10.1. General

(1) This Chapter sets out the requirements for an Islamic bank:

• (a) to establish and implement policies to manage liquidity risk; and
• (b) to maintain an adequate level of liquidity;

in compliance with Shari’ah rules and principles and in the context of available Shari’ahcompliant instruments and markets.

(2) This chapter also requires an Islamic Bank to have sufficient Shari’ah-compliant resources and funding to withstand severe liquidity stress.

(3) Liquidity risk is the risk that a firm may not be able to meet its financial obligations as they fall due. Overall liquidity risk for an Islamic Bank largely depends on the mix of Shari’ahcompliant modes of financing and investment in its asset portfolio and the concentration of individual customers exposed to each type of contract.

(4) An Islamic Bank’s overall liquidity may be affected by other risks. Liquidity risk is related to group risk more than any other risk because an Islamic Bank that is a member of a group could be called on to make good on commitments and guarantees in favour of the other members of its group.

(5) Liquidity risk can be classified into funding liquidity risk and market liquidity risk. An Islamic Bank must take into account the interaction between funding and market liquidity in its analysis of liquidity risk.

10.2. Funding liquidity risk

(1) Funding liquidity risk, of an Islamic Bank, is the risk that an Islamic Bank will not be able to efficiently meet:

• (a) its expected and unexpected current and future cash flow; and
• (b) its collateral needs;

without affecting its daily operations or financial condition.

(2) Funding liquidity risk may arise because of unexpected withdrawals or transfers of funds by an Islamic Bank’s IAHs and other account holders.

(3) On the assets side, an Islamic Bank may face funding strain due to problems in its financing and investment portfolio. An Islamic Bank may also face liquidity risk because of counterparties’ operational and information system failures, or because problems in a payment and settlement system result in late payment or non-payment of funds.

Examples of problems that may lead to liquidity risk

(i) fall in the value of marketable assets held for trading or in the banking book

• (ii) lack of liquid markets for holdings of sukuk and other Shari’ah-compliant instruments
• (iii) impairment of Islamic financing assets due to the financial distress of customers
• (iv) large drawdowns under committed line-of-credit agreements.

10.3. Market liquidity risk

Market liquidity risk, of an Islamic Bank, is the risk that an Islamic Bank cannot offset or eliminate a position at the market price because of market disruption or inadequate market depth.

Guidance

i) In a period of crisis, problems with funding liquidity may lead to asset sales and may lower asset prices and affect an Islamic Bank’s market liquidity. Efforts by an Islamic Bank to sell a significant amount of its assets because of doubts about their quality and future performance can affect market liquidity by reducing the price of assets.

ii) The collapse of market liquidity is also likely when market-makers are risk-averse or lack absorption capacity. The interaction can also become significant when firms start stockpiling liquid assets because of pessimistic expectations about market conditions.

iii) Overall market confidence is an important factor in understanding the interrelationship between funding and market liquidity. Because of the lack of depth and breadth of markets for Shari’ah-compliant instruments and sukuk and the lack of sufficiently large market-makers in such instruments, funding liquidity risk is likely to be transformed into market liquidity risk in stress events, and vice versa.

10.4. Liquidity risk tolerance

(1) Liquidity risk tolerance refers to both the absolute risk that an Islamic Bank is open to take and the actual limits that an Islamic Bank pursues. An Islamic Bank’s liquidity risk tolerance must be appropriate for its business and its role in the financial system, and must be expressed in a way that clearly states that it is a trade-off between risks and profits.

(2) In approving an Islamic Bank’s liquidity risk tolerance, the governing body must ensure that the limit is commensurate with an Islamic Bank’s ability to have sufficient recourse to Shari’ah-compliant funds to mitigate liquidity risk.

Guidance

The terms ‘risk tolerance’ and ‘risk appetite’ are used interchangeably to describe both the absolute risks that a firm is open to take (which some may call risk appetite) and the actual limits within its risk appetite that a firm pursues (which some call risk tolerance). For example, an Islamic Bank may have set, as the absolute liquidity risk it is willing to take, a limit of 20% (risk tolerance) but at the same time prefer to keep to an actual level of 10% (risk appetite).

10.5. Requirements—managing liquidity and withstanding liquidity stress

(1) An Islamic Bank must manage liquidity risk; it must adopt a prudent liquidity risk management policy that allows it to identify, measure, evaluate, manage and control or mitigate that risk. The policy must be appropriate for the nature, scale and complexity of an Islamic Bank’s business and for its risk profile.

(2) An Islamic Bank must, at all times, maintain sufficient liquidity to meet its obligations as they fall due. It must also maintain a portfolio of high-quality liquid assets sufficient to enable an Islamic Bank to withstand any reasonably foreseeable liquidity stress.

(3) An Islamic Bank must maintain a robust funding strategy to ensure that its activities are, and will continue to be, funded from stable sources. It must prepare a contingency funding plan to meet liquidity shortfalls.

(4) In particular, an Islamic Bank must be able to model and monitor the contractual and behavioural profiles of its IAHs, current account holders and other fund providers. In doing so, an Islamic Bank must take account of the effects of any smoothing techniques (such as PER or IRR) that it has adopted in making profit pay outs to its IAHs.

Guidance

An Islamic bank’s liquidity management should take account of an Islamic Bank’s liquidity needs under periods of liquidity stress (including those involving the loss or impairment of funding sources, whether secured or unsecured), as well as normal conditions. The source of liquidity stress could be specific to an Islamic Bank, market-wide or a combination of both.

10.6. Future shortfalls in liquidity

An Islamic Bank must be able to identify future shortfalls in liquidity by constructing maturity ladders based on appropriate periods.

Guidance

Because of an Islamic bank’s dual role in meeting its obligations to current and murabahah accounts and managing the expectations of its IAHs, an Islamic Bank should carry out liquidity cash-flow analysis periodically under various market conditions. The analysis should state the assumptions about the repayments of invested funds to IAHs, and the extent that Capital erosion from investment losses is mitigated by IRR.

10.7. Notification about liquidity concerns

(1) An Islamic Bank must ensure that its governing body and senior management are informed immediately of new and emerging liquidity concerns.

Examples of concerns

(i) increasing funding costs, concentrations and requirements

• (ii) the lack of alternative sources of funding
• (iii) significant or persistent breaches of limits to liquidity risk exposures
• (iv) any significant decline in an Islamic Bank’s holdings of unencumbered highquality liquid assets

(v) changes in external market conditions that could signal future difficulties

• (vi) significant withdrawal of deposits and PSIAs.

(2) An Islamic Bank must notify the AFSA of any significant concerns that an Islamic Bank may have about its current or future liquidity. In particular, an Islamic Bank must immediately notify the AFSA if an Islamic Bank experiences a severe liquidity stress.

(3) The notice must describe any remedial action taken, or planned, to address the concerns or liquidity stress.

10.8. Role of governing body—liquidity risk

(1) An Islamic Bank’s governing body must ensure that an Islamic Bank’s liquidity risk management policy gives an Islamic Bank a comprehensive firm-wide view of liquidity risk, and is consistent with an Islamic Bank’s risk profile and systemic importance.

(2) The governing body must also ensure that:

• (a) an Islamic Bank’s senior management and other relevant staff have the necessary experience to manage liquidity risk and to effectively implement the liquidity risk management policy;
• (b) stress-tests, funding strategies, contingency funding plans and holdings of highquality liquid assets are effective and appropriate for an Islamic Bank; and
• (c) an Islamic Bank’s senior management:
• (i) develops a liquidity risk management policy in accordance with an Islamic Bank’s liquidity risk tolerance;
• (ii) monitors an Islamic Bank’s liquidity, and reports to the governing body regularly;
• (iii) determines, and sets out in an Islamic Bank’s liquidity risk management policy, the structure, responsibilities and controls for managing liquidity risk and for overseeing the liquidity positions of all legal entities, branches and subsidiaries in the jurisdictions in which an Islamic Bank is active; and
• (iv) monitors trends and market developments that could present significant, unprecedented or complex challenges for managing liquidity risk so that appropriate and timely changes to the liquidity risk management policy can be made.

(3) The governing body must regularly review reports on an Islamic Bank’s liquidity and, where necessary, information on new or emerging liquidity risks.

(4) The governing body must approve:

• (a) its liquidity risk tolerance;
• (b) its funding strategy; and
• (c) its contingency funding plan.

10.9. Policies—liquidity risk environment

(1) An Islamic Bank’s liquidity risk management policy:

(a) must set, and must provide for the regular review of, an Islamic Bank’s liquidity risk tolerance and other quantitative and qualitative limits to liquidity risk exposures and vulnerabilities;

(b) must establish procedures, systems, processes, controls and approaches to identify, measure, evaluate, manage and control or mitigate its liquidity risk and to ensure the integrity of its liquidity risk management;

(c) must set out the organisational structure, and must define the responsibilities and roles, for managing liquidity risk;

(d) must describe an Islamic Bank’s approach to day-to-day (and, where appropriate, intraday) liquidity management;

(e) must specify the criteria and responsibility for reporting, and the scope, manner and frequency of reporting, to the governing body or a committee of the governing body;

(f) must establish procedures for tracking and reporting exceptions to, and deviations from, limits or policies;

(g) must include an Islamic Bank’s funding strategy and contingency funding plan;

and

(h) must establish effective information systems to enable the identification, measurement, monitoring and control of liquidity risk exposures and funding needs.

(2) The policy must enable an Islamic Bank to carry out stress-tests using various scenarios based on appropriate assumptions.

(3) The policy must take into account an Islamic Bank’s liquidity risk profile (including onbalance-sheet and off-balance-sheet risks) and tolerance in the context of the markets and macroeconomic conditions in which an Islamic Bank operates.

(4) An Islamic Bank must have specific policies on:

• (a) the composition and maturity of assets and liabilities;
• (b) the diversity and stability of funding sources; and
• (c) the approach to managing liquidity in different currencies, across borders, and across business lines and legal entities.

10.10. Funding strategy

(1) An Islamic Bank must establish, and must regularly review, strategies for the ongoing measurement and monitoring of funding requirements. An Islamic Bank must identify the main factors that affect its ability to raise funds and must monitor those factors closely to ensure that its estimates of its fund-raising capacity remain valid.

(2) An Islamic Bank’s funding strategy must take into account how other risks affect an Islamic Bank’s overall liquidity. The funding strategy must be supported by robust assumptions in line with an Islamic Bank’s liquidity risk management policy and business objectives.

(3) The strategy must include:

(a) an analysis of funding requirements under various scenarios;

(b) the maintenance of a reserve of unencumbered high-quality liquid assets that can be used, without impediment, to obtain funding in times of liquidity stress;

(c) the regular review of, and diversification in, the sources and terms of funding;

(d) regular efforts to establish and maintain relationships with liability holders and funding sources; and

(e) the regular assessment of an Islamic Bank’s capacity to sell assets and raise funds quickly.

(4) In preparing its strategy, an Islamic Bank must be aware that sources of funding such as guarantees and other commitments that are readily available to an Islamic Bank in normal conditions may not be available in times of stress, even if the guarantee or commitment is described as irrevocable.

(5) An Islamic Bank must inform the AFSA of any significant changes to an Islamic Bank’s funding strategy.

10.11. Contingency funding plan

(1) An Islamic Bank must have a written contingency funding plan that sets out the strategies for addressing a liquidity shortfall in an emergency. The plan must set out available funding sources and the amount of funds that an Islamic Bank estimates can be obtained from those sources.

(2) The contingency funding plan must be flexible enough to enable an Islamic Bank to respond quickly in various situations. It must address the issues over various periods (including intraday) and must establish clear lines of responsibility and communication.

(3) An Islamic Bank must review and update its plan every year (or more often as changing business or market circumstances require) for the governing body’s approval.

10.12. Stress-testing and liquidity risk tolerance

(1) An Islamic Bank must carry out stress-testing using various short-term and long-term firmspecific and market-wide liquidity stress scenarios, to ensure that an Islamic Bank’s exposures remain within its liquidity risk tolerance. The tests must be carried out at intervals appropriate for the nature, scale and complexity of an Islamic Bank’s business and for its risk profile.

(2) An Islamic Bank must use conservative and regularly-reviewed assumptions in stresstesting and must use the scenarios individually and in combination.

(3) An Islamic Bank must report to the AFSA, in the form that the AFSA directs, the results of its stress-testing. An Islamic Bank must use the results to adjust its positions, to review its liquidity risk management policy, and to develop effective contingency funding plans.

10.13. Firms that conduct foreign currency business

(1) This rule applies to an Islamic Bank if:

• (a) an Islamic Bank’s foreign currency business is significant; or
• (b) an Islamic Bank has significant exposure in a particular foreign currency.

(2) An Islamic Bank’s business in a currency is significant, and an Islamic Bank’s exposure in a currency is significant, if 5% or more of the gross value of its balancesheet assets, balance-sheet liabilities or off-balance-sheet financial activities is denominated in the currency.

(3) An Islamic Bank to which this rule applies must undertake separate analysis of its policies (and monitor its liquidity needs) for each significant currency.

(4) An Islamic Bank must carry out regular stress-testing to determine the extent of mismatches in each significant currency and, if appropriate, to set limits on its cash flow mismatches for each such currency and for all those currencies in total.

(5) An Islamic Bank must monitor its liquidity needs in each significant currency and must be able to demonstrate to the AFSA that it can transfer liquidity from 1 currency to another across jurisdictions and legal entities.

10.14. Management of encumbered assets

(1) An Islamic Bank must set a prudent limit for encumbered assets and must keep within that limit.

(2) An Islamic Bank must keep adequate records to enable it to disclose the level of its encumbered assets to the AFSA.

(3) An Islamic Bank must identify its needs for Shari’ah-compliant collateral over different periods, and must address any Shari’ah, legal or operational constraints on the use of such collateral.

Guidance

The limit for encumbered assets is intended to mitigate the risks arising from excessive levels of encumbrance in terms of the effect on an Islamic Bank’s cost of funding and the implications for the sustainability of its long-term liquidity position.

10.15. Consequences of breaches and changes

(1) If a liquidity risk limit is breached, an Islamic Bank must review the exposure and reduce it to a level that is within the limit.

(2) An Islamic Bank must make appropriate adjustments to the management of its liquidity risk in the light of an Islamic Bank’s changing risk profile, funding strategy, and developments in the markets and macroeconomic conditions in which it operates.

10.16. Guidance on liquidity risks arising from Islamic financial contracts

This Section gives guidance on the liquidity risks that may arise from various Islamic Financial Contracts. An Islamic Bank should look into risk transformation in these contracts during their various stages, because such transformations may directly or indirectly affect the liquidity of the contracts.

10.17. Liquidity risks—murabahah

In a murabahah contract, an Islamic Bank’s liquidity may be affected by late payment or nonpayment by the customer.

10.18. Liquidity risks—commodity murabahah

(1) An Islamic Bank may offer commodity murabahah accounts as a means of raising funds. Because raising funds in this way requires an Islamic Bank to pay back the principal and agreed share of profit to the customer on maturity, an Islamic Bank may be exposed to liquidity risk.

(2) If commodity-murabahah-based funds (which are usually short-term in nature) are used by an Islamic Bank to finance longer-term assets, a maturity mismatch will result. Such a mismatch may become acute if an Islamic Bank has a high reliance on such deposits to fund its assets.

10.19. Liquidity risks—salam

In a salam contract, the illiquidity of commodity markets and the non-permissibility of exiting the contract before delivery can give rise to liquidity risk for an Islamic Bank.

10.20. Liquidity risks—ijarah

In an ijarah contract, an Islamic Bank may be exposed to liquidity risk because of:

• (a) late payment or non-payment of instalments by the customer;
• (b) the inability to sell or lease the asset to a new customer at the end of an earlier contract; or
• (c) default by the customer.

10.21. Liquidity risks—mudarabah and musharakah

In a mudarabah or musharakah contract, an Islamic Bank may be exposed to liquidity risk because of:

• (a) late payment or non-payment of profit payments during the contract; or
• (b) non-payment by the customer of the remaining principal at the end of the contract.

10.22. Liquidity risks—PSIA

An Islamic Bank may be affected by panic withdrawals of funds by IAHs. Such withdrawals may result from rate of return risk, Shari’ah non-compliance risk or reputational risk.

10.23. Liquidity risks—qardh

An Islamic Bank may offer unremunerated current accounts on the basis of qardh, under which an Islamic Bank guarantees the nominal amount of the accounts. An Islamic Bank should pay back the full amount on demand and should therefore ensure that sufficient funds are available to do so as and when the demand arises.