Islamic Capital Markets and Products

CHAPTER 11Liquidity Risk Management and High Quality Liquid Assets

By Simon Archer and Rifaat Ahmed Abdel Karim

The way in which banks have typically operated as financial intermediaries exposes them to liquidity risk. They seek to earn a ‘spread’ from an upward sloping yield curve, with the cost of funds increasing as maturities increase, by raising funds through short-term liabilities such as deposits and placing them in longer-term assets such as medium- or long-term loans. This ‘maturity transformation’ exposes banks to the risk of being caught short of funds to repay short-term liabilities. In such circumstances, a bank may need to realise longer-term assets at distressed prices, and may end up insolvent. To avoid such a fate is the role of liquidity risk management.

While this has long been well known, prudential standards and regulation prior to the Basel Committee for Banking Supervision's (BCBS's) set of Basel III standards largely overlooked liquidity risk, focusing mainly on capital adequacy and related credit and market risks. This was true of the Basel II standards which were introduced in 2004.

The financial and economic crisis of 2007–8 and its grave sequels drew attention to this gap in prudential standards and regulation. The result, in terms of international prudential standards, was Basel III, which placed great emphasis on two major issues: the quantity and quality (loss absorbency) of bank capital, and liquidity risk management.

LIQUIDITY RISK CHALLENGES ...