Panel Data Estimation of Liquidity Risk Determinants in Islamic Banks: A Case Study of Pakistan

By Salman Ahmed Shaikh

Abstract

The two most important problems identified in a post-financial crisis look back are perverse incentives and de-linking of financial sector growth and activities with the real sector of the economy. These problems are inherently avoided by Islamic banks. In this study, we take 7 year data from 2007 to 2013 for all 5 full-fledged Islamic banks in Pakistan. We attempt to empirically explore the determinants of liquidity risk in Islamic banks. As per the findings, deposits to total capital ratio increases the liquidity risk. It is plausible since greater deposit mobilization implies greater liabilities of banks. The increase in this ratio implies that a greater portion of funds with banks are in the form of deposit liabilities as compared to own capital. We also find that increase in capital to financing ratio decreases the liquidity risk which is again consistent with a priori expectations. The results further highlight that improvement in efficiency also reduces the liquidity risk by freeing tied up resources. Finally, the increase in spread increases liquidity risk since there is a tradeoff between increasing spread and credit risk. Higher spreads improve profitability, but they narrow the scale of operations due to which finance to deposit ratio decreases. For Islamic banks, it is true that finance to deposit ratio and spread move in opposite directions.