Risk and profitability of Islamic banks: A religious deception or an alternative solution?

Abstract

The aim of this paper is to examine whether Islamic finance could be an alternative to the traditional financial system and could guarantee stability in times of crisis. To this end, 78 Islamic banks in 12 countries have been studied over the 2004–2013 period. A series of bank-specific and other country-specific indicators are combined to explain the soundness of Islamic banking in terms of profitability as measured by ROA and ROE, and risk divided into credit risk measured by IMLGL and EQL, and insolvency risk measured by Z-SCORE. The aim is to estimate five regressions using dynamic panel data econometrics (GMM system). The results indicate that bank size and capital are the main factors responsible for increasing profitability and stability of Islamic banks and reducing their credit risk. However, the ratios forming the variable liquidity and asset quality often lead to inconclusive results. It is also found that macroeconomic variables, except inflation, are able to improve Islamic banks’ stability. This is not the case for credit risk where the ratio is still unfavorable. The conclusion is that there are no major differences between IBs and CBs in terms of their profitability and risk features.

Keywords

• Islamic banks
• Credit strength
• Risk and profitability
• GMM system