Liquidity risk management: A comparative study

between conventional and Islamic banks of

Pakistan

ABSTRACT

We conduct this study to see how islamic and conventional banks managing
their liquidity position. For this purpose we used secondary data of banks and
collected from annual reports for the year 2007-2017.We applied statistical
tools like descriptive statistics, correlation matrices, regression and robustness
for islamic and conventional banks. Findings showed

KEY WORDS:

Islamic Banks, Conventional banks, Liquidity risk Pakistan

INTRODUCTION:
The issue of liquidity management is concerned with all financial institutions either Islamic or
conventional. Liquidity management is a critical but complex issue in Islamic financial system as
well as conventional financial system. Lack of attention on this issue leads to many serious
consequences such as collapse of financial institutions and the stability of financial systems.
Most banks fail due to their liquidity problems. Regulatory authorities are very much concerned
with liquidity position of banks and financial institutions. Currently authorities are thinking how
to strengthen the liquidity management (Majid, 2003). Both financial systems have their own
instruments for liquidity management.

Islamic banks start functioning in 1970’s. After 1970 Islamic bank start growing all around the
globe including Pakistan.

Banks are important for businesses, as they provide financial aid, either its. Risk is an important
element for banks also but the most important risk is liquidity risk. Here in our paper we will talk
about this (liquidity risk).

So, what is liquidity? Liquidity is the strength of a firm to pay short-term liabilities, or
availability of cash or liquid asset to pay its liabilities. Liquidity is basically presence of liquid
asset to market or a company. liquidity is where a company can buy or sold its asset and security
without effecting asset price. Liquidity is the firm’s ability to pay short-term liabilities. It also
means availability of cash or liquid assets for paying firm’s short-term liabilities.

Islamic banks cannot book liabilities. But it is very important for banks to monitor its liquidity
position carefully and for islamic banks with their unique operations and under sharia principles
(Ray, 1995) and the main hurdle to the growth of Islamic banks (Vogel & Hayes, 1998).

Basic difference between islamic and conventional banks

Fundamentals:
fundamental difference is islamic banks work under the islamic principles where
conventional bank doesn’t work under the islamic principles.

Main purpose
Main purpose of C.B is to earn profit and earning profit is also IB primary function but the
condition is under shariah law.

Relationship between the depositor and bank

 Your relationship with the conventional bank is creditor or debtor.it is banks responsibility
to pay your money back with or without interest according to the contract where as to
perceive the link between islamic bank and the customer you need to follow the agreement.

Basis of transaction:
When you make investment in conventional bank your fixed return is secured according to
the agreement but in islamic bank profit or return is not assured.
Modes of financing
Modes of financing of both banks are different, like islamic banks use musharka,
Mudarabah

Money is a commodity
Commercial banks use money as a commodity so it but islamic banks use money as a
interchange.

Extra Charges:
Conventional banks charge extra payment on late repayments and delayed payments,
whereas Islamic banks cannot charge extra

It is essential to classify the factors which cause the liquidity situation of the banking
institutions with respect to Pakistan. This paper is an attempt to analyze the factors
in both Islamic and conventional banks.

Objective of study

In this study is to determine how liquidity risk is associated with the financial
institution, with a purpose to apraise liquidity risk management (LRM) through a
relative scrutiny between conventional and Islamic banks of Pakistan.

The elemental objective of the study is to compare the liquidity risk of the Islamic
and the conventional banks in Pakistan. The difference between the liquidity risk in
Islamic and conventional banking is also the study uses the secondary data and the
aspects influencing the liquidity risk of banking sector are used in the hypothesis,
tested empirically, by find the descriptive, correlation regression analysis and
robustness test on the data more over the ratio analysis of the name means of the
data. Lastly, the conclusion and suggetions and restraints of the research study are
given. Any conventional and Islamic banks advised to monitor and maintain its
liquidity position adequately and gradually. In this study, we will try to focus
whether any significant differences exist in managing liquidity position of Islamic
and conventional Bank.

This paper investigates the significance of Size of the firm, net working capital,
return on equity, capital adequacu and leverage ratio as the variables determining
the liquidity risk management for both conventional and Islamic banks in Pakistan.

LITERATURE REVIEW:

Extensive studies ae carried out to compare the liquidity risk in Islamic and
conventional banks. Modigliani and Pogue (1974) proposed two measures of risk;
relative measure which is denoted by beta and measure of total risk that is denoted
by standard deviation. Depending on monthly return rate between 1945 to 1970
they proven beta measure more significant for securities pricing and for great
portfolios. Capital ratios were found to be worthless to limit banks insolvency risk.

Kim and Santomero (1988) Regulatory authorities have much concerned with the
liquidity position of banks and other financial institutions. Recently they are
focusing on how to strengthen liquidity Management (Majid 2003) Ghannadian
and Goswami (2004) observed the performance of an Islamic banks and how
Islamic banking scheme can offer liquidity and support in the process of money
creation from side to side contribution transactions accounts and found that in all
developing economies investing funds on basis of profits and losses is an attractive
choice for the banks.
Gabbi (2004) highlighted about the dependence of risks on organization’s place in
the market. The study explained that liquidity risk can be controlled in the course
of practices that are severely connected to the scale and scope of financial
measures, seeing as large banks are capable both to manage additional market
information and to influence monetary policy functions.
Franck and Krausz (2007) examined the liquidity risk in Israel and the results
proposed that for banks liquidity in comparison to lender final option, securities
markets deal more.Anas and Mounira (2008) endorses that risk management
practices should be strenghthen by Islamic Banks and for risk hedging they can
trade Sukuks and Takaful. Isshaq and Bokpin (2009) observed the factors of
corporate liquidity management of listed companies of Ghana Stock Exchange.
The study covered the period of 1991-2007. Panel model was used to inspect the
relationship. The results showed that firms size, networking capital, return on
assets and target liquidity level are important factors of liquidity management of
Ghana’s listed firms.

Hassan (2009) declared that there are 3 types of risk faced by the Islamic banks in
Brunei Darus Salam. These include credit risk, foreign-exchange rate risk, and
operating risk.This study found capital adequacy ratio to be positive and
statistically significant in conventional banks.
Ojo (2010) explained the value of capital adequacy ratio as defined in the Basel II
accord as a measure to reduce risk.
Ahmed et al (2011) studied Islamic banks of Pakistan. A sample of 6 banks were
taken and the time period used was from 2006 to 2009.The source for data
collection was secondary source. The results of the study showed that bank size is
directly associated with liquidity and credit risk. The capital adequacy has a
negative and significant relationship with credit and operational risk, while it is
positively related to liquidity risk.
Ika and Abdullah (2011) compared Indonesia’s Islamic and conventional banks
from 2000 to 2007 and measured profitability credit abilities and liquidity. To
measure the liquidity of the banks financial ratio analysis is used. To test they
pothesis Mann-Whitney model is used and it was concluded that Islamic banks
have more liquidity than conventional banks.

RESEARCH METHODOLOGY
Sample & Data Collection

In this research we have taken 10 number of banks whereas 5 conventional and 5 were Islamic.
The banks were selected not only on the basis of availability of data but also based on their sizes.
In this study we will consider mid-size banks for both conventional and Islamic. Data were
collected from the bank’s annual reports over the period 2007-2011. This paper fully depends on
secondary data. Financial data from these annual reports.
Variables

Here, we have taken Liquidity Risk as our dependent variable. The list of Banks both
Islamic and conventional which we have taken in our study were mentioned below with
their proxies and variables.
 capital
adequacy

return on Leverage
equity ratio

liquidity risk
management

Net-
Capital
working
ratio
capital

Size of the
firm

VARIABLES AND THEIR PROXIES

Symbol Variables Proxies

Liquidity Risk Cash to Total Assets
Size of the Bank Logarithm of total assets
Net working Capital Current asset less current liabilities
Return on Equity Net income/ total equity
Capital Adequacy Ratio (Tier 1 capital + Tier 2 capital) / risk weighted
asset
Leverage ratio Debt / Equity
Error term

Symbol Variables FORMATION

Liquidity Risk Ln (Liquidity Risk)
Size of the Bank Ln (Size of the Bank)
Net working Capital Ln (Net working Capital)
Return on Equity Ln (Return on Equity)
Capital Adequacy Ratio Ln (Capital Adequacy Ratio)
Leverage ratio Ln (Leverage ratio)
Error term

Liquidity risk is the dependent variable of this study whereas Size of the Bank (size), Net
Working Capital (NWC), Return on Equity (ROE), Capital Adequacy Ratio (CAR), and
Return on Assets (ROA) are the independent variables.
Liquidity Risk
Liquidity risk is the risk that a company or bank may be unable to meet
short term financial demands. This usually occurs due to the inability to convert a
security or hard asset to cash without a loss of capital and or income in the process.
Size of the Bank
This ratio shows the holdings of assets by banks. High asset ownership enables banks to
offer more financial services at low cost
Net working Capital

It is to determine a company’s liquidity and its competence to meet short-term liability,

as well as fund operations of the business. For banks optimal position is to retain more
current assets than current liabilities, and hence to have a positive net working capital
balance.
Return on Equity
Return on equity is one of the most typical metrics used by significant analysis and
integral investors when looking for opportunities.
Capital Adequacy Ratio

Capital Adequacy Ratio (CAR) is likewise normal as Capital to Risk (Weighted) Assets Ratio
(CAR), is the proportion of a bank's money to its risk. National controllers track a bank's CAR to
guarantee that it can retain a sensible amount of loss and agrees to statutory Capital prerequisites
It is a measure of a bank's capital. It is communicated as a level of a bank's risk weighted credit
exposures. The requirement of managed levels of this proportion is expected to ensure
contributors and advance solidness and productivity of monetary frameworks around the globe.

Leverage ratio

A leverage ratio is any of a few budgetary estimations that measures how much capital comes as
an obligation (credits) or evaluates the capacity of an organization to meet its financial
commitments. The leverage ratio is imperative given that organizations depend on a blend of
value and obligation to back their activities and knowing the measure of obligation held by an
organization is helpful in assessing whether it can pay its obligations astoundingly due.

Research Model Hypothesis:

Firstly, research started to check or to find out that how liquidity risk is depending on other
variables. For that purpose we use linear regression model. Linear regression model was already
implement by Akhter & Sadaqat in 2011.

MODEL
The linear regression will be run separately for Islamic and conventional banks.
Therefore, the hypotheses that need to be tested are as follows:
Liquidity risk=B0 + B1CAR + B2size+B3ROA + B4ROE+ B5NETWORKING
CAPITAL +B6CAPITAL RATIO

H0: There is significance relationship between liquidity risk and Net-working capital,
Capital Ratio return on equity, capital adequacy ratio, return on asset, size of bank

H1: There is significance relationship between liquidity risk and Net-working capital,
Capital Ratio return on equity, capital adequacy ratio, return on asset, size of bank

Procedure for Data Analysis

Different financial tools and techniques namely maximum, minimum, mean, standard deviation,
coefficient of variation, Pearson’s correlation, multiple regression etc. have been used here to
analyze the collected data and make the comparison. Using regression analysis findings are
presented based on types of banks.

Theoretical background

In such economic condition liquidity problem can occur in banks due to

mismanagement of funds or withdrawals of funds by the depositors. The global
financial 2007-2008 arise due to liquidity. It very challenging for banks for banks to
maintain liquidity in such competitive economic situation. Banks work as a arbitrator
between business and the stakeholders to run business successfully and they also
manage supply and demand of liquidity. Liquidity management enhances
complexity in Islamic banks as compare to conventional banks and the reason is
Islamic banks cannot invest in real asset. (Iqbal & Mirakhor, 2007).

RESULTS AND INTERPRETATION:

SUMMARY STATISTICS:

The descriptive analysis below shows the maximum, minimum, Range, mean,
standard deviation values of conventional and Islamic banks.
From the above Table we can identify different variables such as the minimum value
of conventional bank’s ROE is less than that of Islamic banks but
LIQRISK,LEVRATIO,NWCAP,SIZE and CAR is greater than that of Islamic
banks. Maximum value of NWCAP,ROE and Size are also greater than Islamic
banks. Standard deviation of Islamic banks’ in all variables except CAR less than
conventional banks.

COEFFICIENTS:
ROBUSTNESS:
ROBUSTNESS:
CONCLUSION:
List of Banks

SR no Islamic Banks SR NO Conventional Banks

1 Bank Islami 1 Allied Bank

2 Soneri Bank 2 AlFalah Bank

3 Meezan Bank 3 Faysal Bank

4 Bank Al Baraka 4 Askari Bank

5 Dubai Islamic Bank 5 National Bank