Islamic Banking - Focus on Treasury Management

As Islamic banking continues to grow at an accelerated pace, the technology, systems and financial instruments used within the marketplace in turn must grow quickly. This presents some key challenges moving forward for pure Islamic banking institutions and conventional banks with Islamic windows. In addition to maintaining overall Shariah compliance, these challenges include managing the various interpretations of Shariah standards, the hampered development of Shariah-compliant, Islamic financial instruments, a limited inter-bank market and the absence of a fully developed Islamic secondary market. All of these challenges and current limitations within the market can put strain on a treasury management system.

Two key trends in treasury management for Islamic banking currently are: ensuring that investments with companies conform to the Halal index; and the need to develop a secondary market for treasury, as hedging, in its true form, is not permissible under Shariah law. There are two new bonds available to cater to this need – the Sukuk (Malaysia) and the Musharakah Mutanaqisah – both of which are currently being discussed and reviewed by Shariah scholars. In Malaysia, there has been a strong surge in demand for Shariah-compliant treasury products over the last few years, and there are no indications that demand will wane. As treasury products within Islamic banking are relied upon as tools to invest and hedge with, the need for systems that can automate and support these processes while maintaining Shariah compliance will continue to grow.

Essentially, a treasury management system (TMS) that meets the demands of the compliance-focused Islamic banking landscape will also cater for banks where Shariah compliance is not required. Cash management, debt, investment and currency management are common threads, as is the need for strong audit and controls. In addition to these requirements, an Islamic treasury system should also help manage and control operational risk within defined parameters. Efficiency is maximised through straight-through processing at each stage in the transaction lifecycle. The ability to quantify and report the impact of market volatility through a comprehensive risk management framework and real-time integration with core systems is key. As is the ability to adapt as the clients’ business and the competitive landscape changes, particularly as new instruments come to market.

Interpretative Shariah Law Creates Challenge for Standardisation

One of the challenges noted earlier is that Shariah compliance and interpretations vary throughout the Islamic banking world, creating a turbulent environment for accounting standards and practices. First and foremost, any TMS must comply with the requirements of the Islamic products that are offered. The complexity is due largely to the fact that the workflow characteristics of every transaction need to be managed in order to maintain Shariah compliance. Any potential Islamic treasury solution needs to be able to manage this and similar situations, as well as maintain all the functionality of a traditional system. In Islamic finance, many transactions consist of a number of underlying transactions in an effort to maintain Shariah compliance. To be effective, the TMS needs to be able to record and manage each aspect of the entire event in real-time and manage the workflow throughout the lifecycle of the deal.

Recently, a number of new Shariah-compatible financial instruments have been introduced to the market in the form of a number of applications derived from the Sukuk structure; one such instrument currently under review is Musharakah Mutanaqisah. As Shariah boards and organisations approve more of these complex financial instruments, treasury systems must be adaptable to allow customers to manage these new products.

Currently the recent establishment of the International Islamic Financial Market (IIFM), which is working to develop an active secondary market in Shariah-compatible instruments, is strengthening the legal and institutional infrastructure for the development of an Islamic secondary market. Until that is achieved, it is of critical importance to the customer that a TMS provides a fast and flexible method to create new trade management screens for these financial instruments. A treasury system with these features in place would be paramount for an Islamic bank trying to stay ahead of the competition in an ever-changing and tough market space.

An example to illustrate the challenges faced by Islamic treasury management is the rising popularity of Musharakah Mutanaqisah bonds. This instrument is one of the newly created products within the Sukuk market and ranks second in overall total volume. A Musharakah Mutanaqisah bond means the issuer regularly purchases partners’ shares in a project until their full shares are purchased. This is referred to as Idfa al Sukuk (or, full acquisition of bonds). Similar to shares, these bonds have borne some controversy due to the presence of a commitment made by the issuers of some of these bonds to buy back the bonds using a previous cost or predetermined amount. This type of agreement guarantees capital, which is prohibited by Shariah law. Additionally, under this commitment the partner’s capital is transformed into a loan and any increase in the loan value falls under the type of interest that is prohibited by Shariah.

The non-compliant elements ingrained in these offerings do not invalidate these bonds and nullify them from the structure of Islamic bonds. Conversely, the error will likely be corrected, with a number of Shariah-compliant alternatives used to cover the risks that cause the controversy. A TMS must be equipped to handle a scenario such as this by detailing every additional step created to achieve and maintain Shariah compliance.¹

Conclusion

Shariah compliance adds another layer of complexity to the treasury management needs of Islamic banks. The majority of the methods used by treasury managers to manage liquidity are non-Shariah compliant due to the fact that they heavily involve the use of interest in ways that would be difficult to replicate with an eye on compliance. One such method of managing Islamic banking treasuries is through inter-bank Murabaha deposits. These Shariah-compliant cost plus mark-up arrangements can be a useful tool for managing liquidity to the treasury manager. As tools and investment vehicles are created and used, the systems supporting these instruments must be able to affirm their compliance and their ability to remain ahead of the curve as new products and efforts are constantly being cultivated and developed.

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