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National and Global Islamic Financial Architecture:

Prolems and Possible Solutions for the OIC Member Countries

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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.

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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

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For a discussion on the BCBS guidelines on liquidity risks see Vento and La Ganga (2009).