Maturity Transformation Risk and Profitability of Islamic Banks – An International Evidence

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1. Maturity Transformation Risk and Profitability of Islamic Banks – An International Evidence Haroon Mahmood, Christopher Gan, Cuong Nguyen Abstract This study aims to analyze the impact of IFSBs’ proposed new structural measure of liquidity on financial performance of Islamic banking sector. We apply a 2-step system GMM technique for the period covering 2006 –2015. We demonstrate that profitability persists and there exists a significant and negative relationship between maturity transformation risk and Islamic banks’ profitability. Our findings reveal that the inclusion of NSFR leads to a better financial performance of Islamic banks, thus providing support for the adoption of new liquidity regulation. In addition, we find bank capital, market concentration and gross domestic product as significant contributors to the increased profitability of Islamic banks. Whereas, bank size, management efficiency, asset quality and inflation are the restraints to the Islamic banks’ profitability. Our results remain consistent after applying for alternative profitability measure and estimation technique. Key Words: IFSB, maturity transformation risk, profitability, GMM, Islamic banking 1.0 Introduction Islamic banking system is based on the principle of risk sharing (profit and loss) on both financing and deposits and posits that all transactions must involve tangible assets (Hassan & Lewis, 2009; Iqbal & Mirakhor, 2011). The guidelines of Islamic finance stem from the Shari'ah, the unique and global legislation for Muslims with the Quran, Hadith (Sunnah), Ijma (consensus) and Qiyas (deduction of juridical principles from Quran and Sunnah) as its main sources. Shari'ah compliant financing does not allow to charge riba (interest payments) - as only physical commodities and services are assumed to hold a value, gharar (uncertainty), mayser (speculation or gambling) and all such transactions that involve trade of illegitimate goods and services like weapons, drugs, etc. Though, contributing to a small share in global financial system, the superior financial performance and resilience shown by Islamic banking sector, as compared to its conventional counterpart, during the recent 2007-09 global financial crisis (GFC), has made its existence as an important player in the global financial system (Hasan & Dridi, 2011). The latest statistics estimates the managed asset value of Islamic financial institutes (IFIs) between US$ 1.816 to 2.1 trillion as at year end 2014, with the five years compound annual growth rate of around 17%, to which Islamic banks hold more than 80 percent share with a growth rate of 14%, from year 2009 to 2014 (ICD & REUTERS, 2015). Similar to their conventional counterparts, Islamic banks perform their prime role of liquidity creation by transforming relatively short-term liquid liabilities (fund deposits) to relatively long-term illiquid assets (financing). Although, such transformation offers the underlying principle for the existence of the banks, this prime role is also attributed to the intrinsic maturity transformation risk, such as mismatch of maturities in bank’s assets and liabilities (Berger & Bouwman, 2009).
2. The maturity transformation risk is highlighted as among the leading causes of GFC and has drawn substantial attention of the regulators towards the need of improved bank liquidity management practices , across the globe. To provide a revised liquidity framework, the Islamic Financial Services Board (IFSB), the standards setting body for IFIs, in unification with the Basel III new liquidity management framework, has proposed the implementation of the net stable funding ratio (NSFR) for Islamic banks. The IFSB has issued Guidance Note No. 6 for the proposed criteria to calculate the NSFR, taking into account the unique balance sheet structure of Islamic banks.1 Considering the importance of liquidity management for the growth and resilience of the Islamic banking industry, this study aims to investigate the impact of the IFSB’s proposed NSFR on financial performance of Islamic banks. Utilizing a dataset of 55 fully-fledged Islamic banks from 11 countries, between 2006 and 2015, we find empirical evidence of positive influence of NSFR on profitability of Islamic banks. Our findings remain robust after using an alternative profitability measure and utilizing an alternative estimation technique. Our work contributes to the existing empirical literature on Islamic banks’ profitability, in several ways. First, our work offers a noval perspective in understanding the impact of new liquidity regulatory requirements on bank performace. Earlier studies on profitability of Islamic banks, mainly used the accounting ratios to measure the liquidity risk, such as financing to deposit ratio (Haron, 2004), loan to total assets (Asutay & Izhar, 2007; Chowdhury & Rasid, 2015), liquid assets to total assets (Mirzaei, 2011; Rachdi & Mokni, 2014; Srairi, 2009) and liquid asset to customer and short-term funding (Ariffin, 2012). Moreover, prior studies which utilized NSFR to determine its influence on conventional banks’ profitability, mainly focused on the US and the European markets (Chiaramonte, 2015; Giordana & Schumacher, 2017; King, 2013). To the best of our knowledge, this is the first study which attempted to investigate the influence of maturity transformation risk on Islamic banks’ profitability, using the new structural measure of liquidity as proposed by IFSB. Second, we used hand-collected granular data obtained from publicly available banks’ annual reports, to calculate the NSFR, following the IFSB GN-6 guidelines. Hence, this study could be useful for regulators, practitioners and investors, who can use a similar methodology for the analysis of banks’ positioning in terms of meeting the new liquidity requirements. Third, this study attempts to provide deep insights on understanding the maturity transformation risk – profitability nexus, thus enabling Islamic banking policymakers and regulators to improve the liquidity regulatory framework and to avoid potential systematic risk in future. In addition, to the best of our knowledge, this is the pioneer study that utilizes state of the art two-step system GMM dynamic panel data technique to address the issues of heteroscedasticity, serial correlation and potential endogeneity, while investigating the impact of NSFR on Islamic banks’ profitability. The dynamic specification is important to understand the persistence magnitude of profitability as well as to account for the past effects of explanatory variables on financial performance of Islamic banks. The rest of this paper is organized as follows. Section 2 discusses the existing empirical literature on relationship between liquidity and profitability of Islamic banks. Section 3 decribes the research 1 Guidance Note 6 on quantitative measures for liquidity risk management in institutions offering Islamic financial services [excluding Islamic insurance (takāful) institutions and Islamic collective investment schemes] issued by Islamic Financial Services Board in 2015. Online: https://www.ifsb.org.
3. methodology , data and sample selection. Section 4 discusses the empirical results, followed by a series of robustness checks. Section 5 summarises and concludes. 2.0 Empirical literature on liquidity and Islamic banks’ profitability Very few studies have explicitly examined the influence of liquidity on banks’ profitability, in case of Islamic banks. Besides, the previous literature provides mixed evidence on liquidity – profitability relationship and mainly depends on liquidity measure used in the study. Haron (2004) explains the influence of various internal and external factors on profitability of 14 Islamic banks. The author finds that financing to deposit ratio, as a measure of bank liquidity, is significant in explaining the increased profitability, in the sample Islamic banks. In the similar vein, Srairi (2009) examines the influence of several factors at bank, industry and country level on the profitability of Islamic banks in GCC region. The study finds a significant negative relationship between liquidity and Islamic banks’ profitability. The author argued that the possible reason of this negative association could be the high opportunity cost associated with holding excessive liquid assets. The findings of Asutay and Izhar (2007) also reveal a significant negative relationship between liquidity and Islamic bank’s profitability. Similarly, Rachdi and Mokni (2014) analysed the factors affecting conventional and Islamic banks’ profitability in the MENA region using a sample of 15 conventional and 15 Islamic banks from 2002 to 2009. The authors employed a generalized method of moment estimation technique and found that liquidity risk and ownership status are significant and positively associated with profitability of Islamic banks, while bank capital is significant in determining conventional banks’ profitability. The results also reveal a negative management efficiency – profitability relationship, in case of Islamic banks. On the contrary, using a sample of 16 Islamic banks in Malaysia, during 2005 and 2008, Wasiuzzaman and Tarmizi (2010) find a significant and positive influence of liquidity and management efficiency on Islamic banks’ profitability. Whereas, bank capital and asset quality are negatively associated with the profitability. Besides, Islamic banks’ profitability is positively influenced by the gross domestic product and inflation, during the study period. Whereas, the study of Idris et al. (2011) could not find any significant relationship between liquidity and profitability in 9 Malaysian Islamic banks, during a period from 2007 to 2009. More recently, Chowdhury and Rasid (2015) employed ordinary least squares method using 2013 annual data of 44 Islamic banks from Asian and African region. The results also find no empirical evidence of association between liquidity and profitability in sample Islamic banks. Additionally, the study of Mirzaei (2011) finds a mixed empirical evidence on the influence of liquidity on Islamic banks’ profitability. Using an unbalanced dataset of 175 Islamic and conventional banks from 12 Middle Eastern countries from 1999 to 2008, the authors find that liquid assets ratio is significantly and negatively associated the return on assets of Islamic banks, whereas return on equity of Islamic banks shows significant improvement with the increase in liquid assets. Based on the literature discussed previously, the findings concerning maturity transformation risk and banks’ profitability are mixed. For example, Srairi (2009) and Rachdi and Mokni (2014) among others reveal a negative and significant relationship between liquidity and Islamic banks’ profitability. In contrast, Haron (2004) and Wasiuzzaman and Tarmizi (2010) reveal the significant positive relationship between liquidity and profitability of Islamic banks. Besides, studies of Idris et al. (2011) and Chowdhury and Rasid (2015) could not find any empirical evidence of bank liquidity – profitability relationship. Moreover, to the best of our knowledge, there is no study till date, which has examined the influence of IFSB’s new liquidity measure (NSFR) on Islamic banks’ profitability. Therefore, we can
4. conclude that the impact of banks’ liquidity transformation function on financial performance remains ambiguous and further research is required. 2.1 Measuring the Net Stable Funding Ratio The IFSB, while endorsing the Basel III new liquidity management framework, has issued the GN- 6 for the proposed criteria to calculate the NSFR, taking into account the distinctive nature of assets and liabilities of Islamic banks. Similar to the Basel III liquidity framework, the NSFR requirements under IFSB’s guidelines is the ratio of available amount of stable funding (ASF) to the required amount of stable funding (RSF). However, the computation of ASF and RSF is different because of the unique characteristics of Islamic banks’ balance sheet components. The net stable funding ratio is calculated as: