Will Islamic Banking Make the World Less Risky? An Empirical Analysis of Capital Structure, Risk Shifting and Financial Stability

Tinbergen Institute Discussion Paper 15-051/VI/DSF92

34 Pages Posted: 19 May 2015 Last revised: 2 Jun 2015

See all articles by Moazzam Farooq

Moazzam Farooq

Central Bank of Oman; Tilburg University - CentER, European Banking Center (EBC); IQRA University

Sweder van Wijnbergen

Universiteit van Amsterdam; Tinbergen Institute; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Sajjad Zaheer

State Bank of Pakistan - Monetary Policy Department

Date Written: April 24, 2015

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.

Keywords: Islamic Banking, risk shifting, asset quality, financial stability

JEL Classification: G02, G21, Z12

Suggested Citation

Farooq, Moazzam and van Wijnbergen, Sweder and Zaheer, Sajjad, Will Islamic Banking Make the World Less Risky? An Empirical Analysis of Capital Structure, Risk Shifting and Financial Stability (April 24, 2015). Tinbergen Institute Discussion Paper 15-051/VI/DSF92. Available at SSRN: https://ssrn.com/abstract=2605358 or http://dx.doi.org/10.2139/ssrn.2605358

Moazzam Farooq (Contact Author)

Central Bank of Oman ( email )

P.O. Box 1161
Postal Code 112,Ruwi
Oman

Tilburg University - CentER, European Banking Center (EBC) ( email )

PO Box 90153
Tilburg, 5000 LE
Netherlands

IQRA University ( email )

Defence View
Shaheed-e-Millat Road (Ext.)
Karachi, Sindh 75500
Pakistan

Sweder Van Wijnbergen

Universiteit van Amsterdam ( email )

Roetersstraat 11
Amsterdam, 1018 WB
Netherlands
+31 20 525 4011 / 4203 (Phone)
+31-35-624 91 82 (Fax)

Tinbergen Institute

Burg. Oudlaan 50
Rotterdam, 3062 PA
Netherlands

Centre for Economic Policy Research (CEPR)

London
United Kingdom

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Sajjad Zaheer

State Bank of Pakistan - Monetary Policy Department ( email )

I.I. Chundrigar Road
Karachi, 74000
Pakistan

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