National and Global Islamic Financial Architecture:
Prolems and Possible Solutions for the OIC Member Countries
49
increased is by the use of standardized contracts and documents among the financial sector
stakeholders. In this regard, the regulatory authorities can facilitate coming up with
standardized documents and contracts that can be used by both the financial institutions and
financial markets.
3.4. Liquidity Infrastructure
To meet liquidity needs from private sources a bank must hold assets that can be sold or used
as collateral to obtain credit from other financial intermediaries (Holmstrom and Tirole 1998).
However, market failures may constrain access to liquidity from private sources. Opaque bank
assets create information related problems where financial institutions may not be able to
screen and monitor the prospective borrowers adequately (Rochet 2008). Failure of markets
to provide liquidity can be resolved in two ways. Private arrangements can be used between
banks to create liquidity pools. However, this is difficult to implement, particularly when the
financial sector experiences economy-wide negative shocks. In such cases, public bodies such
as the central bank need to provide the liquidity to prevent serious interruptions in operations
that can lead to bank failures. One of the tools used by central banks is to provide emergency
funding to banks as the lender of the last resort (LOLR).
3.4.1. Liquidity Markets and Instruments
While BCBS has published guidelines relating to liquidity risk management prior to the GFC,
the central role of liquidity in exacerbating the crisis has lead to the inclusion of specific
liquidity requirements in Basel III.13 The objective to introducing the regulatory liquidity
requirements along with the capital requirements is to promote a more resilient banking
sector by improving its ability to withstand shocks from different sources (BCBS 2010). As
liquidity problems faced by banks are a key feature of the crisis, Basel III has added liquidity
requirement ratios in addition to reinforcing the capital requirements. Specifically, the
liquidity coverage ratio (LCR) has been introduced to ensure liquidity in banks in the short
term and net stable funding ratio (NSFR) has been proposed to promote medium and long-
term resilience to liquidity shocks.
IFSB (2012) principles for liquidity risk management identify the following for liquidity
infrastructure for Islamic finance: business laws (securities, capital markets, bankruptcy, etc.),
secure and efficient payment systems, well-functioning Islamic money markets, and timely and
accurate information disclosure and transparency. IFSB (2015) issued Guidance Notes on
quantitative measures for measuring liquidity risk management in Islamic financial
institutions and identifies issues related to LCR and NSFR. Given the short history of its
development and the restrictions imposed by Shariah principles, the Islamic banking sector
faces several restrictions that will constrain its adoption of Basel III liquidity requirements.
The challenges that Islamic banks will face in meeting their liquidity needs will be identified.
The chapter will also outline some key infrastructure institutions that are needed to support
the Islamic financial sector at both the private and public levels.
In conventional banks, the funding of liquidity needs of banks can be met either from private
sources such as other financial institutions or inter-bank money markets. As interest based
13 For a discussion on the BCBS guidelines on liquidity risks see Vento and La Ganga (2009).