Liquidity Management of Islamic Banks: The Evidence from ...

The Global Journal of Finance and Economics, Vol. 11, No. 2, (2014) : 175-186

* Graduate Student & Research Assistant, INCEIF, The Global University of Islamic Finance, Lorong UniversitiA, 59100 Kuala Lumpur, Malaysia, E-mail: [email protected]

** Associate Professor of Islamic Law of Transactions, UBD School of Business and Economics, UniversitiBrunei Darussalam, Jalan Tungku Link, Gadong BEI410, Negara Brunei Darussalam, E-mail:[email protected]

LIQUIDITY MANAGEMENT OF ISLAMIC BANKS:THE EVIDENCE FROM MALAYSIAN PRACTICE

Mohammad Ashraful Mobin* and Abu Umar Faruq Ahmad**

ABSTRACT

Islamic banks, similar to their conventional counterparts face plethora of risks, which ultimatelyaffect their operations and hence the performance. They are also required to take additionalmeasures for scaling liquidity management due to their unique characteristicsand requirements of the strict compliance of Shari‘ah principles. Banks without having adequateliquidity, face various forms of risks such as those of fiduciary, displaced commercial, and otherrisks associated to them, which might lead to affect their financial stability as a whole. The keyobjective of this paper is to analyse the management of liquidity risk in Islamic banks’ liabilities.Malaysian Islamic banking sector has been chosen as a case study. Keeping in view of this, thestudy examines inter alia the significance of size of the firm, capitalization, bank specializationand loan loss reserve ratio of some selected Islamic banks in Malaysia. The results show thatthe liquidity management of these Islamic banks is formed by the bank specification factors. Thestudy recommends the concerned authority to implement all necessary means of integrated andcomprehensive program in order for the management of liquidity risk to improve.

Keywords: Liquidity, risk, financial stability, Islamic banking, Shari‘ah principles, Malaysia

INTRODUCTION

The global Islamic banking industry has continuously been growing over the last three decades.At present, its assets are estimated at around USD500 billion – USD1 trillion with an annualgrowth rate between 10%-20% (Eedle, 2009:1). However, despite the progressive developmentof the Indonesian Islamic banking industry, the potential problem of liquidity risk must not beignored: the recent economic/business conditions require the banking industry (including theIslamic banking industry) to have a robust liquidity risk management program. The globalfinancial crisis (2008-2009) has hampered some well-established financial institutions and,indeed, the global banking industry in general.

According to the theories of financial intermediation, the two most crucial reasons for theexistence of financial institutions, especially banks, are their provision of liquidity and financial

176 Mohammad Ashraful Mobin and Abu Umar Faruq Ahmad

services. Regarding the provision of liquidity, banks accept funds from depositors and extendsuch funds to the real sector while providing liquidity for any withdrawal of deposits. However,the banks’ role in transforming short-term deposits into long-term loans makes them inherentlyvulnerable to liquidity risk (Bank for International Settlements (BIS), 2008b:1).

Bank liquidity is a key element in managing the assets of a bank. The robust and soundliquidity management could raise funds to meet the demands of depositors and borrowers atany time with a satisfactory price. Without sufficient liquidity, the bank may face other risks,such as various forms of fiduciary risk, displaced commercial risk as well as other risks thataffect the banks financial stability as a whole.

Similar to conventional banks, Islamic banks face a number of risk areas, which may affecttheir performance and operations. Both the international banking standards and the Shariaguidance suggest that banks should have: robust liquidity risk management policies, a responsiveasset and liability committee, effective information and internal control systems and, methodsfor managing deposits to reduce on demand liquidity, to manage liquidity risk.

The concept of liquidity in finance principally lies in two areas: (a) the liquidity of financialinstruments in the financial market, and (b) the liquidity related to solvency. The former relatesto liquid financial markets and financial instruments. Examples of these include: marketablefinancial instruments, smooth transactions, and no financial barriers.

Managing liquidity risk, however, is more challenging in the current financial market becausesignificant financial innovations and global market developments have transformed the natureof liquidity risk (BIS, 2008a:2).

Islamic banks minimize the liquidity risk from both internal and external perspectives.Sharia values and principles, which permeate the industry from the inside, treat the bankmanagement, shareholders and stakeholders as trusted business partners (Yaqoobi, 2007:3).This creates a system of cooperation, symmetric information, transparency, and equilibrium inthe allocation of funds on both the asset and liability sides.

Externally, any liquidity risk problem is curtailed by the Islamic financial market mechanismwhich only engages in real business activities because Sharia requires the attachment of a realasset to every Islamic financial market contract (Kahf, 2000:2).

To measure and monitor liquidity risk, Islamic banks have to continuously measure thecash inflows of the business/projects being financed and the cash outflows of deposit withdrawals.In addition, Islamic banks should construct the structure of future payments by differentiatingbetween the reality of payment and the forecasting of payment (Fiedler, 2000:452). Extra liquiditywith Islamic banks cannot be straightforwardly relocated to conventional banks as the Islamicbanks do not recognize interest. Conversely the larger the quantity of Islamic banks and broadtheir functions, the better will be the capacity of assistance in this area. We make a humbleattempt in the present research, take lead from these studies and examine the banks liquidity ingrowing region Malaysian Islamic banking industry.

LITERATURE REVIEW

In general, liquidity risk is considered as a determinant of other risks, such as credit risk (Shen.,Chen., Kao, & Yeh, 2009; Arif, & Anees, 2012).

Liquidity Management of Islamic Banks: The Evidence from Malaysian Practice 177

However, some studies focus on the causes of liquidity risk. Vodovà (2011), in a study on22 banks during the 2006-2009 periods, emphasizes the determinants of liquidity risk measuredwith different balance sheet indices. The results show that the liquidity of Czech commercialbanks is higher when capital adequacy is higher and when the interest rates on loans are higher.Furthermore, the liquidity measures identify a positive relationship with capitalization and withsize. The author finds that bigger banks present lower liquidity in line with the “too big to fail”theory, where it would seem that bigger banks are less motivated to hold liquidity since theyrely on government intervention in case of shortages. Also Bonfim & Kim (2011) underlinethat banks with a better capital adequacy present a lower liquidity risk exposure.

Liquidity risk management in banks is defined as the risk of being unable either to meettheir obligations to depositors or to fund increases in assets as they fall due without incurringunacceptable costs or losses (Ismail, 2010:230). This risk occurs when the depositors collectivelydecide to withdraw more funds than the bank immediately has on hand (Hubbard, 2002:323),or when the borrowers fail to meet their financial obligation to the banks. In the other words,liquidity risk occurs in two cases.

Firstly, it arises symmetrically to the borrowers in their relationship with the banks, forexample when the banks decide to terminate the loans but the borrowers can’t afford it. Secondly,it arises in the context of the banks’ relationships with their depositors, for example, when thedepositors decide to redeem their deposits but the banks cannot afford it (Greenbaum and Thakor,1995:137).

Holmstrom and Tirole (1998) and Kashyap et al. (2002) suggest banks to also create liquidityfrom the balance sheet through loan commitments and similar claims to withdraw funds (Berger,2009). Liquidity is necessary for banking institutions to replace the expected and unexpectedimbalances that occur in the balance sheet and to provide funds for the purpose of bank growth.

It usually reflects the ability of banks to adjust deposits and other liabilities andaccommodating the increase of funds in the financing and investments portfolio. A bank is saidto have a sufficient liquidity potential when it is able to obtain the necessary funds (throughincreased liability, securitization and sale of assets) promptly at a reasonable price. This isbecause the liquidity of a bank is a function of situation and market perception of existing risksfor institutions offering credit facilities (Van Greuning et al., 2009).

A study by Samad and Hassan (2000) assessed the performance between time and interbank(Bank Islam Malaysia Berhad, BIMB) in terms of profitability, liquidity, risk, solvency andcommunity involvement for the period 1984-1997. Financial ratios are applied in measuringthe performance of Islamic banks, while the t-test and F-test are used in determining thesignificance of the factors involved in the study.

Obiyatullah (2004) analysed the rationality of a bank financed by deposits and equity informing an optimum risk management strategy for a period of time. In the study, the researcheridentified a few known conditions that are associated with risk management strategy such ascomplete hedging, maximal speculation, or irrelevance of the hedging decision are obtained.The initial debt ratio, the size of the liquidation costs, regulatory restrictions, the volatility ofthe risky asset and spread between riskless interest rate and deposit rate are shown to be the


important parameters that drive the bank’s hedging decisions. The researcher then extendedthis basic model to include counterparty risk constraints on the forward contract used for hedging.

Janice C. Y. How, Melina Abdul Karim and Peter Verhoeven (2004) made an evaluationwhether Islamic finance can explain three major risks, namely credit risk, interest rate risk andliquidity risk in a country that practices a dual banking system such as Malaysia. The study usesdata from 23 Malaysian commercial banks for a period of eight years from 1988 to 1996. Fromthe multiple ordinary least square regression made, the study found out that commercial banksoffering Islamic financing will experience significantly lower credit and liquidity risk, but facea significantly higher interest rates risk than conventional banks that do not offer Islamic financingservices.

Eric Chan et al. (2007) discussed on corporate bonds and its relationship with bank liquidity.In the study, the researchers found that most of corporate bonds’ function is based on the largedeveloped market. By using previous dataset, they examine the movement of marketing activitiesin a small-scale bond market of Malaysia. The results showed that the liquidity rate in theMalaysian market is similar to the international market. Aside from that, rates of return showedan increase between 1998 and 2004, but showed little changes after this period. The researchersalso stressed the importance of increased levels of liquidity and market developments on theeconomy.

Other sources of liquidity risks include liquid asset’s components, the dependency on externalfactors financing, supervision and regulations, and macroeconomic factors. The research alsofound that liquidity risk may reduce bank profits (return on average assets and return on equity)because the higher the cost of funds, the greater the increase in the bank’s net interestmargin.Gianfranco et al. (2009) analysed recent liquidity risk management techniques andinternal monitoring methods. They then reviewed how both methods can be used to improvethe sub-prime crisis that occurred late 2007. Recent risk liquidity models are used to assesswhether they affect the funding and market risk in the current global scenario. The study furtheremphasizes the most significant method in facing liquidity risks. Eventually, when liquiditydrought happens in the interbank market, Italian banks used a method of boosting interbankliquidity circulation when faced by the problem of liquidity.

In practice, the banks regularly find imbalances (gaps) between the asset and the liabilityside that need to be equalized because, by nature, banks accept liquid liabilities but invest inilliquid assets (Zhu, 2001:1). If a bank fails to balance such a gap, liquidity risk might occur,followed by some undesirable consequences such as insolvency risk, government bailout risk,and reputation risk. The failure or inefficiency of liquidity management is caused by thestrength of liquidity pressure, the preparation of a bank’s liquid instruments, the bank’s conditionat the time of liquidity pressure, and the inability of the bank to find internal or external liquidsources.

Basel Committee on Banking Supervision in a consultation paper made in June 2008 putsome clear definition of liquidity in the banking institutions, namely;

1. Liquidity is the ability of a bank to fund increases in assets and meet obligations asthey come due, without incurring unacceptable losses.


2. The fundamental role of banks in the maturity transformation of short-term depositsinto long-term loans makes banks inherently vulnerable to liquidity risk, both of aninstitution-specific nature and that which affects markets as a whole.

3. Virtually every financial transaction or commitment has implications for a bank’sliquidity. Effective liquidity risk management helps ensure a bank’s ability to meetcash flow obligations, which are uncertain as they are affected by external events andother agents’ behaviour. Liquidity risk management is of paramount importance becausea liquidity shortfall at a single institution can have system-wide repercussions.

These regulations become the main references for Islamic banks, although they are allowedto conduct any adjustment due to their typical business operations and environments.Essentially, as the infrastructures of liquidity vary from country to country, Islamic banks arealso expected to comply with the local requirements and stand alone to monitor and manageliquidity risk.

The recent development in the banking industry exposes Islamic banks to new risks. Thefinancial market conditions and economic changes such as increased market volatility andcompetition, financial innovations, and regulatory changes require Islamic banks to prepare acomprehensive liquidity risk management program (Iqbal and Mirakhor, 2007:227-228).However, Islamic banks should not only consider such external factors but also take into accountthe interconnection among risks in their business operations. After all, it is no unlikely thatliquidity risk can result from other risks such as credit risk, market risk and, default risk.

The essential feature of Islamic banking operations is the requirement to comply with Shariaprinciples and guidance, especially the prohibition against generating profit without bearingany risk (loss). From a Sharia perspective, risks are inherent in all business activities of thebanks and must be borne by all related business parties. There are however some issues relatedto Sharia principles and approaches to manage liquidity risk in Islamic banks, which are discussedbelow.

An essential part of a robust liquidity management program is the credibility and effectivenessof the risk assessment process (Alsayed, 2007:3). To this end, the IFSB, as the internationalstandard-setting organization, has published two references, i.e. (i) the Guiding Principles ofRisk Management for Institutions Offering Only Islamic Financial Services (December 2005)and (ii) the Technical Note on Issues in Strengthening.

The Islamic Financial Service Board (IFSB) has published two references to manage liquidityrisk in the contemporary business environment. These are: (i) the Guiding Principles of RiskManagement for Institutions Offering Only Islamic Financial Services and (ii) the TechnicalNote on Issues in Strengthening Liquidity Management of Institutions Offering Islamic FinancialServices: the Development of Islamic Money Markets.

Liquidity Management of Institutions Offering Islamic Financial Services: the developmentof Islamic Money Markets (March 2008). These guidelines have accommodated the riskmanagement principles of the Basel Committee on Banking Supervision (BCBS) and otherinternational standard setting bodies.


Islamic banks play critical roles in liquidity management (Askari et al., 2009:134). Theyengage depositors, business partners and all stakeholders in their business operations to manageliquidity. As such, the approaches entail three important components with respect to the processof depositing and advancing funds to balance asset and liability in Sharia perspective (Ismail,2010:20-30):

The involvement of depositors and entrepreneurs in managing liquidity risk distinguishesthe Islamic banking operations from the conventional ones in their approach to liquidityrisk problems. From a Sharia perspective, depositors cannot simply receive return ondeposits without any accompanying responsibility in bearing business losses (Alsayed,2007:1).

Rather than establishing a full-fledged Islamic bank, some conventional banksprefer opening Islamic banking windows as a preliminary step instead. The parent companyand subordinate agreement (internal commitment) emerges at this stage, and often theparent company agrees to supply emergency funds to the Islamic banking windows (IFSB,2005:20).

Rifki Ismal (2008) in his research on Shariah issues that arise in the management of liquidityrisk discovered that Islamic banking needs to develop its liquidity risk management environmentas a practice of modern banking standards to ensure safe operations and maintaining businessoperations. Taking into account the characteristics and risk profiles of banks, he found out thatthe Shariah has provided a variety of methods and approaches for Islamic banking in managingliquidity risk, considering barriers and challenges to be faced. In practice, he also found that inreducing liquidity risk, Islamic banking needs to develop an organizational approach and liquidityinstruments from the perspective of the Islamic financial market and a regulatory framework inmeeting ordinary and extraordinary liquidity needs.

Due to Islamic prohibitions against interest and in adhering to the allowed trade contracts,savings and investment contracts offered by Islamic banking has a different risk profile comparedto conventional banking. This raises several regulatory issues on capital adequacy and liquidityrequirements. Islamic banking also has a few constraints in selecting the risks and liquiditymanagement instruments such as derivatives, options and bonds. Chung et al. (2009) usesalternative liquidity risk measurement as well as liquidity ratios to investigate sources of liquidityrisk by using an unbalanced panel dataset of 12 commercial banks in the developed countriesover the period of 1994-2006. The study adopted two stages least squares (2SLS) method toestimate bank’s liquidity risks and the performance of the model. The study found that liquidityrisk is a determinant of a bank’s internal performance.

Other sources of liquidity risks include liquid asset’s components, the dependency on externalfactors financing, supervision and regulations, and macroeconomic factors. The research alsofound that liquidity risk may reduce bank profits (return on average assets and return on equity)because the higher the cost of funds, the greater the increase in the bank’s net interest margin.Gianfranco et al. (2009) analyzed recent liquidity risk management techniques and internalmonitoring methods. They then reviewed how both methods can be used to improve the sub-prime crisis that occurred late 2007. Recent risk liquidity models are used to assess whether


they affect the funding and market risk in the current global scenario. The study furtheremphasizes the most significant method in facing liquidity risks. Eventually, when liquiditydrought happens in the interbank market, Italian banks used a method of boosting interbankliquidity circulation when faced by the problem of insufficient liquidity at that time.

Ahmad (2013), in his research shows that Malaysian Islamic banking liquidity managementis formed by the bank specification factors (affected by the level of bank management) andMalaysian economic cycle. We attempt to contribute to this line of inquiry in several aspects.The project analyzes the liquidity management banks deposit in a panel of fifteen MalaysianIslamic banks.

DATA AND METHODOLOGY

The initial sample was composed of 15 Malaysian Islamic banks. The author’s choice to focusonly on the Malaysia market is dictated by the desire for as homogeneous a sample as possiblein terms of bank characteristics and the territory in which they operate.

The dependent variables used in the empirical analysis concern liquidity risk and it’s basedon previous studies (Gian-notti et al., 2010; Van den End, 2010; Angora, & Roulet, 2011;Giordana, & Schumacher, 2012

The difficulty of including all terms required by the Basel Committee, which entails aprecise calculation, is a main limitation of this method. However, the use of these two measuresinstead of the balance sheet indices usually used in literature can more effectively indicate bankliquidity risk.

Different balance sheet indices represent the independent and control variables:

1. Bank capitalization measured with the ratio between equity and total assets (CAP)(Sheng et al., 2009; Bonfim, & Kim, 2011; Nguyen et al., 2012; Horvàth et al., 2012),

2. Bank size measured with the natural logarithm of total assets (SIZE) and frequentlyused in literature (Shen et al., 2009; Giannotti et al., 2010; Ahmed et al., 2011; Bonfim,& Kim, 2011; Angora, & Roulet, 2011; Vodovà, 2011; Nguyen et al., 2012; Horvàth etal., 2012)

3. Bank specialization (SPEC) that measures to what extent a bank is specialized in lending,considering net loans as a percentage of total assets (Bonfim, & Kim, 2011; Angora, &Roulet, 2011).

4. Loan Loss Reserve Ratio (LLRR): this ratio is part of ‘Asset Quality’ ratios of the bankand deter-mines the quality of bank loans. The higher the ratio, the more problematicare the loans and vice versa. The loan loss reserve ratio is given by the ratio betweenthe loan loss reserve and gross loans.

5. Return on Average equity ( ROAE)

Descriptive Statistics Below mentioned table summarizes the variables used in the OLSregression.


The descriptive statistics of the variables used in the analysis are shown here.

Before carrying out the empirical analyses, the existing correlation between the independentand control varia-bles used in the survey has been checked. The analysis of such correlationsseems to support the hypothesis that each independent variable has its own specific informationvalue in its ability to explain the bank liquidity risk.

In term of methodology, the OLS regression is estimated using panel data.

The regression aims to investigate the determinants of liquidity risk:

LIQUIDITY = � + SIZEi,t + LLLRRi,t + �SPECi,t + �CAPi,t + �ROEi,t+�(3)

The LIQUIDITY is the dependent variable here, � is a constant, SIZEi,t indicates thedimension of bank i in the year t, the LLRRi,t is a meas-ure of asset quality of bank i at time t,


CAPi,t is the ratio between equity and total assets of bank i in the year t, SPECi,t measures towhat extent bank i is specialized in lending in the year t, considering net loans as a percent-ageof total assets.

ANALYSIS AND RESULTS

Table presents the regression results obtained for the first liquidity measure.

The equation presents an Adjusted R-squared of 0.85 and, the model therefore showsgood ability to explain the variance of the dependent variable.For the robustness of theanalysis we run the hausman test that suggests that Fixed effect model should be applied forthis equation.

Hausman Test


Fixed Effect model

As Hausman test suggested, we run Fixed effect model instead of Random effect model.

From this fixed effect model, we can see that liquidity has significant relationship withBank SizeIn particular, the size and the specialization measures present a positive relationshipwith Liquidity, similar result with Vodovà (2011), Bonfim, & Kim (2011) and Nguyen et al.(2012), while the assets quality measure shows a pos-itive relationship with the LCR. The crisisdummy variable has a significant relationship with the dependent var-iable, so the short termliquidity risk management is really changed during financial crisis.

The equation presents an Adjusted R-squared of 0.84 and, the model therefore shows agood ability to explain the variance of the dependent variable. With regard to the bank specificindependent variables, simialr with Vodovà (2011), Bonfim, & Kim (2011) but in line withAngora, & Roulet (2011), liquidity creation is positively linked to the size measure; these resultsmay be due to the fact that larger banks need less liquidity in the long time horizon.

ROBUSTNESS CHECK

A number of checks are undertaken to assess the robustness of the empirical results. Morespecifically, some variations to equation (3) are estimated in order to assess the robustness ofthe results in terms of the relationship between liquidity risk and bank specific features.

We estimated equation (3) aggregating panel data by stacking cross sections rather than bystacking time series. Once again, the main results hold. The collinearity test is made and theresults showed no problems of multi-collinearity between selected variables. With reference toliquidity risk, the different balance sheet indices proposed by literature, such as the ratio betweenliquid assets and total assets or the ratio between net loans and customer deposits, were considered.


CONCLUSION

In the last year the liquidity risk management theme has again become a much debated topic.The aim of this study is to investigate the determinants of liquidity risk and to understand whatkind of variables impact on the Islamic Banks. Results highlight that size, Return on Equity andspecialization can have an impact on liquidity risk management. Even if the specific variablesconsidered in the study do not show always a relationship with both liquidity measures, therelationship is present at least in one case. In particular, the research shows that bigger banksmore specialized in the lending activity are more likely to have a higher liquidity. More capitalizedbanks show a better liquidity on long horizon, while banks with a better assets quality are morelikely to manage liquidity on short horizon. In future, studies can be improved by the expansionof the sample, considering also banks of other countries.

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