Bank accepting a wide range of sukuk as collateral for banks to access its special lending facility from April 1, 2015 is an example. “We also believe that sukuk listings on organized markets will become more frequent.” At year-end 2014, 29% of the sukuk issued were listed on organized markets, while the rest consisted of over-the-counter (OTC) instruments. This ratio increased to 51.5% in the first quarter of 2015, although the increase is partly a result of a major drop in issuance from the Central Bank of Malaysia, which decided to switch to other instruments for liquidity management rather than sukuk. Based on the size of the Islamic finance industry, its composition, and its growth trajectory, “we estimate the need for HQLA to reach about $100 billion in the next few years.” Potentially eligible sukuk include central bank and government issuance. Eligibility for HQLA inclusion is subject to regulators' decision as per the criteria outlined in the IFSB guidance note. “We base our estimate on a sample of Gulf Cooperation Council (GCC)-domiciled Islamic banks and have extrapolated our findings to the entire industry. However, we're aware that the asset and liability structures of GCC banks differ from those of Islamic banks domiciled in other countries.” Standard & Poor's believes that sovereigns, central banks, multilateral lending institutions (MLI), and specialized entities such as the Islamic Development Bank (IDB) or the IILM (under the Alternative Liquidity Approaches the IFSB-GN defines) can play a key role in addressing the lack of liquidity management instruments in the industry. These institutions could ramp up their issuance of sukuk in order to bolster HQLA offerings. Such issuance could be eligible for the classification of Level 1 HQLA, which are not subject to haircuts and could be included up to 100% in the HQLA mix of Islamic banks. At the same time, we believe that this process will take some time because the implementation of LCR will be gradual and is restricted to countries where Basel III is adopted. This excludes some emerging markets where Islamic finance has been developing. Another angle that regulators may use to tackle the lack of HQLA is through the reduction of the potential net cash outflows. This could be achieved through the implementation of sharia-compliant effective deposit insurance schemes that reduce by half the run-off rates on certain deposits and profit-sharing investment accounts, according to the guidance note. Effective deposit insurance schemes are those that are able to promptly pay out account holders, with a clearly defined coverage amount and timeline for payment. But it could take a while to implement such schemes. Islamic banks' profitability might benefit from the current regulatory changes, in our view, because sukuk instruments generally carry higher yields than other eligible HQLA instruments (cash and central bank reserves) in banks' balance sheets. As other longer-term instruments become eligible, “we think that banks might benefit from increasing their holding of these instruments to comply with LCR requirements. The positive effect on profitability will probably be short-lived because higher demand on these instruments could eventually push their yield downward. In addition, given the current needs and the structure of Islamic banks assets, we do not expect a material positive impact on profitability.” “For this reason, we do not expect any rating impact of this development alone. Still, we see new liquidity rules as being to the overall benefit of Islamic banks and a step in the right direction,” it noted. — SG
