OBSERVER REPORT
DUBAI/LONDON The recent disruptions caused by the coronavirus and the oil price slump are affecting Islamic banks’ liquidity and highlight the need to develop deeper sharia-compliant repurchase agreements (repo) markets, Fitch Ratings says.We believe a better-functioning Islamic repo market would be credit positive for Islamic banks’ funding and liquidity profiles by providing banks with an additional source of short-term funding on a secure and low-risk basis, especially in times of liquidity stress as we currently see. It can also provide some support to Islamic banks’ earnings generation capabilities through a lower cost of funding due to the collateral held. However, issues with sharia-compliance, the lack of standardisation and regulatory hurdles are hindering the growth of the Islamic repo market and its acceptance among counterparties. The economic downturn caused by the coronavirus pandemic and the sharp fall in oil prices are reducing banks’ liquidity in Islamic finance’s core markets, namely Gulf Cooperation Council (GCC) countries and Malaysia. While each of these countries is at a different stage of development, Malaysia’s money and repo markets are the deepest and most liquid. The country has well-developed domestic debt capital markets that drive a broad range of collateral eligible for repos under sale and buy back agreements (SBBA) with the central bank ranging from sovereign sukuk to Islamic private debt securities. Funding options for Islamic banks in Malaysia are broader than in other countries due to the longer repo tenors available. In the GCC, the Central Bank of Bahrain is leading the way by introducing sharia-compliant liquidity management tools, such as the Islamic Sukuk Liquidity Instrument (ISLI) and the Wakalah, an intraday credit (IDC) facility available to Islamic banks against their tradable Islamic securities holdings (Sukuk-al-ijara). The latter is designed to ensure a level playing field between Islamic and conventional banks, and increase the efficiency of the monetary policy. However, banks’ recourse to repo funding in the past has been limited as high oil prices have supported banks’ liquidity through strong deposits inflows from government and government-related entities, which represent about a third of total deposits on average. However, during the previous oil price shock in 2015-2016, we saw Gulf central banks injecting liquidity into the banking system through repo facilities with commercial banks which had suffered from tightening liquidity, thereby providing banks with contingent liquidity sources. This was accompanied by tenor extension of repo operations, particularly in SaudiArabia and Qatar, and broadening the range of collateral eligible for repo operations in the UAE. With the economic boycott of Qatar, the Qatar Central Bank’s (QCB) repo operations skyrocketed to QAR413.9 billion in 2017 from QAR3.4 billion in 2016 to alleviate banks’ liquidity pressures. Should the economic disruptions caused by the coronavirus continue and oil prices remain low, we expect central banks across the GCC to increase repo facilities and provide additional sources of liquidity to banks. Most GCC countries have already announced that additional liquidity will be made availableto supportthe banksif needed and this includes banks’ access to repo funding at their respective central banks. Compared to their conventional peers, Islamic banks face several constraints to raise funding through repo markets, especially for bank-to-bank transactions. These constraints include differences in sharia interpretation, lack of standardisation and regulatory hurdles faced by Islamic banks. Malaysia’s Islamic repo structure, SBBA, is not viewed as sharia-compliant in GCC countries, where Murabaha, Ijara and Tawaruqq are mainly used. This lack of harmonisation hinders growth. To address the issue of standardisation and provide an alternative to conventional repo,the Bahrain-based International Islamic Financial Market published the Master Collateralized Murabaha Agreement in 2014. While we view the creation of the standard as a positive step, its uptake has been low with implementation mostly limited to the UAE. To support short-term liquidity management at Islamic banks and liquidity in secondary markets, the International Islamic Liquidity Management Corporation, based in Malaysia and owned by various central banks, has issued about USD53 billion of short-term and tradable sukuk denominated in US dollars since 2013. However, we believe this amount would need to be inflated to create a functioning and liquid Islamic repo market. Regulatory hurdles are another challenge. Some countries with less-developed Islamic finance ecosystems, such as Oman, Jordan and Morocco, do not have any Islamic repo facilities with central banks or have a very limited offering. This places Islamic banks at a disadvantage to their conventional peers, which is especially problematic given the current tight liquidity conditions. However, some other jurisdictions are being proactive in developing shariacompliant liquidity management tools. In 2018, Turkey launched the Committed Transactions Market of Sukuk, which enables bank-to-bank repo transactions, while banks can have access to repo funding through the central bank through sovereign sukuk and lease certificates as collateral, albeit with shorter tenors than conventional banks. In the UAE, the adoption of the Accounting and Auditing Organization for Islamic Financial Institutions standards has been compulsory for Islamic banks since September 2018; its impact on the Islamic repo market is evolving and is still being assessed. GCC Islamic banks’ funding profiles continue to benefit from strong retail networks, a high share of low-cost customer deposits and low reliance on wholesale funding, all of which support the stability of their funding base. Their liquidity is supported by a good proportion of liquid assets (in the form of cash balances with central banks and held-to-maturity domestic sovereign sukuk) relative to their customer deposit base. Nevertheless
