Islamic and conventional banks' soundness during the 2007–2008 financial crisis

Review of Financial Economics xxx (2013) xxx–xxx

REVFIN-00291; No of Pages 10

Contents lists available at SciVerse ScienceDirect

Review of Financial Economics

j ourna l homepage: www.e lsev ie r .com/ locate / r fe

Islamic and conventional banks' soundness during the 2007–2008 financial crisis☆

Khawla Bourkhis a, Mahmoud Sami Nabi b,c,d,⁎a FIESTA — Tunis Higher Institute of Management, Tunis University & Sousse Institute of Higher Commercial Studies, University of Sousse, Tunisiab Islamic Research and Training Institute (IRTI), Jeddah, Saudi Arabiac LEGI — Tunisia Polytechnic School, University of Carthage, Tunisiad Economic Research Forum, Cairo, Egypt

☆ The views expressed in this paper do not necessaril⁎ Corresponding author at: Islamic Research and Trainin

Arabia.E-mail address: [email protected] (M.S. Nabi).

1058-3300/$ – see front matter © 2013 Elsevier Inc. Allhttp://dx.doi.org/10.1016/j.rfe.2013.01.001

Please cite this article as: Bourkhis, K., & Naof Financial Economics (2013), http://dx.doi

a b s t r a c t
a r t i c l e i n f o
Article history:Received 21 August 2011Accepted 3 January 2012Available online xxxx

JEL classification:G01G21

Keywords:Islamic bankingConventional bankingFinancial crisis

The recent global financial crisis has induced a series of failure of many conventional banks and led to anincreased interest in the Islamic banking business model. This paper attempts to answer empirically thefollowing question: What was the effect of the 2007–2008 financial crisis on the soundness of Islamic banksand their conventional peers? Using the Z-score as an indicator of bank stability, our regression analysis(covering a matched sample of 34 Islamic Banks (IBs) and 34 conventional banks (CBs) from 16 countries)shows that there is no significant difference in terms of the effect of the financial crisis on the soundness ofIBs and CBs. This finding reveals that IBs are diverging from their theoretical business model which wouldhave allowed them to keep the same level of soundness even during the crisis.

© 2013 Elsevier Inc. All rights reserved.

1. Introduction

The 2007/2008 financial crisis which started as a credit shock hasinduced a series of failure of many conventional banks (CBs), aswitnessed by the collapse of Lehman Brothers. According to theOCDE (2010) this crisis has shown that banks' funding structure isimportant to their resilience. More precisely, the report argues thatbanks relying mostly on wholesale funding (i.e. funding from otherbanks, money market funds, corporate treasuries and other non-bank investors) have been severely affected by the crisis. At the oppo-site, banks which relied mostly on depository funding have been veryresilient to the crisis. The latter were less exposed to the liquidity riskthat propagates through the interlinked relationships in the financialsector. Yet, the liquidity risk generated market risk and produced sys-temic risk which threatened even sound banks. Many theoreticalmodels have analysed the banks' vulnerability to liquidity shocks inthe context of interconnected banks. Freixas, Parigi, and Rochet(2000) show that liquidity shock hitting one bank may prompt thedepositors to run on solvent banks if they fear that there is insuffi-cient liquidity in the banking system. Allen and Gale (2000) showthat an unforeseen liquidity shock could generate the bankruptcy ofthe entire banking system under different configurations of theinterbank market structure.

y reflect the views of IRTI.g Institute (IRTI), Jeddah, Saudi

rights reserved.

bi, M.S., Islamic and conventi.org/10.1016/j.rfe.2013.01.00

Khan (1987) argues that the theoretical model of Islamic banks(IBs) can successfully fill the failure of CBs in maintaining stability.In fact, IBs are assumed to separate investment funds from demanddeposits and apply 100% reserve on the latter. IBs are different fromCBs because they operate upon the principles of the Islamic law(the Shari'ah) which prohibits the payment or receipt of interest(riba) and encourage risk sharing. This is reflected on the liabilitiesside of the balance sheet since IBs collect funds through two catego-ries of deposits: demand deposits and investment deposits. Whiledemand deposits are perfectly guaranteed and yield no return, invest-ment deposits should be similar to mutual fund shares and notguaranteed a fixed return. The difference between IBs and CBs shouldalso be reflected on the asset side since IBs have developed interest-free financing instruments based on two principles: Profit and losssharing (PLS) and markup principle (Hassan, Farhat, & Al-Zubi,2003; Zaher & Hassan, 2001). However, it seems that the practice ofIBs is not diverging from that of CBs since all over the world IBs arerelying more on markup financing modes rather than PLS based fi-nancing instruments (Siddiqi, 2006). The 2007/2008 financial crisisrepresents a good experiment to test the divergence between thetwo models of banking. According to Shamshad Akhtar,1 Islamicbanks (IBs) have illustrated a degree of resilience and stability tothe recent crisis but have been impacted because of their higherexposure to real estate and their limited reliance on risk sharing or

1 The Ex-Vice-president of the World Bank for MENA in her speech during the“Symposium on Islamic Finance in Roma: Developments in MENA region”, Bank Italia,Rome, Italy, November, 11th, 2009.

onal banks' soundness during the 2007–2008 financial crisis, Review1

http://dx.doi.org/10.1016/j.rfe.2013.01.001

mailto:[email protected]


http://www.sciencedirect.com/science/journal/10583300


2 K. Bourkhis, M.S. Nabi / Review of Financial Economics xxx (2013) xxx–xxx

equity based transactions. Hasan and Dridi (2010) is the only study inour knowledge which has analysed the effect of the recent financialcrisis on IBs and CBs. It delved the effects of the crisis on profitability,credit growth, asset growth and external ratings of 120 Islamic andconventional banks in 8 countries. The authors found that IBs' showedstronger resilience (according to the above indicators) in the earlystages of the crisis. However, as the crisis moved to the real economyin 2009, IBs' profitability has steeply declined relatively to the CBs.They conclude that IBs contributed to financial and economic stabilityduring the crisis, given that their credit and asset growth was at leasttwice as high as that of CBs.

This paper attempts to provide a complementary analysis aboutthe effect of the crisis on the financial soundness of IBs and CBs. Itdeparts from Hasan and Dridi (2010) in many aspects. Firstly, we con-sider a matched sample of IBs and CBs in order to avoid testing rela-tionships on incomparable banks and reduce the model dependenceand thereby obtaining more robust results (Ho, Imai, King, & Stuart,2007). Secondly, we use not only a non-parametric approach asdone by Hasan and Dridi (2010) but also a regression analysis. Thefirst approach enables us to analyse the 2007–2008 crisis's impacton a set of financial soundness indicators (FSIs) related to banks'earnings and profitability, capitalization, asset quality, efficiency andliquidity. Whereas, the regression analysis assesses the impact ofthe crisis on a particular indicator of banks' stability which is theZ-score.2 Finally, we believe that controlling for the heterogeneity ofthe institutional environment is very important and constructed anaggregate indicator based on six governance indicators (compiledby Kaufmann, Kraay, &Mastruzzi, 2010). Our matched data comprises34 IBs and 34 CBs from the 16 countries covered on the period 1998–2009 which enables us to assess the crisis's effects on the financialsoundness of IBs and CBs. The two types of banks are matched inpairs according to three characteristics: total assets, country, andperiod of observation. We perform inter-temporal and inter-bankcomparisons, using the Wilcoxon signed rank test. The inter-bankcomparison enables us to compare the financial soundness indicatorsof IBs relatively to those of the CBs separately before (1998–2006),during (2007–2008), and after (2009) the crisis. Whereas, the inter-temporal comparison enables us to analyse the effect of the crisis onthe financial soundness of each type of banks. The results show thatthe two types of banks are indistinguishable in terms of their liquiditysituation and the level of their non-performing loans. However, IBsoutperformed CBs in regards to the return on average assets (ROAA)during and after the financial crisis. This better performance seemsto be partially due to differences in the provisioning strategies ofthe two types of banks during the crisis. Indeed, CBs increased theirLoan Loss Provision (LLPs) during 2007–2008 in response to the in-crease of their Non Profit Loans (NPLs). However, IBs increased theirLLPs only in 2009 although their NPLs increased in 2007–2008 simi-larly to their conventional peers. Therefore, it seems that IBs operatedwith greater risk exposure than their counterparts during the crisis.This opposite evolution of the LLPs in 2009 hasn't prevented the IBsto outperform the CBs (in term of ROAA). This is in part due to thefact that they were far more cost effective than the CBs during thisyear. Considering the impact of the financial crisis on the bankingsoundness (measured by the Z-score and capital to asset ratio) wefind no significant difference between IBs and CBs. However, thereis some evidence that IBs were in average more sound (in regardsof the Z-score). The similar behaviour of the two groups of banks re-garding the financial crisis is coherent with the results of a growingnumber of studies showing that IBs are mimicking the commercial

2 To our knowledge, Cihak and Hesse (2010) is the first study that used the Z-scoreto assess the stability of IBs relatively to CBs in a cross-country analysis during theperiod 1993–2004. Cihak and Hesse (2010) found three main results: (i) small IBs tendto be more stable than small CBs; (ii) large CBs tend to be more stable than large IBs;and (iii) small IBs tend to be more stable than large IBs.

Please cite this article as: Bourkhis, K., & Nabi, M.S., Islamic and conventiof Financial Economics (2013), http://dx.doi.org/10.1016/j.rfe.2013.01.00

strategies of their conventional peers and diverging from their theo-retical business model. Indeed, as will be detailed in Section 2 the lat-ter would have allowed the IBs to keep the same level of soundnesseven during the crisis since the losses occurring on the asset sidewould have been totally absorbed on the liability side. The rest ofthe paper is organized as follows: Section 2 provides an overviewabout the advantages of using PLS and mark-up financial modes andpresents the risks related to the deviation of the IBs' practices fromtheir specific business model. Section 3 defines the banking sound-ness concept and its indicators which are used in this paper.Section 4 assesses the impact of the crisis using a non-parametricand a parametric approach. Section 5 concludes with a summary ofthe main results.

2. PLS and mark-up financial modes: two specificities of theIBs model

Many economists (Ahmed, 2002; Cihak & Hesse, 2010; Khan,1987; Syed Ali, 2007) argue that the PLS mechanisms allow IBs tomaintain their net worth and avoid the deterioration of their balancesheets under difficult economic situations. Indeed, IBs channel invest-ment deposits into PLS loan (Mudharabah and Musharakah). Giventhat neither the principal nor the return of the investment depositsis guaranteed, any loss which occurs on the asset side could be totallyabsorbed on the liability side. Thus, the PLS allows the IB to transferthe credit risk from its asset side to its liability side (the investmentdeposits). Consequently, if the value of the assets decreases, thevalue of the liabilities should decrease respectively. The other typesof Islamic financial modes based on mark-up (e.g. Murabaha, Ijaras,and Istisnaa) require that a real asset underlies the financial transac-tion. Consequently, financial assets and derivatives based on otherdebt financial assets (like CDS) cannot be traded. This linkage withthe real economy reduces leveraging and prevents the exposure ofIBs to speculative behaviour that leads to instability. However, IBsmay lose their comparative advantages against their conventionalpeers due to the deviations of the current practices from the theoret-ical model. In particular, the mimicking of CBs may raise multiplerisks that are not assumed to be for IBs. The first deviation is in thecomposition of their balance sheets. In a typical IB, more than 80%of total assets are fixed income and short term maturity assets.While, only 20% are dedicated to long term and risk sharing invest-ments. El-Hawary, Grais, and Iqbal (2007) and Greuning and Iqbal(2008) claim that the dominance of less risky, low return assetsdeprives the bank of the benefits of portfolio diversification, asMudarabah and Mushrakah contracts are more profitable. Analystsexplain this behaviour by the fact that sale-based transactions areless associated with moral hazard and adverse selection problemsthan PLS investments (Siddiqi, 2006). In fact, the latter need addition-al effort to capture good investment opportunities and to analyse pro-jects adequately. Besides, Islamic banks cannot request for collateralto reduce credit risk. Thus, risk sharing investments require a highlevel of confidence and transparency between investors, banks anddepositors.

The second divergence with the Islamic banking theory is in the in-comedistribution. In some cases, IBs distribute profits to the investmentdepositors evenwhen they accrue loss and pay the profits out of equity.This phenomenon is called the displaced commercial risk (El-Hawary etal., 2007; Greuning & Iqbal, 2008). Zainol and Kassim (2010) and Cevikand Charap (2011) found that the conventional banks' deposit ratesGranger cause returns on PLS accounts inMalaysia and Turkey. An anal-ogous result was established by Chong and Liu (2009) in the case ofMalaysia showing that the retail Islamic deposit rates mimic the be-haviour of conventional interest rates. Therefore, the current practicesdo not make a clear differentiation between shareholders and invest-ment account holders' rights. Finally, IBsmay not fully respect Shari'ahprinciples in their activities. For instance, Chong and Liu (2009) claim



3K. Bourkhis, M.S. Nabi / Review of Financial Economics xxx (2013) xxx–xxx

that Malaysian banks are not very different from traditional banks inthe adoption of the PLS principle.

3. Indicators of banking soundness

Lindgren, Garcia, and Saal (1996) define bank soundness as theability of the bank to withstand adverse events such as bank run,major policy changes, financial sector liberalization and natural disas-ter. Hence, it reflects the bank capacity to be solvent and remain sounder difficult economic conditions by means of their capital andreserve accounts. The IMF's financial soundness indicators (FSIs) in-clude, in addition to measures related to bank's capitalization, a num-ber of indicators related to asset quality and profitability whichprovide complementary information about the health of the bank.In this paper we consider the Z-score as a measure of bank stabilityand 10 accounting ratios which are mostly part of the IMF financialsoundness indicators3 (FSIs).

3.1. The Z-score

The Z-score ratio is a popular measure of bank soundness since itis inversely related to the probability of bank's insolvency. It is denot-ed as follows: Z=(μ+K)/σ where μ denotes the bank's averagereturn on assets (ROA), K the equity capital in percentage of total as-sets and σ is the standard deviation of the ROA as a proxy for returnvolatility. The probability of insolvency is defined as the probabilitythat losses π exceed equity E i.e.

P π≤−E½ � ¼ P ROA≤−K½ � ¼ ∫−K

−∞f ROAð Þd ROAð Þ:

According to De Nicolo (2000) this probability satisfies the follow-ing inequality

P ROA≤−K½ �≤ σ2

μ þ Kð Þ2 ¼ 1z2

:

Therefore, an increase of the Z-score is equivalent to a decrease ofthe upper bound of the insolvency risk. Under the assumption ofbank's return normality, the Z-score can be interpreted as the numberof standard deviations below the mean by which profits would haveto fall in order to deplete equity.

3.2. Accounting soundness indicators

Table 1 presents the 10 accounting ratios that we consider in thisstudy in addition to the Z-score to assess the banks' soundness.

4. Effects of the financial crisis on the soundness of IBs and CBs

We analyse the effect of the financial crisis on the soundness of IBsand CBs using the set of measures introduced in Section 3. We focuson fully fledged IBs and CBs and use unconsolidated bank statementswhenever consolidated statements are not available.4 Our matchedsample is composed of 34 IBs matched with 34 CBs from 16 countries5

where the two groups of banks coexist and IBs' assets account morethan 1% of the total banks' assets at least in one year in the period1998–2009. The two types of banks are matched in pairs according tothree characteristics: total assets,6 country, and period of observation.

3 See Financial Soundness Indicators Compilation Guide, IMF (2006).4 The source of the data is the Bankscope database.5 Bahrain, Bangladesh, Brunei, Egypt, Gambia, Indonesia, Jordan, Kuwait, Malaysia,

Mauritania, Pakistan, Qatar, Saudi Arabia, Tunisia, United Arab Emirates and Yemen.6 We allow a variation in the interval [50%, 150%].


4.1. Non-parametric analysis

4.1.1. MethodologyWe perform inter-temporal and inter-bank comparisons, using the

Wilcoxon signed rank test.7 The inter-bank comparison enables us tocompare the financial soundness indicators of IBs relatively to thoseof the CBs separately before (1998–2006), during (2007–2008), andafter (2009) the recent global financial crisis.8 Whereas, the inter-temporal comparison enables us to analyse the effect of the crisis onthe financial soundness of each type of banks (Table 2).

4.1.2. Results

4.1.2.1. Capital adequacy. Fig. 1 illustrates the mean change in the cap-ital to asset ratio (CAR) between the three sub-periods for Islamic andconventional banks. For IBs, we note a slight augmentation from14.01% before the crisis to 14.20% during the crisis period, then an in-crease to 14.72% in 2009. However, for the CBs the ratio increasedfrom 12.58% during 1993–2006 to 16.13% during the crisis period2007–2008, and then it went down to 13.03% in 2009. Based on theWilcoxon signed rank test, there is no significant difference betweenthe two groups of banks in the capitalization ratio before, during andafter the financial crisis (p>0.1). Regarding the inter-temporal com-parison neither for IBs nor for CBs the capital to asset ratio is changedafter the crisis. Therefore, based on the CAR, we conclude that there isno significant difference in the soundness of the two types of banksover the considered period.

4.1.2.2. Asset quality. Fig. 2 shows that the net loans to total assets ratio(NL/TA) for IBs (53.32%) was higher than for CBs (46.77%) as con-firmed by the Wilcoxon test during the period 1993–2006 (pb0.01).However, there was no significant difference between the two groupsof banks in the second and third periods (p>0.1). Furthermore, themean of the net loans to deposits ratio (NL/D) for CBs was higherthan 60% however it was larger than 80% for IBs (Fig. 3). The compar-isons of the (NL/D) ratios by the Wilcoxon test reveal that the ratiowas significantly larger for IBs than for CBs at the 1% level of risk be-fore the financial crisis. This analysis shows that, during the period offinancial stability, IBs were able to make more loans than their con-ventional peers. But during and after the (2007–2008) financial crisisthe two groups of banks follow the same behaviour.

Fig. 4 shows that for CBs, the nonperforming loans to gross loans(NPL/GL) and the loan loss provision to net interest revenue (LLP/NIR) increased during the 2007–2008 financial crisis and decreasedin 2009. Hence the CBs increased their provisioning in response tothe increasing of NPL/GL. For the IBs, the NPL/GL increased from4.91% during the period 1993–2006 to 5.51% during 2007–2008 andto 6.53% during 2009 respectively. On the other side, Fig. 5 showsthat the LLP/NIR fell from 26.3% to 20.01% in 2007–2008 period.Then, it increased sharply in 2009 to attain 69.75%. The Wilcoxontest reveals that there is no significant difference in the NPL/GL ratiobetween the IBs and CBs over the period of study (p>0.1). Howeverthe LLP/NIR for CBs was larger than for IBs at the 10% level of risk(z=1849; pb0.1) during the (2007–2008) financial crisis. Thus, IBsoperated with greater risk exposures than their counterparts duringthe crisis. Based on the inter-temporal analysis, we conclude thatthere are no significant differences in the overall asset quality indica-tors before and after the financial crisis for both Islamic and conven-tional banks (p>0.1, Wilcoxon signed rank test).

7 Thenull hypothesis tested by theWilcoxon test is that the twopopulations representedby the respective members of the matched pairs are identical.

8 We distinguish between the first wave of the world financial crisis and its economicwave starting from 2009.



Table 1Variables: Categories and raison d'être.

Variables Raison d'être and comments

Capital adequacy:Capital to asset ratio

Capitalization is one of the most important criteria for identifying the bank's soundness (Gaganis, Pasiouras, & Zopounidis, 2006).

Earning and profitability:Return on average assets (ROAA)Return on average equity (ROAE)

Banks cannot be permanently solvent if they are not profitable. High earnings are necessary to implement investments and make fullprovision for the absorption of losses. Maechler, Mitra, and Worrel (2007) show that profitability is negatively related to the probabilityof insolvency. Using six profitability ratios, Olson and Zoubi (2008) find that IBs are more profitable than CBs.

Asset quality:Net loans to total assets (NL/TA)Net loans to deposits (NL/D)Non-performing loans to gross loans(NPL/GL)Loan loss provision to net interestrevenue (LLP/NIR)

High levels of assets that are not generating income reduce the bank's capacity to honour its liabilities.Loan loss provision and non-performing loans to gross loans are often used as a proxy for asset quality of an individual bank. Using PEA(provision to earnings assets) and APL (adequacy of provision for loans) as indicators of asset quality in a sample of 237 observations forbanks operated in the GCC region over the period 2000–2005, Olson and Zoubi (2008) find that IBs keep up lower provisions for possibleloan losses than CBs.For IBs, the net interest revenue is defined as the sum of the positive and negative income flows associated with mark-up financing and PLSarrangements

Liquidity:Liquid assets to total assets ratioLiquid assets to deposits ratio

Liquid assets refer to cash and its equivalent that are easily convertible to cash at any time without significant losses.

Efficiency:Cost to income ratio

It measures the bank's operating costs (salaries, technology, administrative expenses, etc.) as a proportion of its total income.


4.1.2.3. Efficiency. Contrarily to the findings of Hammim, Abdullah, andAl-Habshi (2006) and Cihak and Hesse (2010) the efficiency ratiowas found to be similar between the two groups of banks before andduring the financial crisis (p>0.1; Wilcoxon signed rank test). Where-as, the CBs became less efficient in 2009 (z=1922; pb0.1; Wilcoxonsigned rank test). Besides, we find no evidence of significant difference

Table 2Descriptive statistics of the soundness indicators for Islamic and conventional banks.

Pre-crisis period (1993–2006) Crisis peri

N Mean Std Min Max N Me

Capital adequacyCapital/assets

Islamic banks 104 14.01 9.32 2.97 39.76 44 14.2Conventional banks 104 12.58 8.51 −1.87 43.38 44 16.1

Earnings and profitabilityROAA

Islamic banks 104 1.61 1.99 −3.53 8.43 44 1.9Conventional banks 104 1.64 2.16 −4.01 13.2 44 1.0

ROAEIslamic banks 104 12.30 14.12 −53.64 69.92 44 14.5Conventional banks 104 11.58 26.53 −88.43 196.74 44 6.1

Asset qualityNPL/gross loans

Islamic banks 25 4.91 4.76 0.36 19.95 25 5.5Conventional banks 50 12.43 14.6 0.41 60.83 29 12.9

LLP/net interest revenueIslamic banks 87 26.3 80.14 −550 313.83 36 20.0Conventional banks 96 32.54 40.38 −31.93 207.46 38 76.3

Net loans/total assetsIslamic banks 104 53.32 21.89 0.02 91.97 44 51.9Conventional banks 102 46.77 17.53 0.01 78.23 44 50.3

Net loans/depositsIslamic banks 104 80.32 81.68 0.02 668.94 44 99.9Conventional banks 102 58.41 23.50 0.01 119.23 43 66.7

EfficiencyCost/income


LiquidityLiquid assets/total assets


Liquid assets/depositsIslamic banks 104 45.98 43.80 6.85 295.46 44 51Conventional banks 104 40.41 21.58 0.58 106.89 43 36.5


in the cost to income ratio before and after the crisis for each type ofbanks (p>0.1, Wilcoxon signed rank test).

4.1.2.4. Liquidity. Figs. 7 and 8 show that the liquidity ratios for IBsincreased during the (2007–2008) financial crisis but decreased gradu-ally during the last three years for the CBs. Based on the Wilcoxon test,

od (2007–2008) Post-crisis period (2009)

an Std Min Max N Mean Std Min Max

0 9.37 3.04 50.09 13 14.72 6.82 5.53 26.733 15.31 4.06 99.78 13 13.03 6.51 2.57 29.81

9 2.61 −2.48 11.39 13 1.18 2.13 −3.11 4.961 2.44 −5.39 8.99 13 −0.33 2.78 −5.69 2.29

7 13.47 −9.36 63.15 13 8.72 12.63 −14.92 25.14 23.43 −99.87 42.69 13 −5.52 34 −94.33 26.61

1 5.73 0.17 22.25 10 6.53 4.29 1.29 12.72 16.87 0.21 65.35 8 9.06 10.63 1.16 29.3

1 23.77 −3.68 110.75 13 69.75 165.17 1.52 6154 149 −44.29 774.77 12 46.89 68.93 3.93 226.85

8 14.27 19.6 81.75 13 51.86 11.8 35.15 74.163 17.07 8.03 82.47 13 50.30 14.49 14.51 63.48

4 139.47 21.49 743.09 13 90.06 97.29 38.31 409.752 30.76 9.35 170.02 13 63.52 18.15 17.15 84.5

0 33.28 16.65 170.53 13 54.97 34.52 20.2 146.367 57.38 9.09 258.14 13 143.43 227.11 29.37 826.17

1 125.77 8.34 859.32 13 27.41 7.66 15.07 40.198 14.79 6.17 82.40 13 25.74 19.6 8.14 84.3

51.05 9.03 272 13 43.90 37.05 19.97 163.930 18.97 7.46 103.91 13 32.37 23.43 9.27 99.68



Table 3Description of the used variables.

VariableName

Definition Source

Zi,j,t Z-score for bank i at time t in country j Authors' calculations based on Bankscope dataBi,j,t−1 Vector of bank specific variables Total assets of a bank (in U.S. billion dollars) Bankscope

Loan/assetsCost/incomeIncome diversity

1− net interest−income−other operatingtotal operating income

��

��

Authors' calculations based on Bankscope data

Ii,j,t−1 Vector of industry specific variables Herfindahl Hirschman Index Authors' calculations based on Bankscope dataMarket share of Islamic banksGovernance Kaufmann et al. (2010)

Ti,j Islamic bank dummy variable Equals 1 for Islamic bank, 0 otherwise BankscopeTsSi,j,t−1 Islamic bank dummy variable∗share of Islamic banks

Conventional bank dummy variable∗share of Islamic banksMj,t−1 Vector of macroeconomic variables GDP growth (growth rate of nominal GDP,

adjusted for inflation (in local currency))World Bank development indicators

Inflation (year-on-year change of the CPI index) (percent)Exchange depreciation (year-on-year change in the nominalexchange rate, U.S. dollars per local currency (percent))

Cj Country dummies variablesP Period dummy variables Equals 1 for the crisis-period, 0 otherwise

Table 4Summary statistics for Islamic and conventional banks.

N Mean Std Min Max

Panel 1: Conventional banksZ-score 161 18.01 15.11 −0.613 84.24Total Assets (Mill$) 161 4100.89 9147.62 0.58 47,039.81Net loans/total assets 159 48.04 17.17 0.01 82.47Cost/income 157 60.37 78.04 6.83 826.17Income diversity 156 0.599 0.234 0.426 0.994

Panel 2: Islamic banksZ-score 161 29.09 51.88 0.30 300.87Total assets (Mill$) 161 3847.47 8351.62 0.399 45,527.92Net loans/total assets 161 52.84 19.34 0.02 91.97Cost/income 157 53.46 25.77 14.3 170.53Income diversity 155 0.478 1.37 0.162 0.98


we find no statistically significant difference in the (LA/TA) and (LA/D)ratios between Islamic and conventional banks over the period of study(p>0.1). The two groups of banks follow the same liquidity policy overthe period study.

4.1.2.5. Earnings and profitability. Fig. 9 shows that the mean of ROAAfor IBs (CBs) varies between 2.45 (2.42) and 0.65 (−0.33) over theperiod of study. We note that the two lines are almost superimposedover the (2002–2006) period. Since 2007, the ROAA for CBs had de-creased significantly passing from 1.57 to −0.33 in 2009. Concerningthe ROAA for IBs, it had recorded a slight decrease since 2008. Fig. 10shows that the mean of ROAE for IBs (CBs) varies between 17.44(26.35) and 7.5 (−5.52) over the period of study. The ROAE for CBshad decreased in 2007 passing from 8.05 to (−5.52) in 2009. Howev-er, there is no significant difference in the profitability ratios (ROAAand ROAE) between the two types of banks during the period(1998–2006) (p>0.1, Wilcoxon signed rank test). This result in oppo-site to that obtained by Olson and Zoubi (2008) who found a signifi-cant different (at the 10% level) in favour of Islamic banks of the GulfCooperation Council (GCC) region over the period 2000–2005. Butour comparison shows that IBs became more profitable (ROAA)than their conventional peers at the 1% and 5% level of risk duringand after the (2007–2008) financial crisis respectively. In fact, theCB profitability ratios decreased significantly after the crisis at 1%level of risk. Therefore, based on the evolution of the (ROAA), we con-clude that the IBs outperformed the CBs during and after the financialcrisis. Could we explain this higher performance in line with the pre-vious results?

We know that the profitability of banks is negatively correlated totheir provision and to their cost. Fig. 6 shows that during 2007–2008,IBs and CBs have almost the same cost/income ratio whereas the LLPof CBs largely exceeds that of IBs. Thus the better performance of IBsduring 2007–2008 in term of ROAA is at least partially due to thishuge gap in the provisioning. Contrarily to CBs, the increase of thenon-performing loans of IBs was not accompanied by an increase intheir provisioning. Therefore, this difference in the provision strategyhas naturally contributed to higher performance of IBs during the cri-sis. We have now to interpret the relatively higher performance of IBsduring 2009. Fig. 6 shows that for 2009, the cost/income ratio for CBshas largely increased whereas it remained almost the same for IBs.Meanwhile, the gap between the LLP of the two types of banks hasreduced in favour of CBs. However it could be noted that the relative


increase of the cost/income for CBs was larger than the relative de-crease of their LLP which once again has pushed in favour of thehigher profitability of the IBs of our sample.

4.2. Regression analysis

4.2.1. Methodology and variables definitionsWe construct the Z-score for each bank i at time t in country j.

Based on panel data analysis, we estimate a modified version ofCihak and Hesse (2010)'s econometric model that enable us to testfor the effect of the financial crisis while controlling for the bank spe-cific variables, industry specific variables and macroeconomic vari-ables:

Zi;j;t ¼ α þ β1Bi;j;t−1 þ δTi;j þ β2Ii;j;t−1 þ∑sγsTsSi;j;t−1

þ β3Mj;t−1 þ∑sθjCj þ∑

sφsTsPþ εi;j;t

where the dependent variable is the Z-score Zi,j,t for bank i in countryj at time t; Bi,j,t−1 is a vector of bank-specific variables; Ti,j is adummy variable equals to one if bank i is an Islamic bank,Ii,j,t−1 con-tains time-varying industry-specific variables; TsSi,j,t−1 is the inter-action of the type of the bank with the share of the Islamic banksin the total assets of the banking system of country j at date t−1;



Table 5Random-effects (GLS regression).

All banks (1) All banks (2) All banks (3) All banks (4) Large banks (5) Large banks (6) Large banks (7) Large banks (8) Small banks (9) Small banks (10) Small banks (11) Small banks (12)

log (total assets)(−1)

0.383 (0.367) 0.036 (0.907) 0.094 (0.720) −0.014(0.755)

0.553 (0.648) −0.390**(0.037)

−0.505**(0.043)

0.161 (0.899) 0.507 (0.430) −0.251 (0.504) −0.087 (0.857) −0.627 (0.348)

NL/A (−1) −0.076(0.220)

−0.116***(0.007)

−0.105**(0.017)

−0.113(0.118)

0.124 (0.171) 0.016 (0.647) 0.069 (0.347) 0.048 (0.296) −0.196**(0.035)

−0.162**(0.015)

−0.108**(0.042)

−0.282**(0.033)

Cost/income (−1) −0.016(0.594)

−0.011 (0.412) −0.018 (0.492) −0.015(0.350)

−0.085(0.129)

−0.083**(0.041)

−0.079 (0.111) −0.066(0.121)

0.001 (0.974) 0.012 (0.456) 0.012 (0.729) 0.008 (0.763)

Income diversity(−1)

−3.29 (0.497) −3.071 (0.402) −4.511 (0.341) −2.166(0.588)

−5.371(0.288)

−4.855 (0.153) −6.474 (0.161) −4.569(0.272)

4.207 (0.514) −1.028 (0.841) −1.905 (0.797) 1.651 (0.736)

Islamic dummy 12.69* (0.073) 8.893 (0.141) 11.09* (0.059) 9.08 (0.203) 2.728 (0.634) 2.181 (0.704) 0.186 (0.973) 1.403 (0.803) 18.41 (0.159) 15.42 (0.178) 22.31* (0.074) 16.48 (0.211)log (HHI (−1) 0.0001 (0.961) 0.000 (0.615) 0.002 (0.283) 0.001 (0.186) 0.002 (0.636) 0.002 (0.510)Governance −42.40*

(0.089)−30.33*(0.067)

−7.757(0.471)

−2.083 (0.834) −42.69 (0.102) −37.064(0.103)

CB dummy∗shareof IB (−1)

−14.34(0.421)

−3.068 (0.784) 18.338(0.446)

−1.084 (0.914) −29.33 (0.189) 15.04 (0.586)

IB dummy∗shareof IB (−1)

−28.14(0.158)

−9.718 (0.457) 11.66 (0.632) 8.677 (0.413) −21.87 (0.447) −15.87 (0.618)

Exchange ratedepreciation(−1)

−0.089(0.603)

0.146 (0.207) 0.029 (0.795) 0.018 (0.812) −0.093 (0.763) 0.213 (0.315)

Inflation (−1) 1.161* (0.064) 0.342 (0.066)* 0.273 (0.624) 0.109 (0.535) 1.946** (0.042) 0.675* (0.081)Real GDP growth(−1)

−0.059(0.940)

0.128 (0.821) 0.162 (0.725) 0.288 (0.212) −0.427 (0.766) 0.119 (0.913)

IB dummy∗crisisperiod dummy

−0.029(0.847)

2.654 (0.156) 1.410 (0.439) 2.345 (0.244) −1.956(0.445)

1.488 (0.243) −0.047 (0.978) 0.408 (0.765) −0.566 (0.866) 4.41 (0.334) 1.302 (0.744) 4.274 (0.374)

CB dummy∗crisisperiod dummy

0.012 (0.993) 0.878 (0.276) 0.841 (0.498) 0.512 (0.645) −1.664(0.548)

0.063 (0.945) −0.556 (0.724) −0.017(0.990)

2.339 (0.305) 1.261 (0.228) 2.048 (0.313) 1.901 (0.251)

Constant −37.03(0.189)

19.62 (0.034)** −12.60 (0.439) 16.65 (0.125) 5.63 (0.753) 32.02 (0.011)** 27.83* (0.051) 25.60* (0.063) −53.45 (0.125) 16.59 (0.20) −31.86 (0.215) 13.60 (0.355)

Observations 173 234 203 198 85 120 102 97 88 114 101 101R-squared(between)

0.581 0.540 0.552 0.550 0.272 0.244 0.240 0.272 0.640 0.580 0.596 0.596

* Significant at 1%.** Significant at 5%.***Significant at 10%.

6K.Bourkhis,M

.S.Nabi/

ReviewofFinancialEconom

icsxxx

(2013)xxx

–xxx

Pleasecite

thisarticle

as:Bourkhis,K.,&

Nabi,M

.S.,Islamic

andconventionalbanks'soundness

duringthe

2007–2008

financialcrisis,ReviewofFinancialEconom

ics(2013),http://dx.doi.org/10.1016/j.rfe.2013.01.001


Table 6Country dummies variables.

Country

Bahrain 53.18 (0.134)Bangladesh 0.497 (0.956)Brunei 88.63** (0.035)Egypt 33.60* (0.099)Gambia 26.18* (0.083)Indonesia 28.07* (0.091)Jordan 55.27* (0.069)Kuwait 67.73 (0.069)*Malaysia 63.95 (0.104)Mauritania 168.83 (0.008)***Pakistan −8.307 (0.216)Qatar 72.19* (0.084)Saudi Arabia 32.02* (0.094)Tunisia 69.20** (0.031)

* Significant at 1%.** Significant at 5%.***Significant at 10%.

Table 7Summary of the results.

Non-parametricanalysis

Capital/assets • No significant difference between IBs and CBsduring the three periods relatively to thecapitalization ratio.• No significant effect of the crisis on thecapitalization of IBs and CBs.

ROAA • No significant difference in the profitabilityratios between IBs and CBs during 1998–2006.• IBs became more profitable than CBs duringand after the financial crisis.

NPL/GL andLLP/NIR

• No significant difference between IBs and CBsduring the three periods relatively to thenonperforming loans to gross loans.• Loan loss provisions were significantly largerfor CBs relatively to IBs during the crisis'speriod 2007–2008.

Cost/income • No significant difference between IBs and CBsbefore and during the financial crisis.• IBs became more efficient in 2009.

LA/TA LA/D • No significant difference between IBs and CBsduring the three periods in terms of liquiditypolicy.

Panel dataanalysis

Effects of thetype of banksand the crisison Z-score

• There is some evidence that across the entireperiod 1998–2009, IBs were sounder than CBs.• No significant effect of the 2007–2008's crisison IBs and CBs.


Mj,t−1 and Cj are vector of macroeconomic and country dummy vari-ables, respectively;TsP the interaction of the type of the bank withthe crisis period (2007–2008) dummy; finally εi,j,t is the residual.Table 3 presents the variables' definition in more details as well asthe data sources. The summary statistics of the variables are givenin Table 4. The dummy variable (T) is needed to examine if the bank-ing soundness of IBs is superior to that of CBs. Similarly, the interac-tion between the dummy variable (P) (which takes the value of 1 ifthe year in question belongs to the crisis period 2007–2008) andthe Islamic and conventional banks dummies is useful to test if thebanking soundness of IBs was less impacted by the 2007–2008 finan-cial crisis relatively to their conventional peers. When examining thebanks' soundness, it is imperative to control for macroeconomic vari-ables GDP growth rate, inflation rate, and exchange rate deprecia-tion). We also have to control for the institutional environment. Tothis end we construct index (per year and country) by averagingthe 6 following governance indicators compiled by Kaufmann et al.(2010): voice and accountability, political stability, government ef-fectiveness, regulatory quality, rule of law and control of corruption.To take into account the impact of market concentration on the fi-nancial stability, we use the Herfindahl–Hirschman Index (HHI).9

The model includes also the country dummies variables (Cj) inorder to reveal the potential role of country-specific unobserved fac-tors in maintaining banking stability.

We use the Random-effect Generalized Least Squares estimationand analysed the following three models: none effect model, fixed ef-fect model and random effect model. The best model is selected basedon the Hausman test. To overcome the problem of heteroscedasticityin the data, we perform a robust regression technique. In order tocapture possible past effect, we lag by one year all the bank specificand macroeconomic variables, the Herfindahl–Hirschman Index andthe interaction of Islamic banks' share with Islamic and conventionalbank dummies. We test the lagged effect by comparing estimationusing lagged variables with estimation using contemporaneousvariables.

4.2.2. ResultsThere is some evidence that IBs were in average more sound (in

regard of the Z-score) over the entire period 1998–2009 (Table 5),

9 Defined as the sum of squared market share in terms of total assets of all banks inthe country.


(Fig. 11). Indeed, the sign of the Islamic dummy variable is alwayspositive but significant only at the 10 percent level for only three re-gressions (1, 3 and 11) out of the twelve performed. However, thereis no evidence that the financial crisis has affected differently thesoundness of the two types of banks during the period 2007–2008.Indeed, the interaction of the crisis dummy variable (P) with IB andCB dummies does not appear significant in all regressions. This sim-ilar behaviour of the two groups of banks regarding the financial cri-sis shows that IBs are diverging from their theoretical businessmodel. Indeed, as detailed in Section 2 the latter would have allowedthe IBs to keep the same level of soundness even during the crisissince the losses occurring on the asset side (due to defaults of theborrowers) would have been totally absorbed on the liability side.This result confirms the finding of a growing number of studies(Cevik & Charap, 2011; El-Hawary et al., 2007; Greuning & Iqbal,2008; Zainol & Kassim, 2010) showing that IBs are mimicking thecommercial strategies of their conventional peers and that in prac-tice they distribute profits to the investment depositors even whenthey accrue loss and pay the profits out of equity. Concerning thebank specific variables; the net loans to total assets ratio is negativeand statistically significant at 5% level of risk for the small banks(see regressions (9), (10), (11) and (12)). Then, the small bankswith a high concentration of loans are less sound. The coefficient ofthe cost to income ratio is negative and statistically significant differ-ent to zero at the 5% level of risk (see regression (6)). Then, the moreefficient banks are the more sound they are. The income diversitydoes not appear significant in all the regressions. The presence ofIBs in a banking system has no significant impact on the soundnessof CBS. In fact, the share of IBs interacted with conventionaldummy variable does not appear significant in all the regressions.Regarding the governance, there is some evidence that it has a nega-tive impact on the banks' soundness (see regressions (1) and (3)).HHI, exchange rate depreciation and real GDP growth have no clearlinear dependence with the Z-score. Finally, the results show thatbank soundness (as indicated by the Z-score) is better in Mauritania,Tunisia and Brunei (see Table 6).

The main results obtained from the two approaches are summa-rized in Table 7.



Fig. 2. The mean change in the net loans to total assets ratio.

Fig. 3. The mean change in the net loans to deposits ratio.


5. Conclusion

The recent global financial crisis has induced a series of failure ofmany conventional banks and led many economists to advocate forfavouring the development of Islamic banks in the MENA region argu-ing their higher soundness during the financial crises. This paperattempted to answer empirically the following question: What was theeffect of the 2007–2008 financial crisis on the soundness of the Islamicbanks and their conventional peers?

To answer this question we considered a matched sample com-prising 34 IBs and 34 CBs from 16 countries and applied two comple-mentary approaches. The first one is a non parametric analysis of thefinancial crisis's impact on a set of financial soundness indicators(FSIs) related to the banks' earnings and profitability, capitalization,asset quality, efficiency and liquidity. The second one is a parametricapproach analysing the impact of the crisis on a particular indicatorof bank stability which is the Z-score. The results showed that thereis no significant difference between IBs and CBs in terms of the effectof the financial crisis on the banking soundness (measured by theZ-score and capital to asset ratio). The similar behaviour of the twogroups of banks regarding the financial crisis is coherent with the re-sults of a growing number of studies showing that IBs are mimickingthe commercial strategies of their conventional peers and divergingfrom their theoretical business model. This was also confirmed bythe other results of the non-parametric approach showing that thetwo groups of banks are indistinguishable in terms of their liquiditysituation and the level of their non-performing loans. Nevertheless,we found that IBs outperformed CBs in regard to the return to asset in-dicator during and after the financial crisis. This better performanceseems to be partially due to the differences in the provisioning strate-gies of the two types of banks during the crisis and to the better costefficiency of IBs during the year 2009.

Acknowledgement

We appreciate the helpful comments and suggestions of the twoanonymous referees. We thank Sami Ben Naceur and Sabri Boubakerfor their comments on an earlier version of this paper. Any errorsremain our own. This work was sponsored by the Economic ResearchForum (ERF) and has benefited from both financial and intellectualsupport. The contents and recommendations do not necessarily re-flect ERF's views.

Appendix

Fig. 1. Mean change in the capital to assets ratio. Fig. 4. The mean change in of nonperforming loans to gross loans ratio.

Please cite this article as: Bourkhis, K., & Nabi, M.S., Islamic and conventional banks' soundness during the 2007–2008 financial crisis, Reviewof Financial Economics (2013), http://dx.doi.org/10.1016/j.rfe.2013.01.001


Fig. 6. Mean change of cost to income ratio.

Fig. 7. Mean change of liquid assets to total assets ratio.

Fig. 8. Mean change of liquid assets to deposits ratio.

Fig. 9. Trend of ROAA.

Fig. 10. Trend of ROAE.

Fig. 11. Comparison of average Z-score.

Fig. 5. The mean change in the Loan Loss Provision to net interest revenue.


Please cite this article as: Bourkhis, K., & Nabi, M.S., Islamic and conventional banks' soundness during the 2007–2008 financial crisis, Reviewof Financial Economics (2013), http://dx.doi.org/10.1016/j.rfe.2013.01.001



References

Ahmed, H. (2002). A microeconomic model of an Islamic bank. Research Paper IslamicResearch and Training Institute, No. 59.

Allen, F., & Gale, D. (2000). Financial contagion. Journal of Political Economy, 108(1), 1–33.Cevik, S., & Charap, J. (2011). The behavior of conventional and islamic bank deposit

returns in Malaysia and Turkey. IMF WP 11/156.Chong, S. C., & Liu, M. H. (2009). Islamic banking: Interest free or interest-based?

Pacific-Basin Finance Journal, 17, 125–144.Cihak, M., & Hesse, H. (2010). Islamic banks and financial stability: An empirical analysis.

Journal of Financial Services Research, 38(2), 95–113 (Springer, December).De Nicolo, Gianni (2000). Size, charter value and risk in banking: An international

perspective. International finance discussion papers 689. Board of Governors of theFederal Reserve System (U.S.).

El-Hawary, D., Grais, W., & Iqbal, Z. (2007). Diversity in the regulation of Islamic financialinstitutions. The Quarterly Review of Economics and Finance, 46, 778–800.

Freixas, X., Parigi, B., & Rochet, J. C. (2000). Systemic risk, interbank relations andliquidity provision by the central bank. Journal of Money, Credit, and Banking,32(3/2), 611–640.

Gaganis, C., Pasiouras, F., & Zopounidis, C. (2006). A multicriteria decision frameworkfor measuring banks' soundness around the world. Journal of Multi-Criteria Decisionanalysis, 14, 103–111.

Greuning, H. V., & Iqbal, Z. (2008). Risk analysis for Islamic banks. Washington, D.C.: TheWorld Bank (2008).

Hammim, M., Abdullah, N., & Al-Habshi, S. (2006). Efficiency of Islamic banks inMalaysia:A stochastic frontier approach. Journal of Economic Cooperation among IslamicCountries, 27, 37–70 (N°2).

Hasan, M., & Dridi, J. (2010). The effects of the global crisis on Islamic and conventionalbanks: A comparative study, IMF WP 10/201.


Hassan, M. K., Farhat, J., & Al-Zubi, B. (2003). Dividend signalling hypothesis and shortterm asset concentration of Islamic interest free banking. Islamic Economic Studies,11 (N°1).

Ho, D. E., Imai, K., King, G., & Stuart, E. A. (2007). Matching as nonparametric prepro-cessing for reducing model dependence in parametric causal inference. PoliticalAnalysis, 15(3), 199–236.

IMF (2006). Financial soundness indicators: Compilation guide. International Monetary Fund.Kaufmann, D., Kraay, A., & Mastruzzi, M. (2010). The worldwide governance indicators:

Methodology and analytical issues. Policy Research WP 5430.Khan, M. (1987). Islamic interest-free banking: A theoretical analysis. In Mohsin Khan, &

Abbas Mirakhor (Eds.), Theoretical studies in Islamic banking and finance (pp. 15–36)The Institute of Islamic Studies.

Lindgren, C. J., Garcia, G., & Saal, M. I. (1996). Bank soundness and macroeconomic policy.International Monetary Fund.

Maechler, A., Mitra, S., & Worrel, D. (2007). Decomposing financial risks and vulnerabilitiesin Eastern Europe; IMF WP 2007/248.

OCDE (2010). Competition, concentration and stability in the banking sector,DAF/COMP(2010)9.

Olson, D., & Zoubi, T. A. (2008). Using accounting ratios to distinguish between Islamicand conventional banks in the GCC region. The International Journal of Accounting,43, 45–65.

Siddiqi, M. N. (2006). Islamic banking and finance in theory and practice: A survey ofstate of the art. Islamic Economic Studies, 13 (No. 2).

Syed Ali, A. S. (2007). Financial distress and bank failure: Lessons from closure fromIhlas Finans in Turkey. Islamic Economic Studies, 14 (N°1).

Zaher, T. S., & Hassan, M. K. (2001). A comparative literature survey of Islamic financeand banking. Financial Markets, Institutions & Instruments, 10 (No 4).

Zainol, Z., & Kassim, S. H. (2010). An analysis of Islamic banks' exposure to rate ofreturn risk. Journal of Economic Cooperqtion and Development, 31(1), 59–83.



Documents

Islamic and conventional banks' soundness during the 2007–2008 financial crisis