Liquidity Transformation Factors of Islamic Banks: An Empirical Analysis Mahir Alman* Bamberg University e-mail: [email protected] Andreas Oehler Chair of Finance, Bamberg University Department of Management, Business Administration and Economics Kirschaeckerstr. 39, D-96045 Bamberg Tel.: (+49) 951-863-2536, Fax: (+49) 951-863-2538 e-mail: [email protected] This Version: November 2010 Abstract Islamic banks face restrictions in refinancing due to the guidelines of the Shari´ah prohibiting financial contracts and transactions based on interest, gambling and speculation as same as due to the lack of liquidity sources such as an interbank market, a lender of last resort or an asset market. This is the first study with empirical cross-country results focusing on liquidity transformation of Islamic banks. Over the period from 2000 to 2007, we analyze the influence of specific financial system and institutional characteristics of Islamic banks on liquidity transformation. We include bank data from Gulf Cooperation Countries (GCC), Southeast Asia and further Brunei, Egypt and Turkey. Our results reveal that the liquidity transformation of Islamic banks is highly negatively determined by especially bank risk-taking and interbank demand compared with a control group of (interest-based) banks which conduct their business according to Western industrial countries. Key Words: Islamic Banking, Liquidity Transformation, Bank Risk, Interbank Market JEL classification: G21, G32, E51 * Contact author We thank Daniel Kohlert, Henrik Schalkowksi and Stefan Wendt for helpful comments and the support of Bureau van Djik Electronic Publishing (Bankscope) for providing us the reports on banks. We are grateful to Sylvia Eichhorn, Jan Christoph Gertenbach, Lisa-Marie Müller, Manuel Steigerwald for technical support. Liquidity Transformation Factors of Islamic Banks: An Empirical Analysis Islamic banks face restrictions in refinancing due to the guidelines of the Shari´ah prohibiting financial contracts and transactions based on interest, gambling and speculation as same as due to the lack of liquidity sources such as an interbank market, a lender of last resort or an asset market. This is the first study with empirical cross-country results focusing on liquidity transformation of Islamic banks. Over the period from 2000 to 2007, we analyze the influence of specific financial system and institutional characteristics of Islamic banks on liquidity transformation. We include bank data from Gulf Cooperation Countries (GCC), Southeast Asia and further Brunei, Egypt and Turkey. Our results reveal that the liquidity transformation of Islamic banks is highly negatively determined by especially bank risk-taking and interbank demand compared with a control group of (interest-based) banks which conduct their business according to Western industrial countries. Key Words: Islamic Banking, Liquidity Transformation, Bank Risk, Interbank Market 1 Introduction Islamic banking is one of the new trends of the international financial sector with double- digit growth rates since 2003/2004. In the four decades of its existence and with its geographical dispersion beyond the borders of the Islamic world, the estimated managed asset value has reached at least US$500 billion at the end of 2008 according to Booz & Company (see Vayanos et al., 2008) and IFSL research (2010). Due to the current financial crisis, Islamic Finance has reached a higher degree of attention in several aspects such as in questions of regulation or complementarities towards the Western financial system (Western in the following). The guidelines of Islamic finance stem from the Shari´ah, the unique and global legislation for Muslims with the Quran, Hadith (Sunna), Ijma and Qiyas as its four main sources. The Shari´ah prohibits interest, gambling and speculation in terms of riba, gharar and maysir for all contracts and transactions. Further fundamental principles of the Shari´ah are profit and loss sharing and real assets as basis of financial contracts. The involvement of assets in branches like defense or entertainment industry or in companies that do not fulfill additional capital structure criteria are also forbidden (see for the list of negative and financial screens Table 1 in the appendix, see also Quran: 2:275-2:280, Lewis and Algaoud 2001, Usmani 2002, Henry and Wilson 2004, Jaffer 2004, Mirakhor and Iqbal 2007). The management of liquidity risk is actually one of the most important challenges for Islamic banks because it prohibits the use of interest-based instruments. There are only limited possibilities to refinance with an interbank money market, for instance a lender of last resort or with an asset market. Under these conditions they have no comprehensive possibilities to do in particular term and risk transformations as two of the main functions of a financial intermediary (see Bitz 2005, Oehler 2006). These intermediary functions also implicate liquidity 2 transformation (for distinguishing between them, see Bhattacharya et al. 1998, Berger and Bouwman 2009). Pioneering steps to solve the liquidity management restrictions of Islamic banks by including a money and capital market in conformity with the Shari´ah have been done in Bahrain, Malaysia and Saudi Arabia. However, the Islamic financial sector will need proceeding innovations on the product portfolio level, on the institutional level and in regulations to solve the restrictions in the refinancing of banks. Although profit and loss sharing is a main principle of the Shari´ah, short-term fixed- income contracts typically dominate the product portfolio of Islamic banks. Its share can exceed 80% of the whole product portfolio on the asset side, thus the portfolio exhibits a low- diversification and low-risk structure. This is mainly because most Islamic banks intermediate in countries with relatively weak legal, institutional and financial environment. It usually leads to high degrees of asymmetric information and opportunistic behavior (moral hazard, hidden action) of market participants as well as to liquidity constraints and higher costs of capital for financial intermediaries resulting also from market segmentation (see Aggarwal and Yousef 2000, Chong and Liu 2007, Akacem 2008, Visser 2009, Al-Hassan et al. 2010, Hearn et al. 2010, Choudhury and Hoque 2006). As a consequence, the preference of Islamic banks is a rational and optimal reaction, even more to the alternative of equity financing contracts in a dual financial system with possible adverse selection between both. But the mark-up instruments used in practice are seen critically by Shari´ah scholars and economists because they are close to interest-based instruments and therefore there is no difference from the functional perspective (see Khan and Ahmed 2001, El-Gamal 2002, Rosly 2005, Sundararajan 2007, Chapra 2007, Cihak and Hesse 2008). Typically, in earlier studies and in our sample, Islamic banks have significantly higher equity ratios on the average (see in the appendix Table 6 and 7). Thus, the higher equity ratio is a response to limited refinancing sources, which then builds an additional capital buffer against 3 defaults. The restrictions in refinancing, the conservative credit policy and the higher holdings of equity capital create an interesting environment for research, especially to their liquidity creation function. The purpose of this paper is to study the influence of restrictions concerning to financial instruments in conformity with the Shari´ah, refinancing sources and macroeconomic environment on liquidity transformation of Islamic banks. Our hypothesis is that Islamic banks face a negative relationship between leverage, bank risk-taking in the loan portfolio and interbank demand on the one hand and the amount of liquidity transformation on the other. Given this, the specific financial and business characteristics of an Islamic bank hinder them from undertaking an optimal functioning of liquidity transformation. For robustness and comparability we apply the model also to a control group of Western banks. Although there have been prior studies that examined the Islamic interbank money market and the particular risk management requirements of Islamic banks, most of them are based on theoretical or on empirical analyses which are restricted to one country or which have a descriptive character (see Iqbal and Molyneux 2005, Khan and Ahmed 2001, Obiyathulla 2008, Rosly 2005, Brown et al. 2007). Our study attempts to fill this gap in the empirical literature on Islamic banking. To our knowledge, it is the first cross-country empirical analysis that focuses on the restricted refinancing sources and its influence on liquidity transformation of Islamic banks. We analyze the liquidity transformation determinants referring particularly to the financial ratios of bank risk, leverage and interbank demand from 2000 to 2007. Our dataset comprises 36 Islamic banks and it covers about 50 percent of the total Islamic banking assets in the world as of 2007. 4 Our results provide significant evidence for our hypothesis. Liquidity transformation is negatively determined by the special characteristics of an Islamic bank referring to solvency, bank risk and interbank demand. Further, we observe that Islamic banks’ liquidity creation increases in size. Finally, we find evidence that increasing diversification in product portfolio of an Islamic bank with a higher share of more risky lending leads to a lower amount of liquidity transformation. The remainder of the paper is organized as follows: Section 2 presents the review of the related literature on liquidity transformation function and liquidity risk of banks and how this study extends the existing work. In Section 3, we describe our dataset and methodology and discuss our results. Section 4 concludes our paper. 2 Related Literature In the framework of risk and term transformations of financial intermediaries, the latter undertake especially the tasks of liquidity creation and insurance for inter-temporal smoothing of income and consumption of economic agents. The insurance function of financial intermediaries against liquidity shocks as an explanation for their existence takes place through liquidity pooling of deposits in which there is a part as liquidity reserves and the rest is used for profitable illiquid investments (see e.g. Bryant 1980, Diamond and Dybvig 1983, Bhattacharya and Thakor 1993, Diamond and Rajan 2001, Kashyap et al. 2002). Liquidity risk can occur on the liability side and on the asset side of banks and it has an exceptional position in the regulation of banks. While the risk types of default, price and operation have to be securitized with minimum equity capital, liquidity risk underlies limited requirements. The external sources of liquidity transfers are the interbank money market, the asset market and typically the central bank’s role of a lender of last 5 resort. In the literature there are numerous studies referring to the liquidity creation role of banks and the determinants of this function. Our paper is related to the large literature on the role of interbank markets and its influence on stability, regulation and on the incentive of banks to hold liquid assets (see among others Bhattacharya and Gale 1987, Goodfriend and King 1988, Allen and Gale 2004, Acharya et al. 2008a, Allen et al. 2009, Brunetti et al. 2009, Cai and Thakor 2009, Diamond and Rajan 2009, Freixas et al. 2009,). This paper is also related to the synergies between liquidity transformation and risk which can be influenced on the individual bank level by the diversification and structure of their product portfolios (see Diamond 1996, Acharya et al. 2006, Behr et al. 2007, Lepetit et al. 2008), by size or by capital structure (see Boyd and Runkle 1993, Diamond and Rajan 2000, Koziol and Lawrenz 2009) and on the macroeconomic level by the development and structure of financial sector institutions and refinancing sources (see Cole et al. 2008, Dinger and Von Hagen 2009). Rochet and Tirole (1996) argue that an interbank market can make a contribution to bank regulation and supervision and also to market discipline and reduced systemic risk by creating incentives of peer monitoring by the interbank-lending banks. The market disciplining function of an interbank market depends on the assumption that banks have additional private information on risks of other banks. Likewise, it assumes that banks are responsible for their losses in interbank transactions and receive no intervention of a central bank. This will happen usually, and has to be clearly declared to the interbank participants. Dinger and Von Hagen (2009) can confirm this hypothesis empirically for a sample of Central and Eastern European countries with a focus on small banks whose interbank lending is characterized by longer maturities. Further researches justify however the central bank intervention by asymmetric information, monopoly power and moral hazard which lead to an incomplete interbank market (see Holmstrom and Tirole 1998, Gorton and Huang 2004/2006). 6 On the individual bank level there are different strands of the literature about optimal organization forms of banks. Traditional banking theory predicts infinite diversification benefits which are based on a delegated monitoring argument (for this theoretical argument see Diamond 1984, Boyd and Prescott 1986). Diversification benefits and therefore risk reduction for banks are supported by few studies on product portfolio level (interest and non-interest income) and on the level of asset-side and liability-side (see Kashyap et al. 2002, Gatev et al. 2005). However, the model of Diamond (1984) disregards agency problems that cause higher costs of monitoring with growing diversification and size. Thus, another strand of literature finds contrary results to the delegated monitoring argument. These find no diversification benefits and even diseconomies with increasing risk on the product portfolio level as well as on the level of the bank’s asset portfolio (industrial and sectoral exposure) (see Hellwig 1998, DeYoung and Roland 2001, Stiroh 2004, Acharya et al. 2006). As a result, specialization outweighs the benefits of risk sharing in the sense of higher returns but these potentially exhibit higher volatility. Empirical evidence based on measurement constructions of bank liquidity transformation can be found especially in two studies. First, Deep and Schaefer (2004) approximates liquidity creation as the scaled difference between liquid liabilities and assets. They ran a panel regression analysis on data of the 200 largest US banks in the ranking of total assets from 1997 to 2001. Yielding an unexpected low liquidity transformation of only about 20%, the function is explained rather with deposit insurance than with credit risk in loan portfolios. Second, a different and more generalized approach in the measurement construction of bank liquidity creation and in the application of data is done by Berger and Bouwman (2009). They differentiated between four measures in their classification of loans by category rather than maturity. In the panel regression analysis the authors included almost all US banks in business from 1993 to 2003 and found dependence of bank capital and liquidity creation differing for small, middle and large size 7 intermediaries based on total assets. One of the main results of this study is the positive relationship between capital and liquidity creation for large banks while it is negative for small banks. Our study further explores the existing studies at least in the following aspects. First, the liquidity transformation determinants are studied for Islamic banks which do not operate under comparable conditions on the financial system level, institutional level and product portfolio level. Within this framework we have the possibility to analyze banks in a developing Islamic financial system environment, wherein banks are mainly deposit-financed and practice a conservative strategy towards their leverage position and in their loan portfolio. Second, while most of the empirical studies related to this research field focus on US or European data, our study focuses on a cross-country sample of banks based in Middle East and Southeast Asia. 3 Empirical Analysis 3.1 Dataset Our empirical analysis is based on a sample consisting of an unbalanced panel of annual and unconsolidated report data of Islamic banks between 2000 to 2007. The inclusion of annual accounting data is necessary since (x type of) data is frequently not available. The choice of this time period has the advantage that it covers a cyclical downturn and upturn in world economics and that Islamic banking experienced the strongest growth with annual rates of 20% on the average. Another important fact is that the restriction to this time period is due to data availability. The source of the bank data used for the empirical estimates is from Bankscope.1 In 1Bankscope, Bureau van Dijk Electronic Publishing is a comprehensive and global database containing financial information on public and private banks. It is supplied by Bureau van Djik and is usually used in the academic research of banks. 8 our analysis we only include Islamic banks of states that operate in a dual financial system where the Islamic financial system and the financial system of Western industrial countries exist in parallel. A further characteristic of the dataset is that every bank is represented with annual reports of at least 2 years over this period. Furthermore, we limit our analysis to banks which are full-fledged Islamic banks, thus Western (interest-based) financial institutions with separate Islamic departments as so-called Islamic windows are excluded. A further criterion to data choice is that the banks are based in countries where Muslims form the majority of the population. Finally, for comparability under similar development conditions we restrict to Islamic banks from high-income or upper-middle-income economies according to the classification of the World Bank and from countries with the highest amount of Shari´ah compliant assets. The total sample which fulfills these criteria consists of 36 Banks from 10 countries. Please insert Table 2 and 3 about here. As Table 2 illustrates, 28 banks are from the region of the Gulf Cooperation Council2 (GCC) and the remaining ones are from Brunei, Egypt, Indonesia, Malaysia and Turkey. Hence, the data set is focused on the Persian Gulf states of the GCC with a concentration of total assets of about 82 % in 2007. This focus on the GCC states represents also their high market position in the share of managed asset values by Islamic banks in the world which is about 60%. To distinguish between large and small banks we used Bankscope’s criterion, which is also used widely in the literature (see e.g. Dinger and Von Hagen 2009, Lepetit et al. 2008). Therefore the sample contains 22 Islamic banks with total assets greater than US$ 1 billion on the average over the period 2000-2007 in which 16 of them are from countries of the GCC (see Table 3 for the size 2 The Gulf Cooperation Council (GCC) consists of Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates. It was founded 1981 in Abu Dhabi to cooperate in several fields as in economy, politics and culture. 9