What affects the liquidity position of Islamic banks?

This article was originally published in Islamic Finance News (IFN).

Maturity transformation is the primary business of banks and which by definition is the conversion of a bank’s short-term liabilities into longer-term investments through loans and advances. The very nature of a bank’s business model requires them to hold a mix of liquid liabilities with illiquid assets.

While the primary target of banks is to strive for profitability by optimal utilization of available funds, they also have to maintain an adequate amount of liquidity to stay afloat and deal with any unforeseen liquidity demands.

There are certain fundamentals that affect the liquidity of Islamic banks. They lack sufficient money market instruments that can be easily traded and converted to pay off any near-term obligations immediately, unlike conventional banks, which can easily swap long-term securities for liquid assets in the secondary market.

Unanticipated withdrawal requests by depositors also affect a bank’s liquidity position. The risk of rapid and unanticipated withdrawals by customers resulting in a bank run may also leave a bank exposed to liquidity risk.

In many countries worldwide, there are still no formalized mechanisms in place that provide lender of last resort facilities to Islamic banks.

These facilities are typically provided in the form of interest-bearing loans which do not comply with Shariah rules that govern the institutions that offer Islamic financial services unlike conventional banks.

Liquidity entails a cost and therefore will impact profitability. In other words, higher liquidity will mean lower profitability

As Islamic securities are usually less liquid and since Islamic banks do not have the backing of the central bank to bail them out through lender of last resort facilities, it becomes particularly crucial for Islamic banks to actively readjust their liquidity positions as and when there is a mismatch in maturity in financial intermediation in order to avoid any liquidity risk.

Although the IFSB is currently considering lender of last resort facilities, they have yet to materialize.

Liquidity entails a cost and therefore will impact profitability. In other words, higher liquidity will mean lower profitability.

While the excess liquidity lowers the profitability of Islamic banks, the lack of liquidity may cause banks to struggle in times of crisis and hence the need for a delicate balance.

In addition, a bank’s liquidity position may also depend on regulatory changes by the governing body, the financing structure and the bank’s credit standing and reputation.