Pundits in the financial press have been asking an intriguing question: if too much debt and insufficient equity was partly responsible for the financial crisis, might Islamic banking be part of the solution? After all, Islamic principles require that financial transactions cannot include interest rate payments on debt, but rather have to rely on profit-loss risk-sharing arrangements (as in equity). For example, demand deposits that do not pay interest are fine, but savings deposits generally participate in the profits of the bank since these cannot accrue interest. Lending also generally follows a partnership model where the bank provides the resources and the client provides effort and expertise, and profits are shared at some agreed ratio. So can the heightened risk-sharing required by Sharia curb excess risk-taking by banks?
In practice Islamic scholars have also developed products that resemble those offered by conventional banks, replacing interest rate payments and discounting with fees and contingent payment structures. Nevertheless, Islamic banking still retains a strong element of equity participation. How does this affect bank risk-taking? Conceptually, the answer is not immediately clear. On the one hand, the equity-like nature of savings instruments may increase depositors’ incentives to monitor and discipline banks. On the other hand, if deposit instruments are equity-like, banks’ incentives to monitor and discipline borrowers may also be reduced since banks no longer face the threat of immediate withdrawal. Similarly, the equity-like nature of partnership loans can reduce the important discipline imposed on entrepreneurs by debt contracts.
There is also the possibility that the uncertainty of depositor returns may increase the likelihood of bank runs—whether justified or not. If so, Islamic banks may have greater difficulty meeting depositor demand since terminating or restricting the maturity structure of partnership loans is difficult.
In a recent paper with my co-authors Thorsten Beck and Ouarda Merrouche, we use bank-level data to construct and compare indicators of business model, efficiency, asset quality, and the stability of conventional and Islamic banks. We look at over 2900 banks in 141 countries, focusing particularly on 20 countries with both conventional and Islamic banks (a subset of 486 banks of which 89 are Islamic). This sample allows us to include country-year fixed effects, making it possible to compare conventional and Islamic banks within a country in a given year. Mostly, we look at the 1995-2007 pre-crisis period, but also compare the pre- and post-crisis performance of Islamic and conventional banks using more recent data.
What do we find? There seem to be few significant differences between the two groups. While we find that Islamic banks are more cost-effective (measured either by a cost-income ratio or overhead costs) in a large sample of countries, this advantage reverses when we focus on the sample of countries with both conventional and Islamic banks. Hence, it is conventional banks that are more cost-effective than Islamic banks in countries where both banks exist. We failed to find any significant differences in business model, as measured by the share of fee-based income to total income or share of non-deposit funding in total funding. Neither do we find significant differences in asset quality (loss reserves, provisions, or non-performing loans) or the stability of Islamic banks as captured by z-scores (distance from default), though we find that Islamic banks have higher capital-asset ratios. One interesting finding has to do with the potential impact of Islamic banks on conventional banks: in countries where the market share of Islamic banks is higher, conventional banks tend to be more cost-effective but less stable.
How did the different groups fare during the crisis? Islamic banks were better capitalized throughout the 2005-2010 period, had greater liquidity and also significantly increased this liquidity during the crisis period. Figure 1 below provides a comparison of quarterly bank returns over this period. The differences between Islamic and conventional banks are small and highly correlated. Nevertheless, we see that while Islamic banks yield lower returns for their investors in general, this pattern reversed during the crisis period—the result of higher liquidity and capitalization.
Overall, our results suggest that conventional and Islamic banks are more alike than sometimes assumed and Islamic banks are not likely to be the solution to financial crises. But certainly there is much we do not know about them. Cross-country comparisons mask the differences in ways that Sharia-compliant products are structured in different countries; how specific products are different across conventional and Islamic banks within each country; and, how conventional banking products and practices are affected by greater exposure to Islamic banking and what the implications are for regulation and supervision—all interesting areas for future research.
Beck, Thorsten, Asli Demirguc-Kunt and Ouarda Merrouche, “Islamic vs. Conventional Banking: Business Model, Efficiency and Stability,” World Bank Policy Research Working Paper # 5446, October 2010.