Impact of Basel III liquidity requirements on Islamic and conventional banks’ performance in Pakistan

Abstract

Since the financial crisis of 2007-2008, Basel III issued new regulations to enhance the resilience of the banking industry, including robust liquidity guidelines requiring all banks to maintain a net stable funding ratio (NSFR) and liquidity coverage ratio (LCR) of 100% or more. These regulations apply to both conventional and Islamic banks, though Islamic banks face unique challenges due to Shariah compliance requirements on liquidity product structures and mechanisms to avoid usury and highly speculative exposures. This study explores the impact of Basel III liquidity requirements on the stability, profitability, and intermediation cost of banks in Pakistan, focusing on the differences between conventional and Islamic banks. Addressing key gaps, the study examines the differential impact of the financial crisis on conventional and Islamic banks, the Basel Committee's uniform application of standards to both banking systems, and the lack of tailored regulatory standards for Islamic finance. Using a balanced panel data set from 2007-2021, comprising seventeen conventional banks and four full-fledged Islamic banks, various bank-specific and macroeconomic variables are analyzed. The Generalized Method of Moments (GMM) and Driscoll-Kraay covariance estimator are applied to conventional banks, while the Autoregressive Distributed Lag (ARDL) model is used for Islamic banks. Results indicate that for conventional banks, NSFR significantly enhances stability, has no impact on profitability, and reduces intermediation cost, while LCR significantly enhances stability but reduces both profitability and intermediation cost. For Islamic banks, NSFR shows no impact on stability and negatively affects profitability. In contrast, LCR negatively impacts stability and intermediation cost but positively affects profitability. The findings underscore the significant influence of Basel III liquidity requirements on both banking systems, highlighting the need for differentiated regulatory approaches. Policymakers should consider the unique characteristics of Islamic banking when formulating liquidity regulations. The results suggest that while Basel III requirements positively influence stability, they may adversely affect profitability and intermediation cost. This implies that regulators should continue to enforce these regulations to ensure that banks maintain adequate liquidity buffers to withstand financial shocks. Given the distinct impact on Islamic banks, tailored liquidity requirements that better suit Islamic banking products and services are necessary. Encouraging the diversification of funding sources can enhance bank stability, as indicated by the positive impact of NSFR. Additionally, promoting best practices in liquidity risk management, such as stress testing and contingency planning, can enhance banks' resilience to financial shocks. Overall, a balanced approach by policymakers is essential to promote financial stability without compromising the provision of financial services. Moreover, the study highlights the importance of regulatory compliance and the potential benefits of differentiated treatment for Islamic banks to address their unique needs. The emphasis on stability through NSFR and LCR compliance illustrates the trade-offs faced by banks in managing liquidity risks and profitability. The policy implications drawn from this study can guide future regulatory frameworks to ensure the soundness and growth of both conventional and Islamic banking sectors in Pakistan.