Definition and Scope
The standard covers all operations undertaken by Islamic financial institutions to obtain and deploy funds in a manner that meets operational and business needs through Shari'ah-compliant modes. The standard addresses three core dimensions: 1. Sources of liquidity — where and how the institution raises funds 2. Uses of liquidity — how the institution deploys those funds productively 3. Prohibited sources — funding channels that are categorically forbidden The standard also covers inter-bank liquidity operations (-7) — the mechanisms Islamic banks use to lend to and borrow from each other in the short-term money market without resorting to interest-based instruments.
Sources of Liquidity (the Liquidity standard)
Islamic banks raise funds through several Shari'ah-compliant channels, each with distinct legal and contractual characteristics: 1. Current Accounts — Qard-Based: Current accounts operate on the basis of Qard (قرض, interest-free loan). The depositor lends money to the bank, which guarantees repayment on demand. The bank bears all risk and owes no profit share to the depositor. These accounts are the primary source of on-demand liquidity. 2. Investment Accounts — Mudarabah-Based: Term investment accounts operate under Mudarabah (مضاربة), where the depositor is the capital provider (Rabb al-Mal) and the bank is the fund manager (Mudarib). Profits are shared per a pre-agreed ratio; losses fall on the capital provider unless caused by the bank's negligence or misconduct. These accounts provide medium- to long-term funding but cannot be withdrawn on demand without notice. 3. Sukuk Issuance: The bank may issue Sukuk (صكوك, Islamic certificates) to raise funds from capital markets. Sukuk must be asset-backed — they represent ownership shares in tangible assets, usufructs, or services. The bank uses Sukuk proceeds and shares returns with certificate holders based on the underlying asset performance. 4. Inter-Bank Facilities: Islamic banks may obtain short-term funding from other financial institutions through Shari'ah-compliant inter-bank arrangements, primarily Commodity Murabahah (Tawarruq), Wakala bi al-Istithmar, and temporary Musharakah (detailed below).
Uses and Deployment of Liquidity (the Liquidity standard)
Once raised, the institution deploys its liquidity through Shari'ah-compliant channels: 1. Customer Financing: The primary deployment channel. The bank provides financing to retail and corporate customers through Murabahah (cost-plus sales), Ijarah (leasing), Musharakah (partnership), Istisna'a (manufacturing contracts), and Salam (forward sales). Each mode must comply with its respective standard. 2. Sukuk Investment: The bank may invest surplus liquidity in Sukuk issued by other institutions, sovereigns, or corporates. This provides a liquid, tradeable instrument that generates Shari'ah-compliant returns — the Islamic equivalent of a conventional bond portfolio. 3. Working Capital and Operational Expenses: The bank retains liquidity to fund day-to-day operations: staff salaries, rent, technology costs, and regulatory fees. These are funded from the bank's own equity or from the returns it earns as Mudarib on investment accounts.
Prohibited Sources of Liquidity (the Liquidity standard)
the Liquidity standard categorically prohibits the following funding sources: 1. Interest-Bearing Deposits or Borrowings: The institution may NOT accept deposits that guarantee a fixed return (interest) or borrow from conventional inter-bank markets on an interest basis. This is the fundamental prohibition of Riba (ربا). 2. Speculative Instruments: Funds may NOT be raised through derivatives, options, or other instruments that involve excessive uncertainty (Gharar Fahish) or speculation (Maysir). This includes conventional futures, swaps, and structured notes that derive value from interest rate movements. 3. Forbidden Commodities or Activities: The institution may NOT generate liquidity through trading in prohibited commodities (alcohol, pork, weapons of mass destruction) or financing prohibited activities (gambling establishments, conventional insurance). All underlying assets must be Halal.
Inter-Bank Liquidity Operations (the Liquidity standard, -7)
Inter-bank liquidity management is critical because Islamic banks need short-term funding mechanisms to manage daily cash positions, just as conventional banks use the overnight inter-bank market. the Liquidity standard recognizes three primary structures: 1. Commodity Murabahah / Tawarruq: The most widely used Islamic inter-bank instrument. Bank A (needing funds) purchases a commodity (typically London Metal Exchange metals) from a broker, then sells it to Bank B at cost plus an agreed markup payable on a deferred basis. Bank A receives immediate cash from the broker's delivery, while Bank B receives repayment at maturity with the markup representing its return. The commodity must be real, identifiable, and actually delivered — paper-only transactions are void. 2. Wakala bi al-Istithmar: Agency-based fund placement. Bank A (with surplus funds) appoints Bank B as its Wakil (agent) to invest a specified amount for a defined period. Bank B manages the funds and returns the principal plus any profit (minus an agreed agency fee). The key distinction from Mudarabah is that the Wakil may be given a fixed fee rather than a profit-sharing ratio, and the principal is guaranteed only if the agent is negligent. 3. Temporary Musharakah: Short-term partnership where two banks contribute capital to a joint venture (often a commodity pool or financing portfolio) for a limited period (e.g., 7-30 days). Profits are shared per agreement; losses are borne proportionally to capital contribution. At maturity, the partnership is dissolved and capital is returned. This structure is less common than Commodity Murabahah but is considered more authentic by Shari'ah scholars because it involves genuine risk-sharing.
Liquidity Risk and Regulatory Compliance
Islamic banks face unique liquidity risk challenges. Unlike conventional banks, they cannot access the conventional inter-bank overnight market or central bank discount windows that charge interest. the Liquidity standard implicitly requires institutions to: • Maintain sufficient liquid Shari'ah-compliant assets (Sukuk, commodity positions) to meet withdrawal demands • Diversify funding sources across current accounts, investment accounts, and Sukuk • Establish Shari'ah-compliant standby facilities with other Islamic banks • Comply with IFSB (Islamic Financial Services Board) capital adequacy and liquidity coverage ratio requirements • Ensure all liquidity management activities are reviewed by the Shari'ah Supervisory Board The tension between regulatory reserve requirements and Shari'ah compliance is a recurring practical challenge: the bank must hold adequate reserves but cannot invest those reserves in interest-bearing government securities.