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Liquidity and the Secondary Market

Muhammad Faisal Siddiqui, Member, Shariah Advisory Department
BankIslami Pakistan

May 2010
 

Islamic finance is prohibited by its very mandate to invest in certain businesses and not using various conventional modes of financing. As a result, excess liquidity has always been a challenge for it.

One of the methods to utilise excess funds is placement with conventional banks. As interest-based lending is not allowed nor is placement under the partnership mode possible with conventional banks, a technique called tawarruq is used by Islamic financial institutions whereby a commodity is sold to conventional institution on deferred payment at a higher price than is prevalent in the spot market. The institution sells the purchased commodity on cash and generates liquidity. The reason this product is disliked by scholars is that it provides cash to conventional banks for interest-based lending.

The very basis of Islamic finance negates interest; then how is mutual co-operation possible, at least in lending operations? This should not be confused with co-operation in halal operations like internet banking, letter of credit services and funds transfers. If Islamic banks continue to use this product, it may adversely affect their long-term profitability and even existence when the large Shariah-compliant customer base, which is its key strength, comes to believe that it makes no difference whether to deposit with Islamic or conventional banks as ultimately the user of their funds is a conventional bank.

This situation calls for the development of further products in the area of corporate banking rather than treasury products that provide a flow of funds to conventional banks. Consumer finance products like education finance are the area that has much potential for growth. They will certainly reduce the pressure of excess liquidity. They also demand that Islamic financial institutions should be bound by a code of practice that permits tawarruq for placements with conventional financial institutions only in case of dire need such as a survival issue. The product should not be used just to increase profitability. Besides this, a time frame should be given by users of the product by which they intend to rid of this product rather than making it a permanent practice.

This issue of excess liquidity should also be addressed by central banks and finance ministries as conventional banks, in addition to having vast investment avenues, are able to purchase government interest-bearing securities while Shariah-based government securities are very few. A large portion of government budgets are taken up by development projects which can be financed by the Islamic modes of istisna’a and musharakah. Besides this, existing national assets can be used to finance on the basis of an Islamic sale and lease back structure. Contrary to excess liquidity, the challenge of Islamic banks needing liquidity is relatively easy. Islamic banks can accept funds from conventional banks under any acceptable mode, be it mudharabah, musharakah, wakalah or tawarruq. However, generating liquidity by selling debts (receivables) is an issue that is controversial. Hanafi scholars do not allow sale of debt. It is widely believed that Shafi’i scholars’ stance is in favour of sale of debt, but this sale should be at par and not at discount.

So, it is evident that in the Islamic system of finance, debt discounting is not possible. The logic behind this prohibition is that it is the creditor who grants credit after checking on the creditworthiness of the debtor. If the sale of debt is allowed, it means there will be no recourse of the buyer to the seller of the debt in case of default. This will encourage the trend of less prudent lending and then shifting the garbage to less informed sectors. This will enhance gambling, too, as the buyer will be speculating on the creditworthiness of the debtor.

The acquisition of conventional portfolios by Islamic financial institutions is related to this issue of debt discounting. As the deposit size of Islamic financial institutions grow larger, such acquisitions are surging and are likely to continue. Principally, these portfolio purchases are a good thing as not only will they cater to the excess liquidity issue, but interest-bearing liabilities will be converted to Islamic finance, which is desirable. However, debt discounting and recourse to creditor are challengeable matters. This is because conventional banks have provided loans for house financing rather than houses (as done by Islamic financial institutions), and portfolio acquisition will mean debt assignment. Now, the acquirer of the portfolio cannot acquire the portfolio at a discount which is normally the case. Also, the acquirer will have recourse to the seller (assignor of the debt) until the interest-bearing debt is converted to a Diminishing Musharakah (DM) structure by the Islamic bank (assignee of the debt) under a sale and lease back arrangement.

Since the conversion of an interest-bearing liability into a DM structure can be done within months, this issue is resolvable if the seller of the portfolio agrees to wait until the portfolio is converted. Discounting the value of the portfolio is commercially indispensable. This could be done by taking some larger debts in the portfolio in a manner that the Islamic financial institution approaches a debtor and offers to take up his/her liability. The Islamic bank assumes his liability in return for x% share in the property of the debtor. Now, this liability which the Islamic bank owes to the conventional bank can be settled by paying any value with mutual consent. Obviously, the settlement amount will be less than the face value of the debt.

Restrictions on the sale of debt or debt securities should not be taken as complete exclusion of the secondary market for Islamic  financial products. All such financing that involve ownership of fixed assets (such as Ijarah and DM) or are equity-based are tradable at any value as is the case with sukuk. Sukuk also provides opportunity for an Islamic swap. A sukuk certificate with floating yield in the form of variable rental can be sold for a fixed price to be paid in instalments. It will thus be tantamount to a swap of two assets where one’s yield is floating and another’s is fixed. We can see that a number of options exist for secondary markets in Islamic finance. It is also observable that every transaction that does not lead to injustice and deception is doable in Islamic ways. However, transactions that are meant to circumvent the objectives of the Shariah are undesirable and lack general acceptability. They may attract increased profitability in the short run but will consequently lead to a cost no Islamic bank can bear.

 

 

This article first appeared in Islamic Finance News (Pg 15, Vol 7, Issue 16, 21 April 2010). For more details, please visit www.IslamicFinanceNews.com.

 

 

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