Islamic banks differ in significant ways from conventional banks. The authors find that Islamic banks are less cost-efficient but maintain higher asset quality. They also determine that during the 2007–09 financial crisis, Islamic banks fared better than conventional banks.
The efficiency and stability of Islamic banks compared with conventional banks merits further research, particularly in light of the 2007–09 financial crisis. Using a sample of 510 banks—out of which 88 are Islamic—from 22 countries, the authors compare conventional and Islamic banks and find that Islamic banks are less cost-efficient but have higher asset quality. Furthermore, Islamic banks are less likely to disintermediate during a financial crisis.
How Is This Research Useful to Practitioners?
In theory, Islamic banking differs significantly from conventional banking. Five main principles set Islamic banking apart from conventional banking. The three main prohibitions of Islamic banking are against interest, speculation, and investing in banned industry sectors. Shari’a-compliant transactions also need to be based on profit- and loss-sharing principles and need to have an underlying tangible asset. These principles result in a different business model from that of conventional banks.
Islamic banks, for example, do not suffer from interest rate risk but do experience pass-through risk between depositor and borrower. Partnership loans are subject to a dual agency problem and are not always suitable as a transaction type from either the bank’s or the depositor’s perspective. Such transaction types as trade-based and leasing transactions, which provide financing and demand deposits to attract customer funds, are often applied in practice to manage the agency problem and pass-through risks.
The theoretical differences between Islamic and conventional banks do not have clear implications for total earnings, the capability to access market capital, or efficiency. Higher complexity in combination with the relatively young age of the Islamic financial institutions is likely to result in higher costs and thus a lower level of cost efficiency. Even in theory, it cannot be determined with clarity whether and how the business orientation, cost efficiency, asset quality, and stability differ between Islamic and conventional banks.
How Did the Authors Conduct This Research?
The authors use a data sample of 510 banks, of which 88 are Islamic, from 22 countries over the period 1995–2009. Each country in the sample has both Islamic and conventional banks. To determine the difference in business model, the ratio of fee-based income to total income, the level of nondeposit funding, and the loan-to-deposit ratio are considered. The results suggest that Islamic banks intermediate more of their deposits than their conventional counterparts do.
Bank efficiency is measured by overhead cost and the cost/income ratio, which indicate that Islamic banks have significantly higher overhead cost but only a marginally higher cost-to-income ratio. Asset quality is assessed using loss reserves, loan loss provisions, and nonperforming loans. Although there is no significant difference in loan loss provisions between the two types of banks, the authors find that loss reserves and nonperforming loans are significantly lower for Islamic banks. Finally, bank stability is assessed using the liquidity ratio, which does not appear to be significantly different between the two types of institutions. In addition, the Z-score—an indication of the likelihood of insolvency—indicates that Islamic banks are significantly closer to insolvency. They are thus less stable, and their returns are more volatile.
The general conclusion is that Islamic banks are less efficient, have higher intermediation ratios and higher asset quality, and are better capitalized. The latter two indicators in particular have helped Islamic banks outperform during the financial crisis.
The authors raise some interesting points, but their research also appears to miss a number of significant issues. Islamic financial institutions globally have suffered significantly from the real estate crisis that occurred at the end of 2009, which should have been captured by the data at least in part. In addition, the fact that Islamic banks are better capitalized seems to be taken as a given, without further investigation into the underlying reasons. Islamic banks’ better capitalization is not necessarily by choice; it is mainly caused by the significant lack of liquidity in the market. It is thus not necessarily a strong argument in their favor. But the high level of capitalization is potentially one of the most important reasons Islamic banks did well during the crisis. At a time when conventional banks did not have any funds to lend, Islamic banks still had capital available and were open for business. As a final point, the authors are incorrect as to the number of Islamic banks in the United Kingdom: There were five at the end of 2009, not two as reported. This mistake raises a concern about the quality of the underlying data.