Relation between Liquidity Creation, Profitability, and Regulatory Capital in Islamic and Conventional Banks of GCC Countries

Abstract

This study examines the interrelationship between liquidity creation, regulatory capital, and bank profitability in the Gulf Cooperation Council (GCC) banking sector. Using dynamic panel data and the ‘generalized method of moments’ (GMM) estimator for the period 2009–2023, we explore how these variables influence each other in a region characterised by oil-dependent economies and a dual banking system (comprising both Islamic and conventional banks). Our findings reveal a negative bidirectional relationship between liquidity creation and regulatory capital, supporting the financial fragility hypothesis. However, this relationship varies significantly across bank types. We also find a positive association between liquidity creation and bank profitability, suggesting that banks generating more liquidity tend to perform better, which is contrary to the bankruptcy cost theory. In contrast, regulatory capital negatively affects bank profitability, although the magnitude and direction of this relationship depend on the capital definition used. By focusing on this unique regional and institutional setting while incorporating bank type heterogeneity, this study offers novel insights into the regulatory-performance-liquidity nexus and contributes to the literature on banking in emerging economies. 

JEL: G21, G28