Liquidity Creation and Liquidity Risk Exposures in the Banking Sector:
A Comparative Exploration between Islamic, Conventional and Hybrid Banks in the Gulf Corporation Council Region

Abstract

Banks as intermediary institutions raise funds by offering deposits and invest them in assets, by means of which they transform the maturities of their positions on the balance sheet. Such a function enables the banks to channel available liquidity into investments whereby they contribute to economic growth. In other words, when banks use their liquid liabilities to finance illiquid assets, they consequently create liquidity and hence promote productive investments that boost the economy. However, as a result of such a function, banks may face the risk of illiquidity that may cause an early liquidation of productive business activities, which in turn may lead to a disruption to the economy.
Given the importance of the liquidity transformation function of banks, this research examines the ability of Islamic banks in creating liquidity in a comparative manner with conventional and hybrid banks in the Gulf Corporation Council (GCC) countries. In doing so, this study also explores the key determinants of such a function in the identified bank types. This study, furthermore, assesses the liquidity risk that Islamic banks are exposed to in comparison with conventional and hybrid banks and investigates the significant factors that may affect such exposures in the case of the GCC region. In conducting the empirical study, this research examined 58 GCC commercial banks during the period between 1992 and 2011 through developing two empirical models through panel data regressions with a fixed effects model in relation to the identified aims.
In the first empirical model, the results demonstrate that Islamic banks create higher levels of liquidity than conventional and hybrid banks in the examined sample. The results also show that officially supervisory power, stringency on capital regulations and banking activity restrictions negatively and significantly determine the liquidity creation of the examined banks. The empirical results also detect a positive and significant impact of restrictions on the banking market entry standards on liquidity creation. In addition, while this study found that credit risk has a negative and significant impact on liquidity creation, the results show a positive and significant association between liquidity creation and bank size. This study also finds insignificant positive association between GDP and liquidity creation of the examined GCC banks.
In the second model in this study, further statistical and empirical evidence demonstrates that Islamic banks are more exposed to liquidity risk than conventional and hybrid banks in the case of the examined sample of the GCC region. In addition, the results show that the stringency on capital regulations, credit risk, banks size and GDP has a negative and significant impact on liquidity risk. Moreover, the results detect that liquid assets and long- term debts are positively associated with liquidity risk exposures. While the empirical results show that the liquid assets significantly affect liquidity risk, the results detect an insignificant impact of long-term debt on the liquidity risk exposures of the examined banks in the GCC region.
Accordingly, it can be stated that the empirical results of this study, consistently with the conceptual framework of Islamic financial principles as well as with previous studies, stress the importance of exploring the liquidity creation and liquidity risk in promoting the role of banks in the economic system and highlighting their key determinants that need to be well examined to fully understand the liquidity creation and liquidity risk issues.