Islamic Finance: The New Regulatory Challenge, 2nd Edition

Chapter 16

Liquidity Risk

Richard Thomas

1. INTRODUCTION

Liquidity is defined by the Basel Committee on Banking Supervision (BCBS) as “the ability of a bank to fund increases in assets and meet obligations as they become due, without incurring unacceptable losses.”1 Liquidity risk in banking is thus often defined as “the risk that the bank becomes unable to fund increases in assets and meet its financial obligations as they fall due.” It is also the risk of loss related to premature or inappropriate liquidation of assets, where the asset–liability mix has been poorly managed and value has been wrongly determined (e.g., collateralised debt obligations in U.S. subprime securitisations).

As such, liquidity is derived from both sides of a bank’s balance sheet. Specifically, it comprises:

• The ability to turn bank assets into funds.
• The ability to raise liabilities to fund the bank’s assets.

Regulators are paying a great deal more attention to liquidity risk ratios since the fallout from the financial crisis, evident in changes in new iterations of the Basel Accords. However, their attention is drawn to the systemically risky global banks, and there is a question mark hanging over the appropriateness of the “one size fits all” regulations to measure this risk in smaller, and particularly in Islamic, banks.

2. THE REGULATORY RESPONSE TO LIQUIDITY RISK

Basel II has rightly and often been criticised for its concentration on bank capital and for subsequently paying little attention to ...