Need for calibration: applying a maximum threshold to liquidity ratio for Islamic banks

Abstract

PurposeThe purpose of this paper is to highlight the effects of liquidity regulations on Islamic banking using Turkey as a case study. It recommends an alternative mechanism using capital market standards for liquidity requirement of Islamic banks to mitigate certain risks.Design/methodology/approachThe paper evaluates the correlation between cash and profit and between liquidity coverage ratio and capital adequacy ratio of participating banks in Turkey.FindingsIslamic banks hold higher cash than they should. The paper suggests a maximum liquidity ratio for Islamic banks. Applying a cap to the liquidity coverage ratio will impose discipline on Islamic banks to manage their assets appropriately as well as to encourage their financial intermediation to the real sector. In addition, the authors argue that even if the cash outflows from investment account on the right side of Islamic banks’ balance sheets are included in the short-term projection, they should not be included in the denominator of the liquidity coverage ratio.Practical implicationsThe current Basel requirements and Islamic Financial Services Board standards are disincentives to Islamic banks to provide risk-sharing or partnership-based investments and services to their customers and depositors. Effective legal and regulatory framework and supervisory oversight need to take into account the difference between the risk profile of a typical Islamic bank and a conventional bank.Originality/valueAlthough it is well accepted that without adequate regulatory involvement it would not be possible to control and mitigate the risks related to Islamic banking financial intermediation, there should be a balance between the growth and stability of the industry. The regulatory involvement that satisfies this balance would be welcome.