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The prolonged lower oil price has placed continuous pressure on the local Islamic- and conventional treasury managing hedging and liquidity. These market conditions have caused profit margins to deplete due to increasing “cost of funds”, whilst delays on projects or cancellations have contributed to reduced lending levels within the GCC and adding further to overall profitability declines of the financial institutions. Moreover, the local money markets have witnessed upward pressures on profit rates (Islamic term) and interest rates (conventional term), and customers demanding higher yields for their deposits, and similarly facility seeking customers reducing their finance requirements due to upward moving borrowing costs as well.
These market conditions create challenges for the Islamic- and conventional treasuries alike, whereby the liquidity management emphasis and aim should be the lowering of “cost of borrowings”. The “cost of borrowings” is an integral part of the overall “cost of funds”, which consist of items like: cost of capital, operational costs, funding cost etc. and this end-calculation then may form part of the calculation of lending profitability incorporating Risk- and Liquidity premiums, which have dynamic characteristics especially under the current market environment.
Balance Sheet Management
The balance sheet management, i.e. Asset and Liability Management (ALM) falling under the treasury function, has a medium- to longer-term focus, and is instrumental in protecting the balance sheet to adverse movement in profit- (Islamic term) and interest rates, whilst the shorter time horizons are handled directly by the treasury, by managing customer deposit- and lending (facilities, loans, advances) pricing, but at the same time bearing in mind the current market conditions, and the regulatory ratios that the financial institutions must abide by. It means that the treasury functions in either environment must be extremely creative and pro-active in managing the bank’s books within the Board of Directors approved framework. Any decision made has a long-term effect on the overall results of the bank. These decisions are referring to the hedging of the balance sheet risks (natural gap, mismatches of tenors, foreign exchange risks) that are constantly being monitored by the treasury department.
Any longer dated exposures relating to the balance sheet mismatches of tenors, i.e. time horizons, might have hedging requirement using the “Profit Rate Swap”, which is an Islamic derivative product, whereby the principal amount is never exchanged, but purely a mechanism to fix a longer term profit rate (in conventional terms the fixed interest rate part). In the event that long-term profit rates are rising, the “Profit Rate Swap” fixed profit rate contract that has been executed (contractually agreed with the counterparty), will remain the same until its maturity, hence the bank’s balance sheet exposure is then protected, since any higher borrowing costs in the cash market will be offset by the gain of the Profit Rate Swap. The conventional treasury would employ the “Interest Rate Swap” for the same purposes. This hedging may be a challenging task in times of stress, since the local GCC derivative may not be as liquid, i.e. limited number of counterparties providing pricing for it, hence the Islamic- or conventional treasury may decide to hedge using US Dollars derivative instead, and then create a foreign exchange forward hedge to close the gap, or in some cases accept the profit- or interest rate differential as is and run this risk instead.
There may be opportunities using the same derivatives increasing the bank’s mismatches by lending the fix part of the derivative creating income, may be strategies used for income generation. After all, the banks are suffering asset sides, so the logical conclusion is to seek other opportunities that may be as profitable, and perhaps even attracting lesser credit risks could be the general view.
Foreign Exchange Risk Management
Further, the foreign exchange exposures a bank may have incurred, are due to foreign currency asset and liabilities mismatches, i.e. more-, or lesser assets than the liability side. This exposure can be managed by buying foreign exchange spot (two working days into the future settlement date), or using a “Foreign Exchange Waad” (or Foreign Exchange Forward for the conventional Treasury) transaction, which is an ‘in to the future’ settlement date longer than the spot date. Both possibilities would eliminate the exposure of foreign currencies.
For the liquidity management the limited products used in the Islamic Treasury for the execution of liquidity are — the “Wakala”, which is can be either a placement or borrowing of funds for or by the bank. It’s an “agency agreement”, whereby the counter party or the bank itself (in case of borrowing of funds) provides an estimated profit rate of return, and the recipient can cancel the transaction in the event the prospective profit rate is not as the expected rate of return, and therefore then demanding the return of the funds with the accrued profit amount. Of course this does not happen very often. The other liquidity product is the “Murabaha” transaction based most commonly on commodities, which is a money market transaction whereby the principal amount is created from the purchase and sale of a commodity transaction. The profit rate is being fixed for the tenor of the borrowing or placement funds. The conventional treasury uses mainly interbank placements and borrowings.