LENDER OF LAST RESORT FACILITY- SHORT RUN OPTIONS FOR BANK OF TANZANIA.

INTRODUCTION.

The recent economic and financial crisis has highlighted the need for a well-designed financial safety net comprising a number of crisis prevention strategies as part of a comprehensive regulatory and supervisory framework to ensure the soundness and stability of the financial system. The lender of last resort (LOLR) is one such preventive strategy. LOLR is taken to mean the discretionary provision of liquidity to a financial institution (or the market as a whole) by the central bank in reaction to an adverse shock that has caused an abnormal increase in demand for liquidity which cannot be met from an alternative source (Freixas et al., 1999.)

The characteristic nature of banking operations fundamentally makes banks more susceptible to the liquidity problem. This is because a bank’s assets are dominated by illiquid (long-term) receivables, while its liabilities predominantly comprise liquid (short-term) deposits. This condition potentially creates a liquidity problem if depositors unexpectedly withdraw their deposits (known as a bank run), leaving the bank in a condition of insolvency. In such difficult circumstances, a bank may request emergency liquidity from the central bank, which is usually assigned as the lender of last resort.

Chapra (1983) suggests that Islamic banks should also have such liquidity support. This emergency liquidity should take into account Islamic banks’ vulnerability to unscheduled withdrawals as well as systemic liquidity crunches. Similar with conventional banks, the unavailability of emergency liquidity may potentially change liquidity pressure in Islamic banks into a solvency problem unless the banks sell their assets with a substantial haircut on their price. Without an LOLR facility, Islamic banks are even more vulnerable to liquidity problems, and thus to a banking crisis, since they often have a shallow interbank market and limited liquidity instruments. Hence, a report from the IDB-IFSB Taskforce on Islamic Finance and Global Financial Stability (2010) has acknowledged the LOLR facility as an important element for the liquidity management of Islamic financial institutions.

BASIC MECHANISM OF LOLR.

Both the "classic" and other type of liquidity run highlight the need for a LOLR facility. In general, there are two types of last resort facilities: temporary capital injection and collateralised lending. An emergency capital injection will expose the central bank to all the risks of the bank, while collateralised lending is perhaps less risky to the central bank as the loan is backed by good collateral (normally, central bank or government paper, valued at a high rate relative to the pre-crisis period). In such lending, the central bank can manage its risk through various measures – for example, by limiting the proportion of loan to value, levelling of the haircut of the collateral and maximising the amount of loan, in addition to establishing collateral eligibility and solvency criteria. In an extremely stressed condition, though, these parameters may need to be relaxed to avoid a time consistency problem in the implementation of a last resort policy or regulation.

Nevertheless, in practice, the risks associated with providing a last resort facility may not be avoided at all. The central bank often has only a very short time to decide whether to extend a loan to an illiquid but solvent bank. A loan provided to an insolvent bank will incur a financial loss to the central bank. Moreover, in the case of a systemic liquidity run, the potential losses from providing the last resort facility may be significant, given that the central bank may not be in a position to independently absorb that risk due to its budget limitations. In such an exceptional case, the central bank may ask for assistance from the government's guarantee scheme. The rationale for this form of joint crisis management is the high cost to society of a systemic bank failure. For example, a systemic bank failure may result in a cutback in the supply of credit, which may be the only source of funds for small firms and households – that is, the vast majority of society.

ISLAMIC PERSPECTIVE ON LOLR.

One of the important roles of the state in Islam is to work towards securing the public interest and promoting the general (including material) welfare of society. In implementing this role, government intervention may in certain cases be inevitable,
although in general Islam does not prescribe anything like a state with huge control over or intervention in the private sector, other than taking control or intervening to preserve the basic needs of society. This important role can also be seen as a function of Bait al-Māl (Baitulmāl), or the house of wealth – in this case, the state. This function has been around since the era of Rasullullah SAW and rightly guided caliphate, when Muslims were the recipients of large amounts of treasure handed out to them and were distributed to deserving receipient including those in difficulty situations due to immense size of debts.

From the Islamic perspective, pertaining to this role as a representative of the state, the central bank has at least three main tasks, namely: (i) maintaining the stability of money;(ii) fostering economic growth with full employment; and (iii)distributing justice. With regards to banking activities, the central bank is responsible for the robust performance of the banking operations, part of which involves anticipating banks' liquidity problems requiring the LOLR facility and be prepared to solve the problem in conjuction with Sharia rules and principles.

BANK OF TANZANIA AS LENDER OF LAST RESORT TO ISLAMIC BANKS.

As per the Bank of Tanzania Act,2006 part IV clause 41 states " the Bank shall be a lender of last resort and shall in that respect at penal interest rates published each year, grant advances or contigent commitments on an exceptional basis to banks and financial institutions in Tanzania that are deemed to be solvent but illiquid if (a) in the opinion of the Board such advance or commitment is necessary having regard to the financial condition of the bank or the financial institution and to its systemic significance to the stability in the financial markets and (b) in the opinion of the Bank, the bank is solvent and provides adequate collateral and the request for financial assistance is based on the need to improve liquidity;..."

As per the BOT regulation, it appears that Islamic banks operating in the country can hardly qualify due to lack of accceptable collateral required on one hand ( Clause 40 (1)) and on the other hand Islamic banks are restricted not to take advance on interest basis. Is there a way to defeat the obstacles? Yes, of course, the central bank can offer money on Mudaraba basis on fixed deposit account maintained by Islamic Banks just like individual or institutions which opens an FDR on Islamic Banks expecting a return equivalent to penal interest rate published each year as per the BOT Act and collateral issue may be solved if we treat such money as protected by Deposit Insurance Fund after the Minister of Finance in consultation with the Insurance Fund Board and BOT reviewed mandatory protection ceiling in regards to money provided by BOT to Islamic Banks.

Second, Bank of Tanzania should reduce statutory minimum reserve (SMR) for Islamic banks during the liquidity crisis. Currently, all banks are required to maintain SMR not less than 10% of total deposit with the Bank of Tanzania and shall have to seek LOLR facility in case of emergency. While for conventional banks this is possible, for Islamic banks it cannot work and thus depending on the level of liquidity problem, SMR can be reduced as deem fit in order for Islamic banks to address her liquidity problem.

Third, open special account with Islamic Bank as an official depository where in money of the government entity or public authority shall be deposited to provide liquidity to Islamic Banks. According to BOT ACT clause 32 (2) ..the Bank may after consultation with the governments or the public authority and the bank concerned, select any other bank to be the official depository of the governments or the public authority and shall in respect therewith (a) maintain and operate special official accounts in accordance with arrangements made between the Bank and the governments or public authority concerned.

Fourth, the central bank may consider the recent initiative of the International Islamic Liquidity Management Corporation (IILM) to develop a liquidity Sukūk that can be traded across borders by both Islamic banks and conventional banks.From the perspective of LOLR provider this particular Sukūk may potentially reduce the tendency of banks to ask for last resort support, as its cross-border feature will provide an alternative line for liquidity not impacted by idiosyncratic shock in the domestic market.

Nevertheless, a more fundamental solution – that is, an approach to improve the liquidity risk management of the bank – should also be part of the strategy. There are at least four alternative solutions: (i) institutional deepening – meaning to deepen public understanding of the operations of Islamic banks; (ii) restructuring liquidity management on both the asset and liability sides – for example, matching the tenor of the deposits on the liability side and financing on the asset side; (iii)implementing a profit-sharing scheme both on the asset and liability sides; and (iv) revitalising the liquid instruments by utilising a variety of Sukūk instruments (short- and long-term tenor).

CONCLUSION.

The central bank or supervisory authorities, despite their strong regulatory and supervisory provision to the banking system, cannot guarantee that any particular bank will be saved from the liquidity problem. Therefore, it is important to develop an effective arrangement of the LOLR that not only limits the inherent risk of the facility, but also minimises the distortion to the market signals as this may otherwise spur the moral hazard problems inherent in such a guarantee scheme.In any particular situation, the central bank or supervisory authority should not take full charge of the LOLR role; rather, a broader crisis management protocol should be developed with the government.

In terms of LOLR facility, Bank of Tanzania should have LOLR framework for Islamic Banks. An Islamic bank may ask for a Sharī`ah compliant LOLR facility or even a capital injection from a provider of LOLR and expect to be served in conformity with specific features pertinent to the Islamic contract, or `Aqd. As Islamic finance continues to become an integral part of the global financial system,it is essential to have an integrated initiative for both conventional and Islamic finance that includes,among other initiatives, the development of a more effective LOLR and crisis management framework.