## _wp15234

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---

### I. INTRODUCTION — scope and context
- Purpose:
  - Assess the monetary policy operational framework for Islamic banking in the Gulf Cooperation Council (GCC) countries.
  - Identify challenges and outline options to achieve a more effective monetary transmission mechanism.
- Key contextual facts:
  - Islamic banking assets in the MENA region represent 14 percent of total banking assets; in the GCC the market share has crossed the 25 percent threshold.
  - GCC Islamic banking assets reached $490 billion at end-June 2013.
  - Country shares of GCC Islamic banking assets (end-June 2013): Saudi Arabia 49 percent, United Arab Emirates 19 percent, Kuwait 16 percent, Qatar 11 percent, Bahrain 5 percent; segment nascent in Oman.
  - Combined assets of Islamic banks and windows in Oman represented 6 percent of total banking system assets (end-August 2015).
  - Exchange rate regimes: pegged to the US dollar in all countries except Kuwait; Kuwait had a dollar peg from 2003 to May 2007 and a basket peg with undisclosed weights before and after.
- Institutional and policy backdrop:
  - Pegged exchange rate regimes provide a nominal anchor and have helped anchor inflationary expectations at low levels.
  - Monetary policy independence is limited by the peg; macroeconomic management relies on fiscal policy, prudential regulation, and controls.
  - GCC monetary authorities manage short-term liquidity via short-term central bank instruments, Treasury-bills (T-bills), and standing facilities; reserve requirements, long-term government bonds, and macroprudential instruments manage structural liquidity (Espinoza and Prasad, 2012).
- Core challenge:
  - Designing market-based monetary policy instruments consistent with Islamic principles (notably the banning of interest rates) is complex; consequence: Islamic banks hold excess liquidity in cash.
- Structure of paper:
  - Section II: performance of conventional and Islamic banks in GCC (2008–14).
  - Section III: cross-country experiences with monetary operations under Islamic finance.
  - Section IV: GCC experience with Shari’ah-compliant monetary instruments.
  - Section V: regulatory aspects of liquidity management.
  - Section VI: conclusions.

### II. PERFORMANCE OF CONVENTIONAL AND ISLAMIC BANKS IN THE GCC — empirical findings
- Data and sample:
  - Annual banking data from BankScope for GCC countries spanning 2008–14.
  - Sample: 65 banks (38 conventional, 27 Islamic); Omani banks excluded.
  - Limited set of financial indicators; lacks metrics on cash holdings and short-long funding structure.
- Aggregate size and growth:
  - Total Islamic banking assets of US$564 billion as of H1 2014; GCC accounted for 38.2 percent of global Islamic banking assets.
  - Saudi Islamic banking sector constituted 51 percent of total domestic banking assets; sector shares: Kuwait 38 percent, Qatar 25 percent, United Arab Emirates 17 percent.
  - Compound growth rates (2008–12): Islamic banks assets 17.4 percent vs conventional banks 8.1 percent.
  - Net lending and customer deposits growth (2008–12): Islamic banks 18.2 percent and 19.9 percent, respectively; conventional banks 8.1 percent and 10 percent, respectively.
  - Loans growth by country (strongest to weakest): Qatar 32 percent, Saudi Arabia 22.3 percent, United Arab Emirates 14.5 percent, Bahrain 13 percent, Kuwait 10.5 percent.
- Access to market financing:
  - Islamic banks have limited access to securities and other placement opportunities compared with conventional banks, creating market segmentation.
- Comparative performance and asset composition (averages 2008–14):
  - Deposits: Conventional Banks 64.1 percent of assets; Islamic Banks 62.3 percent.
  - Securities: Conventional Banks 18.4 percent; Islamic Banks 14.6 percent.
  - Liquid Assets: Conventional Banks 19.8 percent; Islamic Banks 23.0 percent.
  - Non Performing Loans (percent of gross loans): Conventional Banks 4.4 percent; Islamic Banks 4.2 percent.
  - Return on Assets: Conventional Banks 1.6 percent; Islamic Banks 1.3 percent.
  - Return on Equity: Conventional Banks 10.2 percent; Islamic Banks 6.7 percent.
- Nonperforming loans (NPLs), dynamics and country patterns:
  - GCC average NPLs (2008–14): Conventional banks 4.4 percent; Islamic banks 4.2 percent.
  - Time-series patterns:
    - Conventional banks: NPLs rose from 2.3 percent (2008) to 4.9 percent (2012), peaking at 5.4 percent (2011).
    - Islamic banks: NPLs rose from 2.5 percent (2008) to 4.7 percent (2013), peaking at 6.3 percent (2012).
  - Country-specific deterioration (2008–13):
    - Bahrain: NPLs increased by 7.5 percentage points for conventional banks and 8.2 percentage points for Islamic banks.
    - United Arab Emirates: NPLs deteriorated by 6.7 percentage points for conventional banks and 4.6 percentage points for Islamic banks.
    - Qatar: spike in 2010; afterward Islamic banks’ NPLs fell by a lower rate than conventional banks.
    - Saudi Arabia: NPLs for both bank types similar in magnitude and trends.
    - Kuwait: no larger second-round effect for Islamic bank NPLs observed.
  - Interpretation:
    - Islamic banks were less affected than conventional banks by the initial impact of the global crisis, but experienced larger second-round effects in some jurisdictions, resulting in higher NPLs and larger declines in profitability.
- Liquid assets and funding:
  - Liquid assets as share of total assets (2008–14): Islamic banks slightly higher on average than conventional banks, with convergence toward end of period.
  - Patterns:
    - Liquid asset ratios for Islamic banks jumped in 2009 and 2011, then declined and converged toward conventional banks’ ratios.
    - Qatar and Saudi Arabia: rapid increases in Islamic banks’ liquid asset ratios after 2008; convergence in Qatar from 2010 onward.
    - Kuwait: similar trends with delay; limited convergence.
    - United Arab Emirates: no observable difference between bank types.
    - Bahrain: conventional banks held more liquid assets throughout the period.
  - Funding composition trends (2006–12, Islamic vs conventional averages):
    - Core deposits (average): Islamic Banks 69.1 percent; Conventional Banks 65.8 percent.
    - Non-core deposits (average): Islamic Banks 8.7 percent; Conventional Banks 12.1 percent.
    - Other borrowing (average): Islamic Banks 1.9 percent; Conventional Banks 6.3 percent.
    - Total Equity (average): Islamic Banks 15.7 percent; Conventional Banks 12.4 percent.
- Profitability and leverage:
  - Average return on assets: Islamic Banks 1.3 percent; Conventional Banks 1.6 percent.
  - Average return on equity: Islamic Banks 6.7 percent; Conventional Banks 10.2 percent.
  - Explanations for lower profitability of Islamic banks:
    - Higher holdings of liquid assets and property investments.
    - Limited investment opportunities and marketable securities.
    - Lower leverage (smaller pool of income-generating assets per unit of equity).
    - Portfolio concentration in real estate requiring higher provisions.
    - Higher operating expenses and lack of yielding liquid assets.
  - Country-specific ROE dynamics:
    - Saudi Arabia: ROE for Islamic banks fell after 2008 but recovered to surpass conventional banks later.
    - Bahrain: Islamic banks show incipient recovery at end of sample but still substantially below conventional banks.
    - Kuwait and Qatar: post-2009 contraction, ROE for conventional and Islamic banks converged.

### III. MONETARY OPERATIONS: ISLAMIC FINANCE — cross-country experiences and instruments
- Cross-country experience highlights:
  - Difficulties in designing Shari’ah-compliant instruments limit Islamic banks’ access to market financing and placement opportunities.
  - Limited market instruments contribute to excess cash holdings and higher liquid asset ratios for Islamic banks.
  - Jurisdictions that have developed Shari’ah-compliant short-term instruments (e.g., Shari’ah-compliant T-bills and bonds) have facilitated higher securities holdings among Islamic banks (notably Qatar).
- Liquidity challenges and market implications:
  - The difficulty in defining rates of return on general funding instruments has:
    - limited the development of money and interbank markets,
    - constrained the efficiency of central bank liquid facilities,
    - limited the scope of monetary management.
  - Liability portfolio characteristics and practical consequences:
    - The liability portfolio of Islamic banks is substantially liquid in practice.
    - The absence of money markets for short-term liquidity management can impose significant costs on Islamic banks.
    - High proportion of callable deposits, and unrestricted, short maturity Investment Accounts based on unrestricted Murabahah contract (term deposits) predisposes the system, in the absence of adequate available liquidity, to large holdings of very liquid assets.
- Shortage of Shari’ah-compliant liquid instruments and market fragmentation:
  - General lack of tradable Sharīʿah-compliant instruments that can serve as high-quality short-term liquid assets.
  - Multiple and complex ways of structuring Islamic government securities and money market instruments can result in fragmented markets.
  - Fragmentation impairs the formation of a stock of fungible High Quality Liquid Assets (HQLA) that can be more easily priced, traded, and used as collateral.
  - Recommended strategic approach (view of the authors):
    - Rationalize the number of different instruments created with similar functions.
    - Once key Islamic money and government Sukuk markets have been developed, introduce other instruments gradually.
- Progress, standardization efforts, and remaining impediments:
  - IIFM has issued master agreements for treasury placements under Murabahah and Wakalah, and a concept paper on collateralization and tripartite agreement for Islamic securities.
  - Association of Islamic Banking Institutions in Malaysia has introduced standardized interbank master agreements for Murabahah and Wakalah transactions, separately for corporate and interbank transactions.
  - Central banks in the United Arab Emirates and Malaysia have issued standardized contracts for collateralized Murabahah transactions.
  - Sudan has issued Musharakah and Mudarabah papers.
  - Persistent impediments:
    - Limited money market activity is a key impediment to monetary operations.
    - Earlier studies suggested lower average daily volume of interbank money market transactions in selected jurisdictions among IFSIs, between IFSIs and conventional banks, and between IFSIs and central banks compared to trades in conventional money markets.
    - Large differences in the rates of return between Islamic money markets and conventional money markets, indicative of market segmentation (IFSB Technical Note 2008).
    - Main obstacles preventing secondary market trading:
      - lack of adequate supply of Shari’ah-compliant securities (Sukuk),
      - difficulty in their valuation,
      - legal uncertainty surrounding Shari’ah compliance of their tradability.
    - Challenge: create noncontroversial tradable Sukuk structures and develop markets characterized by effective instrument valuation.
- Jurisdictional experience and market development examples:
  - Malaysia and Bahrain:
    - Malaysian Islamic Money Market has been a pioneer since 1994.
    - Bahrain Monetary Authority established the Liquidity Management Center (LMC) in 2002 to allow Islamic banks to handle liquidity and surplus fund investment needs.
    - Bahrain and Malaysia regarded in the market as credible Islamic financial centers.
  - Specific country measures and instruments:
    - Bahrain:
      - In 2001, sovereign introduced long-term Ijara Sukuk and short-term Al-salam Sukuk for investment opportunities and monetary policy.
      - Al-salaam Sukuk used to engage Islamic banks in monetary operations via sale-forward and agency arrangements; initial spot payment constitutes liquidity withdrawal.
      - In 2015, Central Bank of Bahrain launched a Shari'ah compliant Wakalah liquidity management instrument with a one-week duration, available every Tuesday, based on an IIFM standard contract.
    - Kuwait:
      - Central bank designed monetary operation based on Tawarruq to manage system liquidity; involves commodity purchases and resale, with liquidity withdrawal constituted by spot sale payment.
    - Qatar:
      - In 2010, Ministry of Finance issued securities (bonds and Ijārah Sukūk) for liquidity management; Qatar Central Bank issues short-term Treasury Bills on a calendar to Islamic banks.
    - United Arab Emirates:
      - Central bank issued standardized contracts for collateralized Murabahah transactions.
    - Saudi Arabia:
      - SAMA permits banks to use Murabaha as collateral for repo transactions and does not distinguish between conventional and Islamic banks in monetary operations.
- Market liquidity observations and Sukuk trading evidence:
  - Standard & Poor’s study on liquidity trends of U.S.-denominated investment grade Sukuk:
    - New issuances are substantially more liquid than outstanding ones.
    - Secondary market liquidity is better for Sukuk with very large par values (more than US$1 billion).
    - The average volume traded is higher in 2013 than in 2012.
- GCC empirical bank liquidity indicators:
  - Bahrain example:
    - In 2008, average cash holdings made up 7.1 percent of assets for Islamic banks, and 2.4 percent for conventional banks.
    - By 2013, average cash holding had converged to 6.1 percent and 5.8 percent for Islamic and conventional banks, respectively.
- Central bank facilities and market-based instruments:
  - IMF survey conducted in 2011 revealed Shari’ah-compliant central bank facilities are limited, reflecting the difficulty in designing market-based instruments satisfying the Islamic prohibition on ex-ante interest payments.
  - The IFSB assessment (2013) corroborated this view.
  - Most central banks do not provide deposit or credit facilities for IFSIs.

### IV. LIQUIDITY MANAGEMENT, BASEL III, AND HQLA ISSUES
- Basel III and HQLA scarcity:
  - Islamic security markets are nascent, more shallow and less developed than conventional securities markets, so Shari’ah-compliant HQLAs are in short supply—squeezing Islamic banks.
  - The Basel Committee on Banking Supervision (2013) noted that even where supply of HQLA exists, an insurmountable impediment to meeting the LCR may still exist.
- Basel III LCR requirement:
  - Banks must hold enough HQLAs to cover net cash outflows for a 30-day period under a high-stress scenario.
  - Outflows are calculated by applying different weights (run-off rates) to funding sources, including PSIAs.
- Specific issues regarding PSIAs (Profit Sharing Investment Accounts):
  - Run-off rates for PSIAs:
    - The riskier the funding source, the larger the amount of HQLAs needed to cover it.
    - Much will depend on the weights or "run-off rates" which national regulators choose to assign to PSIAs.
    - Regulators are unlikely to assign punitive weights but may not treat PSIAs on the same footing as conventional bank deposits.
    - PSIAs held by Islamic banks tend to have relatively short maturities.
    - Treatment will depend on country-specific factors, including past behavior in stress situations and track record of passing losses to deposit holders.
    - The recently issued Islamic Financial Services Board (IFSB) guidance note will be of significant value to regulators deciding PSIAs treatment.
  - Malaysia’s approach:
    - Classified PSIAs into two types: general PSIAs (broadly equivalent to conventional retail deposits) and specific or restricted PSIAs (deemed similar to managed investment accounts).
    - Given Islamic banks a two-year transition period to differentiate between those types.
    - Has not yet announced run-off rates or HQLA requirements for PSIAs.
  - Basel III indicative run-off rates:
    - National regulators could assign run-off rates of 3 percent to 5 percent to stable, conventional bank deposits, and as much as 10 percent to less stable deposits.
    - Most Islamic banks may end up being assigned numbers within that range; variations of several percentage points could make a big difference to HQLA holdings required.
- Limited supply of HQLAs and market structure:
  - With the exception of Malaysia, Bahrain, and Qatar, few central banks actively issue instruments which qualify as HQLAs.
  - Government-issued Sukuks qualify, but most sovereign Sukuks are either not listed on developed markets or are not actively traded, making it difficult for Islamic banks to obtain them.
  - A key issue is the absence of secondary markets that provide a proven record of being a reliable source of liquidity at all times.
- Role and limits of the IILM:
  - The Malaysia-based International Islamic Liquidity Management Corp. (IILM), backed by nine central banks and monetary agencies as well as the Islamic Development Bank (IDB), has issued three-month and six-month Sukuk to help fill the HQLA gap.
  - The IILM’s short-term Sukuk program:
    - Is backed by sovereign assets of its shareholders.
    - Is rated as A-1 by Standard & Poor’s.
    - Is described as the first money market instrument globally to be backed by sovereign assets while being distributed through a diverse primary-dealer network of nine banks across different regions.
    - Has issued a total of 11 tranches amounting to US$6.7 billion, of which three remain outstanding as of December 5, 2014.
    - The total value of the three outstanding Sukuk is US$1.85 billion (IFSB, 2015).
  - Concerns and limitations:
    - There are concerns that such tools could be insufficient in times of market stress.
    - IILM Sukuk are not explicitly backed by member central banks and there is no clear indication by IILM whether these would be taken back and cashed in through repo-style transactions.
    - Based on this and other considerations, it appears that IILM Sukuk are likely to be treated as corporate rather than sovereigns (unless there is a clear policy by individual central banks to ‘cash-in’ IILM Sukuk at the request of Sukuk holders) (Al-Hashel 2015).
- Deposit insurance and deposit stability:
  - For bank deposits to be deemed stable, they need to be protected by an insurance scheme, but Shari’ah-compliant schemes are rare.
  - Reasons:
    - Government support for domestic banks is considered implicit in many Gulf countries.
  - Examples of Shari’ah-compliant or Islamic deposit insurance developments:
    - Bahrain introduced Islamic deposit insurance in 1993.
    - In May 2014, Qatar announced it would develop an Islamic deposit insurance scheme.
    - In June, Bangladesh announced Islamic deposits would be covered under an existing scheme managed by its central bank.

### V. CONCLUSION — key findings and policy implications
- Findings:
  - The inadequate availability of Shari’ah-compliant financial instruments seems to have forced Islamic banks to hold a significant amount of cash reserves, limiting the flexibility of the central bank’s monetary operations with IFSIs.
  - The interbank money market is generally segmented in many jurisdictions, including the GCC, with IFSIs relying mainly on interbank arrangements with other IFSIs and limited use of special arrangements between IFSIs and conventional banks.
- Policy recommendations and priorities:
  - Broaden the range of Shari’ah-compliant instruments and build liquid markets.
  - Develop market microstructures to enhance secondary market trade.
  - Design Shari’ah-compliant alternatives to foreign exchange hedging and risk management arrangements.
  - Central banks should actively develop Shari’ah-compliant instruments to improve the efficiency of monetary operations, including:
    - A strong commitment by central banks to accommodate IFSIs.
    - Support by central bank Shari’ah-compliant lender of last resort (S-LOLR) facilities that accommodate both IFSIs and conventional banks.
    - More consistent and uniform signaling of the cost of central bank financing.
  - Continue efforts to develop the sovereign Sukuk market to facilitate the Islamic interbank market—essential for managing liquidity, deepening financial markets, and supporting monetary policy.
  - Modify existing legal frameworks to accommodate the specificities of Islamic finance, including banking and securities laws.

*Source: _wp15234 - References (IMF PDF).*

### References .............................................................................................................

### _wp15234 - References

### I. INTRODUCTION — scope and context
- Purpose:
  - Assess the monetary policy operational framework for Islamic banking in the Gulf Cooperation Council (GCC) countries.
  - Identify challenges and outline options to achieve a more effective monetary transmission mechanism.
- Key contextual facts:
  - Islamic banking assets in the MENA region represent 14 percent of total banking assets; in the GCC the market share has crossed the 25 percent threshold.
  - GCC Islamic banking assets reached $490 billion at end-June 2013.
  - Country shares of GCC Islamic banking assets (end-June 2013): Saudi Arabia 49 percent, United Arab Emirates 19 percent, Kuwait 16 percent, Qatar 11 percent, Bahrain 5 percent; segment nascent in Oman.
  - Combined assets of Islamic banks and windows in Oman represented 6 percent of total banking system assets (end-August 2015).
  - Exchange rate regimes: pegged to the US dollar in all countries except Kuwait; Kuwait had a dollar peg from 2003 to May 2007 and a basket peg with undisclosed weights before and after.
- Institutional and policy backdrop:
  - Pegged exchange rate regimes provide a nominal anchor and have helped anchor inflationary expectations at low levels.
  - Monetary policy independence is limited by the peg; macroeconomic management relies on fiscal policy, prudential regulation, and controls.
  - GCC monetary authorities manage short-term liquidity via short-term central bank instruments, Treasury-bills (T-bills), and standing facilities; reserve requirements, long-term government bonds, and macroprudential instruments manage structural liquidity (Espinoza and Prasad, 2012).
- Core challenge:
  - Designing market-based monetary policy instruments consistent with Islamic principles (notably the banning of interest rates) is complex; consequence: Islamic banks hold excess liquidity in cash.
- Structure of paper:
  - Section II: performance of conventional and Islamic banks in GCC (2008–14).
  - Section III: cross-country experiences with monetary operations under Islamic finance.
  - Section IV: GCC experience with Shari’ah-compliant monetary instruments.
  - Section V: regulatory aspects of liquidity management.
  - Section VI: conclusions.

### II. PERFORMANCE OF CONVENTIONAL AND ISLAMIC BANKS IN THE GCC — empirical findings
- Data and sample:
  - Annual banking data from BankScope for GCC countries spanning 2008–14.
  - Sample: 65 banks (38 conventional, 27 Islamic); Omani banks excluded.
  - Limited set of financial indicators; lacks metrics on cash holdings and short-long funding structure.
- Aggregate size and growth:
  - Total Islamic banking assets of US$564 billion as of H1 2014; GCC accounted for 38.2 percent of global Islamic banking assets.
  - Saudi Islamic banking sector constituted 51 percent of total domestic banking assets; sector shares: Kuwait 38 percent, Qatar 25 percent, United Arab Emirates 17 percent.
  - Compound growth rates (2008–12): Islamic banks assets 17.4 percent vs conventional banks 8.1 percent.
  - Net lending and customer deposits growth (2008–12): Islamic banks 18.2 percent and 19.9 percent, respectively; conventional banks 8.1 percent and 10 percent, respectively.
  - Loans growth by country (strongest to weakest): Qatar 32 percent, Saudi Arabia 22.3 percent, United Arab Emirates 14.5 percent, Bahrain 13 percent, Kuwait 10.5 percent.
- Access to market financing:
  - Islamic banks have limited access to securities and other placement opportunities compared with conventional banks, creating market segmentation.
- Comparative performance and asset composition (averages 2008–14):
  - Deposits: Conventional Banks 64.1 percent of assets; Islamic Banks 62.3 percent.
  - Securities: Conventional Banks 18.4 percent; Islamic Banks 14.6 percent.
  - Liquid Assets: Conventional Banks 19.8 percent; Islamic Banks 23.0 percent.
  - Non Performing Loans (percent of gross loans): Conventional Banks 4.4 percent; Islamic Banks 4.2 percent.
  - Return on Assets: Conventional Banks 1.6 percent; Islamic Banks 1.3 percent.
  - Return on Equity: Conventional Banks 10.2 percent; Islamic Banks 6.7 percent.
- Nonperforming loans (NPLs), dynamics and country patterns:
  - GCC average NPLs (2008–14): Conventional banks 4.4 percent; Islamic banks 4.2 percent.
  - Time-series patterns:
    - Conventional banks: NPLs rose from 2.3 percent (2008) to 4.9 percent (2012), peaking at 5.4 percent (2011).
    - Islamic banks: NPLs rose from 2.5 percent (2008) to 4.7 percent (2013), peaking at 6.3 percent (2012).
  - Country-specific deterioration (2008–13):
    - Bahrain: NPLs increased by 7.5 percentage points for conventional banks and 8.2 percentage points for Islamic banks.
    - United Arab Emirates: NPLs deteriorated by 6.7 percentage points for conventional banks and 4.6 percentage points for Islamic banks.
    - Qatar: spike in 2010; afterward Islamic banks’ NPLs fell by a lower rate than conventional banks.
    - Saudi Arabia: NPLs for both bank types similar in magnitude and trends.
    - Kuwait: no larger second-round effect for Islamic bank NPLs observed.
  - Interpretation:
    - Islamic banks were less affected than conventional banks by the initial impact of the global crisis, but experienced larger second-round effects in some jurisdictions, resulting in higher NPLs and larger declines in profitability.
- Liquid assets and funding:
  - Liquid assets as share of total assets (2008–14): Islamic banks slightly higher on average than conventional banks, with convergence toward end of period.
  - Patterns:
    - Liquid asset ratios for Islamic banks jumped in 2009 and 2011, then declined and converged toward conventional banks’ ratios.
    - Qatar and Saudi Arabia: rapid increases in Islamic banks’ liquid asset ratios after 2008; convergence in Qatar from 2010 onward.
    - Kuwait: similar trends with delay; limited convergence.
    - United Arab Emirates: no observable difference between bank types.
    - Bahrain: conventional banks held more liquid assets throughout the period.
  - Funding composition trends (2006–12, Islamic vs conventional averages):
    - Core deposits (average): Islamic Banks 69.1 percent; Conventional Banks 65.8 percent.
    - Non-core deposits (average): Islamic Banks 8.7 percent; Conventional Banks 12.1 percent.
    - Other borrowing (average): Islamic Banks 1.9 percent; Conventional Banks 6.3 percent.
    - Total Equity (average): Islamic Banks 15.7 percent; Conventional Banks 12.4 percent.
- Profitability and leverage:
  - Average return on assets: Islamic Banks 1.3 percent; Conventional Banks 1.6 percent.
  - Average return on equity: Islamic Banks 6.7 percent; Conventional Banks 10.2 percent.
  - Explanations for lower profitability of Islamic banks:
    - Higher holdings of liquid assets and property investments.
    - Limited investment opportunities and marketable securities.
    - Lower leverage (smaller pool of income-generating assets per unit of equity).
    - Portfolio concentration in real estate requiring higher provisions.
    - Higher operating expenses and lack of yielding liquid assets.
  - Country-specific ROE dynamics:
    - Saudi Arabia: ROE for Islamic banks fell after 2008 but recovered to surpass conventional banks later.
    - Bahrain: Islamic banks show incipient recovery at end of sample but still substantially below conventional banks.
    - Kuwait and Qatar: post-2009 contraction, ROE for conventional and Islamic banks converged.

### III. MONETARY OPERATIONS: ISLAMIC FINANCE — cross-country experiences (overview)
- Reference point:
  - Analysis draws on “A Note on Strengthening Liquidity Management of Institutions Offering Islamic Financial Services: the Development of Money Markets,” March 2008 (Technical Note 2008, Sundararajan and the Islamic Money Market Task Force).
- Cross-country experience highlights (as framed in the paper):
  - Difficulties in designing Shari’ah-compliant instruments limit Islamic banks’ access to market financing and placement opportunities.
  - Limited market instruments contribute to excess cash holdings and higher liquid asset ratios for Islamic banks.
  - Jurisdictions that have developed Shari’ah-compliant short-term instruments (e.g., Shari’ah-compliant T-bills and bonds) have facilitated higher securities holdings among Islamic banks (notably Qatar).
- Implication for GCC:
  - Expansion of Shari’ah-compliant money-market instruments and central bank facilities could reduce reliance on cash holdings by Islamic banks and improve monetary transmission.

*Source: _wp15234 - References (IMF PDF).*

### 16.      The difficulty in defining rates of return on general funding instruments has limited

### _wp15234 - 16.      The difficulty in defining rates of return on general funding instruments has limited

### Liquidity challenges and market implications
- The difficulty in defining rates of return on general funding instruments has:
  - limited the development of money and interbank markets,
  - constrained the efficiency of central bank liquid facilities,
  - limited the scope of monetary management.
- Liability portfolio characteristics and practical consequences:
  - The liability portfolio of Islamic banks is substantially liquid in practice.
  - The absence of money markets for short-term liquidity management can impose significant costs on Islamic banks.
  - High proportion of callable deposits, and unrestricted, short maturity Investment Accounts based on unrestricted Murabahah contract (term deposits) predisposes the system, in the absence of adequate available liquidity, to large holdings of very liquid assets.

### Shortage of Shari’ah-compliant liquid instruments and market fragmentation
- Core issues:
  - General lack of tradable Sharīʿah-compliant instruments that can serve as high-quality short-term liquid assets.
  - Multiple and complex ways of structuring Islamic government securities and money market instruments can result in fragmented markets.
  - Fragmentation impairs the formation of a stock of fungible High Quality Liquid Assets (HQLA) that can be more easily priced, traded, and used as collateral.
- Recommended strategic approach (view of the authors):
  - Rationalize the number of different instruments created with similar functions.
  - Once key Islamic money and government Sukuk markets have been developed, introduce other instruments gradually.

### Progress, standardization efforts, and remaining impediments
- International and jurisdictional initiatives:
  - The International Islamic Financial Market (IIFM) has issued master agreements for treasury placements under Murabahah and Wakalah, and a concept paper on collateralization and tripartite agreement for Islamic securities.
  - The Association of Islamic Banking Institutions in Malaysia has introduced standardized interbank master agreements for Murabahah and Wakalah transactions, separately for corporate and interbank transactions.
  - Central banks in the United Arab Emirates and Malaysia have issued standardized contracts for collateralized Murabahah transactions.
  - Sudan has issued Musharakah and Mudarabah papers.
- Persistent impediments:
  - Limited money market activity is a key impediment to monetary operations.
  - Earlier studies suggested lower average daily volume of interbank money market transactions in selected jurisdictions among IFSIs, between IFSIs and conventional banks, and between IFSIs and central banks compared to trades in conventional money markets.
  - Large differences in the rates of return between Islamic money markets and conventional money markets, indicative of market segmentation (IFSB Technical Note 2008).
  - Main obstacles preventing secondary market trading:
    - lack of adequate supply of Shari’ah-compliant securities (Sukuk),
    - difficulty in their valuation,
    - legal uncertainty surrounding Shari’ah compliance of their tradability.
  - Challenge: create noncontroversial tradable Sukuk structures and develop markets characterized by effective instrument valuation.

### Jurisdictional experience and market development examples
- Malaysia and Bahrain (market view):
  - Malaysian Islamic Money Market has been a pioneer since 1994.
  - Bahrain Monetary Authority established the Liquidity Management Center (LMC) in 2002 to allow Islamic banks to handle liquidity and surplus fund investment needs.
  - Bahrain and Malaysia regarded in the market as credible Islamic financial centers.
- Specific country measures and instruments:
  - Bahrain:
    - In 2001, sovereign introduced long-term Ijara Sukuk and short-term Al-salam Sukuk for investment opportunities and monetary policy.
    - Al-salaam Sukuk used to engage Islamic banks in monetary operations via sale-forward and agency arrangements; initial spot payment constitutes liquidity withdrawal.
    - In 2015, Central Bank of Bahrain launched a Shari'ah compliant Wakalah liquidity management instrument with a one-week duration, available every Tuesday, based on an IIFM standard contract.
  - Kuwait:
    - Central bank designed monetary operation based on Tawarruq to manage system liquidity; involves commodity purchases and resale, with liquidity withdrawal constituted by spot sale payment.
  - Qatar:
    - In 2010, Ministry of Finance issued securities (bonds and Ijārah Sukūk) for liquidity management; Qatar Central Bank issues short-term Treasury Bills on a calendar to Islamic banks.
  - United Arab Emirates:
    - Central bank issued standardized contracts for collateralized Murabahah transactions.
  - Saudi Arabia:
    - SAMA permits banks to use Murabaha as collateral for repo transactions and does not distinguish between conventional and Islamic banks in monetary operations.
- Cross-country instruments and limitations (Box 2 highlights):
  - Malaysia: Government Investment Issues (GIIs) pioneered in 1983; used in parallel with conventional interest-bearing government securities; actively traded in Islamic interbank markets in Malaysia; use limited by availability of assets for sale and Shari’ah board acceptance.
  - Iran: Participation paper (PP) on a Musharakah basis with yields linked to government profit; traded only at par and useful for liquidity absorption.
  - Sudan, Malaysia, and Brunei: Ijara certificates representing part ownership of leased assets used for OMOs; supply limited to availability of assets for sale and lease-back.
  - Where governments do not issue Islamic paper, central banks may securitize assets (for example, central bank buildings) to create Shari’ah-compliant instruments, though issuance size would be capped by asset values.

### Market liquidity observations and Sukuk trading evidence
- Standard & Poor’s study on liquidity trends of U.S.-denominated investment grade Sukuk:
  - New issuances are substantially more liquid than outstanding ones.
  - Secondary market liquidity is better for Sukuk with very large par values (more than US$1 billion).
  - The average volume traded is higher in 2013 than in 2012.

### GCC experience and empirical bank liquidity indicators
- Evidence of changing cash holdings (GCC example):
  - Bahrain example:
    - In 2008, average cash holdings made up 7.1 percent of assets for Islamic banks, and 2.4 percent for conventional banks.
    - By 2013, average cash holding had converged to 6.1 percent and 5.8 percent for Islamic and conventional banks, respectively.

### Central bank facilities and market-based instruments
- Survey and assessment findings:
  - IMF survey conducted in 2011 revealed Shari’ah-compliant central bank facilities are limited, reflecting the difficulty in designing market-based instruments satisfying the Islamic prohibition on ex-ante interest payments.
  - The IFSB assessment (2013) corroborated this view.
  - Most central banks do not provide deposit or credit facilities for IFSIs.

### Regulatory aspects and Basel III implications
- Basel III and HQLA scarcity:
  - Islamic security markets are nascent, more shallow and less developed than conventional securities markets, so Shari’ah-compliant HQLAs are in short supply—squeezing Islamic banks.
  - The Basel Committee on Banking Supervision (2013) noted that even where supply of HQLA exists, an insurmountable impediment to meeting the LCR may still exist.
- Basel III LCR requirement:
  - Banks must hold enough HQLAs to cover net cash outflows for a 30-day period under a high-stress scenario.
  - Outflows are calculated by applying different weights (run-off rates) to funding sources, including PSIAs.
- Specific issues regarding PSIAs (Profit Sharing Investment Accounts):
  - Run-off rates for PSIAs:
    - The riskier the funding source, the larger the amount of HQLAs needed to cover it.
    - Much will depend on the weights or "run-off rates" which national regulators choose to assign to PSIAs.
    - Regulators are unlikely to assign punitive weights but may not treat PSIAs on the same footing as conventional bank deposits.
    - PSIAs held by Islamic banks tend to have relatively short maturities.
    - Treatment will depend on country-specific factors, including past behavior in stress situations and track record of passing losses to deposit holders.
    - The recently issued Islamic Financial Services Board (IFSB) guidance note will be of significant value to regulators deciding PSIAs treatment.
  - Malaysia’s approach:
    - Classified PSIAs into two types: general PSIAs (broadly equivalent to conventional retail deposits) and specific or restricted PSIAs (deemed similar to managed investment accounts).
    - Given Islamic banks a two-year transition period to differentiate between those types.
    - Has not yet announced run-off rates or HQLA requirements for PSIAs.
  - Basel III indicative run-off rates:
    - National regulators could assign run-off rates of 3 percent to 5 percent to stable, conventional bank deposits, and as much as 10 percent to less stable deposits.
    - Most Islamic banks may end up being assigned numbers within that range; variations of several percentage points could make a big difference to HQLA holdings required.

*Source: _wp15234 - 16. The difficulty in defining rates of return on general funding instruments has limited (IMF PDF).*

### 30.      Compliance with the Liquidity Coverage Ratio may increase pressure on central

### _wp15234 - 30.      Compliance with the Liquidity Coverage Ratio may increase pressure on central

### Limited supply of HQLAs and market structure
- With the exception of Malaysia, Bahrain, and Qatar, few central banks actively issue instruments which qualify as HQLAs.
- Government-issued Sukuks qualify, but most sovereign Sukuks are either not listed on developed markets or are not actively traded, making it difficult for Islamic banks to obtain them.
- A key issue is the absence of secondary markets that provide a proven record of being a reliable source of liquidity at all times.
- Conventional banks have access to huge markets in high-quality government debt such as U.S. Treasuries and German Bunds, a contrast with Islamic banks’ limited options.

### Role and limits of the IILM
- The Malaysia-based International Islamic Liquidity Management Corp. (IILM), backed by nine central banks and monetary agencies as well as the Islamic Development Bank (IDB), has issued three-month and six-month Sukuk to help fill the HQLA gap.
- The IILM’s short-term Sukuk program:
  - Is backed by sovereign assets of its shareholders.
  - Is rated as A-1 by Standard & Poor’s.
  - Is described as the first money market instrument globally to be backed by sovereign assets while being distributed through a diverse primary-dealer network of nine banks across different regions.
  - Has issued a total of 11 tranches amounting to US$6.7 billion, of which three remain outstanding as of December 5, 2014.
  - The total value of the three outstanding Sukuk is US$1.85 billion (IFSB, 2015).
- Concerns and limitations:
  - There are concerns that such tools could be insufficient in times of market stress.
  - IILM Sukuk are not explicitly backed by member central banks and there is no clear indication by IILM whether these would be taken back and cashed in through repo-style transactions.
  - Based on this and other considerations, it appears that IILM Sukuk are likely to be treated as corporate rather than sovereigns (unless there is a clear policy by individual central banks to ‘cash-in’ IILM Sukuk at the request of Sukuk holders) (Al-Hashel 2015).

### Deposit insurance and deposit stability
- For bank deposits to be deemed stable, they need to be protected by an insurance scheme, but Shari’ah-compliant schemes are rare.
- Reasons:
  - Government support for domestic banks is considered implicit in many Gulf countries.
- Examples of Shari’ah-compliant or Islamic deposit insurance developments:
  - Bahrain introduced Islamic deposit insurance in 1993.
  - In May 2014, Qatar announced it would develop an Islamic deposit insurance scheme.
  - In June, Bangladesh announced Islamic deposits would be covered under an existing scheme managed by its central bank.

### VI. CONCLUSION — key findings and policy implications
- Findings:
  - The inadequate availability of Shari’ah-compliant financial instruments seems to have forced Islamic banks to hold a significant amount of cash reserves, limiting the flexibility of the central bank’s monetary operations with IFSIs.
  - The interbank money market is generally segmented in many jurisdictions, including the GCC, with IFSIs relying mainly on interbank arrangements with other IFSIs and limited use of special arrangements between IFSIs and conventional banks.
- Policy recommendations and priorities:
  - Broaden the range of Shari’ah-compliant instruments and build liquid markets.
  - Develop market microstructures to enhance secondary market trade.
  - Design Shari’ah-compliant alternatives to foreign exchange hedging and risk management arrangements.
  - Central banks should actively develop Shari’ah-compliant instruments to improve the efficiency of monetary operations, including:
    - A strong commitment by central banks to accommodate IFSIs.
    - Support by central bank Shari’ah-compliant lender of last resort (S-LOLR) facilities that accommodate both IFSIs and conventional banks.
    - More consistent and uniform signaling of the cost of central bank financing.
  - Continue efforts to develop the sovereign Sukuk market to facilitate the Islamic interbank market—essential for managing liquidity, deepening financial markets, and supporting monetary policy.
  - Modify existing legal frameworks to accommodate the specificities of Islamic finance, including banking and securities laws.

* _wp15234 - 30.      Compliance with the Liquidity Coverage Ratio may increase pressure on central_*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2015/_wp15234.pdf_