Duration model for maturity gap risk management in Islamic banks

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Islamic bank illustration. (Source:hukumonline)

Islamic banks operate simultaneously with conventional banks all around the world except in Iran and Sudan. This expansion in the business of Islamic banking is significantly different from their conventional counterparts. However, Islamic banks face similar kind of risks, i.e. credit risk, operational risk, market risk, rate of return risk and base rate risk, etc.

Out of many risks affecting Islamic banks, rate of return risk gets its roots from various benchmark and market rates. Considering the importance of rate of return risks in Islamic financial institutions, IFSB has set 15 guiding principles in six sub-categories. With a mechanism for maturity gap risk management in Islamic banks by developing Shariah-compliant duration models of earning assets and return bearing liabilities, our research shall benefit Islamic financial industry.

Various duration models and their differences

Having explored literature on various duration models, we formulate the following, (1) Islamic banks have different structure that requires different risk measures; (2) duration models proposed for banks should take market values as weights. However, as there do not exist market values for all of the assets and liabilities of financial institution, particularly Islamic banks; therefore, there is a need to develop models based on alternative weights, (3) existing models take into account expected values of financial variables, which involve excessive gharrar in Islamic context.

Financial benchmarks for Shariah compliance

Based on Shariah compliance, Islamic banks have unique risk characteristics. The risks to banking structures of Islamic banks are the same as faced by their conventional counterparts because they exist in competition to each other but the nature of impact is altogether different. An Islamic bank cannot use an instrument for risk mitigation in which all parameters, i.e. the cash payment and delivery of commodity are postponed because of appearance of gharrar and riba.

Furthermore, with regard to Shariah compliance there exist requirements consisting of debt to equity ratio not exceeding 33 per cent, account receivable to total assets ratio not exceeding 49 per cent and if the organization is complying these parameters, the mixture of non Shariah-compliant income in Shariah-compliant income is permissible only up to 5 per cent. From this information, we formulate parameters of a financial model for Islamic banks.

Having reviewed the literature, our objective is to present Shariah-compliant mechanism for maturity gap risk management in Islamic banks. This study proposed a Shariah-compliant models of duration of earning assets and return bearing liabilities. The models so developed shall be further used in Saunders and Cornett’s in 2007, which is a mechanism to assess impact of changes in duration, relevant rates of returns earned and paid, benchmark rates and industry standards on net income of an Islamic bank.

This is an innovative study in the area of Islamic economics and finance because there are limited Shariah-compliant models of maturity gap risk management based on duration of earning assets and return rearing liabilities. Therefore, this model requires through implementation along with backward and forward testing to prove their suitability. The proposed models are also required to be tested in the contexts of Islamic and conventional banks to evaluate and compare the results for suitability in both banking structures.

Implications and contributions to science

Shariah-compliant maturity gap risk management mechanism proposed in this study has profound future research implications. Furthermore, it is recommended for analyzing the effects of changing in net stable funding ratio, liquidity coverage ratio and the effects of regulations from Basel committee of banking supervision, Islamic financial services board and specific countries.

Further research is also required to examine on and off balance sheet items within each maturity brackets and their overall impact on financial standing and resilience. The model and mechanism may also be extended to examine modified duration and convexity, to analyze long-term impact on financial standing and resilience.

The mechanism and models proposed in this study are recommended to be applied in fixed and variable rate scenarios with more severe stress testing that includes lowering capital buffers, severe benchmark and rate of return shocks and the effects of country specific regulations to examine soundness and resilience of Islamic banks in varying economic conditions.

Author: Bayu Arie Fianto

Details of thise research can be viewed on:

https://www.emerald.com/insight/content/doi/10.1108/JM2-08-2019-0184/full/html

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