Will Islamic Banking make the World Less Risky Will Islamic Banking make the World Less Risky? An Empirical Analysis of Capital Structure, Risk Shifting and Financial Stability Moazzam Farooq Central Bank of Oman Sweder van Wijnbergen University of Amsterdam Sajjad Zaheer State Bank of Pakistan March , 14 2016

The views expressed here are those of the authors and do not necessarily represent or reflect the views of Central Bank of Oman, or State Bank of Pakistan or its subsidiaries.

Risk Seeking Behavior in Limelight since GFC Motivation Risk Seeking Behavior in Limelight since GFC Claims that Islamic Finance is Augers Well for Financial Stability Same/Similar Capital Requirements & Regulations Higher Loss Absorption Capacity because of Quasi Equity PLS Accounts Does it Affect Asset Mix? Risk Shifting Incentives Differ? 17

Islamic Banking Gaining Momentum Motivation Islamic Banking Gaining Momentum Impact on Stability of Financial Sector Islamic banks gaining higher share, more than trebled during last 5 years. These questions are relevant to the policy makers as Islamic Banking is gaining more systemic importance. Whether the stability of the financial sector will be altered when the Islamic segment of the banking sector becomes even more important. 17

What We Do Use a Classic Merton Credit Risk Framework to Determine if IBIs can be Expected to Take Lower Risks in Comparison to CBIs. We Test it in Empirically Using a Dataset Covering Conventional Banks (CBIs), Islamic Banks (IBIs), and Islamic & Conventional Branches of Mixed Banks in Pakistan. 17

What We Find Islamic Banking Institutions (IBIs) have Less Incentive to Shift / Take Risks. Risk Sharing: More Risk Sharing on Liability Side ~ Lower equity price volatility, given asset side volatility, because of IBIs also have less volatile asset returns, NPLs and lower loan loss provisioning. IBs are better capitalized and more stable than their conventional counterparts. 17

DATA Quarterly Data submitted to the SBP. Both Islamic & Conventional Operations 32 quarters, 06:2002 to 03:2010. 21 conventional banks (CBs), 6 full-fledged Islamic banks (IBs) and 13 mixed banks with both Islamic as well as conventional operations. . Returns on Islamic Deposits depend negatively on volatility of assets 17

Descriptive Statistics 17

Descriptive Statistics 17

Estimation Dependent variable is one of the measures corresponding to asset quality and stability of bank i, branches/operations type j, in quarter t. ISLj is the dummy for Islamic banking institutions, which includes both IBBs and IBs. The dummy is one when the IBI is Islamic and zero otherwise. Bijt are banking characteristics as control variables. Specifically, we include log of assets, non-lending operations and fixed assets of the banks to control size and asset structure of banks. 17

Estimation Also, we also split the dummy for IBIs into dummy for Islamic banks (IBs) and Islamic banking branches (IBBs). And, bank fixed effects 17

Results [EQ 2] 17

Results [EQ 2] 17

Results [EQ 2] 17

Results [EQ 2] 17

Results – Bank Fixed Effects 17

Results – Bank Fixed Effects 17

Less Incentives for More Risk Sharing Contract on Asset Side. Conclusions Islamic Banks have not only better asset quality but also are more stable than CBIs. Islamic Banking Branches of Conventional banks though have higher z-score, do not differ significantly from conventional banking institutions. IBBs on average, are more profitable, have less volatility in ROAs and have lower NPLs and lower loan loss provisioning than CBIs. Less Incentives for More Risk Sharing Contract on Asset Side. 17

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