Are Islamic banks inherently more stable than conventional banks

Islamic banking has expanded steadily over the last three decades and now, with total bank assets of $1.8 trillion and a strong annual growth rate, it is seen increasingly as an important player in global finance. With multiple examples of mismanagement, poor performance and failure in evidence amongst conventional financial institutions during the recent global financial crisis, Islamic Banking proved strikingly resilient.

How did Islamic Banking come through one of the world's greatest financial crises so well? This paper examines whether Islamic banks are inherently more stable and resilient to crisis than conventional banks, contributing to a growing empirical literature comparing the two types of institution.

What differentiates Islamic banks from their conventional peers? Do those factual differences confer advantage in difficult economic times? In terms of its financial products and objectives, Islamic banking differs significantly from so-called conventional banking. It adheres to the principles of Shariah (or Islamic law) which prohibits interest, complex derivatives, and short-selling. Investment in companies dealing in tobacco, gambling and alcohol is also forbidden.

Islamic banking products are asset-backed, a factor which should enhance stability during times of market distress. Debt contracts are generally precluded, meaning that Islamic banks face restrictions on how they obtain liquidity. Furthermore, the tradability of Islamic bonds is curtailed by underdeveloped secondary markets in the region. Yet Islamic banks are subject to the same market conditions as conventional banks. Therefore, to counter these risks, Islamic banks naturally withhold more liquidity, maintain profit-equalisation reserves and protect depositors by shifting losses to shareholders.

Islamic banks favour a strong ethical stance, placing great importance on charitable actions and trust between parties. The role of Islamic banks as business partners in financing operations, in principle, ought to encourage greater diligence from fund suppliers and greater integrity from borrowers.

The Islamic principle that profit should not be made by the lending of money implies that risk-sharing practices are embedded on both sides of the bank's balance sheet. Islamic banks' depositors are treated as investment account holders or preferred stockholders with residual claim to profits but without explicit capital protection; hence they share the risk of the bank's investments. This may exacerbate the bank's withdrawal risk. However, religious beliefs may instil loyalty in depositors, allowing banks to pass on losses in bad times, thereby achieving some pro-cyclical protection.

Other recent studies have compared Islamic and conventional banks on the basis of business models, efficiency, asset quality, credit risk and stability. Some findings include: Islamic banks have lower return volatility and greater resilience to crises; smaller Islamic banks tend to be financially stronger than commercial banks overall (although larger Islamic banks are not as stable, possibly due to the challenges in managing credit risk). Some conclude that Islamic banks were better capitalised and had higher asset quality that made them relatively less vulnerable to the recent financial crisis.

So there is considerable basis to conjecture that Islamic banking may possess attributes that enable it to withstand economic shocks. To investigate whether actual differences in failure risk exist between Islamic banks and their conventional peers, the researchers applied a survival analysis based on the Cox proportional hazard model to a sample of 421 Middle and Far Eastern banks from 1995 to 2010. No previous study has examined the resilience of Islamic and conventional banks from the lens of survival models.

The research finds that, taking both microeconomic and macroeconomic variables into account, Islamic banks on average exhibit lower hazard rates than conventional banks. Importantly the two bank types differ in their sensitivities to risk variables, confirming that their risk profiles are distinct. From the findings we see that the higher the leverage and the higher the net interest margin the higher the survival probability of Islamic banks, while both the leverage-survival and leverage-margin relationships are instead negative for conventional banks. However, we do identify some vulnerabilities. Islamic banking's reliance on cash reserves and use of commodities for collateral makes them comparatively more vulnerable to high inflation and real economic activity, for example. In addition, greater banking sector concentration has an adverse effect on the survival propensity of Islamic banks, while it actually reduces the risk of failure to conventional banks.

The research concludes that the design and implementation of early warning systems for bank failure should recognise that there are distinct risk profiles of the two bank types.

The final report was published by Springer in February 2016. A draft version of the paper is available for download below.