Determinants of Credit Risk: A Comparative Analysis between Islamic and Conventional Banks

Abstract

Using GMM estimation techniques, this paper investigates the determinants of credit risk between Islamic and conventional banks in Bangladesh banking sector for the period from 2001 to 2011. This paper uses three separate proxies of credit risk namely NPL ratio, financial stability Z score and Merton`s probability of default to investigate the determinants of credit risk. Furthermore, this study examines five important bank specific hypotheses, which are adverse selection, moral hazard, efficiency, competition and regulatory requirement along with the three macro-economic factors to investigate the difference on the factors affecting credit risk between Islamic and conventional banks. Findings of this study have several policy implications. First, empirical results show that both banking system face adverse selection and moral hazard problem which indicates the high presence of asymmetric information problem. Banks should have enough skill to minimize asymmetric information problem. Especially high credit growth is positively affecting the credit risk for both banking systems which means banks are not able to extract the diversification benefits. Second important implication is that, Islamic banks are still unable to manage the cost efficiently where conventional banks because of their long experience manage it productively. Finally, based on these empirical results, it can be inferred that Islamic banks do not require separate regulatory requirement other than the regulation of conventional banks.