Credit default risk in Islamic and conventional banks: Evidence from a GARCH option pricing model

Abstract

An important question in banking is whether restrictions placed on Islamic banks make them more resilient to financial market turmoil and less prone to failure than conventional banks. We evaluate this claim by estimating credit default risk measures for a sample of conventional and Islamic banks using a GARCH option pricing model. Using a daily data set that is better suited for the time variation in volatility, we calculate distance to default measures to evaluate credit risk of Conventional Banks (CBs) and Islamic banks (IBs). We find higher default risk measures for IBs than CBs in general except during the Global Financial Crisis. This result holds true after controlling for bank and country specific variables in that IBs seem to have significantly lower default risk during the Global Financial Crisis and higher default risk thereafter. Consequently, while restrictions on risk taking is advantageous in financial turmoil episodes, the same restrictions expose IBs to risks in normal times. Finally, the credit risk of CBs and IBs is negatively affected by the oil crisis in 2014–2015 and the Covid-19 global pandemic. While there is no significant difference between the effects of the oil crisis on IBs versus CBs, the recent Covid-19 pandemic seems to have worsened the credit risk of IBs compared to CBs.