Systemic risk, Islamic banks, and the COVID-19 pandemic: An empirical investigation

Abstract

While operating side-by-side with conventional banks, in a dual-banking system, the systemic risk profile of Islamic banks can be different due to their unique business model. The objective of this study is to understand the evolution of systemic risk in dual-banking systems and determine whether there are any differences in the systemic risk profiles of conventional and Islamic banks during the COVID-19 pandemic. This study also identifies the determinants of systemic importance (measured using spillover indices) of financial institutions. The sample includes ten countries where the Islamic banking sector is considered systemically important and covers the period from November 2015 to November 2020. The empirical results indicate a significant increase in systemic risk, in the sample countries, during the first half which is followed by a recovery in the second half of 2020. Comparative analysis shows that Islamic banks have similar systemic vulnerabilities to systematic and idiosyncratic factors during the exogenously induced real economic shock of the COVID-19. However, Islamic banks pose significantly less spillover to others relative to conventional banks while earning abnormal returns. The results are robust to the inclusion of macroeconomic factors and alternate estimation methodologies. The findings of this study provide valuable insights for the regulators of dual-banking systems.