Karachi, October 18, 2018: An imminent crisis is brewing for the Islamic banking industry as a major chunk of its liquidity instruments starts maturing this December. The Islamic banking industry in terms of deposits is approximately 15 percent of the total banking industry.

The total banking industry as of June 2018 was approximately 13 trillion; of which Islamic banks accounted for PKR 2 trillion in deposits. But when it comes to investments, Islamic banks have only 5% in the form of liquidity instruments.

Currently, conventional banks have two avenues of liquidity instruments available to them: treasury bills and Pakistan Investment Bonds (PIBs). Treasury bills are of 3 months, 6 months, and 1-year tenor, while PIBs are from 3 years to 30 years tenor.

Treasury bills auctions are held every fortnight while PIB auction is held once a month. Islamic banks have one liquidity instrument to invest in: Government of Pakistan Ijara Sukuk (GIS); the last auction of which was held more than a year ago in June 2017.

The difference between the conventional instruments and the GIS is that the former is pure debt securities while the latter has an underlying asset to back the instrument. As of June 2018, the total amount of PIBs and treasury bills held by conventional banks was 2.2 trillion and 4.8 trillion respectively; while Islamic banks held only 368 billion in GIS.

Moreover, these liquidity instruments are kept by banks for their Statutory Liquidity Requirement (SLR) to protect the institution in case of a panic run on the bank. Previously, both conventional and Islamic banks were supposed to keep 19 percent of their demand and time liabilities in the form of SLR-eligible instruments.

But as the inventory of Islamic liquidity instruments was depleting, instead of issuing new instruments, the State Bank of Pakistan (SBP) revised the SLR requirement downward to 14 percent for Islamic banks in November 2016.

This has actually given a wrong signal for the industry. In the eyes of an outsider, technically, Islamic banks are now riskier than conventional banks; as they keep a lesser percentage of their deposits in SLR-eligible instruments.

The Islamic banking industry has come a long way to its current position comprising 5 full-fledged Islamic banks and 16 windows; with the first license being awarded in 2002 to Meezan Bank.

Before the GIS was launched in September 2008, the SBP had given SLR-eligible status to a few Sukuk issued by public sector enterprises (PSEs) like Water and Power Development Authority, Karachi Shipyard & Engineering Works, National Industrial Parks, and Pakistan International Airlines; but after the issuance of GIS, such issuances came to a halt.

Initially, the government issued Sukuk (which are Islamic bonds) against the M1, M2, and M3 motorways and then the Jinnah International Airport. It’s a harsh reality that maximum Sukuk was issued between 2008 and 2013 during the PPP government.

When the PML-N came to power, they pledged that they would work for the growth of the Islamic banking industry. But instead of allocating new assets for the industry, they took the largest motorway asset out of the domestic market and floated international Sukuk against it.

Priorities were clear; international forex reserves were the country’s main need while domestic funding could be raised through treasury bills and PIBs. Hence, consideration for the Islamic banking capital market went on the backburner.

However, to avert a liquidity deployment crisis at that time, SBP issued a circular in October 2015 which allowed the Ministry of Funds to buy the Sukuk that was maturing in a month’s time on deferred payment for one year. This deferred payment purchase by the Government (also known as bai muajjal) took out the tradability component from the instrument but nevertheless was SLR-eligible.

Coming to the present scenario. Currently, PKR 320 billion of Jinnah International Airport Sukuk is maturing in 3 tranches in December, February, and March respectively; while no other asset is in sight.

A small amount asset pertaining to a motorway matured last year; but the current government, following in the footsteps of their predecessors, intends to raise dollar funds against it.

A delegation of presidents of Islamic banks recently met the Finance Minister along with other officials of the finance ministry, but to no avail. In fact, sources privy to the meeting reveals that the Finance Secretary jokingly quipped to the delegation that the Government had not stopped the Islamic banks from investing in treasury bills and PIBs.

In the Islamic banking model, assets have to be created before liabilities; unlike the conventional banking model. Due to the lack of issuance of government guaranteed SLR-eligible paper, Islamic banks have been shoved against the wall; forced to finance PSEs at fine rates, raising the risk of non-performing loans. Moreover, due to lesser returns on their assets, Islamic banks are finding it difficult to raise deposits at higher rates; resulting in deposit attrition.

Neither do these institutions have the luxury of an interest rate corridor (available to conventional banks) where banks can place funds at a minimum rate or borrow at a maximum rate from SBP in dire need. Hence, the traditional economics axiom that the central bank provides “lender of last resort” facility to all banks doesn’t exist for Islamic banks.

It may be noted that these Sukuk are not only the lifeline for Islamic banks, but are also in demand by asset management companies for their Islamic mutual funds. They are also demanded by takaful operators for their fund management requirements.

To address the immediate problem, the following measures are suggested on a war footing:

Ministry buys the Sukuk before maturity on deferred payment from Islamic banks before maturity and sells it back in the market and subsequently buys it again in future on deferred payment. This way, through multiple iterations, Islamic banks will be able to get rid of their excess liquidity.

-Ministry allocates more assets for Sukuk. If motorways can’t be allocated, there should be some other unencumbered assets elsewhere parked in different ministries which could be used for Sukuk issuance.

-There is a misconception in the Ministry that the asset has to be an earning asset. Assets against which Sukuk was issued in the past, i.e. motorway or the airport, have all been earning assets. That doesn’t need to be the case. An asset of the Public Development Sector Program (PDSP) can also be financed through Sukuk.

For example, post offices have to be established in the nook and corner of the country. They don’t necessarily earn a profit; but the government can issue Sukuk against these post office buildings. Another example could be that the government funds its construction of dams through the Islamic banks by issuing SLR-eligible Sukuk.

-The government should come up with a short-term alternative to treasury bills for Islamic banks. A possible solution could be a product whereby the government could fund its quarterly purchases of crude oil/ furnace oil through the Islamic banking industry by issuing SLR-eligible short-term paper.

-A separate desk should be set up in the Ministry of Finance to look after the affairs of the Islamic banking industry. Interestingly, there is a Director General Debt Management Division; but his job is limited to the issuance of treasury bills and PIBs; while Sukuk is sometimes looked by him or otherwise, by the external accounts division (EAD).

The central bank had a few years ago in its 5-year strategy plan visualized Islamic banking to reach 20% of the total banking industry by 2020. But until it doesn’t come up with a proper short-term and long-term Sukuk program for the Islamic banking industry; this appears to be a far-fetched dream. Moreover, if one of the above-suggested measures is not taken in the short-term; there is a risk that Islamic financial institutions will go short in their statutory liquidity requirement, and be forced to supplement this requirement with cash; further eroding their profitability.

By: Shaikh Ahmed

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