Estimation of Duration Gap and its Determinants for Islamic Banks: Empirical Evidence using Two-Step Robust GMM

Abstract

The banking industry is in the business of risk management, which is of significant consideration to banks and their regulators. Islamic commercial banks (ICBs) are no exception as they too deal with a variety of peculiar risks. One specific risk is the rate of return risk (ROR) in the banking book, which is dealt with under Pillar 2 of the Basel Committee on Banking Supervision (BCBS) and the Islamic Financial Services Board (IFSB) standards. The IFSB, similar to the BCBS, provides a detailed framework on the management of ROR risk for the ICBs, including modalities of maturity gap and calculation of precise duration of assets and liabilities. However, existing studies on risk management practices show significant gaps; there are no studies which specifically highlight the assessment of ROR risk with duration gap for ICBs. Therefore, we estimate the duration gap of ICBs and determine the factors influencing the duration gaps in the context of ROR risk. Using Duration Gap Model and Two-Step Robust Generalized Method of Moments (GMM), with a sample of 50 ICBs from 13 countries, for the period 2007-2015, our empirical findings are three-fold: (a) time series and cross-sectional duration gap of ICBs reflecting significant variations across the banks and countries; (b) ICBs have a general tendency of maintaining a higher (more) duration gap compared to their conventional counterparts, and are exposed to increasing ROR risk due to their larger duration gaps and severe liquidity mismatches; and (c) there is significant difference in the estimated coefficients of idiosyncratic factors influencing the duration gaps of ICBs. This study makes profound contributions to the existing corpus of literature and provides direction to the ICBs to reflect upon the significance of liquidity mismatch risk, ROR risk management with the duration gap, factors influencing the duration gaps, and management of the ROR risk under Pillar 2 of the BCBS and the IFSB standards.