Islamic Finance and Economic Development: Risk, Regulation, and Corporate Governance

CHAPTER 3

Risks, Spillovers, and Distress

In most jurisdictions, Islamic and conventional banks operate side by side. Both types of institutions mobilize financial resources and intermediate them to fund economic activities. It can be expected that both types of institutions are susceptible to shocks. For example, one can imagine a failure of a conventional bank that induces a crisis of confidence that spreads to other banks, conventional or Islamic, or to the entire financial system. One can also imagine a macroeconomic failure in the form of unsustainable fiscal or current account deficits that hits the whole economy and shocks both Islamic and conventional banks. For example, the combination of macroeconomic imbalances and idiosyncratic stress affected Ihlas Finance House (IFH) in Turkey and spread to the country's institutions offering Islamic financial services (IIFSs) in the early 2000s.¹ One can also anticipate that some banks in the Arab countries in transition may be adversely affected by the downturn in economic activity in the wake of regime changes.

However, it is legitimate to ask whether the effects of shocks hitting conventional or Islamic banks would spill over to the other group or remain circumscribed. A related question is the degree of vulnerability and resilience of the two groups of banks. These two questions stem from the premise that Islamic and conventional banks have different features even if they perform essentially similar functions.

The following ...