Cost efficiency and liquidity risk in banking: New evidence

Purpose - The financial intermediation role of banks that transform short term deposits to long term loans exposed banks into inherent liquidity risk (Berger & Bouwman 2009). The impact of liquidity risk can be detrimental to banks’ earnings and solvency, as evidenced by failures of a large number of financial institutions including Islamic banks during the second wave of 2008 crisis (Hasan & Dridi, 2010; Ali, 2012; Beck et al. 2013).However, unlike conventional banks (notwithstanding the difference in underlying principles, risk profile and regulatory frameworks), Islamic banks faced higher constraints in managing liquidity risk in the absence of Shariah compliant risk management tools and developed institutional infrastructure (Ali, 2012; Mohammad, 2013).A major policy concern is the implication of liquidity risk management of Islamic banks on financial instability.Thus the question is: What are the determinants of liquidity risk that is unique to Islamic banking framework?The literature on issues of liquidity are largely on conventional banking (Munteanu 2012; Horvath et al. 2012, 2014; Cucinelli 2013; Lei & Song 2013; Chen et al. 2015; Roman & Sargu, 2015) and emerging studies on Islamic banking (Iqbal, 2012; Ghenimi & Omri, 2015; Yaacob et al. 2016).Yet, none of these studies have incorporated the role of efficiency on liquidity risk in banking, although empirically evidenced significant to affect bank risk taking (Brissimis et al. 2008; Fiordelisi et al. 2009; Alam 2012; Radic et al. 2012; Miah & Sharmeen 2015; Sarmianto & Galan 2015).Recently, Altunbas et al.(2007) documented positive efficiency-liquidity risk relationship for conventional European banks (1992-2000) while Khalib et al.(2016) found efficiency has no significantly related with liquidity risk in short term but negatively related in long term for banks in Malaysia (1994- 2014).This inconclusive evidence needs further investigation as to whether different efficiency level between distinct bank types could have resultant impact on liquidity risk profile of a bank that could provide some insights on bank risk taking behavior.Thus, this paper aims to analyze the relationship between cost efficiency and liquidity risk in conventional and Islamic banks in selected 16 OIC countries from 1999 to 2013. The findings document that the impact of cost efficiency on liquidity risk is positive.It shows that cost efficient bank are able to minimize the cost of inputs (for instance cost of funds) to maximize outputs i.e. financing or loans, whereas for inefficient bank, cost constraints have restricted them from engage in high risk investments.This finding is, indirectly, in support of cost-skimping and moral hazard theory which direct the implication of cost efficiency with high risk taking incentives