Analysis of default behavior of borrowers under Islamic versus conventional banking

Purpose - The purpose of this paper is to consider borrower-specific characteristics to understand the factors affecting both the probability and quantum of loan default by individual borrowers under Islamic and conventional banking. Design/methodology/approach - Borrower-specific characteristics that explain the probability of default may not necessarily be similar factors that determine the quantum of default. The authors therefore apply a Box-Cox double hurdle model to treat both the probability and quantum of default in a two-step approach. The authors also explain the differences in default risk and quantum of default between Islamic and conventional banking borrowers from their behavioral perspectives following the Sharia principles in financial transactions between lenders and borrowers. The authors use borrower-specific information of two separate bank branches of the United Arab Emirates that solely deal with either Islamic or conventional banking products. Findings - The paper demonstrates that the probability of default and the quantum of default appear to be influenced by different set of client-specific factors. The results suggest that the probability of default does not vary significantly between Islamic and conventional banking borrowers. The evidence also shows that Islamic banking defaulters, compared to those in conventional banking, repay a large quantum of overdue when their financial leverage improves. However, they do not tend to reduce their outstanding quantum of overdue faster than conventional banking defaulters. Research limitations/implications - Availability of data from only two bank branches may limit the explanatory power of empirical findings. Practical implications - The study findings will enable the Islamic and conventional banks to appropriately address Basel Capital requirements based on the borrowers’ behavior. Social implications - The study findings have the potential for Islamic and conventional financing institutions to be more flexible with equity in their lending practices. Originality/value - Religious beliefs are crucial in borrower’s default behavior in Islamic banking.