REVFIN-00291; No of Pages 10

Review of Financial Economics xxx (2013) xxx–xxx

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Review of Financial Economics

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Islamic and conventional banks' soundness during the 2007–2008 financial crisis☆
Khawla Bourkhis a, Mahmoud Sami Nabi b, c, d,⁎
a
FIESTA — Tunis Higher Institute of Management, Tunis University & Sousse Institute of Higher Commercial Studies, University of Sousse, Tunisia
b
Islamic Research and Training Institute (IRTI), Jeddah, Saudi Arabia
c
LEGI — Tunisia Polytechnic School, University of Carthage, Tunisia
d
Economic Research Forum, Cairo, Egypt

a r t i c l e i n f o a b s t r a c t

Article history: The recent global financial crisis has induced a series of failure of many conventional banks and led to an
Received 21 August 2011 increased interest in the Islamic banking business model. This paper attempts to answer empirically the
Accepted 3 January 2012 following question: What was the effect of the 2007–2008 financial crisis on the soundness of Islamic banks
Available online xxxx
and their conventional peers? Using the Z-score as an indicator of bank stability, our regression analysis
(covering a matched sample of 34 Islamic Banks (IBs) and 34 conventional banks (CBs) from 16 countries)
JEL classification:
G01
shows that there is no significant difference in terms of the effect of the financial crisis on the soundness of
G21 IBs and CBs. This finding reveals that IBs are diverging from their theoretical business model which would
have allowed them to keep the same level of soundness even during the crisis.
Keywords: © 2013 Elsevier Inc. All rights reserved.
Islamic banking
Conventional banking
Financial crisis

1. Introduction
The 2007/2008 financial crisis which started as a credit shock has
induced a series of failure of many conventional banks (CBs), as
witnessed by the collapse of Lehman Brothers. According to the
OCDE (2010) this crisis has shown that banks' funding structure is
important to their resilience. More precisely, the report argues that
banks relying mostly on wholesale funding (i.e. funding from other
banks, money market funds, corporate treasuries and other non-
bank investors) have been severely affected by the crisis. At the oppo-
site, banks which relied mostly on depository funding have been very
resilient to the crisis. The latter were less exposed to the liquidity risk
that propagates through the interlinked relationships in the financial
sector. Yet, the liquidity risk generated market risk and produced sys-
temic risk which threatened even sound banks. Many theoretical
models have analysed the banks' vulnerability to liquidity shocks in
the context of interconnected banks. Freixas, Parigi, and Rochet
(2000) show that liquidity shock hitting one bank may prompt the
depositors to run on solvent banks if they fear that there is insuffi-
cient liquidity in the banking system. Allen and Gale (2000) show
that an unforeseen liquidity shock could generate the bankruptcy of
the entire banking system under different configurations of the
interbank market structure.
☆ The views expressed in this paper do not necessarily reflect the views of IRTI.
⁎ Corresponding author at: Islamic Research and Training Institute (IRTI), Jeddah, Saudi
Arabia.
E-mail address: msnabi@isdb.org (M.S. Nabi).
Khan (1987) argues that the theoretical model of Islamic banks
(IBs) can successfully fill the failure of CBs in maintaining stability.
In fact, IBs are assumed to separate investment funds from demand
deposits and apply 100% reserve on the latter. IBs are different from
CBs because they operate upon the principles of the Islamic law
(the Shari'ah) which prohibits the payment or receipt of interest
(riba) and encourage risk sharing. This is reflected on the liabilities
side of the balance sheet since IBs collect funds through two catego-
ries of deposits: demand deposits and investment deposits. While
demand deposits are perfectly guaranteed and yield no return, invest-
ment deposits should be similar to mutual fund shares and not
guaranteed a fixed return. The difference between IBs and CBs should
also be reflected on the asset side since IBs have developed interest-
free financing instruments based on two principles: Profit and loss
sharing (PLS) and markup principle (Hassan, Farhat, & Al-Zubi,
2003; Zaher & Hassan, 2001). However, it seems that the practice of
IBs is not diverging from that of CBs since all over the world IBs are
relying more on markup financing modes rather than PLS based fi-
nancing instruments (Siddiqi, 2006). The 2007/2008 financial crisis
represents a good experiment to test the divergence between the
two models of banking. According to Shamshad Akhtar, 1 Islamic
banks (IBs) have illustrated a degree of resilience and stability to
the recent crisis but have been impacted because of their higher
exposure to real estate and their limited reliance on risk sharing or
1
The Ex-Vice-president of the World Bank for MENA in her speech during the
“Symposium on Islamic Finance in Roma: Developments in MENA region”, Bank Italia,
Rome, Italy, November, 11th, 2009.

1058-3300/$ – see front matter © 2013 Elsevier Inc. All rights reserved.
http://dx.doi.org/10.1016/j.rfe.2013.01.001

Please cite this article as: Bourkhis, K., & Nabi, M.S., Islamic and conventional banks' soundness during the 2007–2008 financial crisis, Review
of Financial Economics (2013), http://dx.doi.org/10.1016/j.rfe.2013.01.001
2 K. Bourkhis, M.S. Nabi / Review of Financial Economics xxx (2013) xxx–xxx
equity based transactions. Hasan and Dridi (2010) is the only study in
our knowledge which has analysed the effect of the recent financial
crisis on IBs and CBs. It delved the effects of the crisis on profitability,
credit growth, asset growth and external ratings of 120 Islamic and
conventional banks in 8 countries. The authors found that IBs' showed
stronger resilience (according to the above indicators) in the early
stages of the crisis. However, as the crisis moved to the real economy
in 2009, IBs' profitability has steeply declined relatively to the CBs.
They conclude that IBs contributed to financial and economic stability
during the crisis, given that their credit and asset growth was at least
twice as high as that of CBs.
This paper attempts to provide a complementary analysis about
the effect of the crisis on the financial soundness of IBs and CBs. It
departs from Hasan and Dridi (2010) in many aspects. Firstly, we con-
sider a matched sample of IBs and CBs in order to avoid testing rela-
tionships on incomparable banks and reduce the model dependence
and thereby obtaining more robust results (Ho, Imai, King, & Stuart,
2007). Secondly, we use not only a non-parametric approach as
done by Hasan and Dridi (2010) but also a regression analysis. The
first approach enables us to analyse the 2007–2008 crisis's impact
on a set of financial soundness indicators (FSIs) related to banks'
earnings and profitability, capitalization, asset quality, efficiency and
liquidity. Whereas, the regression analysis assesses the impact of
the crisis on a particular indicator of banks' stability which is the
Z-score. 2 Finally, we believe that controlling for the heterogeneity of
the institutional environment is very important and constructed an
aggregate indicator based on six governance indicators (compiled
by Kaufmann, Kraay, & Mastruzzi, 2010). Our matched data comprises
34 IBs and 34 CBs from the 16 countries covered on the period 1998–
2009 which enables us to assess the crisis's effects on the financial
soundness of IBs and CBs. The two types of banks are matched in
pairs according to three characteristics: total assets, country, and
period of observation. We perform inter-temporal and inter-bank
comparisons, using the Wilcoxon signed rank test. The inter-bank
comparison enables us to compare the financial soundness indicators
of IBs relatively to those of the CBs separately before (1998–2006),
during (2007–2008), and after (2009) the crisis. Whereas, the inter-
temporal comparison enables us to analyse the effect of the crisis on
the financial soundness of each type of banks. The results show that
the two types of banks are indistinguishable in terms of their liquidity
situation and the level of their non-performing loans. However, IBs
outperformed CBs in regards to the return on average assets (ROAA)
during and after the financial crisis. This better performance seems
to be partially due to differences in the provisioning strategies of
the two types of banks during the crisis. Indeed, CBs increased their
Loan Loss Provision (LLPs) during 2007–2008 in response to the in-
crease of their Non Profit Loans (NPLs). However, IBs increased their
LLPs only in 2009 although their NPLs increased in 2007–2008 simi-
larly to their conventional peers. Therefore, it seems that IBs operated
with greater risk exposure than their counterparts during the crisis.
This opposite evolution of the LLPs in 2009 hasn't prevented the IBs
to outperform the CBs (in term of ROAA). This is in part due to the
fact that they were far more cost effective than the CBs during this
year. Considering the impact of the financial crisis on the banking
soundness (measured by the Z-score and capital to asset ratio) we
find no significant difference between IBs and CBs. However, there
is some evidence that IBs were in average more sound (in regards
of the Z-score). The similar behaviour of the two groups of banks re-
garding the financial crisis is coherent with the results of a growing
number of studies showing that IBs are mimicking the commercial
2
To our knowledge, Cihak and Hesse (2010) is the first study that used the Z-score
to assess the stability of IBs relatively to CBs in a cross-country analysis during the
period 1993–2004. Cihak and Hesse (2010) found three main results: (i) small IBs tend
to be more stable than small CBs; (ii) large CBs tend to be more stable than large IBs;
and (iii) small IBs tend to be more stable than large IBs.
Please cite this article as: Bourkhis, K., & Nabi, M.S., Islamic and conventional banks' soundness during the 2007–2008 financial crisis, Review
of Financial Economics (2013), http://dx.doi.org/10.1016/j.rfe.2013.01.001
strategies of their conventional peers and diverging from their theo-
retical business model. Indeed, as will be detailed in Section 2 the lat-
ter would have allowed the IBs to keep the same level of soundness
even during the crisis since the losses occurring on the asset side
would have been totally absorbed on the liability side. The rest of
the paper is organized as follows: Section 2 provides an overview
about the advantages of using PLS and mark-up financial modes and
presents the risks related to the deviation of the IBs' practices from
their specific business model. Section 3 defines the banking sound-
ness concept and its indicators which are used in this paper.
Section 4 assesses the impact of the crisis using a non-parametric
and a parametric approach. Section 5 concludes with a summary of
the main results.
2. PLS and mark-up financial modes: two specificities of the
IBs model
Many economists (Ahmed, 2002; Cihak & Hesse, 2010; Khan,
1987; Syed Ali, 2007) argue that the PLS mechanisms allow IBs to
maintain their net worth and avoid the deterioration of their balance
sheets under difficult economic situations. Indeed, IBs channel invest-
ment deposits into PLS loan (Mudharabah and Musharakah). Given
that neither the principal nor the return of the investment deposits
is guaranteed, any loss which occurs on the asset side could be totally
absorbed on the liability side. Thus, the PLS allows the IB to transfer
the credit risk from its asset side to its liability side (the investment
deposits). Consequently, if the value of the assets decreases, the
value of the liabilities should decrease respectively. The other types
of Islamic financial modes based on mark-up (e.g. Murabaha, Ijaras,
and Istisnaa) require that a real asset underlies the financial transac-
tion. Consequently, financial assets and derivatives based on other
debt financial assets (like CDS) cannot be traded. This linkage with
the real economy reduces leveraging and prevents the exposure of
IBs to speculative behaviour that leads to instability. However, IBs
may lose their comparative advantages against their conventional
peers due to the deviations of the current practices from the theoret-
ical model. In particular, the mimicking of CBs may raise multiple
risks that are not assumed to be for IBs. The first deviation is in the
composition of their balance sheets. In a typical IB, more than 80%
of total assets are fixed income and short term maturity assets.
While, only 20% are dedicated to long term and risk sharing invest-
ments. El-Hawary, Grais, and Iqbal (2007) and Greuning and Iqbal
(2008) claim that the dominance of less risky, low return assets
deprives the bank of the benefits of portfolio diversification, as
Mudarabah and Mushrakah contracts are more profitable. Analysts
explain this behaviour by the fact that sale-based transactions are
less associated with moral hazard and adverse selection problems
than PLS investments (Siddiqi, 2006). In fact, the latter need addition-
al effort to capture good investment opportunities and to analyse pro-
jects adequately. Besides, Islamic banks cannot request for collateral
to reduce credit risk. Thus, risk sharing investments require a high
level of confidence and transparency between investors, banks and
depositors.
The second divergence with the Islamic banking theory is in the in-
come distribution. In some cases, IBs distribute profits to the investment
depositors even when they accrue loss and pay the profits out of equity.
This phenomenon is called the displaced commercial risk (El-Hawary et
al., 2007; Greuning & Iqbal, 2008). Zainol and Kassim (2010) and Cevik
and Charap (2011) found that the conventional banks' deposit rates
Granger cause returns on PLS accounts in Malaysia and Turkey. An anal-
ogous result was established by Chong and Liu (2009) in the case of
Malaysia showing that the retail Islamic deposit rates mimic the be-
haviour of conventional interest rates. Therefore, the current practices
do not make a clear differentiation between shareholders and invest-
ment account holders' rights. Finally, IBs may not fully respect Shari'ah
principles in their activities. For instance, Chong and Liu (2009) claim
 K. Bourkhis, M.S. Nabi / Review of Financial Economics xxx (2013) xxx–xxx
that Malaysian banks are not very different from traditional banks in
the adoption of the PLS principle.
3. Indicators of banking soundness
Lindgren, Garcia, and Saal (1996) define bank soundness as the
ability of the bank to withstand adverse events such as bank run,
major policy changes, financial sector liberalization and natural disas-
ter. Hence, it reflects the bank capacity to be solvent and remain so
under difficult economic conditions by means of their capital and
reserve accounts. The IMF's financial soundness indicators (FSIs) in-
clude, in addition to measures related to bank's capitalization, a num-
ber of indicators related to asset quality and profitability which
provide complementary information about the health of the bank.
In this paper we consider the Z-score as a measure of bank stability
and 10 accounting ratios which are mostly part of the IMF financial
soundness indicators 3 (FSIs).
3.1. The Z-score
The Z-score ratio is a popular measure of bank soundness since it
is inversely related to the probability of bank's insolvency. It is denot-
ed as follows: Z = (μ + K) / σ where μ denotes the bank's average
return on assets (ROA), K the equity capital in percentage of total as-
sets and σ is the standard deviation of the ROA as a proxy for return
volatility. The probability of insolvency is defined as the probability
that losses π exceed equity E i.e.
−K
P ½π≤−E ¼ P ½ROA≤−K  ¼ ∫ f ðROAÞdðROAÞ:
−∞
According to De Nicolo (2000) this probability satisfies the follow-
ing inequality
σ2 1 mean of the net loans to deposits ratio (NL/D) for CBs was higher
P ½ROA≤−K ≤ ¼ :
ðμ þ K Þ2 z2
Therefore, an increase of the Z-score is equivalent to a decrease of
the upper bound of the insolvency risk. Under the assumption of
bank's return normality, the Z-score can be interpreted as the number
of standard deviations below the mean by which profits would have
to fall in order to deplete equity.
3.2. Accounting soundness indicators
Table 1 presents the 10 accounting ratios that we consider in this
study in addition to the Z-score to assess the banks' soundness.
4. Effects of the financial crisis on the soundness of IBs and CBs
We analyse the effect of the financial crisis on the soundness of IBs
and CBs using the set of measures introduced in Section 3. We focus
on fully fledged IBs and CBs and use unconsolidated bank statements
whenever consolidated statements are not available. 4 Our matched
sample is composed of 34 IBs matched with 34 CBs from 16 countries 5
where the two groups of banks coexist and IBs' assets account more
than 1% of the total banks' assets at least in one year in the period
1998–2009. The two types of banks are matched in pairs according to
three characteristics: total assets, 6 country, and period of observation.
3
See Financial Soundness Indicators Compilation Guide, IMF (2006).
4 7
The source of the data is the Bankscope database.
5
Bahrain, Bangladesh, Brunei, Egypt, Gambia, Indonesia, Jordan, Kuwait, Malaysia,
Mauritania, Pakistan, Qatar, Saudi Arabia, Tunisia, United Arab Emirates and Yemen.
6
We allow a variation in the interval [50%, 150%].
Please cite this article as: Bourkhis, K., & Nabi, M.S., Islamic and conventional banks' soundness during the 2007–2008 financial crisis, Review
of Financial Economics (2013), http://dx.doi.org/10.1016/j.rfe.2013.01.001
3
4.1. Non-parametric analysis
4.1.1. Methodology
We perform inter-temporal and inter-bank comparisons, using the
Wilcoxon signed rank test.7 The inter-bank comparison enables us to
compare the financial soundness indicators of IBs relatively to those
of the CBs separately before (1998–2006), during (2007–2008), and
after (2009) the recent global financial crisis.8 Whereas, the inter-
temporal comparison enables us to analyse the effect of the crisis on
the financial soundness of each type of banks (Table 2).
4.1.2. Results
4.1.2.1. Capital adequacy. Fig. 1 illustrates the mean change in the cap-
ital to asset ratio (CAR) between the three sub-periods for Islamic and
conventional banks. For IBs, we note a slight augmentation from
14.01% before the crisis to 14.20% during the crisis period, then an in-
crease to 14.72% in 2009. However, for the CBs the ratio increased
from 12.58% during 1993–2006 to 16.13% during the crisis period
2007–2008, and then it went down to 13.03% in 2009. Based on the
Wilcoxon signed rank test, there is no significant difference between
the two groups of banks in the capitalization ratio before, during and
after the financial crisis (p > 0.1). Regarding the inter-temporal com-
parison neither for IBs nor for CBs the capital to asset ratio is changed
after the crisis. Therefore, based on the CAR, we conclude that there is
no significant difference in the soundness of the two types of banks
over the considered period.
4.1.2.2. Asset quality. Fig. 2 shows that the net loans to total assets ratio
(NL/TA) for IBs (53.32%) was higher than for CBs (46.77%) as con-
firmed by the Wilcoxon test during the period 1993–2006 (p b 0.01).
However, there was no significant difference between the two groups
of banks in the second and third periods (p > 0.1). Furthermore, the
than 60% however it was larger than 80% for IBs (Fig. 3). The compar-
isons of the (NL/D) ratios by the Wilcoxon test reveal that the ratio
was significantly larger for IBs than for CBs at the 1% level of risk be-
fore the financial crisis. This analysis shows that, during the period of
financial stability, IBs were able to make more loans than their con-
ventional peers. But during and after the (2007–2008) financial crisis
the two groups of banks follow the same behaviour.
Fig. 4 shows that for CBs, the nonperforming loans to gross loans
(NPL/GL) and the loan loss provision to net interest revenue (LLP/
NIR) increased during the 2007–2008 financial crisis and decreased
in 2009. Hence the CBs increased their provisioning in response to
the increasing of NPL/GL. For the IBs, the NPL/GL increased from
4.91% during the period 1993–2006 to 5.51% during 2007–2008 and
to 6.53% during 2009 respectively. On the other side, Fig. 5 shows
that the LLP/NIR fell from 26.3% to 20.01% in 2007–2008 period.
Then, it increased sharply in 2009 to attain 69.75%. The Wilcoxon
test reveals that there is no significant difference in the NPL/GL ratio
between the IBs and CBs over the period of study (p > 0.1). However
the LLP/NIR for CBs was larger than for IBs at the 10% level of risk
(z = 1849; p b 0.1) during the (2007–2008) financial crisis. Thus, IBs
operated with greater risk exposures than their counterparts during
the crisis. Based on the inter-temporal analysis, we conclude that
there are no significant differences in the overall asset quality indica-
tors before and after the financial crisis for both Islamic and conven-
tional banks (p > 0.1, Wilcoxon signed rank test).
The null hypothesis tested by the Wilcoxon test is that the two populations represented
by the respective members of the matched pairs are identical.
8
We distinguish between the first wave of the world financial crisis and its economic
wave starting from 2009.
4 K. Bourkhis, M.S. Nabi / Review of Financial Economics xxx (2013) xxx–xxx

Table 1
Variables: Categories and raison d'être.

Variables Raison d'être and comments

Capital adequacy:
Capital to asset ratio
Earning and profitability:
Return on average assets (ROAA)
Return on average equity (ROAE)
Asset quality:
Net loans to total assets (NL/TA)
Net loans to deposits (NL/D)
Non-performing loans to gross loans
(NPL/GL)
Loan loss provision to net interest
revenue (LLP/NIR)
Liquidity:
Liquid assets to total assets ratio
Liquid assets to deposits ratio
Efficiency:
Cost to income ratio
Capitalization is one of the most important criteria for identifying the bank's soundness (Gaganis, Pasiouras, & Zopounidis, 2006).
Banks cannot be permanently solvent if they are not profitable. High earnings are necessary to implement investments and make full
provision for the absorption of losses. Maechler, Mitra, and Worrel (2007) show that profitability is negatively related to the probability
of insolvency. Using six profitability ratios, Olson and Zoubi (2008) find that IBs are more profitable than CBs.
High levels of assets that are not generating income reduce the bank's capacity to honour its liabilities.
Loan loss provision and non-performing loans to gross loans are often used as a proxy for asset quality of an individual bank. Using PEA
(provision to earnings assets) and APL (adequacy of provision for loans) as indicators of asset quality in a sample of 237 observations for
banks operated in the GCC region over the period 2000–2005, Olson and Zoubi (2008) find that IBs keep up lower provisions for possible
loan losses than CBs.
For IBs, the net interest revenue is defined as the sum of the positive and negative income flows associated with mark-up financing and PLS
arrangements
Liquid assets refer to cash and its equivalent that are easily convertible to cash at any time without significant losses.
It measures the bank's operating costs (salaries, technology, administrative expenses, etc.) as a proportion of its total income.

4.1.2.3. Efficiency. Contrarily to the findings of Hammim, Abdullah, and
Al-Habshi (2006) and Cihak and Hesse (2010) the efficiency ratio
was found to be similar between the two groups of banks before and
during the financial crisis (p > 0.1; Wilcoxon signed rank test). Where-
as, the CBs became less efficient in 2009 (z= 1922; p b 0.1; Wilcoxon
signed rank test). Besides, we find no evidence of significant difference
in the cost to income ratio before and after the crisis for each type of
banks (p > 0.1, Wilcoxon signed rank test).
4.1.2.4. Liquidity. Figs. 7 and 8 show that the liquidity ratios for IBs
increased during the (2007–2008) financial crisis but decreased gradu-
ally during the last three years for the CBs. Based on the Wilcoxon test,

Table 2
Descriptive statistics of the soundness indicators for Islamic and conventional banks.

Pre-crisis period (1993–2006) Crisis period (2007–2008) Post-crisis period (2009)

N Mean Std Min Max N Mean Std Min Max N Mean Std Min Max

Capital adequacy
Capital/assets
Islamic banks 104 14.01 9.32 2.97 39.76 44 14.20 9.37 3.04 50.09 13 14.72 6.82 5.53 26.73
Conventional banks 104 12.58 8.51 −1.87 43.38 44 16.13 15.31 4.06 99.78 13 13.03 6.51 2.57 29.81

Earnings and profitability

ROAA
Islamic banks 104 1.61 1.99 −3.53 8.43 44 1.99 2.61 −2.48 11.39 13 1.18 2.13 −3.11 4.96
Conventional banks 104 1.64 2.16 −4.01 13.2 44 1.01 2.44 −5.39 8.99 13 −0.33 2.78 −5.69 2.29
ROAE
Islamic banks 104 12.30 14.12 −53.64 69.92 44 14.57 13.47 −9.36 63.15 13 8.72 12.63 −14.92 25.1
Conventional banks 104 11.58 26.53 −88.43 196.74 44 6.14 23.43 −99.87 42.69 13 −5.52 34 −94.33 26.61

Asset quality
NPL/gross loans
Islamic banks 25 4.91 4.76 0.36 19.95 25 5.51 5.73 0.17 22.25 10 6.53 4.29 1.29 12.7
Conventional banks 50 12.43 14.6 0.41 60.83 29 12.92 16.87 0.21 65.35 8 9.06 10.63 1.16 29.3
LLP/net interest revenue
Islamic banks 87 26.3 80.14 −550 313.83 36 20.01 23.77 −3.68 110.75 13 69.75 165.17 1.52 615
Conventional banks 96 32.54 40.38 −31.93 207.46 38 76.34 149 −44.29 774.77 12 46.89 68.93 3.93 226.85
Net loans/total assets
Islamic banks 104 53.32 21.89 0.02 91.97 44 51.98 14.27 19.6 81.75 13 51.86 11.8 35.15 74.16
Conventional banks 102 46.77 17.53 0.01 78.23 44 50.33 17.07 8.03 82.47 13 50.30 14.49 14.51 63.48
Net loans/deposits
Islamic banks 104 80.32 81.68 0.02 668.94 44 99.94 139.47 21.49 743.09 13 90.06 97.29 38.31 409.75
Conventional banks 102 58.41 23.50 0.01 119.23 43 66.72 30.76 9.35 170.02 13 63.52 18.15 17.15 84.5

Efficiency
Cost/income
Islamic banks 101 52.39 20.60 14.3 142.51 43 55.50 33.28 16.65 170.53 13 54.97 34.52 20.2 146.36
Conventional banks 102 50.49 30.88 6.83 220.97 42 58.67 57.38 9.09 258.14 13 143.43 227.11 29.37 826.17

Liquidity
Liquid assets/total assets
Islamic banks 104 29.53 16.12 5.02 85.64 44 47.41 125.77 8.34 859.32 13 27.41 7.66 15.07 40.19
Conventional banks 104 32.07 16.48 0.531 88.53 44 27.58 14.79 6.17 82.40 13 25.74 19.6 8.14 84.3
Liquid assets/deposits
Islamic banks 104 45.98 43.80 6.85 295.46 44 51 51.05 9.03 272 13 43.90 37.05 19.97 163.93
Conventional banks 104 40.41 21.58 0.58 106.89 43 36.50 18.97 7.46 103.91 13 32.37 23.43 9.27 99.68

Please cite this article as: Bourkhis, K., & Nabi, M.S., Islamic and conventional banks' soundness during the 2007–2008 financial crisis, Review
of Financial Economics (2013), http://dx.doi.org/10.1016/j.rfe.2013.01.001
 K. Bourkhis, M.S. Nabi / Review of Financial Economics xxx (2013) xxx–xxx 5

Table 3
Description of the used variables.

Variable Definition Source

Name

Zi,j,t Z-score for bank i at time t in country j Authors' calculations based on Bankscope data
Bi,j,t−1 Vector of bank specific variables Total assets of a bank (in U.S. billion dollars) Bankscope
Loan/assets
Cost/income
Income diversity Authors' calculations based on Bankscope data

net interest−income−other operating

1− total operating income

Ii,j,t−1 Vector of industry specific variables Herfindahl Hirschman Index Authors' calculations based on Bankscope data
Market share of Islamic banks
Governance Kaufmann et al. (2010)
Ti,j Islamic bank dummy variable Equals 1 for Islamic bank, 0 otherwise Bankscope
TsSi,j,t−1 Islamic bank dummy variable∗share of Islamic banks
Conventional bank dummy variable ∗share of Islamic banks
Mj,t−1 Vector of macroeconomic variables GDP growth (growth rate of nominal GDP, World Bank development indicators
adjusted for inflation (in local currency))
Inflation (year-on-year change of the CPI index) (percent)
Exchange depreciation (year-on-year change in the nominal
exchange rate, U.S. dollars per local currency (percent))
Cj Country dummies variables
P Period dummy variables Equals 1 for the crisis-period, 0 otherwise

we find no statistically significant difference in the (LA/TA) and (LA/D) increase of the cost/income for CBs was larger than the relative de-
ratios between Islamic and conventional banks over the period of study crease of their LLP which once again has pushed in favour of the
(p > 0.1). The two groups of banks follow the same liquidity policy over higher profitability of the IBs of our sample.
the period study.
4.2. Regression analysis
4.1.2.5. Earnings and profitability. Fig. 9 shows that the mean of ROAA
for IBs (CBs) varies between 2.45 (2.42) and 0.65 (− 0.33) over the 4.2.1. Methodology and variables definitions
period of study. We note that the two lines are almost superimposed We construct the Z-score for each bank i at time t in country j.
over the (2002–2006) period. Since 2007, the ROAA for CBs had de- Based on panel data analysis, we estimate a modified version of
creased significantly passing from 1.57 to − 0.33 in 2009. Concerning Cihak and Hesse (2010)'s econometric model that enable us to test
the ROAA for IBs, it had recorded a slight decrease since 2008. Fig. 10 for the effect of the financial crisis while controlling for the bank spe-
shows that the mean of ROAE for IBs (CBs) varies between 17.44 cific variables, industry specific variables and macroeconomic vari-
(26.35) and 7.5 (− 5.52) over the period of study. The ROAE for CBs ables:
had decreased in 2007 passing from 8.05 to (− 5.52) in 2009. Howev-
er, there is no significant difference in the profitability ratios (ROAA Z i;j;t ¼ α þ β1 Bi;j;t−1 þ δTi;j þ β2 Ii;j;t−1 þ ∑ γs Ts Si;j;t−1
s
and ROAE) between the two types of banks during the period
þ β3 M j;t−1 þ ∑ θj C j þ ∑ φs Ts P þ ε i;j;t
(1998–2006) (p > 0.1, Wilcoxon signed rank test). This result in oppo- s s
site to that obtained by Olson and Zoubi (2008) who found a signifi-
cant different (at the 10% level) in favour of Islamic banks of the Gulf where the dependent variable is the Z-score Zi,j,t for bank i in country
Cooperation Council (GCC) region over the period 2000–2005. But j at time t; Bi,j,t − 1 is a vector of bank-specific variables; Ti,j is a
our comparison shows that IBs became more profitable (ROAA) dummy variable equals to one if bank i is an Islamic bank,Ii,j,t − 1 con-
than their conventional peers at the 1% and 5% level of risk during tains time-varying industry-specific variables; TsSi,j,t − 1 is the inter-
and after the (2007–2008) financial crisis respectively. In fact, the action of the type of the bank with the share of the Islamic banks
CB profitability ratios decreased significantly after the crisis at 1% in the total assets of the banking system of country j at date t − 1;
level of risk. Therefore, based on the evolution of the (ROAA), we con-
clude that the IBs outperformed the CBs during and after the financial
crisis. Could we explain this higher performance in line with the pre-
vious results? Table 4
We know that the profitability of banks is negatively correlated to Summary statistics for Islamic and conventional banks.
their provision and to their cost. Fig. 6 shows that during 2007–2008,
N Mean Std Min Max
IBs and CBs have almost the same cost/income ratio whereas the LLP
of CBs largely exceeds that of IBs. Thus the better performance of IBs Panel 1: Conventional banks
Z-score 161 18.01 15.11 −0.613 84.24
during 2007–2008 in term of ROAA is at least partially due to this
Total Assets (Mill$) 161 4100.89 9147.62 0.58 47,039.81
huge gap in the provisioning. Contrarily to CBs, the increase of the Net loans/total assets 159 48.04 17.17 0.01 82.47
non-performing loans of IBs was not accompanied by an increase in Cost/income 157 60.37 78.04 6.83 826.17
their provisioning. Therefore, this difference in the provision strategy Income diversity 156 0.599 0.234 0.426 0.994
has naturally contributed to higher performance of IBs during the cri-
Panel 2: Islamic banks
sis. We have now to interpret the relatively higher performance of IBs Z-score 161 29.09 51.88 0.30 300.87
during 2009. Fig. 6 shows that for 2009, the cost/income ratio for CBs Total assets (Mill$) 161 3847.47 8351.62 0.399 45,527.92
has largely increased whereas it remained almost the same for IBs. Net loans/total assets 161 52.84 19.34 0.02 91.97
Meanwhile, the gap between the LLP of the two types of banks has Cost/income 157 53.46 25.77 14.3 170.53
Income diversity 155 0.478 1.37 0.162 0.98
reduced in favour of CBs. However it could be noted that the relative

Please cite this article as: Bourkhis, K., & Nabi, M.S., Islamic and conventional banks' soundness during the 2007–2008 financial crisis, Review
of Financial Economics (2013), http://dx.doi.org/10.1016/j.rfe.2013.01.001
 6
of Financial Economics (2013), http://dx.doi.org/10.1016/j.rfe.2013.01.001
Please cite this article as: Bourkhis, K., & Nabi, M.S., Islamic and conventional banks' soundness during the 2007–2008 financial crisis, Review

Table 5
Random-effects (GLS regression).

All banks (1) All banks (2) All banks (3) All banks (4) Large banks (5) Large banks (6) Large banks (7) Large banks (8) Small banks (9) Small banks (10) Small banks (11) Small banks (12)

log (total assets) 0.383 (0.367) 0.036 (0.907) 0.094 (0.720) −0.014 0.553 (0.648) −0.390** −0.505** 0.161 (0.899) 0.507 (0.430) −0.251 (0.504) −0.087 (0.857) −0.627 (0.348)
(−1) (0.755) (0.037) (0.043)
NL/A (−1) −0.076 −0.116*** −0.105** −0.113 0.124 (0.171) 0.016 (0.647) 0.069 (0.347) 0.048 (0.296) −0.196** −0.162** −0.108** −0.282**

K. Bourkhis, M.S. Nabi / Review of Financial Economics xxx (2013) xxx–xxx

(0.220) (0.007) (0.017) (0.118) (0.035) (0.015) (0.042) (0.033)
Cost/income (−1) −0.016 −0.011 (0.412) −0.018 (0.492) −0.015 −0.085 −0.083** −0.079 (0.111) −0.066 0.001 (0.974) 0.012 (0.456) 0.012 (0.729) 0.008 (0.763)
(0.594) (0.350) (0.129) (0.041) (0.121)
Income diversity −3.29 (0.497) −3.071 (0.402) −4.511 (0.341) −2.166 −5.371 −4.855 (0.153) −6.474 (0.161) −4.569 4.207 (0.514) −1.028 (0.841) −1.905 (0.797) 1.651 (0.736)
(−1) (0.588) (0.288) (0.272)
Islamic dummy 12.69* (0.073) 8.893 (0.141) 11.09* (0.059) 9.08 (0.203) 2.728 (0.634) 2.181 (0.704) 0.186 (0.973) 1.403 (0.803) 18.41 (0.159) 15.42 (0.178) 22.31* (0.074) 16.48 (0.211)
log (HHI (−1) 0.0001 (0.961) 0.000 (0.615) 0.002 (0.283) 0.001 (0.186) 0.002 (0.636) 0.002 (0.510)
Governance −42.40* −30.33* −7.757 −2.083 (0.834) −42.69 (0.102) −37.064
(0.089) (0.067) (0.471) (0.103)
CB dummy ∗ share −14.34 −3.068 (0.784) 18.338 −1.084 (0.914) −29.33 (0.189) 15.04 (0.586)
of IB (−1) (0.421) (0.446)
IB dummy ∗ share −28.14 −9.718 (0.457) 11.66 (0.632) 8.677 (0.413) −21.87 (0.447) −15.87 (0.618)
of IB (−1) (0.158)
Exchange rate −0.089 0.146 (0.207) 0.029 (0.795) 0.018 (0.812) −0.093 (0.763) 0.213 (0.315)
depreciation (0.603)
(−1)
Inflation (−1) 1.161* (0.064) 0.342 (0.066)* 0.273 (0.624) 0.109 (0.535) 1.946** (0.042) 0.675* (0.081)
Real GDP growth −0.059 0.128 (0.821) 0.162 (0.725) 0.288 (0.212) −0.427 (0.766) 0.119 (0.913)
(−1) (0.940)
IB dummy ∗ crisis −0.029 2.654 (0.156) 1.410 (0.439) 2.345 (0.244) −1.956 1.488 (0.243) −0.047 (0.978) 0.408 (0.765) −0.566 (0.866) 4.41 (0.334) 1.302 (0.744) 4.274 (0.374)
period dummy (0.847) (0.445)
CB dummy ∗ crisis 0.012 (0.993) 0.878 (0.276) 0.841 (0.498) 0.512 (0.645) −1.664 0.063 (0.945) −0.556 (0.724) −0.017 2.339 (0.305) 1.261 (0.228) 2.048 (0.313) 1.901 (0.251)
period dummy (0.548) (0.990)
Constant −37.03 19.62 (0.034)** −12.60 (0.439) 16.65 (0.125) 5.63 (0.753) 32.02 (0.011)** 27.83* (0.051) 25.60* (0.063) −53.45 (0.125) 16.59 (0.20) −31.86 (0.215) 13.60 (0.355)
(0.189)
Observations 173 234 203 198 85 120 102 97 88 114 101 101
R-squared 0.581 0.540 0.552 0.550 0.272 0.244 0.240 0.272 0.640 0.580 0.596 0.596
(between)
*
Significant at 1%.
**
Significant at 5%.
***
Significant at 10%.
 K. Bourkhis, M.S. Nabi / Review of Financial Economics xxx (2013) xxx–xxx 7

Table 6 Table 7
Country dummies variables. Summary of the results.

Country Non-parametric Capital/assets • No significant difference between IBs and CBs

analysis during the three periods relatively to the
Bahrain 53.18 (0.134)
capitalization ratio.
Bangladesh 0.497 (0.956)
• No significant effect of the crisis on the
Brunei 88.63** (0.035)
capitalization of IBs and CBs.
Egypt 33.60* (0.099)
ROAA • No significant difference in the profitability
Gambia 26.18* (0.083)
ratios between IBs and CBs during 1998–2006.
Indonesia 28.07* (0.091)
• IBs became more profitable than CBs during
Jordan 55.27* (0.069)
and after the financial crisis.
Kuwait 67.73 (0.069)*
NPL/GL and • No significant difference between IBs and CBs
Malaysia 63.95 (0.104)
LLP/NIR during the three periods relatively to the
Mauritania 168.83 (0.008)***
nonperforming loans to gross loans.
Pakistan −8.307 (0.216)
• Loan loss provisions were significantly larger
Qatar 72.19* (0.084)
for CBs relatively to IBs during the crisis's
Saudi Arabia 32.02* (0.094)
period 2007–2008.
Tunisia 69.20** (0.031)
Cost/income • No significant difference between IBs and CBs
*
Significant at 1%. before and during the financial crisis.
**
Significant at 5%. • IBs became more efficient in 2009.
***
Significant at 10%. LA/TA LA/D • No significant difference between IBs and CBs
during the three periods in terms of liquidity
policy.
Panel data Effects of the • There is some evidence that across the entire
analysis type of banks period 1998–2009, IBs were sounder than CBs.
Mj,t − 1 and Cj are vector of macroeconomic and country dummy vari- and the crisis • No significant effect of the 2007–2008's crisis
on Z-score on IBs and CBs.
ables, respectively;Ts P the interaction of the type of the bank with
the crisis period (2007–2008) dummy; finally εi,j,t is the residual.
Table 3 presents the variables' definition in more details as well as
the data sources. The summary statistics of the variables are given
in Table 4. The dummy variable (T) is needed to examine if the bank-
ing soundness of IBs is superior to that of CBs. Similarly, the interac-
tion between the dummy variable (P) (which takes the value of 1 if (Fig. 11). Indeed, the sign of the Islamic dummy variable is always
the year in question belongs to the crisis period 2007–2008) and positive but significant only at the 10 percent level for only three re-
the Islamic and conventional banks dummies is useful to test if the gressions (1, 3 and 11) out of the twelve performed. However, there
banking soundness of IBs was less impacted by the 2007–2008 finan- is no evidence that the financial crisis has affected differently the
cial crisis relatively to their conventional peers. When examining the soundness of the two types of banks during the period 2007–2008.
banks' soundness, it is imperative to control for macroeconomic vari- Indeed, the interaction of the crisis dummy variable (P) with IB and
ables GDP growth rate, inflation rate, and exchange rate deprecia- CB dummies does not appear significant in all regressions. This sim-
tion). We also have to control for the institutional environment. To ilar behaviour of the two groups of banks regarding the financial cri-
this end we construct index (per year and country) by averaging sis shows that IBs are diverging from their theoretical business
the 6 following governance indicators compiled by Kaufmann et al. model. Indeed, as detailed in Section 2 the latter would have allowed
(2010): voice and accountability, political stability, government ef- the IBs to keep the same level of soundness even during the crisis
fectiveness, regulatory quality, rule of law and control of corruption. since the losses occurring on the asset side (due to defaults of the
To take into account the impact of market concentration on the fi- borrowers) would have been totally absorbed on the liability side.
nancial stability, we use the Herfindahl–Hirschman Index (HHI). 9 This result confirms the finding of a growing number of studies
The model includes also the country dummies variables (Cj) in (Cevik & Charap, 2011; El-Hawary et al., 2007; Greuning & Iqbal,
order to reveal the potential role of country-specific unobserved fac- 2008; Zainol & Kassim, 2010) showing that IBs are mimicking the
tors in maintaining banking stability. commercial strategies of their conventional peers and that in prac-
We use the Random-effect Generalized Least Squares estimation tice they distribute profits to the investment depositors even when
and analysed the following three models: none effect model, fixed ef- they accrue loss and pay the profits out of equity. Concerning the
fect model and random effect model. The best model is selected based bank specific variables; the net loans to total assets ratio is negative
on the Hausman test. To overcome the problem of heteroscedasticity and statistically significant at 5% level of risk for the small banks
in the data, we perform a robust regression technique. In order to (see regressions (9), (10), (11) and (12)). Then, the small banks
capture possible past effect, we lag by one year all the bank specific with a high concentration of loans are less sound. The coefficient of
and macroeconomic variables, the Herfindahl–Hirschman Index and the cost to income ratio is negative and statistically significant differ-
the interaction of Islamic banks' share with Islamic and conventional ent to zero at the 5% level of risk (see regression (6)). Then, the more
bank dummies. We test the lagged effect by comparing estimation efficient banks are the more sound they are. The income diversity
using lagged variables with estimation using contemporaneous does not appear significant in all the regressions. The presence of
variables. IBs in a banking system has no significant impact on the soundness
of CBS. In fact, the share of IBs interacted with conventional
dummy variable does not appear significant in all the regressions.
4.2.2. Results Regarding the governance, there is some evidence that it has a nega-
There is some evidence that IBs were in average more sound (in tive impact on the banks' soundness (see regressions (1) and (3)).
regard of the Z-score) over the entire period 1998–2009 (Table 5), HHI, exchange rate depreciation and real GDP growth have no clear
linear dependence with the Z-score. Finally, the results show that
bank soundness (as indicated by the Z-score) is better in Mauritania,
Tunisia and Brunei (see Table 6).
9
Defined as the sum of squared market share in terms of total assets of all banks in The main results obtained from the two approaches are summa-
the country. rized in Table 7.

Please cite this article as: Bourkhis, K., & Nabi, M.S., Islamic and conventional banks' soundness during the 2007–2008 financial crisis, Review
of Financial Economics (2013), http://dx.doi.org/10.1016/j.rfe.2013.01.001
8 K. Bourkhis, M.S. Nabi / Review of Financial Economics xxx (2013) xxx–xxx

5. Conclusion

The recent global financial crisis has induced a series of failure of

many conventional banks and led many economists to advocate for
favouring the development of Islamic banks in the MENA region argu-
ing their higher soundness during the financial crises. This paper
attempted to answer empirically the following question: What was the
effect of the 2007–2008 financial crisis on the soundness of the Islamic
banks and their conventional peers?
To answer this question we considered a matched sample com-
prising 34 IBs and 34 CBs from 16 countries and applied two comple-
mentary approaches. The first one is a non parametric analysis of the
financial crisis's impact on a set of financial soundness indicators
(FSIs) related to the banks' earnings and profitability, capitalization,
asset quality, efficiency and liquidity. The second one is a parametric
approach analysing the impact of the crisis on a particular indicator
Fig. 2. The mean change in the net loans to total assets ratio.
of bank stability which is the Z-score. The results showed that there
is no significant difference between IBs and CBs in terms of the effect
of the financial crisis on the banking soundness (measured by the
Z-score and capital to asset ratio). The similar behaviour of the two
groups of banks regarding the financial crisis is coherent with the re-
sults of a growing number of studies showing that IBs are mimicking
the commercial strategies of their conventional peers and diverging
from their theoretical business model. This was also confirmed by
the other results of the non-parametric approach showing that the
two groups of banks are indistinguishable in terms of their liquidity
situation and the level of their non-performing loans. Nevertheless,
we found that IBs outperformed CBs in regard to the return to asset in-
dicator during and after the financial crisis. This better performance
seems to be partially due to the differences in the provisioning strate-
gies of the two types of banks during the crisis and to the better cost
efficiency of IBs during the year 2009.

Acknowledgement

We appreciate the helpful comments and suggestions of the two

anonymous referees. We thank Sami Ben Naceur and Sabri Boubaker
for their comments on an earlier version of this paper. Any errors
remain our own. This work was sponsored by the Economic Research
Forum (ERF) and has benefited from both financial and intellectual Fig. 3. The mean change in the net loans to deposits ratio.
support. The contents and recommendations do not necessarily re-
flect ERF's views.

Appendix

Fig. 1. Mean change in the capital to assets ratio. Fig. 4. The mean change in of nonperforming loans to gross loans ratio.

Please cite this article as: Bourkhis, K., & Nabi, M.S., Islamic and conventional banks' soundness during the 2007–2008 financial crisis, Review
of Financial Economics (2013), http://dx.doi.org/10.1016/j.rfe.2013.01.001
 K. Bourkhis, M.S. Nabi / Review of Financial Economics xxx (2013) xxx–xxx 9

Fig. 5. The mean change in the Loan Loss Provision to net interest revenue.
Fig. 8. Mean change of liquid assets to deposits ratio.

Fig. 9. Trend of ROAA.

Fig. 6. Mean change of cost to income ratio.

Fig. 10. Trend of ROAE.

Fig. 7. Mean change of liquid assets to total assets ratio. Fig. 11. Comparison of average Z-score.

Please cite this article as: Bourkhis, K., & Nabi, M.S., Islamic and conventional banks' soundness during the 2007–2008 financial crisis, Review
of Financial Economics (2013), http://dx.doi.org/10.1016/j.rfe.2013.01.001
10 K. Bourkhis, M.S. Nabi / Review of Financial Economics xxx (2013) xxx–xxx
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