Abstract
•We integrate Islamic financial intermediation into a standard microeconomic model to examine the determinants of banking liquidity.•We show the existence of three important determinants of banking liquidity: deposit revenue sharing ratio, financing return rate and Islamic money market rate.•Excess reserves in Islamic banking sector are due to high level of deposits and low level of funds supply in financing and interbank markets.•These results contribute to design guidelines for empirical determinants of liquidity in Islamic banks.
The main objective of this paper is to examine the determinants of banking liquidity by explicitly integrating Islamic financial intermediation into a standard microeconomic model. Our model includes the banks’ liquidity reserves in line with profit-maximization motives and provides an analytical framework for interpreting the excess liquidity behavior commonly seen in the Islamic banking sector. Excess reserves result from an increase in a bank's deposits base combined with Islamic banks’ limited opportunities for financing and placement. The monetary policy rate appears to be a key instrument that central banks can use to resolve the problem of excess reserves.