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Financial Stability of Islamic and Conventional Banks in Saudi Arabia: Evidence using Pooled and Panel Models

Hassan B Ghassan
By Hassan B Ghassan
3 weeks ago
Financial Stability of Islamic and Conventional Banks in Saudi Arabia: Evidence using Pooled and Panel Models

Islam, Islamic banking, PLS, Shariah, Reserves

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  1. M PRA Munich Personal RePEc Archive Financial Stability of Islamic and Conventional Banks in Saudi Arabia : Evidence using Pooled and Panel Models Hassan B. Ghassan and Farid B. Taher Umm Al-Qura University, King Faisal University January 2015 Online at MPRA Paper No. 92889, posted 31 March 2019 04:41 UTC
  2. Financial Stability of Islamic and Conventional Banks in Saudi Arabia : Evidence using Pooled and Panel Models Hassan Belkacem Ghassan and Farid Bashir Taher The full version is available in the Book “Islamic Finance: Risk, Stability and Growth (Volume 2). Edited by Mehmet Asutay and Abdullah Q. Turkistani in Chapter 3: Financial Stability of Islamic and Conventional Banks in Saudi Arabia: Evidence Using Pooled and Panel Models. Pages: 81-114. Published by Gerlach-Press and available at JStor ABSTRACT The financial crises are considered the major challenges facing the prosperity and stability of the banking system and menace its stability. Several studies on financial and banking sector have demonstrated that Islamic banks have shown more financial robustness and stability compared to conventional banks, over periods of financial crises. This research aims to measure the stability extent of the Saudi Arabia banks including Islamic banks and conventional banks using quarterly data from 2005 to 2011. This period is characterized by the global financial crisis shocks (2007-2008). The sample used is composed of six banks including two Islamic banks (AlRajhi Bank and AlBilad Bank) and four traditional banks (Riyad Bank, Saudi Investment Bank, Saudi British Bank and Saudi American Bank). This sample represents an important part of 64% of the Saudi banking sector and covers close to two thirds of banks whose shares are traded on the Saudi stock market. The research focuses on three types of variables related to bank, banking system and macroeconomic levels. The paper is based on quantitative tools using panel regression and pooled regression to model the z-score index for testing the banks stability in Saudi Arabia. The panel data model shows that Islamic banks reduce relatively the value of the financial stability index; meanwhile, they contribute efficiently to enhance the financial stability through the diversification of their assets. The findings indicate those Riyad Bank and SAMBA groups support efficiently the financial stability of banking sector, while AlRajhi bank has a positive but moderate role in enhancing the banking sector stability. The Saudi banking sector has relatively less level of competitiveness, that affecting negatively the financial stability. The limited representation of Islamic banks in the Saudi banking sector jeopardizes any efforts to improve the financial stability index. JEL Classification: Key words: Islamic Banks, Financial Crisis, Financial Stability, Z-score Model, Saudi Arabia.  Professor, Departmet of Economics, Business School, King Faisal Univesity and Umm Al-Qura University. (Corresponding author:  Professor, Departmet of Economics, Business School, King Faisal Univesity. ( 1
  3. I . Introduction Financial crises are strongly related to financial and banking systems, given the international financial liberalization market, where a local financial system is no longer isolated from changes of the global system. In the last decade of twentieth century Islamic banks were firstly established and had growing role in the international financial system since then. In fact, CIBAFI (2010) indicates that total world Islamic finance has reached around one trillion U.S. dollars at the end of 2009. During the last financial crisis (2007-2009) a large number of conventional banks around the world have announced bankruptcy (140 U.S. Banks in 2009)1; while no single Islamic bank failure has been reported. The logical question to be raised here, is whether Islamic banks are immunized against financial shocks? And if so, can this be explained by the free-interest system, or by the fact that the Islamic banks do not invest in derivatives, “Tawaruq” and loans sale?2 (Chapra, 2000a, 2000b; Siddiqi, 2000; Hassan, 2006). In other word, can the immunity of Islamic banks against international financial crises be due to its incomplete integration in the global financial system? Studying the stability of Islamic banks requires the distinction between banks according to its asset structure in its budget. Firstly, Islamic banks adopted single layer Mudarabah, where they mobilize their liabilities directly in different investment opportunities. This model was faced by a lot of operational risks. Accordingly, Islamic banks switched to the use of multilayers Mudarabah Islamic model, i.e., Mudarabah of assets (sources) and liabilities (uses), where all assets are financed through Profit Loss Sharing system (PLS). The purpose of this paper is to test the hypothesis that Saudi Islamic banks are relatively less vulnerable to international financial crises, compared to Saudi conventional banks. The financial system and banking system in particular are always threatened by risks which lead to financial crises. Banking sector could be major driver of financial crises or one of channels transmitting the impacts of crises to other financial sectors and local or international real economies. Historical data shows that the banking sector was mostly the heavily damaged party by financial crises. During the last international financial crisis, the banks losses in the world were estimated to be more than 1.8 trillion dollars, followed by insurance companies with 1 2 The sale of loans is forbidden in Islam even if there are non interest loans. 2
  4. around one trillion dollars . The importance of this paper stems from the perception that the stability of Saudi Islamic banks in responses to financial shocks, due to the adoption of the PLS system, is expected to contribute positively to the international financial stability. II. Nature of financial banks crises Since the financial crises of Latin-America and East Asia during the 1990s, international organizations have paid more attention to find out the causes and factors leading to the international financial crises. These efforts were conducted to elaborate an Early Warning System to expect the occurrence of future crises, to take precaution measures to reduce their damaging impacts. Although each financial crisis has its own features and causes, there are some common internal and external features and reasons for all crises. In light of previous studies, the main reason behind the possibility of financial crises is asymmetry of information available to different participants, concerning rigorous macroeconomic fluctuations, including term of trade changes, variability of world interest rates and incentives to the flow of funds, exchange rate changes, and the vast expansion of banks credit, followed by a sudden collapse of asset prices, causing a miss-match between banks liabilities and assets maturity. In addition, money supply was growing at faster rate than GDP. Moreover, financial crises were caused by excessive government interventions through banking sector regulation (conflicted objectives of government policy and interest groups in banking operations), and the weak accounting and legal systems concerning banks objectivity and comprehensive attitude toward exposure and dissemination of banks financial standing, as well as the inefficient monitoring and control of banks, concerning early corrective actions, and coordination between banks owners, managers, and investors, and concerned government agencies. Banks financial crises may also happen as a result of changes in exchange rates, through banks speculation in FOREX, or the unexpected deterioration of the value of its holding of real and financial assets. Central banks are willing, in such cases, to play its role as last resort to rescue insolvent banks and to prevent the occurrence of a banking system crisis. Accordingly, it is believed that the existence of one of more of the abovementioned factors definitely enhances the possibility of a banking sector crisis. An economy, under these circumstances, will not be able to accommodate or absorb financial shocks generated by the instability of prices, interest rates and exchange rates. It would be difficult for the economy also to resist 3
  5. shocks of liquidity , credit and shocks related to changes in the structure of emerging financial institutions, as a result of reassessment of their financial assets, and changes in organizational structure or in the demand of assets. Therefore, several financial indices have been developed, such an early warning devices, to expect future financial shocks and to moderate its inverse financial and economic impacts. Banks receive loan applications form investors of different levels of risk and moral commitments toward financial deals with banks. Feasibility studies of investor’s project may help banks to assess the applicant level of risks, which consequently lessen adverse selection. However, such studies do not help bank to avoid moral hazards, which normally happen after signing the loan agreement. Furthermore, some loans may involve uncertainty concerning investors’ default intention. It is not an easy task for banks to accurately make the distinction between these risk levels caused by asymmetric information of banks and investors. Financial crises may be an exchange rate crisis, which leads to a large loss of the country international reserves, as a result mainly of the local currency devaluation. Another type of financial crises is that caused by bank failure, a situation that requires central bank interference to provide banks with reserves and to restructuring the banking system. Financial crises may also take place as a result of debt crisis, when debtors default on bank loans, or even when banks believe that defaults become a definite event. Facing such circumstances, banks are expected to adopt credit rationing strategy, depriving the economy from any new loans, settling outstanding loans. In some cases, the financial crisis may be related to the public debt, to Government failure in the repayment of the public debt, raising investment risk, discouraging foreign capital inflow, causing an exchange rate crisis. Facing such uncertainties, banks charge higher interest rates on loans by adding some risk allowance as an insurance premium. However, risky investors are the most likely to be willing to pay the high interest rates, given the high rates of returns expected on their projects. By contrast, low risk and moderate returns projects may turn to be infeasible, given the high financing cost. Accordingly, Banks will be forced to finance mainly risky projects, a practice known as adverse selection, which endanger the financial stability of the banking sector. Moral hazards may also occur as a result of asymmetric information between banks and investors with respect to after contracting behavior of the later. Looking for highest possible 4
  6. profits , some investors violate the loan contract by utilizing funds received from banks in rather riskier projects than those agreed upon in the contract. Thus, moral hazards raise banks’ risk, increase interest on loans, and enhance adverse selection by banks, which all lead to inefficient allocation of financial resources and adverse impacts on the economy performance. III. Literature review There are few papers using quantitative models to analyze the financial stability of the Islamic and conventional banks. Čihak and Hesse (2010, 2008) analyze, via z-score as a criterion of stability, a sample of twenty countries extracted from the BankScope database, which contain the Islamic banks and conventional banks. The Islamic banks are classified into small and large banks following their assets-size with a threshold of one billion dollars and having at least 1% of the total assets of banks in the country. The findings of Čihak and Hesse indicate that small Islamic banks are more stable than small conventional banks and large Islamic banks, large conventional banks are more stable than large Islamic banks, and small Islamic banks are more stable than Islamic banks are large. They don’t show if the large conventional banks are less stable than small Islamic banks. The Islamic banks could be affected positively or negatively by financial crisis or banking crisis or bankruptcies of conventional banks even if the Islamic banks operate with its assets following the Islamic finance. So, Standard & Poor's Credit Rating indicates that the Islamic financial institutions satisfy 15% of Muslims needs of financial services, and that the size of assets compatible to Islamic-Shariah reaches 400 billion dollars in 2009 i.e. approximately 10% of international market, which is around 4 trillion dollars. The expansion of the Islamic finance model could reduce the immunity of Islamic banks. The paper of AlKholi (2009), by using several stability bank indexes, concludes that the Saudi Islamic and conventional banks have been supported by SAMA and reflect fragile stability. He shows that the Saudi banking sector has successfully absorbed the shocks of international financial crisis. This shock absorption increased the customers’ confidence and contributed to avoid a local financial crisis and its detrimental repercussion on real economy. Saudi banks reserves have been increased by more than three times to face the loan losses, SAMA policy and credit rationing by banks reduce significantly the negative effects of the international financial crisis on Saudi banks. During the first nine months of 2009, the profitability of Saudi banks indicates a tenuous decline around 2.6% (18.86 billion Riyals in 5
  7. 2009 versus 19 .37 billion Riyals in 2008). At the same time, AlBilad Bank and Saud British bank recorded losses respectively at 66% and 11%; the losses of AlBilad Bank would be more related to local factors. Hasan & Dridi (2010) determine the effects of recent international financial crisis, especially during the period (2007-2008), on the conventional and Islamic banks in eight countries, including the GCC countries. Using a range of banking indicators such profitability, loan growth, asset growth and the external credit rating, they find that Islamic banks have been affected by the crisis, but in a different way comparatively to conventional banks. The Islamic banks profitability in 2008 reduces the negative impact of the international financial crisis. Also, the growth rate of credits and investments assets (loans granted in the PLS system) exhibit that the performance of Islamic banks is better than conventional banks, given the large losses incurred by conventional banks following the international financial crisis. Then, the Islamic banks contribute to realize the financial stability. However, the Islamic banks have some weaknesses related to their risk management. In that case, they are exposed to potential financial shocks, which require reliable financial instruments to resolve the risk management above all liquidity risk. The study of Imam and Kpodar (2010) identifies the factors affecting the world expansion of Islamic banks, which, in case of success, could be a new alternative financial model for finance industry. They use many factors affecting the international spread of Islamic banks such rate of Muslim population per country, technology of the domestic financial system, competitiveness of the domestic financial system, average of per capita income, real interest rate, events of September 11 2001, crude oil price, and integration degree to Middle East countries. The findings show that the average of per capita income and the competitiveness in the banking system have significant positive impacts on the spread of Islamic banks, expressing the increasing need for Islamic financial intermediation across the world. Also, the decrease in real interest rates less than 3.5% conducts to more deposits in the Islamic banks. The paper of Ariss (2010) focuses on competitiveness conditions of Islamic and conventional banks by using several indicators such PR H-statistic index and Lerner index (market power of bank). Using yearly data from 2000 to 2006, the findings indicate that the weakness competitiveness is related significantly and positively to higher level of profitability, and that traditional banks are more competitive than the Islamic banks. Quasi all research uses annual data; our paper by using quarterly data contributes to enrich the previous research modeling the financial stability 6
  8. of banks in face of shocks due to financial crises . The panel data features are firstly that the sample from 2005 to 2011 represents an important part of 64% of the Saudi banking sector with Islamic and conventional banks and covers close to two thirds of banks whose shares are traded on the Saudi stock market, and secondly that the sample contains the events of the recent global financial crisis (2007-2009). IV. Banks Data and tests Saudi banking system is composed of a total of eleven banks, including two distinguished groups, Islamic and conventional banks (Table 1 and Table 2). Four banks were classified as Islamic banks, according to the non-interest financing practice of this group of banks.3 The rest seven banks are conventional banks. For the purpose of this paper, a sample of six banks were selected, two Islamic banks (AlRajhi and AlBilad banks), and four conventional banks (Riyad bank, Saudi Investment bank, Saud British bank, and Saudi American bank), where the last two represent offshore banks, with its close links to international banks around the world that allow the investigation of the international financial crisis impacts on these banks and on the Saudi financial system (see appendix 8.1: panel definitions). The stability index (z-score) in sub-annual level is calculated using quarterly data collected and constructed from the Saudi financial market “Tadawul” over the period 2005-2011.4 The last financial crisis has revealed some weaknesses of the Saudi banking system, on top of which are: first, the high concentration of bank loans to a limited number of firms and individuals. Second, the large portion of banks’ investment in foreign assets with relatively high rates of returns compared to interest rates on domestic assets, especially after lowering the reverse repo by SAMA, and the lack of new government bonds during the same period, and the resulted liquidity surplus, which were channeled to the international markets (Ghassan et al., 2011). The world financial crisis has caused some Saudi banks to encore losses, particularly those involved in foreign investment, loans trade, speculation in foreign currency and gold markets, and financial derivatives deals. Third, banks showed some degree of credit rationing and become relatively more conservative in issuing new loans. On the other hand, Saudi banking sector have shown some healthy signs during the financial crisis, where its record profitability levels were maintained. Net banks’ profits were declined only by approximately 2.6% after the This link “” specifies Islamic and non Islamic features of firms and banks registered in Saudi stock market. 4 The international database BankScope allows only annual financial data. 3 7
  9. conservative measures taken by banks. Total reserves, voluntarily, boosted to 6.04 billion Riyals, over the period January to September 2009, compared with 1.58 billion Riyals a year before, as a precautionary action to meet any possible losses due to investors’ defaults on banks’ loans. Also, it was noticed that equity capital of Saudi banks have increased, and banks’ assets have not suffered the drastic negative impacts that hit banks’ sectors in industrial countries around the world, where some giant famous banks were forced to announce bankruptcy. Saudi banks’ huge reserves, most likely have shielded domestic banks against the tremendous negative impacts of international financial crisis. Moreover, some well-known international credit rating agencies as Moody’s and Standard & Poor’s, has reported that basic financial forecasts of the Saudi banking sector are relatively stable, flexible and had the ability to absorb negative shocks of the international financial crisis and the declining world economic growth. The prior step is to implement the panel unit root test on the relevant variables given in equation (x) below (Descriptive statistics, Tables 3).5 A widely used panel unit root tests are Hadri (1999) as a common root test and Im, Pesaran and Shin (IPS, 2003) as an individual root test. The Hadri test considers the null hypothesis of no unit root and assumes that persistence parameters are common i.e. identical in the panel data. Accordingly, it assumes a common process of the panel unit root under null hypothesis (ρ