CFA Institute Journal Review summarizes "Liquidity Risk Exposure and Its Determinants in the Banking Sector," by S. Mohammad, M. Asutay, R. Dixon, and E. Platonova, from Journal of Financial Markets, Institutions and Money, May 2020.
Liquidity measures a bank’s ability to generate funds for investment and business costs without substantial negative outcomes. This research demonstrates that liquidity risk is higher for Islamic banks than for conventional and hybrid banks. High liquidity risk can result in a bank becoming insolvent.
What Is the Investment Issue?
The Islamic banking industry is growing significantly. For investment managers to participate in and benefit from this growth, they must understand the relative risk and return parameters for investing in this industry.
Islamic banks operate on a unique set of principles based on Islamic financial law (Shari’ah), setting them apart from conventional banks. These principles are important to understand in order to manage the risk parameters of the investment. In addition to standalone Islamic banks, some conventional banks have Islamic banking windows, making them “hybrid” banks.
To comply with Shari’ah principles, Islamic banks use equity-based and profit-sharing financing instruments rather than charging interest. These approaches result in comparatively illiquid investments relative to those of conventional banks. Hence, it is not surprising that Islamic banks would incur larger financing gaps connected with their higher liquidity risk. Islamic banks also have fewer tools at their disposal to hedge liquidity risks.
This study focuses on funding liquidity risks for Islamic banks compared with conventional and hybrid banks. Further, it explores the impact of capital regulations, credit risk, the liquidity ratio, and the funding profile on Islamic banks’ liquidity risk.
How Did the Authors Conduct This Research?
“Since the GCC [Gulf Cooperation Council] region is considered the home of a dynamic banking sector where Islamic, conventional and hybrid banks operate in parallel under similar economic conditions and banking standards, this research provides empirical analyses of the liquidity creation behavior of GCC banks and their exposure to liquidity risk in a comparative manner.”
Data used in this research consists of 1,454 observations on Islamic banks, conventional banks, and hybrid banks, sourced from Bankscope for the period 1996–2015. The data includes financial statements with balance sheets and income statements of individual banks.
The authors analyzed bank capital regulatory and supervisory data from 2017 World Bank survey data with GDP data supplied from the 2017 International Monetary Fund’s World Economic Outlook database. They used a panel data regression model with the random effect technique to determine sampled banks’ liquidity risk exposure for each different bank type. The authors considered the following measures:
- Financing gap ratio: A higher value indicates a greater degree of liquidity risk.
- Capital requirement regulations (the “CAP Index”): Nine variables measure capital regulation stringency in setting minimum capital requirements for factors such as credit risk, liquidity risk, market value losses, and fund source.
- Credit risk: An increasing ratio of the level of loan loss provision to gross loans indicates illiquid assets.
- Long-term debt funding to total assets: This variable highlights the level of difficulty in generating necessary funds from internal sources.
- Liquid assets ratio: Possessing liquid assets provides banks with a “net defensive position” against liquidity risks.
Control variables used in this study include firm ownership, governance, bank size, and GDP.
What Are the Findings and Implications for Investors and Investment Professionals?
The authors demonstrate that Islamic banks are subject to greater liquidity risk than conventional and hybrid banks because they have an inherently more illiquid asset profile.
They find negative relationships between liquidity risk and the following variables: stringency of capital regulations, GDP, credit risk, quality of regulatory environment, political stability, rule of law, ownership concentration, and bank size. Long-term debt, however, is positively related to liquidity risk exposure.
The results also indicate that greater liquidity will induce banks to undertake greater risk. Further, the negative relationship between GDP and liquidity risk exposure indicates that a growing economy may ease liquidity constraints.