Contemporary Islamic Finance: Innovations, Applications and Best Practices

CHAPTER 7

Managing Liquidity Risk in Islamic Finance

DR. MUHAMMAD AL-BASHIR MUHAMMAD AL-AMINE

Group Head, Shari'ah Assurance Department, Bank Al Khair

INTRODUCTION

Liquidity refers to the promptness with which an asset can be converted into cash. Liquid assets are money and other financial assets that can be turned into money.¹ In banking, liquidity is defined as “proportion of the assets which is held in cash or near cash.”² The liquidity of a bank represents a bank's ability to meet anticipated demand for its funds from depositors and borrowers.³

Liquidity problems arise when there is an unexpected decline in the bank's net cash flow and the bank is unable to raise resources at a reasonable cost in a Shari'ah-compatible manner. This would make it difficult for an Islamic bank to meet its obligations when new opportunities for profitable business arise. The mismatch between deposits and loans and investments exposes any bank, whether it is an Islamic bank or a conventional commercial bank, to liquidity problems. The bank may maintain too much liquidity to avoid getting into this difficulty. But this, in turn, may hurt its profitability. Creating a right balance between the two objectives of safety and profitability is thus the crux of the liquidity management problem.⁴

Monitoring and controlling liquidity is one of the most critical responsibilities of a bank's management. It has been a very important concern in the minds of Islamic banking practitioners since the early days of ...