Put to the Test

• Author: Maher Hasan and Jemma Dridi
• Position: a Deputy Division Chief in the IMF's Monetary and Capital Markets Department, and is a Senior Economist in the IMF's Middle East and Central Asia Department.

Islamic Banking

THE recent global crisis has renewed interest in the relationship between Islamic banking and financial stability—and, more specifically, the resilience of the Islamic banking industry during crises. Some argue that the lack of exposure to the types of loans and securities associated with the losses conventional banks experienced during the crisis—because of the asset-based and risk-sharing nature of Islamic finance—shielded Islamic banks from the crisis. Others contend that Islamic banks relied on leverage and took on significant risks, much like their conventional counterparts, making them vulnerable to the “second-round effects” of the global crisis.

Our study looks at the actual performance of Islamic banks and conventional banks in countries where both have significant market shares, and addresses three broad questions. Did Islamic banks fare differently from conventional banks during the financial crisis? If so, why? And what challenges for Islamic banks has the crisis highlighted?

Using bank-level data covering 2007–10 for about 120 Islamic and conventional banks in eight countries—Bahrain, Jordan, Kuwait, Malaysia, Qatar, Saudi Arabia, Turkey, and the United Arab Emirates (UAE)—we focused on changes in four key indicators: profitability, bank lending, bank assets, and external bank ratings.

The Islamic banking model

The central concept in Islamic finance is justice, which is achieved mainly through the sharing of risk. Stakeholders are supposed to share profits and losses. Hence, charging interest is prohibited.

While conventional intermediation is largely debt based and allows for risk transfer, Islamic intermediation, in contrast, is asset based and centers on risk sharing (see table). “Asset based” means that an investment is structured on exchange or ownership of assets, placing Islamic banks closer to the real economy than conventional banks, which can create products that are mainly notional or virtual.

During the boom period of 2005 to 2007, Islamic banks’ profitability was significantly higher than that of conventional banks. During this period, real GDP growth for countries in our sample averaged 7.5 percent a year before decelerating to 1.5 percent during 2008–09. If this profitability was the result of greater risk taking, one would then expect a larger decline in profitability for Islamic banks during the crisis (defined in our study as beginning at end-2007).

We found that factors related to Islamic...