To debt or not to debt: Are Islamic banks less risky than conventional banks?

Abstract

We empirically analyze the market risk profiles of Islamic banks with two sets of conventional banks taken from the same geographical locations as Islamic banks and from a random global sample respectively for the period 2000–2013. Moreover, we divided our sample period into pre-financial crisis, during financial and post financial crisis. Estimates of Value-at-Risk (VaR) and Expected Shortfall (ES) which incorporates losses beyond VaR are used as market risk measures for both univariate and multivariate portfolios. Our key input is the share price by market capitalization of publicly traded banks of similar size in Islamic and non-Islamic countries. Univariate analysis finds no discernible differences between Islamic and conventional banks. However, dynamic correlations obtained via a multivariate setting shows Islamic banks to be less riskier for both sets of conventional banks; and especially so during the recent global financial crisis. The policy implications are: (i) that the inclusion of Islamic banks within asset portfolios may mitigate potential risk; (ii) that the Basel committee should consider the ES measure of risk for Islamic banks in preference to the current VaR methodology, which over-estimates the market risk of Islamic banks.