Do Islamic Banks Have Higher Credit Risk?

Abstract

This research is undertaken to answer the question whether Islamic banks have higher or lower credit risk than that of their counterpart conventional banks. Since the onset of the financial crisis, researchers have debated over this issue and a growing literature has provided empirical evidence by comparing the stability or the credit risk of Islamic and conventional banks. One of the fundamental drawbacks of previous research that investigated the level of credit risk between these two banking systems is that methodologies used to calculate credit risk or stability of banks, are mostly based on accounting information only such as Z score, NPL ratio and loan loss reserve ratio. Deriving a conclusion whether Islamic banks have higher or lower credit risk based on solely accounting information could be misleading, since accounting based credit risk measurements have a number of limitations. This research contributes in this debate by using Merton’s distance to default model, a market based credit risk measurement technique, to measure the credit risk of 156 conventional and 37 Islamic banks from 13 economies between 2000 and 2012. For a comparative purpose, we also use both the Z score and the non-performing loan (NPL) ratio along with distance to default model to measure the credit risk across both banking systems. Our results show that, in general Islamic banks have significantly lower credit risk than conventional banks when credit risk is measured by DD and NPL ratio. In contrast, Islamic banks have higher credit risk when it is measured by Z score. Therefore, it is hard to draw a simple conclusion about whether Islamic banks have higher or lower credit risk than their counterparts’ conventional bank. This also implies that methodology used to measure credit risk plays an important role in deciding which banking system is safer.