Abstract
This study aims to identify key capital adequacy measures and other parameters that effectively predict distress in Islamic banks taking a panel of 65 banks from 13 countries between 2008-2017 using logistic regression model. The paper also intends to see whether simpler ratios perform better than more complex, risk weighted measures in predicting distress in these banks. A total of nine alternative capital and leverage indicators are used in the model that mainly rely on financial and accounting data, which are supplemented by the addition of market leverage for listed banks. In order to capture variability in cross country analysis and impact of economic conditions and shocks, the study also adds several macroeconomic indicators in the model. The results suggest that most of the standard CAMELS indicators are relevant for studying distress in Islamic banks. Further, it is shown that three other capital ratios – Tier 1, tangible common ratio and market leverage - are equally effective in studying Islamic bank failures. The findings, however, reflect that Basel III leverage ratio and other accounting-based ratios do not offer effective early warning signals of Islamic bank stress. Overall, equity based risk-weighted capital ratios offer a more robust framework of regulation and supervision in Islamic banks.
Highlights
Despite increasing growth and importance of capital market and insurance sectors in last half century, banking sector remains dominant part of financial systems throughout the developing world in Asia, Africa, Middle East, Latin America and others
The results of this study are significant from many perspectives and extend the literature on bank distress in emerging markets and Islamic finance in several ways: First, the result delineate that most of the standard CAMELS indicators are relevant for studying distress in Islamic banks
Risk weighted capital adequacy ratio is significant in analysing resilience in Islamic banks
Summary
Despite increasing growth and importance of capital market and insurance sectors in last half century, banking sector remains dominant part of financial systems throughout the developing world in Asia, Africa, Middle East, Latin America and others. This study attempts to expand the literature on Islamic banks in a number of ways: First, contrary to studies on bank distress that mostly focus on economically advanced markets, this study takes comprehensive dataset of 65 banks from 13 countries between 2008-2017 representing emerging markets in the GCC, North Africa, Asia and Europe; Second, in addition to CAR, several other alternative ratios proposed in literature on conventional banks have been tested for their efficacy in predicting distress in Islamic banks; Third, over half of dataset includes publicly listed Islamic banks that permits the testing of market leverage as one of the potential ratios, which is not tested in other studies on Islamic banks; Fourth, a new ratio called “Islamic banking leverage” is proposed and examined that takes into account the risk absorbency feature of PSIA; and Fifth, it offers insights on the application of Basel III proposals on Islamic banks by testing their relevance and effectiveness for this sector.
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