International Research Journal of Finance and Economics ISSN 1450-2887 Issue 91 (2012) © EuroJournals Publishing, Inc. 2012 http://www.internationalresearchjournaloffinanceandeconomics.com

A Survey on the Level of Effectiveness of Liquidity Risk Management of Islamic Banks in Bahrain Sutan Emir Hidayat Senior Lecturer, Islamic Finance, University College of Bahrain E-mail: [email protected] Maryam Duaij Al-Khalifa Postgraduate Student, University College of Bahrain E-mail: [email protected] Alfatih Gessan Pananjung Aryasantana Senior Lecturer, Islamic Finance, Bahrain Institute of Islamic Banking and Finance E-mail: [email protected] Abstract Like their conventional counterparts, Islamic banks need to have a good liquidity risk management in order to be solvent. This study uses the descriptive approach to describe and understand the effectiveness of liquidity risk management (LRM) of Islamic banks in Bahrain from the perspective of depositors and the employees of the banks. The findings indicate that the respondents are not sure of the effectiveness of LRM of Islamic banks in Bahrain. The findings also indicate that the respondents have positive perception on the status of equity based financing which they believed as effective part of liquidity risk management. The Islamic Banks in Bahrain are perceived to have a good practice of liquidity demand. The findings also reveal that there is no significant difference perception between the employees and depositors on the level of effectiveness of liquidity risk management in terms of deposit portfolio and equity financing. However, there is a significant difference in the perception of depositors and employees on liquidity demands. The depositors showed a lower perception than the employees perhaps because they are not well aware of the policies and procedures of the Islamic banks in handling liquidity demands. Therefore, Islamic banks in Bahrain must strengthen their awareness campaign to the depositors on the policies and procedures of the Islamic banks in handling liquidity demands. Islamic banks in Bahrain also should adopt adequate internal controls over banks’ liquidity risk management process to avoid liquidity problems in the future.

Keywords: Liquidity Risk Management, Islamic Banks, Bahrain

1. Introduction In their operations, banks face a number of risks which may affect their performance. One of such risks is liquidity risk. Liquidity for a bank means the ability to meet its financial obligations as they come due (Smith, 2010). Bank finances investments in relatively illiquid assets, but it funds its loans with mostly short term liabilities (Smith, 2010). The international banking standards suggest that banks should have robust liquidity risk management policies, a responsive asset and liability committee,

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effective information and internal control systems and methods for managing deposits to reduce ondemand liquidity, in order to manage liquidity risk (BIS, 2006). In general, to manage liquidity effectively, there is a need for visibility of cash positions, good forecasting, a way to concentrate funds, and the ability to negotiate foreign exchange and get it done before cut-off times (Halim, 1986). Like their conventional counterparts, Islamic banks need to have good liquidity risk management (LRM) in order to be solvent. However, somewhat different from conventional approaches on managing liquidity, Islamic banks need to construct a liquidity management program which complies with their characteristics and risk profiles. Liquidity in Islamic banks gets into the whole raft of additional complexities which do not exist in conventional markets which is specifically the area of Shariah compatibility and Shariah compliance (Huq, 1986). Given, the uniqueness of Islamic banks, the level of effectiveness of LRM of Islamic banks can be evaluated from three aspects namely deposit management, equity based financing, and liquidity Demand (Alkhalifa, 2012). Islamic banking and finance is currently spread all over the world both in Muslim and non Muslim countries. One of the important countries to the development of Islamic banking and finance is the Kingdom of Bahrain. Bahrain notably is the most developed country in term of Islamic finance infrastructure within the GCC (Wilson, 2009). The kingdom actively promotes itself as an international hub for Islamic finance. In order to achieve this goal, the Central Bank of Bahrain (CBB) through its comprehensive regulatory framework opens its gate to local and international Islamic financial institutions to operate in the country. The kingdom is also the host to several organizations central to the development of Islamic finance, including: i) the Accounting and Auditing Organization for Islamic Financial Institutions ('AAOIFI'); ii) Liquidity Management Centre ('LMC'); iii) the International Islamic Financial Market ('IIFM'), iv) and the Islamic International Rating Agency ('IIRA')1. Given the importance of liquidity risk management in Islamic banks and the status of Bahrain as the international hub for Islamic banking, this study seeks to evaluate the perceptions of the depositors and bank employees on the level of effectiveness of liquidity risk management of Islamic Banks in Bahrain. Specifically, the study aims to answer the following questions: What is the perception of the employees and depositors of Islamic banks on the level of effectiveness of liquidity risk management of Islamic banks in Bahrain in terms of deposit management, equity based financing, and liquidity Demand? Is there a significant difference between the perceptions of the depositors and bank employees on the level of effectiveness of liquidity risk management of Islamic Banks in Bahrain? This study is expected to add value to the limited numbers of existing literatures on liquidity risk management in Islamic banking. To the best knowledge of the authors, there is no prior study that evaluates the perceptions of the depositors and bank employees on the level of effectiveness of liquidity risk management of Islamic banks in Bahrain.

2. Literature Review This section presents several previous studies in the area of liquidity risk management for Islamic banks. Ismal (2010) analyzes and evaluates the present liquidity management in the Indonesian Islamic banking industry. The paper proposes an integrated and comprehensive program of liquidity risk management which captures and assimilates the whole aspects of the issue and brings the industry into a better way of managing liquidity risk based on sharia principles. The paper first examines the organizational structure of Islamic banks and Islamic windows in managing liquidity. Second, it investigates the characteristics of the depositors, their investment behaviors and expectations followed by the banks efforts and policies to manage the liquidity. Then, it identifies the potential liquidity problems and Islamic liquid instruments. Finally, it proposes an integrated and comprehensive program 1

The information is taken from official website of Central Bank of Bahraian http://www.cbb.gov.bh/page.php?p=islamic_finance

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for managing liquidity. The paper suggests institutional deepening; restructuring the liquidity management on the liability and asset sides; and revitalizing the usage of the Islamic liquid instruments, in the integrated program to improve liquidity management of Indonesian Islamic banking. Akhtar et al (2011) look into the liquidity risk associated with the solvency of a financial institution, with a purpose to evaluate liquidity risk management (LRM) through a comparative analysis between conventional and Islamic banks in Pakistan. The paper investigates the significance of size of the firm, networking capital, return on equity, capital adequacy and return on assets, with liquidity risk management in conventional and Islamic banks of Pakistan. The study is based on secondary data that covers a period of four years (2006-2009). The study found positive but insignificant relationship of size of the bank and net-working capital to net assets with liquidity risk. In addition Capital adequacy ratio in conventional banks and return on assets in Islamic banks is found to be positive and significant at 10% significance level. Ahmed et al (2011) determine the firm’s level factors which have significantly influence the risk management practices of Islamic banks in Pakistan. The study selects credit, operational and liquidity risks as dependent variables while size, leverage, NPLs ratio, capital adequacy and asset management are utilized as explanatory variable for the period of four years from 2006 to 2009. The results indicate that size of Islamic banks have a positive and statistically significant relationship with financial risks (credit and liquidity risk), whereas its relation with operational risk is found to be negative and insignificant. The asset management establishes a positive and significant relationship with liquidity and operational risk. The debt equity ratio and NPLs ratio have a negative and significant relationship with liquidity and operational risk. In addition, capital adequacy has negative and significant relationship with credit and operational risk, whereas it is found to be positive and with liquidity risk. The above previous studies focus mostly on the factors that influence the liquidity risk managements. None of the above studies evaluates the level of effectiveness of liquidity risk management of Islamic banks in Bahrain. Therefore, this study aims to fill the gap. The next section explains the research methodology of this study.

3. Research Methodology 3.1. Research and Sampling Designs This study uses the descriptive-survey approach to collect primary data from the depositors and bank employees of Islamic banks in Bahrain. The data are gathered through a questionnaire-checklist. This study utilizes non-probability judgmental or purposive sampling technique. In this type of sampling technique, subjects are chosen to be part of the sample with a specific purpose in mind. With judgmental sampling, it is believed that some subjects are fitter for the research compared to others. As a result, a total of 50 depositors and 50 bank employees are chosen as respondents. The 50 depositors chosen have active relationships with the Islamic banks and the 50 employees chosen are managers and supervisors of Islamic Banks in the Kingdom of Bahrain. The questionnaire is designed according to the objectives of the study. The questionnaire utilizes likert scale to assess the level of effectiveness of liquidity risk management of Islamic banks in Bahrain in terms of deposit management, equity based financing and liquidity demand. Table 1 below presents the numerical scales and their interpretation. Table 1: Scale 5 4

Level of effectiveness of Liquidity Risk Management

Range 4.50-5.0 3.50-4.49

Interpretation Very Effective Effective

Description Liquidity risk management of Islamic Banks in Bahrain is very effective. Liquidity risk management of Islamic Banks in Bahrain is effective.

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Level of effectiveness of Liquidity Risk Management - continued

3

2.50-3.49

2 1

1.50-2.49 1.00-1.49

Neither Effective/nor Ineffective Ineffective Very Ineffective

Liquidity risk management of Islamic Banks in Bahrain is neither effective nor ineffective Lliquidity risk management of Islamic Banks in Bahrain is ineffective. Lliquidity risk management of Islamic Banks in Bahrain is very ineffective.

3.2. Statistical Treatment and Tools Responses to the questions are tallied after their collection. Weights are assigned to the qualitative scales then the weighted mean of each item in the questionnaires are determined. Lastly, T-test is used to test the differences between the means of two groups of respondents (depositors and employees). All statistical analysis will be processed using the SPSS or the Statistical Package for Social Sciences.

4. Findings and Analyis 4.1. Level of Effectiveness of Liquidity Risk Management in Terms of Liquidity Demand This section discusses the presentation, interpretation and analysis of the findings on the average and overall perceptions of the respondents on the level of effectiveness of liquidity risk management in Islamic banks in Bahrain. The level of effectiveness of liquidity risk management of Islamic banks in Bahrain is described in terms of deposit portfolio, equity based financing, and liquidity demand. Table 2 shows the respondents’ perceptions on level of effectiveness of liquidity risk management of Islamic banks in Bahrain in terms of deposit portfolio. Table 2:

Respondents’ Perceptions on the Level of Effectiveness of Liquidity Risk Management In Terms of Deposit Management Level of Effectiveness Weighted Mean Description

INDICATORS a. Charges penalty to depositors for withdrawal on term deposit without giving notice. b. Offers a Mudaraba Muqayyadah account instead of Mudaraba Mutlaqah account. c. Applies Profit and Loss sharing scheme instead of just Revenue Sharing Scheme. d. Compares other Islamic bank’s profit sharing ratio to determine its own profit sharing ratio with depositors. Total

3.04

Neither Effective nor Ineffective

3.33

Neither Effective nor Ineffective

3.43

Neither Effective nor Ineffective

3.88

Effective

3.42

Average Weighted Mean Neither Effective nor Ineffective

As it could be gleaned from the table, it is apparent that the respondents showed their neutrality on the level of effectiveness of liquidity risk management in terms of deposit management with an over-all weighted mean of 3.42 interpreted as “neither effective nor ineffective”. The highest mean is reflected on item d "compares other Islamic bank’s profit sharing ratio to determine its own profit sharing ratio with depositors" with weighted mean of 3.88 which is interpreted as effective. Overall findings imply that the respondents are not sure of the effectiveness of liquidity risk management in terms of deposit portfolio. Table 3 presents the respondents’ perceptions on the level of effectiveness of liquidity risk management of Islamic banks in Bahrain in terms of equity based Financing.

43 Table 3:

International Research Journal of Finance and Economics – Issue 91 (2012) Respondents’ Perceptions on the Level of Effectiveness of Liquidity Risk Management In Terms of Equity Based Financing Level of Effectiveness Weighted Mean Description

Indicators a. Adjusts time frame and total amount of available deposit with time frame and total amount of project to be financed. b. Prefers financing application of those with quality projects which were previously financed by the Islamic Bank. c. Requires entrepreneurs to put collateral or provide Kafalah (third party guarantee). d. Prefers to finance entrepreneurs who also have an account in the Islamic bank. Total

3.72

Effective

3.58

Effective

4.03

Effective

Neither Effective nor Ineffective Average Weighted Mean 3.64 Effective 3.23

Table 3 reveals that the respondents' perception on the level of effectiveness of equity based financing is described as “effective” with an over-all weighted mean of 3.64. The highest mean was found on the item c "Requires entrepreneurs to put collateral or provide Kafalah (third party guarantee)" with weighted mean of 4.03 interpreted as “effective.” This signifies that the respondents have positive perception on the status of equity based financing which they believed as “effective” part of liquidity risk management. This also implies that the respondents are knowledgeable about equity based financing. Table 4 presents the respondents’ perceptions on the level of effectiveness of liquidity risk management in Islamic Banks in Bahrain in terms of liquidity demand. Table 4:

Respondents’ Perceptions on the Level of Effectiveness of Liquidity Risk Management in Terms of Liquidity Demand

INDICATORS a. Puts extra liquidity above the reserve requirement. b. Communicates with depositors who have big amount of deposit regarding their withdrawal. c. Regularly calculates and analyzes pattern of liquidity withdrawal for anticipation d. Pursues depositors to lengthen the duration of time deposit from short term into long term. Total

Level of Effectiveness Weighted Mean Description 3.83 Effective 3.56

Effective

3.68

Effective

4.12

Effective

Average Weighted Mean 3.80 Effective

As it could be gleaned from the table, it is apparent that the respondents rated all the items as “effective”, with the highest mean found on the item d "Pursues depositors to lengthen the duration of time deposit from short term into long term" with the weighted mean of 4.12 interpreted as “effective”. The over-all weighted mean is 3.80 interpreted as ‘effective. This indicates that Islamic banks in Bahrain subscribe to the good practice of liquidity demand. This also implies that both sets of respondents have positive insights about the Islamic banks practices on liquidity demand. This means Islamic banks did not experience liquidity problems in its past operations. A sound liquidity risk management program would prevent banks from the negative impact of unfavorable economic conditions. It would also assist the banks to balance liquidity on the liability and asset sides, and most importantly it would prevent a bank rush and minimize the risk of a government bailout to defaulting banks.

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4.2. Differences in the Perceptions between the Employees and Depositors on the Level of Effectiveness of Liquidity Risk Management of Islamic Banks in Bahrain Table 5 shows the differences of perceptions between the employees and depositors on the level of effectiveness of liquidity risk management.

Table 5:

Differences in the perceptions between the Employees and Depositors on the Level of Effectiveness of Liquidity risk management

Liquidity risk management Deposit Portfolio Equity Based Financing Liquidity Demand

Respondents

N

Mean

employee depositor employee depositor employee depositor

50 50 50 50 50 50

3.3500 3.4325 3.6875 3.6275 3.5625 3.8425

Std. Deviation .70431 .55942 .81465 .52883 .72943 .49956

Mean Difference

T-Value

P-Value

-.0825

-.576

.566

.0600

.419

.676

-.2800

-2.104

.037*

As it could be gleaned from the table, in terms of deposit portfolio, the computed T-value is .576 and a p-value of .566, which by conventional criteria shows no statistical significance. In terms of equity based financing, the computed T-value is .419 and a p-value of .676 which shows again no statistical significance. The last variable, liquidity demand has computed t-value of -2.104 and a Pvalue of.037. These figures connote statistical significance. This finding conveys a significant difference on the perceptions between the employees and the depositors on liquidity demands. Based on the above findings, it is clear that there is no significant difference on the perceptions of the two sets of respondents except on the variable liquidity demand. The depositors showed a lower perception than the employees perhaps because they are not well aware of the policies and procedures used by the Islamic banks in handling liquidity demand. However, it could be noted that both sets of respondents have positive insights (effective) about the Islamic banks practices on liquidity demand. This means Islamic banks did not experience liquidity problems on their past operations

5. Conclusions and Recommendations The study concludes that the respondents are not sure of the effectiveness of the deposit management of Islamic banks in Bahrain. However, the respondents have positive perception on the status of equity based financing which they believed as “effective” part of liquidity risk management. The Bahraini Islamic banks are also perceived by the respondents to have a good practice of liquidity demand. Finally, it is found that there is no significant difference perception between the employees and depositors on the level of effectiveness of liquidity risk management in terms of deposit portfolio and equity financing. However, there is a significant difference of perceptions on liquidity demands between the two sets of respondents. The study also comes out with the following recommendations: a. Islamic banks in Bahrain must strengthen its awareness campaign to its depositors especially in its bid to improve its liquidity risk management. b. Islamic banks in Bahrain must maintain their practice of equity based financing as it was found praiseworthy by their clients. c. The Islamic bank management should adopt adequate internal controls over banks’ liquidity risk management process which should be a part of the overall system of internal control to avoid liquidity problems in the future.

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