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The 2007 US subprime crises had taught banks many valuable lessons on managing liquidity risk. For instance, Basel III now specifies banks to observe the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) requirement. The LCR was supposed to require a bank to hold sufficient high-quality liquid assets to cover its total net cash outflows over 30 days while the NFSR was to require the available amount of stable funding to exceed the required amount of stable funding over a one-year period of extended stress.
Before the crises, it is common practice for banks to use money market funds instead of deposits to make loans. When money market funds during the crises dried up due to rising uncertainties, banks are not able to match their assets and liabilities. One good example is Northern Rock, a bank in the UK. Northern Rock was best known for becoming the first bank in 150 years to suffer a bank run after having had to approach the Bank of England for a loan facility, to replace money market funding, during the credit crisis in 2007.
During the 1997 Asian financial crises Islamic banks in Malaysia heavily resorted to Islamic money market funds to cover deposit outflows when they failed to give competitive rates on their deposits due to the deteriorating performance of fixed rate assets (FRAs) such as BBA and AITAB. Islamic deposits declined by RM200 million (USD55 million) while interbank trading of Islamic paper significantly increased by 176% to RM134 billion (USD 37.2 billion) in 1977.
Although dependency on wholesale funding is evident during events of crises, deposit concentration risk is another form of liquidity risk that many banks face on the daily basis. In 2012, Bank Muamalat Malaysia reported earning contraction due to higher cost of funds as against operating revenues. It says, “The Group registered a profit before zakat and taxation RM124.1 million (USD34.4 million), lower by 3% as compared with the amount posted in the previous corresponding year, despite recording moderate growth of 6% in total distributable income. Decline in profit was partly attributed to higher income attributable to depositors by RM64 million(USD$17.7 million), as a result of increase in total customer deposits by 12%.” (Bank Muamalat 2012 Annual Report).
Table 1: Islamic banks in Malaysia with high concentration of term deposits (Mudarabah investment account)
Deposit concentration problem refers to the concentration of fixed deposits (i.e. investment accounts) over transaction deposits (current and saving account CASA). It poses a serious problem when the former reaches maturity, leaving a funding gap which the bank must fill up at a higher cost. Also, bank’s earning will be adversely affected from this high dependence on term deposits as against CASA. See the Table 2 below:
From Table 1, Islamic banks with high concentration of term deposits (IA/TD > 60%) such as Bank Muamalat, Public Islamic Bank and Asian Finance House have recorded negative earnings growth of 37.04%, 9.98% and 13.54% respectively. This is partly due to increase in deposit growth that has instantly raised cost of funds and therefore reducing earnings.
We were not able to see the same impact on Affin Bank. With high term deposit concentration it was able to pose positive net earnings growth from income recovered from loan loss reserves. In the case of Standard Chartered Saadiq, positive earnings growth was largely attributable to income earned from the use of capital funds, thus diluting adverse effect of term deposit concentration.
By Prof. Saiful Azhar Rosly