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Will Islamic Banking make the World less risky? An Empirical Analysis of Capital Structure, Risk Shifting and Financial Stability

Author

Listed:
  • Moazzam Farooq

    (Central Bank of Oman, Oman)

  • Sweder van Wijnbergen

    (University of Amsterdam)

  • Sajjad Zaheer

    (State Bank of Pakistan, Pakistan)

Abstract

We use a classic Merton credit risk framework to argue that Islamic Banking Institutions (IBIs) face less incentive to take on risks than Conventional Banking Institutions (CBI). IBIs have less incentive for risk shifting both in and outside of distress situations. We test and confirm this prediction in an empirical analysis based on a dataset covering all CBIs, IBIs, and Islamic and conventional subsidiaries of mixed banking institutions in Pakistan. We find that full-fledged Islamic banks (IBs) are indeed more stable than conventional banking institutions (CBIs), and are better capitalized than their conventional counterparts. IBIs also have less volatile asset returns, less non-performing loans (NPLs) and lower loan loss provisioning. Similar results obtain for Islamic windows of mixed banks compared with conventional windows. The analysis suggests that the loss absorption capacity of Islamic banks leads to less risk taking and a more stable banking system.

Suggested Citation

  • Moazzam Farooq & Sweder van Wijnbergen & Sajjad Zaheer, 2015. "Will Islamic Banking make the World less risky? An Empirical Analysis of Capital Structure, Risk Shifting and Financial Stability," Tinbergen Institute Discussion Papers 15-051/VI/DSF92, Tinbergen Institute.
  • Handle: RePEc:tin:wpaper:20150051
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    References listed on IDEAS

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    1. Hassan Belkacem Ghassan & Abdelkrim Ahmed Guendouz, 2019. "Panel modeling of z-score: evidence from Islamic and conventional Saudi banks," International Journal of Islamic and Middle Eastern Finance and Management, Emerald Group Publishing Limited, vol. 12(3), pages 448-468, July.
    2. Alzahrani, Mohammed, 2019. "Islamic corporate finance, financial markets, and institutions: An overview," Journal of Corporate Finance, Elsevier, vol. 55(C), pages 1-5.
    3. Ghassan, Hassan B. & Krichene, Noureddine, 2017. "Financial Stability of Conventional and Islamic Banks: A Survey," MPRA Paper 82372, University Library of Munich, Germany.
    4. Ameenullah Shaikh, Saqib Sharif, Imtiaz Arif, 2016. "Comparison of Islamic Banks with Conventional Banks: Evidence from an Emerging Market," Journal of Management Sciences, Geist Science, Iqra University, Faculty of Business Administration, vol. 3(1), pages 22-38, March.

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    More about this item

    Keywords

    Islamic Banking; risk shifting; asset quality; financial stability;
    All these keywords.

    JEL classification:

    • G02 - Financial Economics - - General - - - Behavioral Finance: Underlying Principles
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • Z12 - Other Special Topics - - Cultural Economics - - - Religion

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