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  • RM-5 RM-5 Liquidity Risk

    • RM-5.1 RM-5.1 Liquidity Risk

      • RM-5.1.1

        This Chapter sets out guidance pertaining to liquidity risks, which highlights the key elements for effective liquidity management within the scope of Islamic bank licensees' exposures. Islamic bank licensees solicit and attract various sources of funds to channel to their financing and investment activities. Islamic bank licensees may have various kinds of obligations, such as requirements to repay current account holders on demand, to provide committed funds in Musharakah transactions, and to make available cash flows for expenses or profit payments.

        January 2013

    • RM-5.2 RM-5.2 Definition and Profiles of Liquidity Risk

      • RM-5.2.1

        Liquidity risk is the potential loss to Islamic bank licensees arising from their inability either to meet their obligations or to fund increases in assets as they fall due without incurring unacceptable costs or losses.

        January 2013

      • Profiles of Fund Providers

        • RM-5.2.2

          There are two major types of fund providers:

          (a) Current account holders; and
          (b) Unrestricted IAH.

          These account holders require a degree of liquidity to be maintained by the Islamic bank licensees to meet their requirements for withdrawals. Subject to contractual conditions, investors in CIUs (while not on-balance sheet fund providers) may also give rise to liquidity management considerations, in so far as Islamic bank licensees may need to replace funds withdrawn by an investor pending realisation of the related assets.

          January 2013

        • RM-5.2.3

          As current account holders do not participate in the profits of the Islamic bank licensees' business activities, a sound repayment capacity is required to meet fully cash withdrawal requests as and when they arise.

          January 2013

        • RM-5.2.4

          Some Islamic bank licensees may rely heavily on funds provided by current account holders. Repayment by the Islamic bank licensees of the principal amounts deposited by current account holders is guaranteed without any rights to share in profits, as the current account holders do not share in the risks of the Islamic bank licensees.

          January 2013

        • RM-5.2.5

          Unrestricted IAH are investors who participate in the uncertainties of an Islamic bank licensee's business; therefore, they share in profits and bear losses arising from investments made on their behalf, to the extent of their share. Apart from general withdrawal needs, the withdrawals made by IAH may be the result of:

          (a) Lower than expected or acceptable rates of return;
          (b) Concerns about the financial condition of the Islamic bank licensees; and
          (c) Non-compliance by the Islamic bank licensees with Shari'a rules and principles in various contracts and activities.
          January 2013

        • RM-5.2.6

          Where the principle of Mudarabah is employed to source the funds, from an asset-liability management perspective, Islamic bank licensees may be viewed as being hedged to the extent that the IAH bears the risks of the assets in which its funds are invested. This statement is true only if the Mudarib has acted in accordance with its fiduciary duties under the Mudarabah contracts and without misconduct or negligence.

          January 2013

        • RM-5.2.7

          IAH do not share in the risks on assets financed by current accounts, which are borne by shareholders alone.

          January 2013

        • RM-5.2.8

          As fiduciary agents, Islamic bank licensees are concerned with matching their investment policies with IAH and shareholders' risk appetites. If these investment policies are not consistent with the expectations and risk appetites of IAH, the latter may withdraw their funds leading to a liquidity crisis for the Islamic bank licensees.

          January 2013

    • RM-5.3 RM-5.3 Operational Considerations

      • RM-5.3.1

        Islamic bank licensees must implement a liquidity management framework (including reporting) taking into account both separately and on an overall basis their liquidity exposures in respect of each category of current accounts, unrestricted and restricted investment accounts.

        January 2013

      • Liquidity Management Policy

        • RM-5.3.2

          Islamic bank licensees must maintain adequate liquidity to meet their obligations at all times. In this regard and taking into consideration the nature of the Islamic bank licensees, its business activities and its capital market environment, the Islamic bank licensees must have in place liquidity management policies, which must be reviewed periodically by the Board, covering:

          (a) Strategy for managing liquidity involving effective board of directors (BOD) and senior management oversight;
          (b) A framework for developing and implementing sound processes for measuring and monitoring liquidity;
          (c) Adequate systems in place for monitoring and reporting liquidity exposures on a periodic basis;
          (d) Adequate funding capacity, with particular reference to the board s assessment of the willingness, ability and likely support of shareholders to provide additional capital when necessary;
          (e) Access to liquidity through fixed asset realizations and arrangements such as sale and lease-back; and
          (f) Liquidity crisis management.
          January 2013

        • RM-5.3.3

          The policies should incorporate both quantitative and qualitative factors. Quantitative factors include the extent of diversity and sources of funds, mismatches of liabilities and assets concentration of the funding base, reliance on marketable assets, or availability of standby lines of external funding. Qualitative factors include assessing the general ability of the management, the particular skills in treasury management and public relations, the quality of MIS, Islamic bank licensees' reputation in the market, the willingness and ability of shareholders to provide additional capital and, in the case of a branch or subsidiary the willingness and ability of the head office or parent to provide liquidity.

          January 2013

        • RM-5.3.4

          Since liquidity infrastructures vary from country to country, the Islamic bank licensees operating across jurisdictions are expected to adhere to local requirements for liquidity management. In this regard, Islamic bank licensees which are part of a group should normally be expected to be able to stand alone, and thus, to monitor and manage their own liquidity separately. However, with the agreement of the CBB, branches of foreign banks operating in Bahrain may take into account the assurance of liquidity provision by head office to the Bahrain branch.

          January 2013

      • Measuring and Monitoring Liquidity

        • RM-5.3.5

          Islamic bank licensees must identify any future shortfalls in liquidity by constructing maturity ladders based on appropriate time bands, including those specified by the CBB in Module LM. The Islamic bank licensees may have their own criteria for classifying cash flows, including behavioral methods, and may consider differentiating the types of cash flows as indicated below:

          (a) Known cash flows — the maturities and the amounts are known in advance. This category includes contractual receivables from Murabaha, Ijara, IMB receivables and Diminishing Musharakah;
          (b) Conditional but predictable cash flows (Salam and Istisna') — conditionality is defined in terms of the type of contract or performance of work based on the agreed terms and conditions over an agreed period; or
          (c) Conditional and unpredictable cash flows — in some cases, an investment in a Musharakah is for an open-ended period and an exit strategy may be assessed periodically. The redemption of invested capital and possible levels of return on investment is conditional upon the performance of the activities.
          January 2013

        • RM-5.3.6

          When calculating net funding requirements (NFR), a substantial influence on the liquidity situation of an Islamic bank licensee relates to the management of IAHs' expectations. While the basis of an NFR calculation is to assume that the funds are repaid at the contractual maturity date, it may not be realistic to assume that all IAHs will maintain their funds at the Islamic bank licensee until maturity. Therefore, an internal assessment of their expectations and incentives will be part of an NFR calculation.

          January 2013

        • RM-5.3.7

          Due to Islamic bank licensees' dual role in meeting their obligations to current account holders and managing the expectations of their IAHs, Islamic bank licensees must make periodical cash flow analyses under various market scenarios and conditions.

          January 2013

        • RM-5.3.8

          The scenarios may vary, depending on local market conditions, and may be based on:

          (a) A "normal" operating environment (for example a steady state condition); and
          (b) Scenarios of adverse (stressed) circumstances (for example non-linear events and chaotic conditions). For example:
          (i) The analysis should include assumptions about the repayment of invested capital to the IAH. In the event of investment losses, the extent to which the losses will be mitigated by the use of the IRR needs to be considered;
          (ii) The scenarios should be based on relevant assumptions based on factors affecting the Islamic bank licensee's on- and off-balance sheet exposures. Liquidity levels and early withdrawal profiles computed under these scenarios will be back-tested periodically to validate the underlying assumptions of the measurement process; and
          (iii) In analyses based on behavioral assumptions and scenarios, Islamic bank licensees should assess and apply the liquidity measures that reflect the specificities of each portfolio. In the case of certain market practices, Islamic bank licensees may have different types of portfolios (i.e. CIUs that are treated as off-balance sheet items). The size and characteristics of the assets, which Islamic bank licensees hold in relation to the investment portfolios financing CIUs, will determine their specific liquidity profiles.
          January 2013

        • RM-5.3.9

          Islamic bank licensees must establish the maximum amounts of cumulative liquidity mismatches which they consider acceptable (subject to the requirements of Module LM) and manageable for different time bands, as a percentage of total funds available. Assets must be clearly segregated according to sources of funds, and Islamic bank licensees must monitor their liquidity exposures separately according to the nature and mix of their fund providers — current account holder and unrestricted IAH, which can be expected to vary substantially. The effects of liquidity shortages may vary according to the fund providers' liquidity preferences; hence, separate limits on liquidity mismatches must be set up accordingly. These limits must be regularly reviewed, taking into account the Islamic bank licensee's liquidity situation, economic climate and market conditions.

          January 2013

      • Liquidity Risk Mitigation

        • RM-5.3.10

          Islamic bank licensees may only assume liquidity risk commensurate with their ability to have sufficient recourse to Shari'a-compliant funds to mitigate such risk.

          January 2013

        • RM-5.3.11

          Islamic bank licensees must assess the necessity and extent of their access to available funding sources. In managing their liquidity, Islamic bank licensees have the following possible funding sources — natural cash flows arising from their usual banking activities, the realization of tradable invested assets, asset securitization, and their capacity to access shareholders' and/or head office funds.

          January 2013

        • RM-5.3.12

          Islamic bank licensees' liquidity management policies must include some form of orderly liquidation procedures, to avoid having to liquidate assets at unfavorable prices, resulting in the erosion of the IAH capital and damage to the Islamic bank licensees' reputation and viability.

          January 2013

        • RM-5.3.13

          Islamic bank licensees must have a liquidity contingency plan addressing various stages of a liquidity crisis. Islamic bank licensees must define the classification of the various stages of a liquidity crisis.

          January 2013

        • RM-5.3.14

          For purposes of Paragraph RM-5.3.13, Islamic bank licensees may consider differentiating the stages of a liquidity crisis as follows:

          (a) Identification of a liquidity gap or a situation which acts as a triggering event where withdrawals do not follow predictable patterns when, for example, the Islamic bank licensees suffers an institutional rating downgrade;
          (b) A need to liquidate assets or investments in an orderly manner to meet such a liquidity gap or situation; and
          (c) Emergency measures to be taken in the event that the previous steps fail to meet the liquidity gap adequately.
          January 2013

        • RM-5.3.15

          Where appropriate, Islamic bank licensees should include in their contingency plans the following factors and define appropriate action points at each stage:

          (a) Holdings of tradable high quality liquid assets, which may be readily disposed of in sizeable amounts in deep markets taking into account the likelihood that it will not be possible to realize full book value;
          (b) Profile of other assets and the degree of liquidity of these assets;
          (c) Assessment of Shari'a-compliant and available funding products in the market including possible cooperation agreements with either other Islamic bank licensees or conventional institutions on an interest-free basis for accessing temporary funding, or sale and leaseback arrangements for longer term funding;
          (d) Establishment of a crisis management team or personnel responsible for taking actions at different stages of the liquidity crisis; and
          (e) Notification procedures for communication with Islamic bank licensees' head office and/or supervisory authorities.
          January 2013

        • RM-5.3.16

          However, to the extent that Islamic bank licensees intend to rely on the types of cooperation agreements mentioned above, they need to ensure that willing and committed counterparties will exist for such arrangements.

          January 2013