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A Survival Analysis of Islamic and Conventional Banks

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Abstract

Are Islamic banks inherently more stable than conventional banks? We address this question by applying a survival analysis based on the Cox proportional hazard model to a comprehensive sample of 421 banks in 20 Middle and Far Eastern countries from 1995 to 2010. By comparing the failure risk for both bank types, we find that Islamic banks have a significantly lower risk of failure than that of their conventional peers. This lower risk is based both unconditionally and conditionally on bank-specific (microeconomic) variables as well as macroeconomic and market structure variables. Our findings indicate that the design and implementation of early warning systems for bank failure should recognize the distinct risk profiles of the two bank types.

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Notes

  1. Although most studies tend to look at efficiency and stability in isolation, there are a few that examine the link between these concepts (see, e.g., Koutsomanoli-Filippaki and Mamatzakis (2009) and Koetter and Porath (2007) for applications using conventional banks, and Saeed and Izzeldin (2014) for a comparative study between Islamic and conventional banks). However, the exact link between efficiency and stability is not clear cut. For the Islamic versus conventional bank exposition, Kuran (2004) suggests that higher efficiency leads to higher stability, while Beck et al. (2013) finds the inefficient Islamic banks are more stable. Saeed and Izzeldin (2014) offer a nice exposition of the theories linking efficiency and stability in conventional banking. We opt not to address the issue of efficiency and stability in this paper due to data limitations arising from the necessity to use listed banks; we leave it instead for future research.

  2. Mudarabah and Musharakah are commonly used equity/participation type of contracts. In Mudarabah an investor (usually an Islamic bank) and an entrepreneur (individual or institutional) enter a joint venture where the bank provides the necessary funds and the entrepreneur provides the know-how. Fee-based services include the widely used contracts of Murabahah and Ijarah. Murabahah is in essence a cost-plus-profit sale. The bank arranges to sell a good to a customer at a premium which incorporates risks, costs and a profit margin. Ijarah is a lease contract where the bank leases an asset to an investor (or consumer) and the latter pays fees for utilising the asset.

  3. Islamic banks operating alongside conventional banks are subject to displaced commercial risk which is the risk arising from managing assets on behalf of investment accountholders that is effectively transferred to the Islamic banks’ own capital. This risk unfolds as the bank may forgo its profit share on such investment when it considers this essential due to the commercial pressure in order to increase the rate of return payable to investment accountholders.

  4. Relatedly, Ostergaard et al. (2015) find that banks in communities with high social capital, such as interpersonal trust, civic engagement and charitable work are more likely to survive compared to banks driven by profit-maximization motives.

  5. For a deeper technical discussion on survival analysis, see Hosmer et al. (1999) and Kalbfleisch and Prentice (2002).

  6. The log likelihood function that is maximized to estimate the sensitivities, β, is a partial log likelihood function as it is confined to the failure times and does not consider times when there is no failure. Thus, the only data that enter the log likelihood are the values of the covariates for both the failed and non-failed banks at the end of the sample years that immediately precede each of the observed failure times x(t 1), …, x(t j ), …, x(t K ), where K is the number of banks that failed during the sample period, and NK is the number of survivors.

  7. Interval-censoring arises from the imprecise measurement of time-to-failure. All we know is that a bank has failed within a certain month (this can be considered a limitation of Bankscope). The problem then is that in the event of more than one failure in any given month we do not observe the exact ordering of events. In the survival analysis, tied events are often handed via approximations. We use Efron’s (1977) approximation to compromise between speed and accuracy (Cleves et al. 2010).

  8. The only exception is Iran where there are no conventional banks.

  9. As a robustness check, we conduct the 1st–99th winsorization by using all of the (survived and failed) observations. Although the main findings are not challenged, we observe slightly worse goodness-of-fit statistics. The results are available on request.

  10. Suppose that a bank failed in March 2005. Because the last year-end accounting statement available for this bank corresponds to 2004, 2004 is in effect the year of failure for modelling purposes.

  11. See http://www.islamicfinanceservice.com (IFIS), http://www.isdb.org (IDB) and http://www.zawya.com.

  12. Accounting ratios are also good indicators of corporate default risk (see, e.g., Duffie et al. 2007).

  13. Management and sensitivity-to-market-risk variables are not included due to data constraints.

  14. Ownership information from Bankscope or the other data sources we could access is scarce. Therefore, we do not have an ownership variable. Nevertheless, it is well known that Islamic banks are primarily domestically owned.

  15. Real GDP and FX rates are from the IMF database and Datastream, respectively. The sovereign ratings are from Standard & Poor’s. The banking sector’s concentration and the Islamic Bank Share are based on Bankscope data.

  16. Panel unit root tests indicate that the included variables behave as stationary processes during the sample period. Detailed results are available from the authors on request.

  17. Islamic banks do not offer or receive interest payments but share ratios of profits. However, effectively, the same “net interest” principle applies because depositors are offered a low share ratio of the bank’s profits whereas banks charge a high share ratio when taking part in a venture through a business loan.

  18. Some studies find that managerial competency is higher for the Islamic banks than for the conventional banks. Yet the Islamic banking system, due to constraints imposed by Shariah law, is less efficient than the conventional one (Johnes et al. 2014; Abdul-Majid et al. 2010)

  19. For the Islamic banks there are no recorded failures beyond this point as these banks are generally younger.

  20. The validity of the proportional hazards assumption that underpins the Cox model is assessed via the Schoenfeld (1982) residuals-based statistic. The null hypothesis is that, although bank failure risk is itself time-varying, the bank-level and macroeconomic covariates contribute to the hazard rate in the same proportion at any point in time. The test statistic, shown as PH test χ 2 in Tables 5, 6, and 7, fails to reject the assumption.

  21. As a robustness check we repeat the analysis by narrowing our definition of failed banks to exclude mergers and acquisitions. The results do not challenge our main findings and are omitted for brevity.

  22. Due to insufficient data on asset quality (loan loss reserves, Tier 1 ratio) these variables are excluded. Nonperforming loans, ROA, and ROE have not been qualified based on our automatic variable selection process. As a robustness check we insert them into the model but they never reach statistical significance. These versions of Table 7 are available on request.

  23. Leverage impacts Islamic and conventional banks in different ways, which might explain the finding that higher leverage increases (reduces) survival rates of Islamic (conventional) banks. Fully understanding the link between leverage and stability in the two bank types requires an appreciation of the relation between leverage and profitability, which can be illustrated by the two main theories on capital structure: the pecking order (Myers and Majluf 1984) and the trade-off theory (Bradley et al. 1984). The pecking order theory assumes a negative leverage-profitability relation and applies more to companies. The trade-off theory is particularly relevant for banks (Toumi et al. 2011). It assumes a positive leverage-profitability relation and posits that higher leverage allows a bank to raise its profitability by committing more funds to investments (i.e., leverage multiplier effect). Under this theory higher leverage can lead to higher profitability and hence higher survival.

  24. Analogous conclusions are reached when the explanatory variables are drawn from the balance sheet and the income statement and are therefore omitted for brevity.

  25. This is the model reported in page 109, column (4) of Table 5, in Čihák and Hesse (2010). Consistent with their analysis, we adopt an OLS as the estimation approach with Newey-West h.a.c. standard errors for inference.

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Acknowledgments

We thank the participants of the Finance and Development in the Muslim Economies Conference at Bangor University; the 4th Islamic Banking and Finance Conference at Lancaster University; the Royal Economic Society Conference 2014 at Manchester; the BMRC-QASS Conference on Macro and Financial Economics at Brunel University; the IFABS Conference on Rethinking Banking and Finance: Money, Markets, and Models at the University of Valencia, Spain; and the seminar participants at the University of Bangor, University of Keele, Lancaster University Management School, and Manchester Business School, for valuable suggestions. The authors also want to thank Iftekhar Hassan, Sabur Mollah, Jonathan Moore, Anthony Murphy, Gerry Steele and Haluk Ünal (editor) for their helpful comments. Financial support from Gulf One Investment Bank, Bahrain, is gratefully acknowledged. A previous version of the paper was circulated under the title “Do Islamic Banks “Live Free and Die Harder”?”

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Pappas, V., Ongena, S., Izzeldin, M. et al. A Survival Analysis of Islamic and Conventional Banks. J Financ Serv Res 51, 221–256 (2017). https://doi.org/10.1007/s10693-016-0239-0

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