Bank Liquidity Risk and Capital Structure: A Conceptual Review of Theoretical and Empirical Research on Islamic Banking Perspective

Abstract

This paper conducts a comprehensive review of relevant empirical literature on the impact of capital structure on bank's liquidity risk. Based on the existing literature, capital structure has a considerable impact on banks' liquidity risk either in positive or negative thought. However, we discover that empirical evidence on all of this relationship is heavily skewed in favour of conventional banks and firm's perspective. As a result, we urge that further research should be done in this area specifically in Islamic banking standpoint in order to gain a better understanding of the impact of capital structure on banks liquidity risk. This is due to the fact that the optimal capital structure for bank will trade-off the effects of bank capital specifically on the liquidity creation. Therefore, it is hoped that this paper can give a guideline to the policymakers, banking regulators, shareholders and other stakeholders to balance between capital structure and liquidity creation in order to evade from the issues of bank run and insolvency.

Capital Structure and Financial Performance of Banks in Indonesia

“…Leverage decreases a manager's freedom in making decisions, making them confined to less risky investments whose returns are lower than those promising higher return, despite the cost Proceedings of the 3 rd Asia Pacific International Conference on Industrial Engineering and Operations Management, Johor Bahru, Malaysia, September 13-15, 2022 © IEOM Society International of higher risk. Harun et al (2021) suggests that banks being highly leveraged, have the ability to determine the appropriate amount of capital to support unpredicted losses arising from its daily transactions. Such eventuality unsettles the initial MM theorem (1958) whereby bankruptcy costs do not affect firm value (CFI, N.d.).…”

“…High equity capital benefits a bank's profitability by lowering funding costs, enhancing creditworthiness, lowering the need for external funding, and enhancing depositor safety during periods of macroeconomic turbulence (Paolucci, 2016;Tan, 2017;Sufin and Kamrudin, 2012;Ha,2020). Capital markets are yet to be efficient in emerging economies like Vietnam, in which cost expectation of finance difficulties reduces (Ha, 2020). While the eventuality is true in developing economies, equity as a source of funds is more expensive than deposits, raising the bank's cost of capital and hence calling for a greater margin.…”