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Assets-Liabilities Mismatch:
Risks and Challenges
Sami Al-Suwailem
IRTI, IDB
Jumada Thani, 1430H – June, 2009
Overview

Maturity mismatch:
◦ Liabilities are shorter than assets (borrow
short and lend long)
◦ Reduces costs (short term interest usually
lower)

Currency mismatch:
◦ Borrow in a currency and lend in another
◦ Exploits interest rate differentials
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Maturity Transformation
Benefits: liquidity—micro level
 Costs:

◦
◦
◦
◦
◦
Fallacy of composition
Risk of runs
High leverage
Endogenous risk—financial fragility
Systemic risk—macro level
International crises
 “The original sin”

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Endogenous Risk
Financial sector is more volatile than real
economy
 Richard Bookstaber (2007):

◦ “The fact that total risk of financial markets
has grown in spite of a marked decline in
exogenous economic risk is a key symptom of
the design flaws within the system”
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Maturity Mismatch vs. Ponzi Schemes

Both have serial structure:
◦ Take from B to pay A; from C to pay B; from
D to pay C, etc.
◦ Default arises when the chain stops
MM is solvent, PS is not
 Ponzi scheme is a “naked” MM design
 “Optimal Ponzi design” when government
is expected to step in!

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Historical Responses
Bank runs
 Saving & Loans 1980’s
 Lender of Last Resort, Deposit Insurance,
and government bailout
 Problem: moral hazard

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Shadow Banking System
In the past two decades nonbank financial
institutions replicated the commercial
banking model via money markets
 Banks also shifted from deposits to
money markets
 Size of the shadow system in 2007
reached $10.5 trillion, while commercial
banking system was $10 trillion

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Liquidity Party
By end of 2006, investment banks were
rolling over 25% of their balance sheets
on daily basis
 Overnight repos = $2.5 trillion
 “When the music stops, in terms of
liquidity, things will be complicated. But as
long as the music is playing, you’ve got to
get up and dance.We‘re still dancing.”

 C. Prince, CEO, Citigroup, July 10, 2007
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Asset-Backed Commercial Paper Issuance
Monthly MA, $billions
Source: Baily et. al., 2008
More Risky System
Money market is more risky and volatile
than deposits
 Plus, no insurance or LOLR for such
institutions
 “What is truly shocking is that the risks
posed by this funding mismatch have gone
so unnoticed, for so long.”

 Gillian Tett, Financial Times, Sep. 2007
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Global Financial Crisis
Triggered by classical run, but in the
shadow banking sector
 The same mechanism of other
international crises
 The system needs to be redesigned

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International Responses
BIS: Macro-prudential measures against
systemic and liquidity risks
 FSA: Core funding ratio
 IMF: Balance-sheet approach for financial
assessment
 CMBS: Mark-to-funding
 Group of Thirty & WEF: Less short term
debt

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Islamic Finance
Integration of debt creation with wealth
creation
 Alignment of funding and spending
 Alignment of assets and liabilities
 Mismatch may arise incidentally but not
deliberately

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Deliberate Mismatching
A loan to be paid by another loan, to be
paid by another, etc.
 Each loan is an obligation that bank does
not have ability to pay on time—“sale of
what you don’t have”
 Highly risky—gharar
 “Two sales in one”: Fulfillment of one
contract is conditioned on another

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Islamic Model of Intermediation
Profit and loss sharing on both sides
 “Mutual funds banking”
 “Limited purpose banking”
 Perfect match and inherent stability

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Islamic Banks in Practice
Used to be stable with ample liquidity
 Recently they are increasingly misaligning
their balances
 Borrow short through reversed tawarruq
 Lend long through organized tawarruq
 Islamic banks face the same vulnerabilities
of conventional banks

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Diversity

Islamic finance promotes diversity:
◦ It is directly linked to the diverse real
economy

The more finance becomes detached
from real economy, the more it becomes
homogenous
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Liquidity “Black-hole”
A homogenous market fails to meet “law
of large numbers”
 Herd behavior and correlated risk
 Fallacy of composition: if every one wants
to sell, liquidity disappears
 Diversity is essential for market liquidity

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Role of Regulation
Andrew Haldane, BoE (2009):
◦ Deregulation swept away banking segregation
and, with it, robustness of the financial
network
◦ That is why Glass-Steagall Act is back on the
international policy agenda
◦ It may be the wrong or too narrow an answer.
But it asks the right question: Can network
structure be altered to improve network
robustness?
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Firm Boundaries
Firms may be segregated based on aligned
maturity structures
 Financial landscape is distributed along
maturity horizon
 This assures stability and diversity
 No need for Glass-Steagall act

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Conclusion
Deliberate mismatching is Islamically
questionable and economically dangerous
 Glass-Steagall Act is outdated and
incomprehensive
 Regulation based on aligned maturities
might provide a better approach

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‫والحمد هلل رب العاملين‬
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