Duration model for maturity gap risk management in Islamic banks

Abstract

Purpose The purpose of this paper is to propose models of duration for maturity gap risk management in Islamic banks. Design/methodology/approach A thorough review of literature on duration modeling, duration measurement in Islamic banks and Shariah compliance has been conducted to set parameters to develop Shariah-compliant maturity gap risk management mechanism. Findings Models based on durations of earning assets and return bearing liabilities using various rates of return earned and paid, benchmark rates and industry standards commonly used by Islamic and conventional banks. Practical implications Increased Shariah compliance has threefold impact. Firstly, it will increase trust of customers. Secondly, it will help improve profitability by reducing non-Shariah compliance penalties from the regulators. And finally, it will enhance market capitalization and returns stability to investors because of enhanced customer base, increased level of trust and increased profitability. Originality/value This research proposes Shariah-compliant maturity gap risk management models based on the concept of duration according to recommendations of Bank for International Settlements. As there is no such maturity gap risk management mechanism that meets the requirements of Shariah using benchmarks that are common between Islamic and conventional banks; therefore, this research presents risk management solutions that can be applied simultaneously in the entire banking sector.

Stage-I Shariah compliant Macaulay’s duration model testing

“…This research uses four alternates models of Sharīʿah-compliant duration. Two long run duration models are from Shah et al (2020a) and two alternate models of short run duration are proposed on the same parameters as recommended by Shah et al (2020a). The model of Shah et al (2020a) to be tested in this research are:…”

“…For the purpose of this research, changes in returns of Islamic banks have been calculated in terms of Shah et al (2020a) as hereunder: …”

“…This research proceeds by reviewing all existing duration models under Sharīʿah parameters, followed by developing a framework and methodology for testing Sharīʿah-compliant duration models. The parameters of Sharīʿah-compliance as developed by Shah et al (2020a) are hereunder:…”

“…Chattha et al (2020) and Shah et al (2020b) recommend and Shah et al (2020a) propose Sharīʿah-compliant models of duration for earning assets and return bearing liabilities of Islamic banks. These models are based on Sharīʿah-compliant benchmark rates, rates of return earned, rates of return paid, book values of assets and liabilities and Sharīʿah-compliant concept of the time value of money, which they termed as “reversed present values.” However, they do not provide empirical results.…”

“…The purpose of this study is to test the Sharīʿah-compliant duration models of Shah et al (2020a). This is achieved by following the theme of implementing duration models under the theory of Macaulay’s duration (Shah et al , 2020b).…”