The Malaysia-based Islamic Financial Services Board (IFSB) will issue draft guidance by year-end on how Islamic banks, which face a lack of short-term funding instruments, can use sukuk as a key tool for meeting the liquidity requirements of Basel III.

Guidance from the IFSB, one of the main standard-setting bodies for Islamic finance, would help Islamic banks manage their short-term funding needs as they take a greater share of the banking sector in several Muslim-majority countries.

Banks across the Gulf have been waiting for regulatory guidance on how debt instruments such as sukuk will be treated under Basel III, a set of stricter banking rules which are being phased in around the world over the next several years.

The guidance note would address the use of an alternative mechanism to help Islamic banks meet the liquidity coverage ratio (LCR) found in Basel III, the IFSB's secretary general Jaseem Ahmed said in a speech last week.

Basel III provides an alternative liquidity arrangement for jurisdictions with limited high-quality assets, and this mechanism would be extended to markets where Islamic finance features prominently, Ahmed said.

Basel rules require high quality assets to be both low-risk and traded in deep secondary markets, a combination that is lacking in many nascent Islamic capital markets.

"The immediate issue that has featured in the IFSB's dialogue with the Basel Committee is that many if not most Islamic finance jurisdictions will be challenged to provide markets and assets that meet them," said Ahmed.

Islamic banks' liquidity is mainly found in the form of cash rather than such high-quality assets, with guidance aiming to clarify what sharia-compliant assets can be used, Ahmed said.

"Sukuk issued by sovereign and quasi-sovereign entities, and by multilateral development banks and other international institutions, are likely to feature prominently."

A reliance on cash reflects inefficient resource allocation that puts Islamic banks at a disadvantage in relation to conventional banks, Ahmed said.

"The scarcity of sharia-compliant securities that meet liquidity needs also leads to buy-and-hold strategies that limit trading."

Further guidance would be developed to cover a Basel III requirement known as the net stable funding ratio, Ahmed said.

That rule will force lenders to hold enough liquidity to cover longer-term liabilities held by a bank to limit their dependence on short-term funding.

The IFSB has also launched a research programme to study the development of sharia-compliant financial safety nets, including lenders of last resort to deposit insurance schemes, which would form the basis for further guidance in these areas, Ahmed added.-Reuters