Bank lending procyclicality: A comparative study of conventional and Islamic banks

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1. Accountancy Business and the Public Interest 2020 Bank lending procyclicality : A comparative study of conventional and Islamic banks Zaid Zaid Senior Officer State Bank of Pakistan – Banking Services Corporation, Pakistan Email: Zaidmuhammad10@gmail.com Dr. Ajid ur Rehman Assistant Professor Faculty of Management Sciences Riphah International University, Islamabad, Pakistan Email: Ajid.rehman@riphah.edu.pk Imran Imran Research Scholar in Basic Islamic Sciences Bursa Uludag University, Turkey Email: iabuzaid75@gmail.com Abstract: The paper examines the bank lending procyclicality of the dual banking system in Pakistan with the aim to ascertain if conventional or Islamic banks have role in stabilizing credit. For the purpose, quarterly banking and macroeconomic data is gathered covering mostly a business cycle from 2006:Q1 to 2016:Q4. For analysis purpose, system GMM estimators are applied on the dynamic panel data model used in the study. Results obtained confirm the procyclical lending behavior of the dual banking system as suggested in existing literature. However, the lending behavior of Islamic banks is observed to be more procyclical when compared with the conventional peers. It implies that Islamic banks are more exposed to external economic down turns and would experience an intense decrease in lending if the economy contracts. These results are found to be robust to an alternative estimation technique. Hence, our findings are against the “stability” view of Islamic banks and necessitate further investigations of the subject. Key Words: Islamic Banks; Conventional Banks; Bank Lending; Business Cycle; Pakistan 1. Introduction Existing literature discusses various bank-specific operational measures, variables, standards, and policy regulations that play a vital role in strengthening banking institutions and provide a cushion to tackle any type of minor or major distresses. Among others, bank lending behavior is considered crucial bank specific variables in determining the resilience capacity and stability of a banking system (Bouheni & Hasnaoui, 2017; Belke, Haskamp, & Setzer, 2016). In times of financial and economic disruptions, with stagnating banking system efficiency, a procyclical bank lending behavior would intensify the liquidity crunch and severe the crisis. Gulati and Kumar (2016) ascertain that performance of Indian banks was declining during the financial crisis, however, its long lasting adverse effects on the economy were avoided by 254
2. utilizing different macroeconomic tools for injecting substantial liquidity into the economy . Thus, a less procyclical or anticyclical bank lending behavior would signify its ability to stabilize credit and avoid crisis intensifying tendency during cyclical downturns. The advent of Islamic banking industry has opened a new avenue for comparative financial research studies. Further, the relatively stable performance by Islamic banks during the 2007-09 financial crisis has further strengthened the need to investigate the “stability” view of Islamic banks (Ibrahim, 2016; Farooq & Zaheer, 2015). Different studies using different bank stability measures in different jurisdictions have found varying results. Some established conventional banks to be more stable to economic crisis (Alqahtani, Mayes, & Brown, 2017; Miah & Uddin, 2017) while others witnessed better resiliency of Islamic banks (Berger, Boubakri, Guedhami, & Li, 2019; Saeed & Izzeldin, 2016; Farooq & Zaheer, 2015). The current study intends to re-assess the subject after it has obtained mixed results in existing literature. The study will analyze the bank lending procyclicality of the dual banking system in Paksitan over a complete business cycle to ascertain the resilience capabilities of Islamic and conventional banks through sustaining credit in time of economic crisis. Thus, it will assess how bank lending is affected by the surrounded economic conditions. The resilience and stability view of Islamic banks needs to be based on solid grounds before being presented as a superior alternate to conventional banks. The research contributes to the existing finance literature in several ways. It is adding the Shari’ah compliance feature of Islamic banks to the thread of researches taking into account different basic attributes, presumed to be the reasons behind the various types of banks responding heterogeneously to the external economic conditions, like ownership of the bank, fundamental philosophy etc. (Bertay, Demirguc-Kunt & Huizinga, 2015; Merilainen, 2016). Further, several studies on the subject like Ibrahim and Rizvi (2017) are based on cross country analyses, which create hurdles in reaching reliable results, particularly in countries with varying social, financial and infrastructural levels (Huang, Fang, Miller, & Yeh, 2015). Therefore, the current study is incorporating data from only one developing country with dual banking system, Pakistan. Since the 1980s, efforts were made for Islamization of the banking system in Pakistan, which was further spurred by favorable regulatory reforms in 1990s. As a result of decades of struggle, the first fully-fledged Islamic bank was awarded banking license by the State Bank of Pakistan in 2002. Since then, Islamic banking sector is flourishing in the country. The current asset share of the sector in the overall banking industry have reached to 14.6 percent and have gained an YoY growth rate of 23.5 percent as on December, 2019 (SBP published Islamic banking bulletin, 2019). Lastly, Bank lending has not been examined as a measure of financial stability in Pakistan nor been used to compare between the resilience capacity of the two banking systems. Further, whatever research is being done on the subject has not taken a complete business cycle in their analysis (Farooq & Zaheer, 2015; Rosman et al., 2014). The current study is taking a complete business cycle from 2006 to 2016 in order incorporate different lending behaviors exhibited by the dual banking system in varying external economic conditions. 255
3. Literature relevant to the subject is reviewed in the next chapter . Afterwards research methodology is discussed in section 3. Section 4 will talk about the study results and section 5 will discuss the study limitations, policy suggestions and future research directions. 2. Literature review and development of hypotheses According to Farooq and Zaheer (2015) Islamic banks avoid uncertainty (Gharar), interest, speculation and objective less rapid selling of financial contracts in their transactions, and comply with a legal system that prohibits them from being engaged in any sort of financial bubble creation, non-real and uncertain activities. They reported that the lending decisions of Islamic banking branches from September to October 2008 in Pakistan were less vulnerable to widespread financial panic. Meanwhile, they were even able to generate extra deposits. Religion oriented depositors are less sensitive to profits on their deposits, hence, to the earnings of their banks. This avoids unfavorable deposit withdrawals that may adversely affect Islamic banks financing sustainability and help them to operate and behave in a way that may not be highly sensitive to conditions in the external economic and financial atmosphere. Banks follow an anticyclical approach while assessing different possible advances and lending opportunities to different clients approaching in varying financial and economic conditions. They usually maintain a low level of credit standards for financing opportunities that approach in times of expansion. Such loose credit analysis and risk management sometimes lead to shocking unexpected defaults (Thakor, 2016). Henceforth, banks would tighten their financings and set irrationally high level of standards and tough financing criteria purely based on anticipating negative future outcomes. This anticyclical standardization approach in times of downfall widens the credit spread and triggers credit crisis (Thakor, 2016). Caporale, Colli and Lopez (2014) ascertain that credit quality is inversely related to the business cycle. Loans tend to increase, however, credit quality tends to decrease when economy prospers and vice versa when it contracts. Islamic banks are expected to not follow this economically and financially disastrous mechanism. It is pertinent to note that Islamic banks normally generate deposits in two ways, first, qard (Debt) based and the second is mudaraba (Investment) based (Ayub, 2007, p. 194). In qard based, the bank assumes the sole responsibility to return the customer his principal amount even in case of losses. However, a large portion of deposits held with Islamic banks are mudaraba based. Mudaraba is a profit and loss sharing partnership arrangement, where capital is provided by one partner (depositor) and business is managed by the other (bank). In case of loss, the manager will be losing his services and the actual financial losses will be wholly born by the capital provider. Since the fund manager in mudaraba partnership is further granted the capacity of amin (trustworthy) with respect to the capital entrusted to him, he is bound not only to professional responsibilities but also strict religious obligations (Ayub, 2007, p. 322). Mudarib is required to maintain high quality rational standards in utilizing the fund in all types of financial and economic conditions. Thus, Islamic banks are bound to manage the mudaraba fund in the best possible ways with best practices to earn 256
4. maximum possible profits for their depositors . Such responsible financing behavior prevents Islamic banks from developing ill-fated loose credit standards in times of economic expansion and irrational tight lending standards when it contracts. According to Ibrahim (2016), the overall lending of the Malaysian dual banking system was found to be procyclical. However, when results for Islamic and conventional banks’ lending were distinct, the procyclical financing behavior was found to be limited to the conventional banks. Islamic banks were noticed for even behaving anticyclically in terms of financings. Caporale, Lodh and Nandy (2017) find that domestic banks in the MENA region had out performed foreign banks during the global financial crisis, reason being domestic banks in the said region mostly contain world’s largest Islamic banks, which resisted the crisis and showed a stabilizing behavior. Most recently, a study conducted by Ibrahim and Rizvi (2017) examined the financing sustaining capacity and its growth in Islamic and conventional banks of 10 dual banking economies during the financial crisis. Unlike the observed decline in the conventional banks’ financing, Islamic banks were sustaining their credit supply during the period. This stability oriented Islamic financing was confirmed of not being influenced by additional deposits or assuming extra risks. Hassan, Khan and Paltrinieri (2018) find Islamic banks to be having better credit risk management and hence, lower loan losses during and after the financial crisis. Similarly, there are many other studies advocating the dominant stability view of Islamic banks including Hasan and Dridi (2011), Farooq and Zaheer (2015) and Saeed and Izzeldin (2016). Despite the above mentioned facts in support of the credit sustaining and resilient view of Islamic banking system, the subject remains to be a continuous issue. In fact, evidence in support of a similar or less stable and resilient nature of Islamic banking system is not difficult to find. Islamic banks are so much similar in their operations to the conventional banks. The modes considered ideal for Islamic banking are still rarely practiced by Islamic financial institutions. Further, instead of opting for profit-and-loss sharing (PLS) mechanisms, Islamic banks are intensely inclined towards debt based products and fixed profit generating modes. Thus, In spite of innovating financial products in compliance with the form and spirit of the fundamental philosophy of Islamic finance, Islamic banks are concentrating on imitating and replicating existing conventional financial products, and are far away from the theoretical Islamic banking business model (Hassan, & Aliyu 2018; Ayub, 2016; Azmat, Skully, & Brown, 2015; Khan, 2010; Mirza, Rahat, & Reddy, 2015). Therefore, according to these studies, the overall financial impact of Islamic banking system on the economy and the prevalent financial and economic conditions on Islamic banking system may not be mentionably different from its conventional peer, if not worse. These findings have added further suspicion to the stability view of Islamic banks and justified the need for further research in this particular area. The above discussion leads to the below given hypotheses: H1A: Financing growth of conventional banks is procyclical over the business cycle. H1B: Financing growth of Islamic banks is procyclical over the business cycle. H1C: Financing growth of Islamic banks is less procyclical as compared to conventional banks over the business cycle. 257
5. 3. Research method 3.1. Sample and data description The study gathers both banking and economic quarterly panel data for most of the 2006:Q1 to 2016:Q2 period. Banking data sources are available financial statements of the commercial banks and periodic reports of the central bank in Pakistan. A twofold screening criteria is being set and data of only qualifying banks was incorporated in the study. Banks should have been operational for at least 4 years of our total study period and for the crisis years of 2009-10. Further, in case of banks providing both conventional and Islamic financial services, data of only those banks are included that report separate financial details for their Islamic and conventional banking practices. As a result, data of 4 conventional banks, 4 Islamic banking divisions of conventional banks and 4 full fledge Islamic banks qualifying the screening phase were selected for the study. GDP growth data at market price with constant prices (1999-2000) was collected from the study of Hanif, Iqbal and Malik (2013). Inflation and discount rate data was obtained from the webpages of central bank in Paksitan and International Monetary Fund respectively. 3.2. Estimation strategy and empirical models Following Bertay et al., (2015), the appended econometric equations are developed to examine the procyclicality of lending behavior of the dual banking system over a complete business cycle. Model for bank lending behavior of conventional banks