Comparative Credit Risk in Islamic and Conventional Banks

Abstract

This study considers whether Islamic banks and conventional banks have different levels of credit risk. One problem with existing research in this area is the dominance of accounting information to assess credit risk, and this could be especially misleading in the case of Islamic banking. Using Merton’s distance-to-default (DD) model, a market-based credit risk measure, we evaluate the credit risk of 156 conventional banks and 37 Islamic banks across 13 countries between 2000 and 2012. We also calculate the accounting information-based Z-score and nonperforming loan (NPL) ratio for the purpose of comparison. Our results show that Islamic banks have significantly lower credit risk than conventional banks when measuring credit risk with the DD. In contrast, and as expected, Islamic banks exhibit much higher credit risk using the Z-score and NPL ratio. Overall, the findings suggest that the methodology used plays a significant role in assessing the apparent credit risk of Islamic banks.