Credit risk differential between Islamic and Conventional Banks in Malaysia

Koh, Eric HY, Banna, Hasanul and Lee, Youmkyung (2022) Credit risk differential between Islamic and Conventional Banks in Malaysia. Journal of Southeast Asian Economies, 39 (1). pp. 21-41. ISSN 2339-5095

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Abstract

Despite the renewed interest post-2008, experts remain divided on whether Islamic banks (IBs) are riskier than conventional banks (CBs). Hence, we aim to study their credit risk differential more closely. Extant studies have analysed IBs collectively as a group in multicountry settings. We differ by studying one country, Malaysia, over 2006–19. We chose Malaysia because of its established dual banking system and global leadership in Islamic banking. We studied two credit risk aspects (the bank’s bankruptcy risk and its customers’ default risk) in a twophased approach (a t-test and a regression). We also tested the robustness of our findings through a feasible generalized least squares linear model. We find that IBs are generally riskier but the customer default risk differential is insignificant. Moreover, the IB-CB risk differential has narrowed in recent years. Our findings present three implications. First, we studied this phenomenon in a single country so as to remove potential noise from crosscountry differences. We also reaffirmed our regression findings through a robustness test. Such efforts help enhance the accuracy of our findings. Second, practitioners may note the risk differential reasons and opportunities arising from the narrowing gap. Third, policymakers may consider increasing the market liquidity and risk management options for IBs. Future research may consider studying the recent narrowing risk gap and whether the standalone IBs differ from those which are part of a CB group.