Are Islamic Banks More Resilient During Financial Panics?

• Published date: 01 February 2015
• Author: Moazzam Farooq,Sajjad Zaheer
• DOI: http://doi.org/10.1111/1468-0106.12096
• Date: 01 February 2015

ARE ISLAMIC BANKS MORE RESILIENT DURING

FINANCIAL PANICS?

MOAZZAM FAROOQ Central Bank of Oman

SAJJAD ZAHEER*State Bank of Pakistan and Iqra University

Abstract. Islamic banking is one of the fastest growing segments of the financial sector in developing

countries. Rapid growth of this segment is accompanied with claims about its relative resilience to

financial crises as compared to conventional banking. However, little empirical evidence is available

to support such claims. Using data from Pakistan, where Islamic and conventional banks co-exist,

we compare the behaviour of Islamic and conventional banks during a financial panic. Our results

show that Islamic bank branches are less prone to deposit withdrawals during financial panics, both

unconditionally and after controlling for bank characteristics. The Islamic branches of banks that

have both Islamic and conventional operations tend to attract (rather than lose) deposits during

panics, which suggests a role for religious branding. We also find that Islamic bank branches grant

more loans during financial panics and that their lending decisions are less sensitive to changes in

deposits. Our findings suggest that greater financial inclusion of faith-based groups may enhance the

stability of the banking system.

1. INTRODUCTION

Maturity transformation, that is, the conversion of short-term liabilities into

long-term assets, is a core function of banks. Therefore, by the very nature of

their business, banks hold a mix of illiquid assets and liquid liabilities which

exposes them to liquidity mismatch risk. This, in turn, may lead to bank runs

and insolvency (Diamond and Dybvig, 1983). As history painfully illustrates,

bank runs sometimes occur just because of rumour-mongering about the health

of the financial sector, regardless of the actual financial strength of individual

banks. This kind of panic situation can test the resilience of banking systems

(e.g. one that comprises relatively new faith-based financial institutions such as

Islamic banks) during liquidity crises. However, research into the behaviour

of Islamic banks compared to conventional banks during financial stress is

limited.

*Address for correspondence: State Bank of Pakistan, I. I. Chundriagar Road, Karachi, Pakistan.

E-mail: sajjad.zaheer@sbp.org.pk. We are thankful to two anonymous referees, to Andrew Berg,

Mario Catalan, Galina Hale, Camelia Minoiu, Chris Papageorgiou and Catherine Pattillo, and to

participants at the International Monetary Fund–Department for International Development

(IMF-DFID) conference on ‘Macroeconomic Challenges Facing Low-Income Countries: New Per-

spectives’. All remaining errors are our own. We are most grateful to the State Bank of Pakistan for

providing the data used in this paper. This paper is part of a research project on macroeconomic

policy in low-income countries supported by the UK’s DFID. The paper was presented at the

Conference on ‘Macroeconomic Challenges Facing Low-Income Countries: New Perspectives’

(Washington, DC, 30–31 January 2014). The views expressed herein are those of the authors and

should not be attributed to the IMF, its Executive Board or its management, or DFID, the State

Bank of Pakistan and its subsidiaries, or the Central Bank of Oman.

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Pacific Economic Review, 20: 1 (2015) pp. 101–124

doi: 10.1111/1468-0106.12096

© 2015 Wiley Publishing Asia Pty Ltd

In this paper we examine the impact of a financial panic on the deposit and

lending behaviour of Islamic and conventional banks in Pakistan, where no

explicit deposit insurance exists. Starting in the last week of September 2008,

the banking sector in Pakistan faced massive deposit withdrawals induced by

rumours in the media about the potential failure of several financial institu-

tions. These withdrawals led to a severe liquidity crunch. Demand deposits

in the banking sector continuously fell over a period of 7 weeks (from 27

September 2008 to 14 November 2008). In just 3 weeks (from 27 September

2008 through 18 October 2008), demand deposits declined by 4% or 131

billion PKR (Pakistani rupee). The panic was contained within approximately

2 months through central bank interventions aimed at restoring liquidity in

the banking sector.

We find that Islamic banks (in particular, Islamic bank branches and subsidi-

aries) experienced fewer deposit withdrawals than conventional banks and some

even recorded deposit increases during this panic, leading to an average inflow

of deposits into Islamic branches and subsidiaries over the period. This result

holds in a variety of specifications with and without bank characteristics, and

suggests a role for ‘religious branding’. As a result, Islamic banks were better

able to maintain the supply of credit to the real economy during the financial

panic. We also find that lending by Islamic banks is less sensitive to the change

in deposits than it is for their conventional counterparts.

Our study adds to the literature on performance of Islamic and conventional

banking sectors during the financial crisis. For instance, in a cross-country

analysis, Hasan and Dridi (2010) find that during 2008–2009, Islamic banks

fared better than conventional banks in terms of credit and asset growth, con-

tributing to the ‘financial and economic stability’. Using the data of 141 coun-

tries over the period 1995–2007, Beck et al. (2013) conclude that during the

global financial crisis, Islamic banks had a higher intermediation ratio, had

higher asset quality and were better capitalized. They also observe a relatively

better stock market performance of Islamic banks during the same period.

However, the performance of Islamic banks is not universally superior as there

are significant size effects. Using data from 18 countries with substantial pres-

ence of Islamic banking, C

ˇihák and Hesse (2010) conclude that Islamic banks

are financially stronger when they are small; however, they lose their relative

strength as they grow bigger in size, which reflects challenges of credit risk

management in large Islamic banks.

This paper also contributes to the literature on the evidence of transmission of

financial sector shock to the real sectors of the economy as documented by

Kapan and Minoiu (2013), de Haas and van Horen (2013), Giannetti and

Laeven (2012), Ivashina and Scharfstein (2010) and Khwaja and Mian (2008),

among others. For example, Kapan and Minoiu (2013) use variation in banks’

dependence on wholesale funding and their structural liquidity in 2007Q2 to

gauge the impact of financial turmoil in bank funding markets during the global

financial crisis on the supply of corporate loans. Their findings suggest that

banks with stronger balance sheets, that is, banks with more high-quality capital

and in a better structural liquidity position before the crisis, were better able to

M. FAROOQ AND S. ZAHEER

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