Systemic Risk, Islamic Banks and the COVID-19 Pandemic: An Empirical Investigation

Abstract

While operating side-by-side with conventional banks, the systemic risk profile of Islamic banks could be different due to their unique business model. Using a sample of ten countries with dual-banking systems, where the Islamic banking sector is considered systemically important, this paper evaluates the systemic risk and identifies the determinants of systemic importance (measured using spillover indices) of financial institutions. The objective is to understand whether there are any differences in the systemic risk profiles of conventional and Islamic banks during the COVID-19 pandemic. The results indicate a significant increase in systemic risk in the sample countries during the first half, followed by a recovery in the second half, of 2020. Comparative analysis shows that Islamic banks, while earning abnormal returns, pose significantly less spillover to others relative to conventional banks. During the COVID-19 pandemic, there is an overall increase in spillovers, the magnitude of the effect of systematic risk increased, and higher abnormal return performance shows a negative association with spillover. Furthermore, we find that sensitivity to oil prices is a systemic risk factor for financial institutions, especially for Islamic banks. The results are robust to alternate estimation techniques. The findings of this study provide valuable insights for regulators of dual-banking systems.

Keywords: Systemic Risk, COVID-19, Dual-Banking Systems, Financial Institutions

JEL Classification: G01, G21, G32, G18