Does Islamic Banking Promote Financial Stability? Evidence From An Agent-Based Model

In recent years, Islamic banking has come to the forefront as one of the fastest growing branches of the global financial industry. In this study, we evaluate whether the coexistence of Islamic and conventional banks promotes financial stability. In this respect, we evaluate two types of financial system: (1) one solely comprising conventional banks, and (2) a dual system in which conventional and Islamic banks coexist and interact with each other. Accordingly, we designed two different agent-based models representing these systems and built two artificial banking networks consisting of both conventional and Islamic banks. We then ran simulations and examined possible contagion effects and the causes of bank failures by employing volatility spillover methodology. We found that Islamic banks significantly promote stability by providing liquidity during financial shocks and creating more liquidity per asset compared to conventional banks. We also found that they tend to hold more cash than conventional banks, which cushions the effects of possible liquidity squeezes. Conventional banks, on the other hand, tend to have reserve deficits, which rise during shock periods. We conclude that the coexistence of both bank types creates a win-win situation and contributes to financial stability.