DOES ISLAMIC BANKING PROMOTE FINANCIAL STABILITY? EVIDENCE FROM AN AGENT-BASED MODEL

  • Omer Faruk Tekdogan Ministry of Treasury and Finance, Turkey https://orcid.org/0000-0002-4397-1718
  • Burak Sencer Atasoy Ministry of Treasury and Finance, Turkey
Keywords: Islamic Banking, Conventional Banking, Contagion, Spillovers, Credit Risk

Abstract

Islamic banking has come to the forefront as being one of the fastest growing branch of the global financial industry in recent years. In this study we evaluate whether coexistence of Islamic and conventional banks promote financial stability. In this respect, we evaluate two types of financial systems: (1) A system solely comprised of conventional banks, (2) a dual system in which conventional and Islamic banks coexist and interact with each other. Accordingly, we design two agent-based models representing aforementioned systems and examine possible contagious effects and causes of bank failures by employing the volatility spillover methodology. We find that Islamic banks greatly promote stability by providing liquidity during financial shocks and create more liquidity per asset compared to conventional banks. We also find that they tend to hold more cash than conventional banks, which cushion the effects of a possible liquidity squeeze. Conventional banks, on the other hand, tend to have reserve deficits, which intensify during shock periods. We conclude that coexistence of both bank types creates a win-win situation and contributes to financial stability.

Author Biography

Omer Faruk Tekdogan, Ministry of Treasury and Finance, Turkey

Dr. Omer Faruk Tekdogan is Head of Department at Directorate General of Economic Programs and Research of Ministry of Treasury and Finance. He obtained his BA degree in business administration from İstanbul University, and his master’s degree in economics from North Carolina State University. He received his Ph.D. in Islamic Economics and Finance from İstanbul University. Previously, he worked as a Team Leader at Public Finance Transformation Office of Ministry of Treasury and Finance, and as a Policy Analyst at Development Co-Operation Directorate in Organization for Economic Co-operation and Development, and as a specialist at Undersecretariat of Treasury. He is on the editorial board of Turkish Journal of Islamic Economics (TUJISE). His research interests include Islamic economics and finance, monetary economics, banking, financial economics, and agent-based modeling.

References

Abdel Megeid, N. S. (2017). Liquidity risk management: conventional versus Islamic banking system in Egypt. Journal of Islamic Accounting and Business Research, 8(1), 100–128. https://doi.org/10.1108/JIABR-05-2014-0018

Abdulle, M., & Kassim, S. (2012). Impact of Global Financial Crisis on the Performance of Islamic and Conventional Banks: Empirical Evidence from Malaysia. Journal of Islamic Economics, Banking and Finance, 8(5).

Abedifar, P., Molyneux, P., & Tarazi, A. (2013). Risk in Islamic banking. Review of Finance, 17(6), 2035–2096.

Akram, H., & Rahman, K. ur. (2018). Credit risk management: A comparative study of Islamic banks and conventional banks in Pakistan. ISRA International Journal of Islamic Finance, 10(2), 185–205. https://doi.org/10.1108/IJIF-09-2017-0030

Alandejani, M., Kutan, A. M., & Samargandi, N. (2017). Do Islamic banks fail more than conventional banks? Journal of International Financial Markets, Institutions and Money, 50, 135–155. https://doi.org/10.1016/j.intfin.2017.05.007

Alqahtani, F., & Mayes, D. G. (2018). Financial stability of Islamic banking and the global financial crisis: Evidence from the Gulf Cooperation Council. Economic Systems, 42(2), 346–360. https://doi.org/10.1016/j.ecosys.2017.09.001

Alqahtani, F., Mayes, D. G., & Brown, K. (2016). Economic turmoil and Islamic banking: Evidence from the Gulf Cooperation Council. Pacific-Basin Finance Journal, 39(C), 44–56.

Arinaminpathy, N., Kapadia, S., & May, R. M. (2012). Size and complexity in model financial systems. PNAS, 109(45), 18338–18343. https://doi.org/10.1073/pnas.1213767109

Aysan, A. F., & Ozturk, H. (2018). Does Islamic banking offer a natural hedge for business cycles? Evidence from a dual banking system. Journal of Financial Stability, 36, 22–38. https://doi.org/10.1016/j.jfs.2018.02.005

Baber, H. (2018). How crisis-proof is Islamic finance? : A comparative study of Islamic finance and conventional finance during and post financial crisis. Qualitative Research in Financial Markets, 10(4), 415–426. https://doi.org/10.1108/QRFM-12-2017-0123

Baele, L., Farooq, M., & Ongena, S. (2014). Of religion and redemption: Evidence from default on Islamic loans. Journal of Banking & Finance, 44, 141–159. https://doi.org/https://doi.org/10.1016/j.jbankfin.2014.03.005

Battiston, S., Delli Gatti, D., Gallegati, M., Greenwald, B., & Stiglitz, J. E. (2012). Liaisons dangereuses: Increasing connectivity, risk sharing, and systemic risk. Journal of Economic Dynamics and Control, 36, 1121–1141. https://doi.org/10.1016/j.jedc.2012.04.001

Battiston, S., Gatti, D. D., Gallegati, M., Greenwald, B., & Stiglitz, J. E. (2012). Default cascades: When does risk diversification increase stability? Journal of Financial Stability, 8(3), 138–149. https://doi.org/10.1016/j.jfs.2012.01.002

Beck, T., Demirguc-Kunt, A., & Merrouche, O. (2013). Islamic vs. conventional banking: Business model, efficiency and stability. Journal of Banking & Finance, 37(2), 433–447.

Berger, A.N., & Bouwman, C. H. . (2009). Bank liquidity creation. Rev. Financ. Stud., 22, 3779–3837.

Berger, Allen N., Boubakri, N., Guedhami, O., & Li, X. (2019). Liquidity creation performance and financial stability consequences of Islamic banking: Evidence from a multinational study. Journal of Financial Stability, 44, 100692. https://doi.org/10.1016/j.jfs.2019.100692

Bourkhis, K., & Nabi, M. S. (2013). Islamic and conventional banks’ soundness during the 2007-2008 financial crisis. Review of Financial Economics, 22(2), 68–77. https://doi.org/10.1016/j.rfe.2013.01.001

Chamberlain, T., Hidayat, S., & Khokhar, A. R. (2020). Credit risk in Islamic banking: evidence from the GCC. Journal of Islamic Accounting and Business Research, 11(5), 1055–1081. https://doi.org/10.1108/JIABR-09-2017-0133

Chan-Lau, J. A. (2017). ABBA: An Agent-Based Model of the Banking System (No. WP17/136).

Choi, D. B., Eisenbach, T. M., & Yorulmazer, T. (2016). Sooner or later: Timing of monetary policy with heterogeneous risk-taking. American Economic Review, 106(5), 490–495. https://doi.org/10.1257/aer.p20161077

Chong, B. S., & Liu, M. H. (2009). Islamic banking: interest-free or interest-based? Pacific-Basin Finance Journal, 17(1), 125–144.

Cihak, M., & Hesse, H. (2010). Islamic banks and financial stability: an empirical analysis. Journal of Financial Services Research, 38(2), 95–113.

Cincotti, S., Raberto, M., & Teglio, A. (2010). Credit Money and Macroeconomic Instability in the Agent-Based Model and Simulator Eurace. Economics: The Open-Access, Open-Assessment E-Journal, 4(2010–26). https://doi.org/10.5018/economics-ejournal.ja.2010-26

Claessens, S., & Dornbusch, P. Y. (2001). International Financial Contagion: How It Spreads and How It Can Be Stopped. In S. Claessens & J. K. Forbes (Eds.), International Financial Contagion. Boston: Kluwer Academic Publishers.

Clerc, L., Giovannini, A., Langfield, S., Peltonen, T., Portes, R., & Scheicher, M. (2016). Indirect contagion: the policy problem (No. 09).

De Caux, R., McGroarty, F., & Brede, M. (2018). Growth and collapse: An agent-based banking model of endogenous leverage cycles and financial contagion. International Journal of Computational Economics and Econometrics, 8(3–4), 370–387. https://doi.org/10.1504/IJCEE.2018.096376

Diebold, F. X., & Yılmaz, K. (2009). Measuring financial asset return and volatility spillovers, with application to global equity markets. The Economic Journal, 119(534), 158–171.

Diebold, F. X., & Yılmaz, K. (2012). Better to give than to receive: Predictive directional measurement of volatility spillovers. International Journal of Forecasting, 28(1), 57–66.

Dolgun, M. H., Ng, A., & Mirakhor, A. (2020). Need for calibration: applying a maximum threshold to liquidity ratio for Islamic banks. International Journal of Islamic and Middle Eastern Finance and Management, 13(1), 56–74. https://doi.org/10.1108/IMEFM-03-2018-0098

Dornbusch, R., Park, Y., & Claessens, S. (2000). Contagion: Understanding How It Spreads. The World Bank Research Observer, 15(2), 177–197.

Farooq, M., & Zaheer, S. (2015). Are Islamic banks more resilient during financial panics? Pac. Econ. Rev, 20(1), 101–124.

Farooqi, M. F., & O’Brien, J. (2019). A comparison of the impact of the Basel standards upon Islamic and conventional bank risks in the Gulf state region. Journal of Islamic Accounting and Business Research, 10(2), 216–235. https://doi.org/10.1108/JIABR-10-2016-0125

Ferhi, A. (2018). Credit risk and banking stability: a comparative study between Islamic and conventional banks. International Journal of Law and Management, 60(4), 1009–1019. https://doi.org/10.1108/IJLMA-05-2017-0112

Hammoudeh, S., Mensi, W., Reboredo, J. C., & Nguyen, D. K. (2014). Dynamic dependence of the global Islamic equity index with global conventional equity market indices and risk factors. Pacific-Basin Finance Journal, 30, 189–206.

Harkati, R., Alhabshi, S. M., & Kassim, S. (2020). Does capital adequacy ratio influence risk-taking behaviour of conventional and Islamic banks differently? Empirical evidence from dual banking system of Malaysia. Journal of Islamic Accounting and Business Research. https://doi.org/10.1108/JIABR-11-2019-0212

Hasan, M., & Dridi, J. (2011). the Effects of the Global Crisis on Islamic and Conventional Banks: a Comparative Study. Journal of International Commerce, Economics and Policy, 02(02), 163–200. https://doi.org/10.1142/s1793993311000270

Hassan, M. K., & Mahlknecht, M. (2011). Islamic Capital Markets: Products and Strategies (Vol. 4). West Sussex: John Wiley and Sons.

Hkiri, B., Hammoudeh, S., Aloui, C., & Yarovaya, L. (2017). Are Islamic indexes a safe haven for investors? An analysis of total, directional and net volatility spillovers between conventional and Islamic indexes and importance of crisis periods. Pacific-Basin Finance Journal, 43(C), 124–150.

Hussain, M., Shahmoradi, A., & Turk, R. (2016). An overview of Islamic finance. J. Int.Commerce Econ. Policy, 7(1), 1650003–1650101.

Ibrahim, M. H., & Rizvi, S. A. R. (2017). Do we need bigger Islamic banks? An assessment of bank stability. Journal of Multinational Financial Management, 40, 77–91. https://doi.org/10.1016/j.mulfin.2017.05.002

Iori, G., Jafarey, S., & Padilla, F. G. (2006). Systemic risk on the interbank market. Journal of Economic Behavior and Organization, 61(4), 525–542. https://doi.org/10.1016/j.jebo.2004.07.018

Kabir, M. N., Worthington, A., & Gupta, R. (2015). Comparative credit risk in Islamic and conventional bank. Pacific Basin Finance Journal, 34, 327–353. https://doi.org/10.1016/j.pacfin.2015.06.001

Kenourgios, D., Naifar, N., & Dimitriou, D. (2016). Islamic financial markets and global crises: Contagion or decoupling? Economic Modelling, 57, 36–46. https://doi.org/10.1016/j.econmod.2016.04.014

Khan, I., Khan, M., & Tahir, M. (2017). Performance comparison of Islamic and conventional banks: empirical evidence from Pakistan. International Journal of Islamic and Middle Eastern Finance and Management, 10(3), 419–433. https://doi.org/10.1108/IMEFM-05-2016-0077

Khediri, K. Ben, Charfeddine, L., & Youssef, S. Ben. (2015). Islamic versus conventional banks in the GCC countries: A comparative study using classification techniques. Research in International Business and Finance, 33, 75–98. https://doi.org/10.1016/j.ribaf.2014.07.002

King, M., & Wadhwani, S. (1990). Transmission of Volatility between Stock Markets. Review of Financial Studies, 3(1), 5–33. Retrieved from https://econpapers.repec.org/RePEc:oup:rfinst:v:3:y:1990:i:1:p:5-33

Kodres, L. E., & Pritsker, M. (2002). A rational expectations model of financial contagion. Journal of Finance, (57), 769–800.

Korbi, F., & Bougatef, K. (2017). Regulatory capital and stability of Islamic and conventional banks. International Journal of Islamic and Middle Eastern Finance and Management, 10(3), 312–330. https://doi.org/10.1108/IMEFM-06-2016-0079

Krause, A., & Giansante, S. (2012). Interbank lending and the spread of bank failures : A network model of systemic risk. Journal of Economic Behavior and Organization, 83(3), 583–608. https://doi.org/10.1016/j.jebo.2012.05.015

Kyle, A. S., & Xiong, W. (2001). Contagion as a Wealth Effect. The Journal of Finance, (56), 1401–1440. https://doi.org/10.1111/0022-1082.00373

Lassoued, M. (2018). Comparative study on credit risk in Islamic banking institutions: The case of Malaysia. Quarterly Review of Economics and Finance, 70, 267–278. https://doi.org/10.1016/j.qref.2018.05.009

Liu, A., Paddrik, M., Yang, S., & Zhang, X. (2016). Interbank Contagion : An Agent-based Model Approach to Endogenously Formed Networks.

Majdoub, J., & Mansour, W. (2014). Islamic equity market integration and volatility spillover between emerging and US stock markets. North Am. J. Econ. Financ, (29), 452–470.

May, R. M., & Arinaminpathy, N. (2010). Systemic risk : the dynamics of model banking systems. J. R. Soc. Interface, (7), 823–838. https://doi.org/10.1098/rsif.2009.0359

Mohamed, S., & Al Taitoon, J. (2019). Islamic Finance Development Report 2019 - Shifting Dynamics.

Mohammad, S., Asutay, M., Dixon, R., & Platonova, E. (2020). Liquidity risk exposure and its determinants in the banking sector: A comparative analysis between Islamic, conventional and hybrid banks. Journal of International Financial Markets, Institutions and Money, 66, 101196. https://doi.org/10.1016/j.intfin.2020.101196

Mwamba, J. W. M., Hammoudeh, S., & Gupta, R. (2017). Financial tail risks in conventional and Islamic stock markets: A comparative analysis. Pacific Basin Finance Journal, 42, 60–82. https://doi.org/10.1016/j.pacfin.2016.01.003

Pappas, V., Ongena, S., Izzeldin, M., & Fuertes, A. M. (2017). A Survival Analysis of Islamic and Conventional Banks. Journal of Financial Services Research, 51(2), 221–256. https://doi.org/10.1007/s10693-016-0239-0

Parashar, S. P., & Venkatesh, J. (2010). How did Islamic banks do during global financial crisis?. Banks and Bank Systems, 5(4).

Paulin, J., Calinescu, A., & Wooldridge, M. (2019). Understanding flash crash contagion and systemic risk: A micro–macro agent-based approach. Journal of Economic Dynamics and Control, 100, 200–229. https://doi.org/10.1016/j.jedc.2018.12.008

Pesaran, H. H., & Shin, Y. (1998). Generalized impulse response analysis in linear multivariate models. Economics Letters, 58(1), 17–29.

Pritsker, M. (2001). The Channels for Financial Contagion. In S. Claessens & K. Forbes (Eds.), Intemational Financial Contagion. Boston: Kluwer Academic Publishers.

Rahim, M. S., & Zakaria, R. H. (2013). Comparison on stability between Islamic and conventional banks in Malaysia. Journal of Islamic Economics, Banking and Finance, 9(3), 131–149.

Rajhi, W., & Hassairi, S. A. (2013). Islamic Banks and Financial Stability: A Comparative Empirical Analysis between Mena and Southeast Asian Countries. Région et Développement, 37(1), 1–31.

Rashid, A., Yousaf, S., & Khaleequzzaman, M. (2017). Does Islamic banking really strengthen financial stability? Empirical evidence from Pakistan. International Journal of Islamic and Middle Eastern Finance and Management, 10(2), 130–148. https://doi.org/10.1108/IMEFM-11-2015-0137

Rizvi, S. A. R., Arshad, S., & Alam, N. (2015). Crises and contagion in Asia Pacific - Islamic v/s conventional markets. Pacific Basin Finance Journal, 34, 315–326. https://doi.org/10.1016/j.pacfin.2015.04.002

Sahyouni, A., & Wang, M. (2019). Liquidity creation and bank performance: evidence from MENA. ISRA International Journal of Islamic Finance, 11(1), 27–45. https://doi.org/10.1108/IJIF-01-2018-0009

Shahzad, S. J. H., Ferrer, R., Ballester, L., & Umar, Z. (2017). Risk transmission between Islamic and conventional stock markets: A return and volatility spillover analysis. International Review of Financial Analysis, 52, 9–26. https://doi.org/https://doi.org/10.1016/j.irfa.2017.04.005

Soedarmono, W., Pramono, S. E., & Tarazi, A. (2017). The procyclicality of loan loss provisions in Islamic banks. Research in International Business and Finance, 39, 911–919. https://doi.org/10.1016/j.ribaf.2016.05.003

Sole, J. (2007). Introducing Islamic Banks Into Coventional Banking Systems. IMF Working Papers, 07(175), 1. https://doi.org/10.5089/9781451867398.001

Tedeschi, G., Mazloumian, A., Gallegati, M., & Helbing, D. (2012). Bankruptcy Cascades in Interbank Markets. PLoS ONE, 7(12). https://doi.org/10.1371/journal.pone.0052749

Teply, P., & Klinger, T. (2018). Agent-based modeling of systemic risk in the European banking sector. Journal of Economic Interaction and Coordination, 14(4), 811–833. https://doi.org/10.1007/s11403-018-0226-7

Tian, S., & Hamori, S. (2016). Time-varying price shock transmission and volatility spillover in foreign exchange, bond, equity, and commodity markets: Evidence from the United States. The North American Journal of Economics and Finance, (38), 163–171.

Uddin, A., Chowdhury, M. A. F., & Islam, M. N. (2017). Resiliency between Islamic and conventional banks in Bangladesh: Dynamic GMM and quantile regression approaches. International Journal of Islamic and Middle Eastern Finance and Management, 10(3), 400–418. https://doi.org/10.1108/IMEFM-06-2016-0083

Yilmaz, M. K., Sensoy, A., Ozturk, K., & Hacihasanoglu, E. (2015). Cross-sectoral interactions in Islamic equity markets. Pacific-Basin Finance Journal, 32, 1–20. https://doi.org/https://doi.org/10.1016/j.pacfin.2014.12.008

Zehri, F.Al Herch, N. (2013). The impact of the global financial crisis on the financial institutions: a comparison between Islamic banks (Ibs) and Conventional Banks (Cbs). Journal of Islamic Economics, Banking and Finance, 9(703), 69–88.

Published
2021-04-21
How to Cite
Tekdogan, O., & Atasoy, B. (2021). DOES ISLAMIC BANKING PROMOTE FINANCIAL STABILITY? EVIDENCE FROM AN AGENT-BASED MODEL. Journal of Islamic Monetary Economics and Finance, 7(2), 201-232. https://doi.org/10.21098/jimf.v7i2.1323
Section
Articles