288 AN INTRODUCTION TO ISLAMIC FINANCE
to liquidity risk if (i) it has not aligned its liabilities and assets on the same
maturity ladder; or (ii) it has invested in market securities which suddenly
face liquidity issues; or it had placed funds in customized over - the - counter
assets (for example, special mudarabah and musharakah assets).
The current fi nancial crisis has highlighted the signifi cance of liquidity
in the assets market. This further highlights the need for a robust secondary
market and mechanisms to securitize the assets of fi nancial intermediaries to
facilitate liquidity in the markets.
The treasury management function becomes a challenging task affect-
ing the performance of Islamic banks, since they are particularly vulnerable
to liquidity risk, given their limited access to external funds to meet their
obligations. For the following reasons, liquidity risk can be considered as
one of the most critical risks faced by Islamic banks:
■ (^) The limited availability of Shari’ah - compatible money and intra -
bank markets is the leading cause of the liquidity risk. Prohibition by
Shari’ah law from borrowing on the basis of interest and the absence
of an active interbank money market have restricted Islamic banks’
options to effi ciently manage their liquidity positions. Conventional
banks have access to borrowing, from overnight to extended short -
term maturity, through well - developed and effi cient interbank markets.
This access to short - term borrowing is vital for meeting short - term
cash - fl ow needs.
■ (^) Shallow secondary markets are another source of the liquidity risk. The
number of Shari’ah - compliant fi nancial instruments that can be traded
in the secondary market is limited. Therefore, there is a need for the
further development of asset - backed tradable securities such as sukuk.
Even where there are instruments currently available, the number of
market participants is limited.
■ (^) Typical avenues of liquidity management available to conventional banks,
namely the interbank market, secondary - market debt instruments, and
discount windows from the lender of last resort (central bank), are all
considered to be based on riba and therefore unacceptable.
■ (^) Certain characteristics of some Islamic instruments can also lead to
liquidity risks. For example, cancellation risks in murabahah, or the non -
permissibility of trading of contracts based on murabahah or bay’ al -
salam, pose liquidity problems.
■ (^) Islamic banks have a considerable amount of funds in current
accounts which are demand deposits and can be withdrawn at any
time. Repayment of principal amounts deposited by current - account
holders is guaranteed by the bank without any rights to a share in
the profi ts. Islamic banks may be investing only a small fraction of the
current - account holders’ funds and may be maintaining high levels of
liquidity in the form of idle cash in the absence of illiquid short - term
instruments.