Liquidity management instrument offerings remain limited in Islamic finance, but Basel III's liquidity coverage ratio is likely to create opportunities for their growth, a Standard & Poor's report said.

Most Islamic bank liquidity management instruments consist of low-profitability assets, such as cash and central bank deposits, according to the latest Standard & Poor's Ratings Services roper.

Sukuk are primarily offered as over-the-counter instruments and only a limited amount of them are listed on developed and liquid exchanges.

“Our base-case scenario assumes that the implementation of Basel III and its new LCR will increase offerings of liquidity management instruments. We also think that sukuk issuers are likely to list more of their sukuk on exchanges and that some regulators will start to accept sukuk as collateral for liquidity provisions,” the report said.

“We expect high credit quality and local currency sukuk offerings to increase because these instruments are part of the Level 1 HQLA definition in the IFSB GN-6. And we believe 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 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.

Although banks may benefit slightly from more profitable liquidity management through new sharia-compliant short-term instruments, these new developments are unlikely to have an impact on our ratings on Islamic banks because we don't believe they will significantly change our view on their capital and earnings.

Liquidity management instrument offerings remain limited

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, the report said.

However, there is a significant lack of Sharia-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 per cent.

“We believe that the adoption of Basel III will create an opportunity for the industry to improve the lack availability of Sharia-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,” Standard & Poor’s said.

“We also believe that sukuk listings on organized markets will become more frequent. At year-end 2014, 29 per cent 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 per cent 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,” it added.

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 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,” the report said.

Basel III LCR is creating new opportunities

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 per cent 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,” said Standard & Poor’s in the report.

“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,” it added.

As other longer-term instruments become eligible, banks might benefit from increasing their holding of these instruments to comply with LCR requirements, according to the report.

“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,” Standard & Poor’s said. – TradeArabia News Service