Is Islamic banking more risky compared to conventional banking?

Islamic banks are less risky and more resilient than their counter parts in terms of bank capital requirement and mobilisation of deposits.

Somewhat perversely, the global financial crisis presented a big opportunity to the Islamic banking and finance industry. In 2008-2009, the Islamic banking industry was estimated to have experienced asset growth of 31.8% compared to 12.6% in the conventional banking. The Islamic bank total assets range between US$1.88 trillion to US$2.1 trillion in 2016 and are expected to reach US$3.4 trillion by 2018 globally. It provides an alternative financial services option to all consumers and investors.

As opposed to conventional banking, depositors to Islamic banks are entitled to be informed about what the bank does with their money and to have a say in where their money should be invested. Another difference is Islamic banks avoid interest at all levels of financial transactions and promote risk-sharing between the lender and borrower.

In case of profit, both the Islamic bank and its customer share it in a pre-agreed proportion. In the case of loss, all financial loss is borne by the lender. In addition to this Islamic bank can’t create debt without goods and services to back it (such as physical assets including machinery, equipment, inventory).

Nevertheless, Islamic banks have fewer instruments to mitigate risk due to the prohibition of trading associated with uncertainty, although one might argue that this same restriction reduces Islamic banks’ exposure to the type of assets associated with most of the losses that many conventional banks experienced during the global finacial crisis. Recently, Shariah-compliant interbank benchmark rate has been developed. Shariah-compliant money markets and government securities are underdeveloped in most countries and Islamic banks’ access to lender-of-last-resort facilities operated by central banks are often limited.

Bank for International Settlement (BIS) regulators are in close contact with Islamic Financial Services Board (IFSB) when devising policies and standards particularly, in relation to how much capital banks should hold and to develop a level playing field for banks across the world. However it is unclear whether bank capital reflects the riskiness of Islamic banks.

The issue of what effect capital has on bank risk, and how this effect may evolve over time, begs the question: compared to conventional banks, are Islamic banks overall more risky?

My current research on 22 countries (including 15 Gulf Cooperation Council (GCC) countries and G7 countries) from the period of 1998-2011 shows that bank capital increases bank liquidity risk for conventional banks. One possible reason for this finding may be that bank capital reflects the bank credit risk (as devised by the Basel Accord) and perhaps ignores the importance of liquidity risk. However, until very recently with the formulation of Basel III accord, the BIS has introduced two new liquidity risk measures; namely net stable funding ratio and liquidity coverage ratio to promote resilient banking sector.

On the other hand, Islamic banks do not show any appreciable evidence between bank capital and liquidity risk, suggesting that bank capital is of a less concern in that riskiness shoots up less when capital is low. Perhaps, depositor and investor conflict at Islamic banks is less acute given their financing and lending is tied less to capital.

My research also confirms that deposits, in particular demand deposits, reduce bank insolvency and credit risks, particularly over post-crisis period (from 2009-2011) for conventional banks and for Islamic banks from 1998-2011. This finding is not surprising because it is consistent with the traditional function of a financial institution, to mobilise deposits.

This result is also consistent with regulators push across the world for banks to reduce dependency on wholesale funding and increase reliance on deposits in order to maintain bank safety and soundness.

Formulating policies that are relevant and effective across the various stages of the business cycle for both conventional and Islamic banks presents itself as a formidable challenge to policymakers.

Although my analyses show that the impact of capital on risk (insolvency risk) reduction is observed in post-crisis period, it is still unknown as to whether this will persist in the longer term.