AS WELL as a lack of long-term assets to invest in, Islamic banks face another serious problem in managing their balance sheets: the lack of an Islamic interbank market. Because Islamic banks cannot borrow at interest to cover sudden calls on their deposits, it is hard for them to mismatch their assets and liabilities.

The way banks have most commonly solved this problem is to place their surplus deposits with conventional banks, which then invest them in commodity murabahas on the understanding that they can get liquidity when they need it. This method, though widespread, is causing increasing controversy within the industry because many people wonder if there is an element of speculation involved in the commodity trades financed by the Islamic banks. There have been some suspicions in the past that not all Western banks are scrupulous about whether they actually put the money into Islamically acceptable transactions or not.

There are alternative approaches, the most systematic of which is that created by Arab Banking Corporation (ABC). ABC has two liquidity vehicles, the ABC Islamic Fund and the ABC Clearing Company, with assets of $150 million and $100 million respectively. An Islamic bank can buy shares in either of the two companies and sell them back at short notice if it needs to meet cash calls from depositors. For this service, it pays a fee. The two companies invest in a range of Islamic assets from leasing and industrial financings to murabaha, though they avoid the commodity markets on principle. Thus the banks which buy the companies' shares do get a return on their deposits, similar to an interbank deposit rate. 'My yield has been around Libor for both call accounts and weekly deposits,' says Abdel-Hak Elkafsi, head of Islamic banking at ABC. 'Last year [the return] on the ABC Islamic fund was consistently above Libor.'

The two companies have been very successful, so successful in fact that they will be the core of a new Islamic subsidiary to be created out of ABC's existing investment banking unit. But running an investment company as if it were an interbank market is a labour-intensive business. 'The secret in maintaining a rate [of return] which is comparable to the [interbank] market is to have a high turnover in the business that you have,' says Elkafsi. To keep the portfolios of the two companies liquid, the preference is for investing in small transactions with a value of $4 million-$8 million. Another reason for keeping the focus on short-term deals is that Islamic investments cannot be hedged. 'Your portfolio has to be a very dynamic one.'

An obvious question is why Islamic banks have not followed ABC into the same niche, given the growing feeling that there needs to be a more ethical way of managing Islamic liquidity than punting on the London Metal Exchange.

The reason may be that Islamic banks have tended to focus on one national market or one product niche, with few taking a regional view of the industry. It is common for Islamic banks to have investment companies, but these lack the flexibility for use in liquidity management. They are like heavy trucks which carry capital for long periods without stopping, when what is needed is pickup trucks which can load and offload funds easily and at short notice.

Elkafsi says he expects that sooner or later, others will do what ABC is doing. 'What is needed is for Islamic banks to have companies which can absorb liquidity for very flexible tenors and also be able to provide liquidity for other banks by buying into those banks' special liquidity companies.' This would, in effect, create an Islamic interbank market. What Elkafsi does not say is that this would require more co-ordination between Islamic banks than has been seen up to now.