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Islamic Banks and Financial Stability: An Empirical Analysis

We kickoff this month with a variety of empirical studies on Islamic finance, complementing theoretical discourse with hard facts & figures. The following working paper arrives from the IMF, scrutinizing the impact that Islamic banks have on financial stability. A very noteworthy finding is that small Islamic banks are more stable than their larger counterparts. This raises the question of whether the "mega Islamic bank" concept being touted around is actually valid! The authors argue that "as the scale of the banking operation grows, monitoring of credit risk becomes rapidly much more complex. That results in a greater prominence of problems relating to adverse selection and moral hazard [for large Islamic banks]. Another explanation is that small banks concentrate on low-risk investments and fee income, while large banks do more PLS [Profit-and-Loss Sharing] business". This further raises the issue of how robust is the risk management system of IFI's and how different should it be from that of conventional banks which focus on other metrics - such as PD (probability of default) and LGD (loss given default).

Islamic Banks and Financial Stability: An Empirical Analysis
Martin Čihák and Heiko Hesse
IMF Working Paper
Monetary and Capital Markets Department

Abstract: "We find that (i) small Islamic banks tend to be financially stronger than small commercial banks; (ii) large commercial banks tend to be financially stronger
than large Islamic banks; and (iii) small Islamic banks tend to be financially stronger than large Islamic banks, which may reflect challenges of credit risk management in large Islamic banks. We also find that the market share of Islamic banks does not have a significant impact on the financial strength of other banks."

- The paper is also discussed in the May 2008 edition of the IMF Survey Magazine.
- PWC has a further discussion on this topic within their Islamic finance blog.



  1. I wrote the following summary of this paper about a year ago that I wanted to share (I had to break it into two comments).

    The motivation for this paper was a lack of solid empirical evidence on the impact of Islamic banking on financial stability. There have been many theoretical and conceptual arguments made regarding how Islamic banks compare with conventional banks in regards to the financial stability of entire banking systems, but none that have taken an econometric approach to the problem.

    This paper attempts to fill a gap in knowledge that is essential to the growing Islamic banking industry. As Islamic banking grows from a niche market, making up only a small part of global banking assets, to one that makes up a more significant share of global banking systems it is imperative to look at their financial stability. Will the growth in Islamic banks create new risk management challenges that, if not properly acknowledged and dealt with could create a risk of contagion to conventional banks and national or international financial systems? There has been no empirical analysis to answer these questions.

    The underlying assumption being tested in this paper is whether Islamic banks are economically distinct from conventional banks. If Islamic banks are different, then they should show different risk profiles to conventional banks. Central bankers and financial regulators would need to ensure that traditional requirements of capital adequacy are sufficient to meet potential risks to financial stability. If Islamic banks are no different from a risk management perspective, for example because they do not use profit-and-loss
    sharing products and instead use products which mimic conventional products like commodity murabaha, then regulators need only to ensure that Islamic banks meet the same regulatory requirements as conventional banks.

    The authors, Martin Cihak and Heiko Hesse, believe a priori, that Islamic banks are different from conventional banks in that risk typically borne by equity owners is moved on the balance sheet but direct credit risk is shifted to depositors.

    This creates danger from a risk management perspective because of the moral hazard created when depositors want a return on their deposits and bankers may deliver this by making more risky investments. The greater return paid to depositors in good times may mask the additional risk of loss of principal caused by this risk sector concentration), the z-scores should be the same.

    The sample of banks includes 397 conventional commercial banks and 77 Islamic banks in countries where Islamic banks make up a non-trivial share of total banking assets. The banks are spread across countries in Africa, the Middle East and Asia, although no conventional banks’ Islamic ‘windows’ are included.

    The analysis of individual bank’s z-scores finds that large Islamic banks (>$1 billion in assets) are less stable than both large conventional banks and small Islamic banks. In contrast, small Islamic banks are more stable than both large Islamic banks and small conventional banks. This finding may indicate that because small Islamic banks are responsible to their depositors for the returns on taking. In addition, prohibitions of gharar and riba make risk management difficult because commonly used hedging and interbank lending are not available. The central bank’s role may also become more difficult because they may not be able to act as a lender of last resort.

  2. (cont.)

    To test the hypothesis that Islamic banks have an impact on the stability of the financial system, the authors look for differences in Islamic and conventional bank’s ‘z-scores’. The z-score “Measures the number of standard deviations a return realization has to fall in order to deplete equity” (27). If Islamic banks were no different, then after controlling for other differences in the banks in the sample (e.g., size of assets and equity) and country differences (e.g. inflation, exchange rates, financial their investments they take
    greater care or are generally more conservative than their conventional equivalents.

    However, it also indicates that there exist challenges to growing larger that are not shared with conventional banks. These include greater need for oversight of individual investments and a greater difficulty implementing adequate internal controls to avoid moral hazard.

    Next, the authors use regression analysis to investigate whether the presence of Islamic
    banks impacts other conventional or Islamic bank’s z-scores. They find that “a higher presence of Islamic banks in a banking system has a negative impact on z-scores in large commercial banks, but a positive impact on z-scores in commercial banks in general [but] a higher presence of Islamic banks in a banking sector tends to weaken the Islamic banks’ own z-scores” (20).

    The result that a greater presence of Islamic banks lowers each individual Islamic banks’ z-score (less stable) may indicate the effects of greater competition among banks to attract depositors and therefore greater risk taking. If this is the explanation, then financial sector regulators will be motivated to follow the growth in Islamic banking with additional regulation, particularly to ensure that internal controls prevent excessive risk taking and avoid moral hazard problems.

    Future research is necessary since this paper represents only one data point. One area that would be of particular interest to explain the final result of the paper is whether depositors who share returns of the bank are sensitive to changes in returns. We fortunately have not yet seen a crisis in the Islamic banking industry, but that also makes it difficult to tell whether Islamic banks are taking excessive risks to attract new depositors.

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  4. A brief discussion also follows in our Linkedin Forum.