Treasury Management in an Islamic Financial Institution

1. Treasury Management in an Islamic Financial Institution Mohammed Tariq Advisor, President IDB Group Islamic Development Bank 3 May, 2011

2. Role of Treasury in an Islamic Financial Institution • Management of liquidity • Resource mobilization • Hedging through profit rate and currency swaps

3. Management of liquidity • What is liquidity? • Availability of funds as and when required. • Hold cash and securities which can be liquefied at short notice. • Securities or instruments should be such which have a minimal negative impact on the sale of such securities, hence, minimum price risk. • Ability to deal in reasonable size or quantity depending on an institution’s needs.

4. Management of the liquidity • Instruments for Management of Liquidity • Conventional Finance: Interbank market and other investments e.g. treasury bills, commercial papers, bonds, etc. • Islamic Finance: Placement of funds under Commodity Murabaha • How does the Commodity Murabaha work? • Lack of liquidity in such placements. • Reciprocal arrangements through reverse Murabaha. • Credit risks similar to conventional: lines to be set up between counter parties. Limits management

5. Management of the liquidity • Islamic institutions can deal with conventional banks. • Other instruments like Sukuk: problems of longer duration, price risk, lack of liquidity, etc. • Trade finance deals with high quality parties and/or bank guarantee. • Sukuk holdings to be held as part of investment portfolio of the Treasury to earn higher returns.

6. Management of the liquidity • Asset Liability Management (ALM) • In order to meet disbursement requirements of the institution, placement of funds should ideally match the liability profile. • Techniques used for matching assets and liability by size as well as maturity. • Need to have active lines with other financial institutions to raise short-term funds as and when needed. • Risks involved, if liabilities are much higher than assets: impact of higher or lower interest rates in future, credit risks etc.

7. Management of the liquidity • Role of the Regulators/Central banks • Lender of last resort role • Lack of Shariah compatible financial instruments to intervene in the market for Islamic institutions. • Treasury bills or other such high quality instruments are not acceptable under Shairah rules. • Need for regulators to provide shot-term instruments for Islamic financial institutions.

8. Resource Mobilization needs • Central to Treasury functions in an Islamic financial institution • Close involvement of the Treasury with the operational units of the bank to assess short and medium-term business plans and hence resource needs. • Clear assessment of the cost of funds for different periods to be provided to the business units in order for pricing such products. • Pricing Methodology for financing.

9. Resource Mobilization needs • Instruments for Resource Mobilization • Short-term: Reverse Murabahaupto 1 year, mostly upto 3 months, Price risk. • Long-term: • Asset backed Sukuk: Over 51% need to be backed by tangible assets e.g. lease rentals, eligible Sukuk, equities, etc. Minority, i.e. less than 50% can be debts e.g. Installment Sales, Istisna’ etc • Availability of acceptable assets • Rollover Commodity Murabaha, upto 3 years, • Issues of fixed vs. floating rate • Asset backed Sukuk tradable, others not so

10. Hedging • Profit rate and currency swaps for managing treasury risks • Objectives and methodology • For profit rate swap: fixed vs. floating rate and vice versa • Currency swap