Islamic banking and the Global Financial Crisis: evidence from the Gulf Cooperation Council

Abstract

The 2007/08 Global Financial Crisis (GFC), which was triggered in the American mortgage market in 2007, had unforeseen consequences that are considered to be the worst since the Great Depression of the 1930s. The GFC did not remain within the American banking sector but swiftly spread to other segments and other parts of the world because of globalisation. For example, it caused another severe crisis on the other side of the Atlantic, with European governments announcing that they would provide Greece with urgent financial aid to stop it from going bankrupt, and the country is still struggling not to default on its massive debts. Despite the damage that the GFC caused and left on the global banking sector, Islamic banking continued to grow, with an average annual growth rate in the Gulf Cooperation Council (GCC) region of 25% between 2000 and 2012. This rapid growth has led many advocates of Islamic finance to have the confidence to propose that Islamic banking is a viable alternative to conventional banking. This thesis investigates empirically these arguments, taking into consideration the direct and the indirect exposure of the GFC using a variety of formal financial and econometric tests. The thesis evaluates the operating performance, efficiency and financial stability of Islamic and conventional banks by means of financial ratios, Data Envelope Analysis (DEA), Distance to Default and Z-score, respectively, prior to, during and post the GFC. It investigates three time periods (prior, during and post the GFC) using samples ranging from 76 to 101 banks for each time period, across six Gulf Cooperation Council (GCC) economies, with data from 1998 to 2013. After controlling for ownership differences, internal factors, macroeconomic factors and unobserved omitted variables (varying across countries and years), the analysis shows that Islamic banks outperformed conventional banks during the GFC in terms of capitalisation, profitability, liquidity and cost efficiency. In addition, Islamic banks narrowed that inherent gap with conventional banks in terms of management quality, profit efficiency and financial stability, as measured by Z-scores. To the best of my knowledge, this finding can be considered some of the earliest empirical evidence supporting the theoretical argument that Islamic banks were less exposed to the GFC because of restrictions on dealing in non-complying assets, believed to be a main reason for the crisis, but not due to their use of profit-and-loss sharing (PLS) instruments. However, in the later stages of financial turmoil, when the initial financial shocks of the GFC spilled over from the financial sector into segments of the real economy, Islamic banks suffered even more than conventional banks due to their lax risk-mitigation tools, size disadvantage, rate-of-return risk and, more importantly , their reliance on debt-based instruments, which make Islamic banks less resilient to shocks. This resulted in Islamic banks losing their advantage in capitalisation, performing worse than conventional banks in terms of profitability, efficiency and financial stability. This finding suggests that Islamic banks are more sensitive to conditions of real economic sectors, whereas conventional banks are more vulnerable to global financial shocks. This thesis was limited by the absence of data regarding the Islamic services windows of conventional banks, the unavailability of data on the underlying assets of Islamic banks, and finally the use of accounting-based data, with the exception of using market-based Distance to Default (DD). These limitations made the modelling and the subsequent inferences a very challenging assignment, one which required the dedication of a significant amount of time and effort. Despite the limitations of the research, a number of recommendations can come out of the findings. Bankers at Islamic banks should focus more closely on economic conditions because the Islamic banking system is more affected by these than by global financial conditions. Furthermore, Islamic bankers should invest more in developing risk-management techniques, taking into consideration the unique needs of Islamic banks, to make their performance more stable and less risky. Finally, Islamic banks should consider growing in size to gain from the benefit of scale, as the data show that size is linked to superior performance.