liquidity management of islamic banks: the evidence

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

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 ultimately affect their operations and hence the performance. They are also required to take additional measures for scaling liquidity management due to their unique characteristics and requirements of the strict compliance of Shari‘ah principles. Banks without having adequate liquidity, face various forms of risks such as those of fiduciary, displaced commercial, and other risks associated to them, which might lead to affect their financial stability as a whole. The key objective 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, the study examines inter alia the significance of size of the firm, capitalization, bank specialization and loan loss reserve ratio of some selected Islamic banks in Malaysia. The results show that the liquidity management of these Islamic banks is formed by the bank specification factors. The study recommends the concerned authority to implement all necessary means of integrated and comprehensive 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 annual growth rate between 10%-20% (Eedle, 2009:1). However, despite the progressive development of the Indonesian Islamic banking industry, the potential problem of liquidity risk must not be ignored: the recent economic/business conditions require the banking industry (including the Islamic banking industry) to have a robust liquidity risk management program. The global financial 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 the existence of financial institutions, especially banks, are their provision of liquidity and financial *

**

Graduate Student & Research Assistant, INCEIF, The Global University of Islamic Finance, Lorong Universiti A, 59100 Kuala Lumpur, Malaysia, E-mail: [email protected] Associate Professor of Islamic Law of Transactions, UBD School of Business and Economics, Universiti Brunei Darussalam, Jalan Tungku Link, Gadong BEI410, Negara Brunei Darussalam, E-mail: [email protected]

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Mohammad Ashraful Mobin and Abu Umar Faruq Ahmad

services. Regarding the provision of liquidity, banks accept funds from depositors and extend such 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 inherently vulnerable 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 sound liquidity management could raise funds to meet the demands of depositors and borrowers at any 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 that affect the banks financial stability as a whole. Similar to conventional banks, Islamic banks face a number of risk areas, which may affect their performance and operations. Both the international banking standards and the Sharia guidance suggest that banks should have: robust liquidity risk management policies, a responsive asset and liability committee, effective information and internal control systems and, methods for 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 financial instruments in the financial market, and (b) the liquidity related to solvency. The former relates to liquid financial markets and financial instruments. Examples of these include: marketable financial instruments, smooth transactions, and no financial barriers. Managing liquidity risk, however, is more challenging in the current financial market because significant financial innovations and global market developments have transformed the nature of 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 bank management, shareholders and stakeholders as trusted business partners (Yaqoobi, 2007:3). This creates a system of cooperation, symmetric information, transparency, and equilibrium in the allocation of funds on both the asset and liability sides. Externally, any liquidity risk problem is curtailed by the Islamic financial market mechanism which only engages in real business activities because Sharia requires the attachment of a real asset to every Islamic financial market contract (Kahf, 2000:2). To measure and monitor liquidity risk, Islamic banks have to continuously measure the cash 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 differentiating between the reality of payment and the forecasting of payment (Fiedler, 2000:452). Extra liquidity with Islamic banks cannot be straightforwardly relocated to conventional banks as the Islamic banks do not recognize interest. Conversely the larger the quantity of Islamic banks and broad their functions, the better will be the capacity of assistance in this area. We make a humble attempt in the present research, take lead from these studies and examine the banks liquidity in growing 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

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However, some studies focus on the causes of liquidity risk. Vodovà (2011), in a study on 22 banks during the 2006-2009 periods, emphasizes the determinants of liquidity risk measured with different balance sheet indices. The results show that the liquidity of Czech commercial banks 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 with size. 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 they rely on government intervention in case of shortages. Also Bonfim & Kim (2011) underline that 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 meet their obligations to depositors or to fund increases in assets as they fall due without incurring unacceptable costs or losses (Ismail, 2010:230). This risk occurs when the depositors collectively decide 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, for example 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 the depositors 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 liquidity from 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 unexpected imbalances 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 and accommodating the increase of funds in the financing and investments portfolio. A bank is said to have a sufficient liquidity potential when it is able to obtain the necessary funds (through increased liability, securitization and sale of assets) promptly at a reasonable price. This is because the liquidity of a bank is a function of situation and market perception of existing risks for 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 and community involvement for the period 1984-1997. Financial ratios are applied in measuring the performance of Islamic banks, while the t-test and F-test are used in determining the significance of the factors involved in the study. Obiyatullah (2004) analysed the rationality of a bank financed by deposits and equity in forming an optimum risk management strategy for a period of time. In the study, the researcher identified a few known conditions that are associated with risk management strategy such as complete 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 of the risky asset and spread between riskless interest rate and deposit rate are shown to be the

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important parameters that drive the bank’s hedging decisions. The researcher then extended this 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 evaluation whether Islamic finance can explain three major risks, namely credit risk, interest rate risk and liquidity risk in a country that practices a dual banking system such as Malaysia. The study uses data from 23 Malaysian commercial banks for a period of eight years from 1988 to 1996. From the multiple ordinary least square regression made, the study found out that commercial banks offering Islamic financing will experience significantly lower credit and liquidity risk, but face a significantly higher interest rates risk than conventional banks that do not offer Islamic financing services. 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 large developed market. By using previous dataset, they examine the movement of marketing activities in a small-scale bond market of Malaysia. The results showed that the liquidity rate in the Malaysian market is similar to the international market. Aside from that, rates of return showed an increase between 1998 and 2004, but showed little changes after this period. The researchers also stressed the importance of increased levels of liquidity and market developments on the economy. Other sources of liquidity risks include liquid asset’s components, the dependency on external factors financing, supervision and regulations, and macroeconomic factors. The research also found 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) analysed recent liquidity risk management techniques and internal monitoring 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 further emphasizes the most significant method in facing liquidity risks. Eventually, when liquidity drought happens in the interbank market, Italian banks used a method of boosting interbank liquidity circulation when faced by the problem of liquidity. In practice, the banks regularly find imbalances (gaps) between the asset and the liability side that need to be equalized because, by nature, banks accept liquid liabilities but invest in illiquid 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 the strength of liquidity pressure, the preparation of a bank’s liquid instruments, the bank’s condition at the time of liquidity pressure, and the inability of the bank to find internal or external liquid sources. Basel Committee on Banking Supervision in a consultation paper made in June 2008 put some 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 as they come due, without incurring unacceptable losses.


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2. The fundamental role of banks in the maturity transformation of short-term deposits into long-term loans makes banks inherently vulnerable to liquidity risk, both of an institution-specific nature and that which affects markets as a whole. 3. Virtually every financial transaction or commitment has implications for a bank’s liquidity. Effective liquidity risk management helps ensure a bank’s ability to meet cash flow obligations, which are uncertain as they are affected by external events and other agents’ behaviour. Liquidity risk management is of paramount importance because a liquidity shortfall at a single institution can have system-wide repercussions. These regulations become the main references for Islamic banks, although they are allowed to conduct any adjustment due to their typical business operations and environments. Essentially, as the infrastructures of liquidity vary from country to country, Islamic banks are also expected to comply with the local requirements and stand alone to monitor and manage liquidity risk. The recent development in the banking industry exposes Islamic banks to new risks. The financial market conditions and economic changes such as increased market volatility and competition, financial innovations, and regulatory changes require Islamic banks to prepare a comprehensive liquidity risk management program (Iqbal and Mirakhor, 2007:227-228). However, Islamic banks should not only consider such external factors but also take into account the interconnection among risks in their business operations. After all, it is no unlikely that liquidity 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 Sharia principles and guidance, especially the prohibition against generating profit without bearing any risk (loss). From a Sharia perspective, risks are inherent in all business activities of the banks and must be borne by all related business parties. There are however some issues related to Sharia principles and approaches to manage liquidity risk in Islamic banks, which are discussed below. An essential part of a robust liquidity management program is the credibility and effectiveness of the risk assessment process (Alsayed, 2007:3). To this end, the IFSB, as the international standard-setting organization, has published two references, i.e. (i) the Guiding Principles of Risk 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 liquidity risk in the contemporary business environment. These are: (i) the Guiding Principles of Risk Management for Institutions Offering Only Islamic Financial Services and (ii) the Technical Note on Issues in Strengthening Liquidity Management of Institutions Offering Islamic Financial Services: the Development of Islamic Money Markets. Liquidity Management of Institutions Offering Islamic Financial Services: the development of Islamic Money Markets (March 2008). These guidelines have accommodated the risk management principles of the Basel Committee on Banking Supervision (BCBS) and other international standard setting bodies.

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Islamic banks play critical roles in liquidity management (Askari et al., 2009:134). They engage depositors, business partners and all stakeholders in their business operations to manage liquidity. As such, the approaches entail three important components with respect to the process of 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 distinguishes the Islamic banking operations from the conventional ones in their approach to liquidity risk problems. From a Sharia perspective, depositors cannot simply receive return on deposits without any accompanying responsibility in bearing business losses (Alsayed, 2007:1). Rather than establishing a full-fledged Islamic bank, some conventional banks prefer opening Islamic banking windows as a preliminary step instead. The parent company and subordinate agreement (internal commitment) emerges at this stage, and often the parent 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 liquidity risk discovered that Islamic banking needs to develop its liquidity risk management environment as a practice of modern banking standards to ensure safe operations and maintaining business operations. Taking into account the characteristics and risk profiles of banks, he found out that the Shariah has provided a variety of methods and approaches for Islamic banking in managing liquidity risk, considering barriers and challenges to be faced. In practice, he also found that in reducing liquidity risk, Islamic banking needs to develop an organizational approach and liquidity instruments from the perspective of the Islamic financial market and a regulatory framework in meeting 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 compared to conventional banking. This raises several regulatory issues on capital adequacy and liquidity requirements. Islamic banking also has a few constraints in selecting the risks and liquidity management instruments such as derivatives, options and bonds. Chung et al. (2009) uses alternative liquidity risk measurement as well as liquidity ratios to investigate sources of liquidity risk by using an unbalanced panel dataset of 12 commercial banks in the developed countries over the period of 1994-2006. The study adopted two stages least squares (2SLS) method to estimate bank’s liquidity risks and the performance of the model. The study found that liquidity risk is a determinant of a bank’s internal performance. Other sources of liquidity risks include liquid asset’s components, the dependency on external factors financing, supervision and regulations, and macroeconomic factors. The research also found 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 internal monitoring methods. They then reviewed how both methods can be used to improve the subprime crisis that occurred late 2007. Recent risk liquidity models are used to assess whether


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they affect the funding and market risk in the current global scenario. The study further emphasizes the most significant method in facing liquidity risks. Eventually, when liquidity drought happens in the interbank market, Italian banks used a method of boosting interbank liquidity circulation when faced by the problem of insufficient liquidity at that time. Ahmad (2013), in his research shows that Malaysian Islamic banking liquidity management is formed by the bank specification factors (affected by the level of bank management) and Malaysian 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 Malaysian Islamic banks. DATA AND METHODOLOGY The initial sample was composed of 15 Malaysian Islamic banks. The author’s choice to focus only on the Malaysia market is dictated by the desire for as homogeneous a sample as possible in 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 based on 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 a precise calculation, is a main limitation of this method. However, the use of these two measures instead of the balance sheet indices usually used in literature can more effectively indicate bank liquidity 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 frequently used 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 et al., 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 bank and deter-mines the quality of bank loans. The higher the ratio, the more problematic are the loans and vice versa. The loan loss reserve ratio is given by the ratio between the loan loss reserve and gross loans. 5. Return on Average equity ( ROAE) Descriptive Statistics Below mentioned table summarizes the variables used in the OLS regression.

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The descriptive statistics of the variables used in the analysis are shown here. Before carrying out the empirical analyses, the existing correlation between the independent and control varia-bles used in the survey has been checked. The analysis of such correlations seems to support the hypothesis that each independent variable has its own specific information value 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 the dimension of bank i in the year t, the LLRRi,t is a meas-ure of asset quality of bank i at time t,


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CAPi,t is the ratio between equity and total assets of bank i in the year t, SPECi,t measures to what extent bank i is specialized in lending in the year t, considering net loans as a percent-age of 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 shows good ability to explain the variance of the dependent variable.For the robustness of the analysis we run the hausman test that suggests that Fixed effect model should be applied for this equation. Hausman Test

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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 with Bank SizeIn particular, the size and the specialization measures present a positive relationship with 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 crisis dummy variable has a significant relationship with the dependent var-iable, so the short term liquidity risk management is really changed during financial crisis. The equation presents an Adjusted R-squared of 0.84 and, the model therefore shows a good ability to explain the variance of the dependent variable. With regard to the bank specific independent variables, simialr with Vodovà (2011), Bonfim, & Kim (2011) but in line with Angora, & Roulet (2011), liquidity creation is positively linked to the size measure; these results may 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. More specifically, some variations to equation (3) are estimated in order to assess the robustness of the 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 by stacking time series. Once again, the main results hold. The collinearity test is made and the results showed no problems of multi-collinearity between selected variables. With reference to liquidity risk, the different balance sheet indices proposed by literature, such as the ratio between liquid assets and total assets or the ratio between net loans and customer deposits, were considered.


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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 what kind of variables impact on the Islamic Banks. Results highlight that size, Return on Equity and specialization can have an impact on liquidity risk management. Even if the specific variables considered in the study do not show always a relationship with both liquidity measures, the relationship is present at least in one case. In particular, the research shows that bigger banks more specialized in the lending activity are more likely to have a higher liquidity. More capitalized banks show a better liquidity on long horizon, while banks with a better assets quality are more likely to manage liquidity on short horizon. In future, studies can be improved by the expansion of the sample, considering also banks of other countries. References Abdul Rahman, Y. (1999), “Islamic Instruments for managing liquidity”, International Journal of Islamic Finance Sevices, Retrieved November 24, 2004, from http://www.islamic-finance.net/journal.html Abdullah, DaudVicary (2007), “Business operations and risk management in Islamic banking” (Kertas Kerja dibentangkan di Financial Regulators Forum on Islamic Finance, 27 Mach 2007, Kuala Lumpur. Abdus Samad dan M. Kabir Hassan (2000), “The Performance of Malaysian Islamic bank During 19841997: An exploratory study”, International Journal of Islamic Financial Services, Vol. 1, No. 3, 1-14. Bacha, Obiyatullah I. (2004), “Value Preservation through Risk Management - A Shariah Compliant Proposal for Equity Risk Management”, MRPA Paper No. 12632, h. 1-32. Bourke, P. (1989), “Concentration and Other Determinants of Bank Profitability in Europe, North America and Australia,” Journal of Banking and Finance, Vol. 13, 65-79. Global Market Information Database (GMID), http://www.portal.euromonitor.com Holmstrom, Bengt, and Jean Tirole (1998), “Public and private supply of liquidity,” Journal of Political Economy, 106, h. 1-40. How, Janice C, Abdul Karim, Melina and Verhoeven, Peter (2004), “Islamic Financing and Bank Risk”, Tunderbird International Business Review, Vol. 47, No. 1, 75-94. Ismail, A. G. (2010), Money, Islamic Banks and the Real Economy. Singapore: Cengage Learning Asia Pte. Ltd. Islamic Financial Service Board. (2005), Guiding Principles of Risk Management for Institutions (Other than Insurance Institutions) Offering only Islamic Financial Services. Retrieved on January 20th, 2008 from: http://www.ifsb.org/. Islamic Financial Service Board (2008), Technical Note on Issues in Strengthening Liquidity Management of Institutions Offering Islamic Financial Services: The Development of Islamic Money Market. Retrieved on September 15th, 2009 from: http://www.ifsb.org/. Iqbal, Z. and Mirakhor, A. (2007), An Introduction to Islamic Finance: Theory and Practices. Singapore: John Wiley & Son Pte, Ltd. Janice C. Y. How, Melina Abdul Karim dan Peter Verhoeven (2005), “Islamic Financing and Bank Risk: The Case ofMalaysia”, Thunderbird International Business Review, Vol. 47, No.1, 75-95.

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