Credit Risk Differential between Islamic and Conventional Banks in Malaysia.

AuthorKoh, Eric H.Y.

Despite the renewed interest post-2008, experts remain divided on whether Islamic banks (IBs) are riskier than conventional banks (CBs). Hence, we aim to study their credit risk differential more closely. Extant studies have analysed IBs collectively as a group in multicountry settings. We differ by studying one country, Malaysia, over 2006-19. We chose Malaysia because of its established dual banking system and global leadership in Islamic banking. We studied two credit risk aspects (the bank's bankruptcy risk and its customers' default risk) in a twophased approach (a t-test and a regression). We also tested the robustness of our findings through a feasible generalized least squares linear model. We find that IBs are generally riskier but the customer default risk differential is insignificant. Moreover, the IB-CB risk differential has narrowed in recent years. Our findings present three implications. First, we studied this phenomenon in a single country so as to remove potential noise from crosscountry differences. We also reaffirmed our regression findings through a robustness test. Such efforts help enhance the accuracy of our findings. Second, practitioners may note the risk differential reasons and opportunities arising from the narrowing gap. Third, policymakers may consider increasing the market liquidity and risk management options for IBs. Future research may consider studying the recent narrowing risk gap and whether the standalone IBs differ from those which are part of a CB group.

Keywords: Islamic banks, conventional banks, credit risk, Malaysia.

Article received: February 2021; revised: August 2021; accepted: October 2021

  1. Introduction

    Islamic banking was institutionalized with the establishment of Mit Ghamr in Egypt in 1963. Despite being fairly new, Islamic banking has grown rapidly across the world, with more than 1,500 Islamic financial institutions operating in forty-six countries, including non-Islamic ones (Johnes, Izzeldin and Pappas 2014; Islamic Finance Development Report 2020). It provides an alternative financing option to Muslims who may feel more comfortable dealing with banking transactions that adhere to their religious beliefs. Non-Muslims may also deal with Islamic banking products because of cost or product features considerations. Malaysia is no exception; its Islamic financing as a proportion of total loans and financing has catapulted from 5 per cent in 2000 to 39 per cent in 2019 (Bank Negara Malaysia 2018, 2020).

    During the tumultuous 2007-9 period, some blamed the speculative activities of conventional banks (CBs) for triggering the Global Financial Crisis. They argued that Islamic banks (IBs) had lower risk as seen in their lower non-performing loan (NPL) ratios. This is because IBs cannot engage in usury and speculative activities (Trabelsi 2011; Abedifar, Molyneux and Tarazi 2013). Others, however, assert that the IBs' risk is not very different from that for CBs (Iqbal and Mirakhor 2011; Bank Negara Malaysia 2011). Yet others argue that IBs are riskier than CBs (Elgari 2003; Hussain and Al-Ajmi 2012). Hence, there are mixed views as to the IB-CB risk differential.

    Moreover, most extant studies compare IBs and CBs across several countries. They analyse IBs collectively as a group distinct from that for CB. Hence, we need to consider reducing the noise from cross-country differences. Accordingly, we focus on one country--Malaysia--and extend Lassoued's (2018) work in terms of the study period, risk measures and robustness tests. We choose Malaysia as a case because it is a global leader in Islamic banking (Sundarajan and Errico 2002). Further, section 27 of the Central Bank of Malaysia Act 2009 explicitly states that Malaysia has a dual banking system. This was the first legislation in the world that expressly acknowledged such a system (Bank Negara Malaysia 2009). Hence, Malaysia's dual banking system (comprising both CBs and IBs) is also seen as a blueprint for many countries that are considering adopting or expanding Islamic banking (Van Greuning and Iqbal 2008).

    While we aim to compare the IBs' and CBs' risk levels in Malaysia, we also need some granular risk categories and measures. We focus on credit risk because it is "the leading source of problems in banks worldwide" (Basel Committee on Banking Supervision 2000). Next, there are several ways of measuring credit risk. This paper measures credit risk through two indicators, namely the z-score and the NPL ratio, as adapted from Bank Negara Malaysia (2017). First, as a borrower, a bank may present credit or default risk to its depositors and lenders. We use the z-score to indicate bankruptcy risk (Chong and Liu 2009). A higher z-score suggests greater financial stability and hence, lower bankruptcy risk. Second, we extend Lassoued's (2018) work by studying another indicator, i.e., the NPL ratio. As a lender, a bank is exposed to its borrowers' credit risk, i.e., the risk that these customers are unable to repay their loans. We use the NPL ratio to measure a bank's exposure to its borrowers' credit risk. A lower NPL ratio is associated with a lower customer default risk and hence, lower credit risk (Johnes, Izzeldin and Pappas 2014).

    Accordingly, this paper aims to determine whether IBs have higher credit risk than CBs in Malaysia, from two dimensions:

  2. The bank's bankruptcy risk, via the z-score (a higher z-score suggests a lower credit risk); and

  3. The customers' credit risk, via the nonperforming loans (NPL) ratio (a lower NPL ratio suggests a lower customer credit risk).

    We arrange the remaining portions of this paper as follows. The next section reviews extant literature that compare the risks of IBs and CBs. The third section discusses the methodology used to make sense of the data. The subsequent section analyses the results and discusses the findings. The final section concludes.

  4. Literature Review

    This section discusses extant studies that compare the credit risks of IBs and CBs.

    2.1 IBs Are Less Risky

    Some studies find that the application of Shariah (Islamic law) principles result in the IBs having lower risks. They argue that IBs are generally more ethical and conservative in their investment decisions (Bourkhis and Nabi 2013). IBs also generally maintain higher levels of cash deposit ratio and avoid excessive debt (Metwally 1997; Alam 2020). Besides, where IBs co-exist with CBs, IBs tend to have more onerous set-up capital requirements. This is because the regulators typically address the IBs' specificities so as to facilitate sound banking practices. Thus, IBs tend to have higher capitalization and lower bankruptcy risk (Kabir, Worthington and Gupta 2015; Trabelsi 2011).

    Islamic bank customers are also more conservative and cautious. For instance, Abedifar, Molyneux and Tarazi (2013) assert that the IBs' customers tend to be more religious and honour their repayment obligations. Further, unlike the CBs' apparently more impersonal or transactional nature of dealing, the IBs' musharakah (partnership) approach promotes a closer bank-customer relationship based on mutual trust (Bank Negara Malaysia 2017). This results in better assessment of customer creditworthiness and hence, reduced credit risks (Johnes, Izzeldin and Pappas 2014).

    Moreover, the IBs' inherent structural setups make them less risky for three reasons. First, IBs share their credit risks with their depositors (Trabelsi 2011; International Monetary Fund 2014). IB depositors do not earn interest but share, as business partners, in the bank's profits or losses. Thus, these depositors are incentivized to monitor the banks' risk and business performance more closely.

    Second, under an IB's murabahah (mark-up) concept of financing, its customers may be more highly motivated to pay. In a CB loan, the customer's motivation to pay is to fulfil the debt repayment obligation and to reduce interest charges. In an IB, however, the bank first owns the asset before selling the asset to the customer who requisitions it. Moreover, the murabahah concept encourages a business partnership mindset wherein the customer should be more motivated to pay the bank in order to own the asset (Johnes, Izzeldin and Pappas 2014; Hassan, Khan and Paltrinieri 2019). Third, Islamic banking prohibits uncertainties. Thus, IBs are not exposed to the risks inherent in, and the vagaries of, complex derivatives prevalent in CBs (Johnes, Izzeldin and Pappas 2014; Khan and Ahmed 2001).

    Among the popularly used risk measures are the accounting-based ones such as the NPL ratio, the ratio of loan loss provisions to assets, and the z-score. Studies such as Abedifar, Molyneux and Tarazi (2013) and How, Karim and Verhoeven (2005) use the NPL ratio and the ratio of loan loss provisions to total assets respectively. Both papers find that IBs have lower risks. In terms of the z-score, some find that the smaller IBs have lower risks than the CBs but the reverse happens for the larger IBs (Cihak and Hesse 2008; Smaoui, Mimouni and Temimi 2020). This is because it is harder to manage the nonstandardized Islamic banking contracts in larger operations. Moreover, there may be limited access to Shariah-compliant hedging instruments, especially when dealing with larger amounts. Meanwhile, Ferhi (2017) finds that the larger IBs have credit risk levels that are closer to (but not higher than) those of CBs.

    Although Abedifar, Molyneux and Tarazi (2013) find that IBs have lower risks in terms of lower NPL ratios, the z-score measure differential is insignificant. Other authors use market-based measures such as the models of Merton's distance to default and the probability of default. Using these measures, IBs seem less risky (Boumediene 2011; Kabir, Worthington and Gupta 2015). Nonetheless, Kabir, Worthington and Gupta's (2015) findings using the NPL ratio and z-score reveal the opposite: IBs are riskier. The preceding discussions suggest that different risk measures may yield...

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