Does the Financing Model of Islamic Banks make them More Stable: A Comparative Analysis of Returns, Stability and Risk in Between Diversified, Interest, and Inventory Based Earning?

Abstract

Most boom-bust cycles witnessed across the world in recent decades have exposed several underlying factors that highlight the vulnerability of conventional banking, namely, high leveraging, wholesale financing, and utilization of complex instruments. Islamic financial institutions largely escaped the direct impact of the global financial crisis. In theory, Islamic banks are more resilient to shocks than conventional banks because ‘gharar’ considerations prohibit them from investing in excessively risky assets, as well as zero-sum betting on derivatives. Moreover, by promoting risk-sharing (as opposed to risk transfer) and endorsing investment in wealth-creating activities, the asset-based nature of Islamic financing naturally curbs excessive leverage. This paper investigates Does the Financing Model of Islamic Banks make them More Stable. For this, we proposed that the risk of fluctuation of the interest-based instrument (risk to banking sector stability) is counterbalanced by non-banking type movements through inventory changes thus making Islamic banking more stable. Specifically, we focused on three factors for comparison between Islamic and conventional banking systems, First factor was returns represented by ROA, ad ROE. The second was the stability, measured by volatility of returns. And the third factor was market risk represented by Beta. We hypothesized that the risk of the banking system is mainly due to interest rate movements. A sharp increase in interest rates would adversely affect the returns not only due to maturity mismatch problem but also due to increased loan loss provisions, taken because of higher chances to default. This makes the banking system more volatile and exposes it to systematic risk. Islamic banks on the other hand have mandatory involvement of underlying products in the lending transactions. This makes banks not only take exposure of those products on their balance sheet in form of inventory but also absorb their fluctuations in returns through mark to market adjustments. As these adjustments would no be highly correlating with interest-based earnings, as well as systematic risk, this would not only make total returns of Islamic banks more stable but also have less exposure to market risk. Since Islamic banks have a diverse earning base, the pure effect of inventory fluctuation was captured by Return of Financing product Inventory of Islamic Banks. Also, we explored the effect of different bank-specific factors on Returns (ROA, and ROE), stability (volatility of ROA, and ROE), and market risk (BETA), and how these factors affect conventional and Islamic banks differently. These included Loan ratio (LR), Asset growth (AG ), the logarithm of total assets (LogTA), the ratio of loan loss provision over assets (LLP), the ratio of equity to assets (EQA), Return of Financing product Inventory (FPI ), and FOCUS measures the degree of specialization/ diversification in a bank's earnings. Dataset of a total of 13 banks (9 Conventional and 4 Islamic banks) operating in Pakistan was collected, for the period from 2009 to 2018. Results were according to expectations. All three factors (returns, stability, and market risk) seem to have a significant difference in their means. Where Islamic banks seem to have higher and more stable returns (high ROA, with lower volatility of ROA and ROE). Pure inventory returns seem to have even lower volatility than both Islamic and conventional banks, supporting the claim that the effect of inventory portion in Islamic banks’ balance sheet makes them more stable. Islamic Banks also seem to have lower market risk (low Beta) as compared to conventional banks, presumably because of countercyclical inventory movements. The results of the regression suggested that size has a significant negative effect on ROE of both conventional and Islamic banks, size also seems to decrease the volatility of ROE in both types. Size also seems to decrease systematic risk in an Islamic bank. loan loss provision also seems to inversely affect ROE and its volatility, but interestingly, does not seem to affect Islamic banks. Capital adequacy also seems to affect the ROE of both Islamic and conventional banks but seems to provide stability in returns for Islamic banks as it has a negative effect on the volatility of both ROE and ROA. Asset growth also seems to be inversely affecting the volatility of ROA for the overall sample. Results also suggested that Diversification in a bank's earnings seems to improve ROA of conventional banks, whereas Financing product Inventory returns seem to be positively affecting the beta.