Risk Management in Islamic Banking

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Aceh International Journal of Social Sciences, 1 (2): 68-75 August 2012 ISSN: 2088-9976

RESEARCH PAPER

Liquidity Risk Management And Financial Performance In Malaysia: Empirical Evidence From Islamic Banks Noraini Mohd Ariffin
Assistant Professor at the Department of Accounting, Kulliyyah of Economics and Management Sciences, International Islamic University Malaysia. The author would like to thank Associate Professor Dr. Salina Kassim from International Islamic University Malaysia for giving valuable comments in completing the paper.

Abstract - Liquidity risk arises from maturity mismatches where liabilities have a shorter tenor than assets. A sudden rise in the borrowers‟ demands above the expected level can lead to shortages of cash or liquid marketable assets (Oldfield and Santamero, 1997). This paper aims to analyse the liquidity risks and disclosure as well as to draw the relationship between liquidity risks and financial performance measures using return on assets (ROA) and return of equity (ROE) of the Islamic banks. Based on selected Islamic banks in Malaysia over the period from 2006 to 2008, the study also attempts to determine the impact of the global financial crisis on the Islamic banks‟ liquidity risks and financial performance. Findings of the study contribute towards enriching the literature on the risk management of the Islamic banks by providing deeper understanding on issues relating to liquidity risk management by the Islamic banks. Keywords: Liquidity risk, Islamic banks, risk management, financial performance

Introduction

Managing liquidity is one of the top priorities of a financial institution‟s assets and liabilities management. In the context of banking, liquidity, or the ability to fund increases in assets and meet obligations as they come due, is critical to the ongoing viability of the banking institution. Since there is a close association between liquidity and solvency of banks, sound liquidity management reduces the probability of banks becoming insolvent, thus reducing the possibilities of bankruptcies and bank runs. Ultimately, prudent liquidity management as part of the overall risk management of the banking institutions ensures a healthy and stable banking sector. Liquidity management is just as important to the Islamic banks as it is to the conventional banks. However, compared to the conventional counterpart, liquidity management for the Islamic banks is unique and even more challenging due to the fact that most of the existing instruments used for liquidity management are interest-based, therefore, not Shari’ah (Islamic law) compatible. In addition, rationality of bank customers in the conventional sense in which profit motive prevails in any economic transaction could result in liquidity withrawal from the Islamic banks when return in the conventional counterpart is higher (Kassim et al., 2009). The Islamic banks might also experience severe liquidity mismatch when the market interest rate changes due to the changing economic environment. For example, in a high interest rate environment, the Islamic banks experience severe liquidity mismatch when assets (financing) tend to be more attractive relative to the conventional banks‟ loans, while Islamic banks‟ deposit is relatively less attractive compared to the conventional banks‟ deposits. In managing liquidty, the Islamic banks dealings are restricted in the Islamic inter-bank market due to the requirement to avoid the interest-bearing instruments. Traditionally, many Islamic banks rely heavily on commodity murabaha (mark-up basis) based on tawarruq for short term investment and liquidity management. As increasing number of Shari’ah scholars are against the adoption of this arrangement since it is considered as a grey area, several new Shari’ah-compatible instruments have been introduced for liquidity management. Among others, several applications of the sukuk structure has been adopted in which the Islamic bank would...
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