THE LIQUIDITY-PROFITABILITY TRADEOFF IN ISLAMIC BANKING: EMPIRICAL EVIDENCE FROM PAKISTAN

Abstract

This study examines the liquidity–profitability tradeoff in Islamic Banking Institutions (IBIs) in Pakistan using a balanced panel of 15 Islamic banking institutions over the period 2015–2025. Return on Assets (ROA) and Return on Equity (ROE) are used as measures of profitability, while liquidity, capital adequacy, non-performing financing, bank size, and inflation are incorporated as explanatory variables. Using a Fixed Effects panel estimation, the findings reveal a significant negative relationship between liquidity and both ROA and ROE, confirming the liquidity–profitability tradeoff. The results suggest that excessive liquidity holdings impose an opportunity cost due to the limited availability of short-term Shariah-compliant investment instruments. Capital adequacy and bank size positively affect profitability, whereas non-performing financing has a significant negative effect. The study emphasizes the need to strengthen Islamic money markets, expand sovereign Sukuk issuance, and develop effective Shariah-compliant liquidity management facilities.