The stability of Islamic Banks during the Subprime

Crisis

Aniss Boumediene, PhD student at the IAE business school, University of Paris 1 Panthéon-Sorbonne
(GREGOR – Organisational Management Research Group)
and
Jérôme Caby, Professor, ICN Business School, CEREFIGE (European Centre for Research in Financial
Economics and Corporate Management)

Abstract
This empirical study examines the stability of Islamic banks during the subprime
crisis. It covers a sample of fourteen Islamic banks and fourteen conventional banks. The
conditional variance (volatility) of returns was used to measure stability. The E-GARCH and
GJR-GARCH asymmetric models were used to estimate volatility due to their ability to take
into account the leverage effect. The results of this study show that conventional bank returns
were highly volatile during the crisis period, while Islamic banks saw their volatility –
initially low – increase during the crisis, though to a much more moderate extent. These
results corroborate both the hypothesis that Islamic banks were at least partially immune to
the subprime crisis and the underlying hypothesis that Islamic banks are not subject to the
same risks as conventional banks – although, due to their links with the real economy, they do
eventually suffer the consequences of the subprime crisis.

Keywords: Islamic banks, financial stability, subprime crisis, volatility, leverage effect.
JEL classification: G12; G15; G21

Electronic copy available at: http://ssrn.com/abstract=1524775

 1. Introduction
Islamic finance has experienced considerable growth over the last three decades. Total
worldwide assets managed in accordance with the principles of Islamic finance are estimated
at over US$ 800 billion, with growth of between 10% and 15% over the last ten years 1 . The
main players in Islamic finance are Islamic banks and investment funds operating in financial
markets such as Bahrain, Dubai, Kuala Lumpur, London and Singapore. Investment funds
invest their clients’ money in companies that comply with Sharia (Islamic law). Compliance
criteria include not operating in a prohibited field (such as arms, alcohol, gambling 2 , etc.),
maintaining borrowing below one third of total liabilities, etc. Islamic banks undoubtedly
represent the most original aspect of Islamic finance, since they are managed according to
totally different principles: charging interest on loans – one of the foundations of traditional
banking – is prohibited. In most countries, the total volume of assets managed by Islamic
banks remains very marginal. However, in others, such banks occupy a significant position,
and in some, the entire banking system is based on Sharia principles (e.g. Iran and the Sudan).
While Islamic banks have the same corporate purpose as conventional banks – i.e.
funding the economy – they make use of very different tools based on the sharing of profit.
The principle of sharing profit replaces that of interest rates used by conventional banks.
Rather than knowing in advance how much of a return they will make on lending, Islamic
banks take a share of any profit from the transactions they finance (representing their
remuneration), as well as assuming any potential losses. They use two tools for this purpose:
mudaraba and musharaka. Moreover, Islamic banks are not allowed to make use of credit
derivatives, securitize their liabilities, etc. In light of the highly specific nature of the
financing tools used by Islamic banks, the risks they incur and the management methods they
use reflect very different realities from those to which conventional banks are subject.
While there has been plenty of research into risk management within Islamic banks (in
particular Sundararajan and Errico (2002) and Khan and Ahmed (2001) among others), the
issue has only been addressed from a theoretical viewpoint. To our knowledge, the only
article that explicitly (and empirically) deals with the issue of the stability of Islamic banks is
Čihák and Hesse (2008). The authors observed that (1) small Islamic banks (with assets under
US$ 1 billion) are financially more solid than conventional banks of the same size; (2) large
Islamic banks are less solid than conventional banks of the same size; and (3) small Islamic
banks are financially more solid than large Islamic banks.

The specific characteristics of Islamic banks, and their consequences in terms of risk,
set them apart from conventional institutions and, in principle, their behaviour during periods
of financial instability should not be similar, since they are not subject to the same types of
risks. The purpose of this article is therefore to test and compare the financial stability of

1
D. Oakley, S. Bond, C. O’Murchu and C. Jones, “Islamic Finance Explained,” Financial Times, 30 May 2008.
The total is still low compared with total global savings. Total assets managed by the world’s largest 500 fund
managers grew by 19 per cent in 2006 to US$ 63.7 trillion, according to the Pensions & Investments/Watson
Wyatt research.
2
From this standpoint, the investment funds in question can be said to fall within the scope of socially
responsible investment.

Electronic copy available at: http://ssrn.com/abstract=1524775

Islamic and conventional banks during the 2007 subprime crisis. To this end, the volatility of
returns on shares in a sample of fourteen Islamic and fourteen conventional banks was
estimated using the E-GARCH and GJR-GARCH models before and after the start of the
subprime crisis (18 July 2007 3 ). It emerges that conventional bank returns were highly
volatile during the crisis, while conversely, Islamic banks saw their volatility – initially low –
increase during the crisis, though this increase remained very moderate, thus empirically
confirming the initial intuition.
This article firstly sets out the context of the study and provides support for the issue
under investigation (2). Secondly, the research methodology is put forward (3), and thirdly,
the results are presented (4).

2. Context of the study

This study relates to the stability of Islamic banks. As a prerequisite, it is therefore
necessary firstly to set out the specific characteristics of Islamic banks and their consequences
in terms of risk (2.1) and secondly to clarify the concept of financial stability (2.2).

2.1 Specific characteristics of Islamic banks 4

Islamic banks are both commercial banks and investment intermediaries. They accept
two types of deposits from the public – current accounts and investment accounts – which
form the basis for two theoretical banking models:

- The two-tier Mudaraba model: in its balance sheet liabilities, the bank enters
into an unlimited Mudaraba contract between itself and the holders of investment
accounts. This contract is unlimited in the sense that the bank’s management has total
discretion to invest this money in what it considers to be the most profitable Sharia-
compliant projects. On the asset side of the balance sheet, funds are invested by way
of limited Mudaraba contracts; the limitation lies in the choice of projects and those
undertaking them. The bank also receives current account deposits. Although the full
amount of such deposits is guaranteed and available at all times, current account
depositors are aware that their deposits are used for risky projects. However, they do
not receive any interest on their deposits. Furthermore, a portion of these deposits is
used for interest-free loans (Qard Hassan). This type of loan forms part of the bank’s
social activities. There is no requirement to hold reserves under this model. In
practice, the two-tier Mudaraba model is the most frequently used model.
- The two-windows model, under which balance sheet liabilities are split into
two windows. Although the bank receives both types of deposits, they are completely
independent, with current account deposits covered by a 100% guarantee and not
available for investment in projects.

3
The date on which Bear Stearns announced that two of its hedge funds had lost most of their value.
4
Adapted from Sundararajan and Errico (2002), and Khan and Ahmed (2001).

3
 These funding models, and the resulting balance sheet structures, inevitably have
implications for Islamic banks’ exposure to risk (default risk, solvency risk, liquidity risk,
etc.).

As with traditional investment firms, neither the capital invested nor any gains are
guaranteed ex ante. However, while investment firms sell their capital to the public in the
form of shares or units representing a portion of their capital, Islamic banks collect money
from the public by accepting deposits. The bank’s own capital remains separate. A second
difference is that shareholders in an investment firm are entitled to monitor the company’s
management and have voting rights to ensure they can exercise this right. Customers
depositing money with an Islamic bank, on the other hand, have no right to interfere with
management of the bank, for example by opposing management’s choice of projects.

Due to the nature of their liabilities (equity capital, sight deposits and deposits in
investment accounts) and the principle of sharing profit and losses, Islamic banks should have
better immunity to external shocks than conventional banks. For example, they are immune to
the risk of a difference in value between assets and liabilities. If the value of their assets is
affected by a shock, they can adjust this difference by lowering the value of investment
deposits on the liability side of the balance sheet. In the two-windows model, it is
theoretically impossible for a bank to be insolvent, since current account deposits are
allocated in full to reserves. Nevertheless, banks using the two-tier Mudaraba model continue
to be partially exposed to this risk, for three reasons: (1) customers may ask to withdraw sight
deposits at any time, (2) the nominal amount of these deposits is invested in longer-term
projects and (3) there is no legal obligation to build up reserves to protect against this risk.

Credit derivatives ought to enable these banks to manage risks related to loans;
however, the use of derivatives is prohibited for Islamic banks. Islamic banks are also not
allowed to raise new funds by selling debt contained in their balance sheets, nor to exit debt
from their balance sheets or invest surplus cash by buying traditional bonds. However, new
tools have appeared that make up for this shortage of risk management tools, such as Sharia-
compliant bonds known as Sukuk.

2.2 Financial stability

It is difficult to give any commonly accepted definition of financial stability. Allen and
Geoffrey (2006) define financial stability as a period where there is an absence of instability:
“We define episodes of financial instability as episodes in which a large number of players,
whether they be households, companies or governments, are subjected to financial crises
which are not justified by their previous behaviour; and where, collectively, these crises have
seriously unfavourable macroeconomic effects.” Financial stability, then, is a period during
which the probability of an episode of financial instability occurring is very low. Similarly,
Illing and Liu (2003) talk about financial stress in relation to financial stability. This type of
stress is a continual variable over time, extreme values of which are known as crises. A crisis

4
is the product of a vulnerable financial system structure and several exogenous shocks.
Financial stability may also be defined as a situation in which the financial system is able to
(1) allocate resources efficiently between businesses and over time; (2) assess and manage
financial risk; and (3) absorb shocks (Houben and al, 2004). The concept of financial stability
is a relatively recent one, explaining why there is no commonly accepted definition for it5 .
However, it must be dissociated from the stability of the banking system, which is a much
older concept for the main central banks and was behind the creation of the US Federal
Reserve (Allen and Geoffrey, 2006). Financial stability relates to the financial system as a
whole and covers the banking, foreign exchange, debt and capital markets (Illing and Liu,
2003).

In order to measure this stability, microeconomic indicators (solvency, distance to

default, etc.) must be dissociated from macroeconomic ones (GDP, interest rates, etc.). Data
relative to the financial market must also be separated out from data that interact with the real
economy. Microeconomic data is often aggregated and added to macroeconomic data to form
macroprudential indicators such as those used by the IMF (Van den End and Tabbae, 2005) or
preventive EWIs (early warning indicators) (Illing and Liu, 2003) 6 .

Illing and Liu (2003) proposed a method for calculating a financial stress index. This
method aggregates various indicators, which are weighted in line with the significance of the
markets they represent (banking, foreign exchange, debt and capital) within the financial
system as a whole. They opted for three alternatives for calculating these indicators. They
initially drew on the existing literature to extract indicators relating to the various markets and
tried to refine measures where possible. Finally, they used the GARCH technique to extract
the volatility of pricing variables for the various markets making up the financial system.

The subprime crisis, which began to affect markets from July 2007 and subsequently
spread to the real economy, may be considered a particularly pronounced period of financial
instability. Its roots were in the banking market, since it resulted from a rapid increase in
default rates within the American subprime mortgage market. It is beyond the scope of this
article to cover the sequence of events that caused this crisis situation; rather, we intend to
show why Islamic banks ought not to be impacted by this instability in the same way as
conventional banks.

Indeed, with regard to charging interest on loans, Islamic banks did not participate in
the rapid expansion of this market either as a lender or as an investor. Consequently, neither
did they make use of securitisation (which is forbidden to them in any case). Furthermore,
since the rate at which their loans are remunerated is not linked to central bank base rates,
their profitability is defined by economic rather than financial factors, with the tools used by
Islamic banks channelling funding towards the real economy. However, as investors, they
could have been impacted by the decline in the property market, or more generally by the

5
An overview of the various definitions can be found in Houben et al (2004).
6
In an appendix to their article, the authors set out a review of the literature on EWIs.

5
resulting economic difficulties, in which case their balance sheet structures would reflect
potential falls in asset values.

One might thus put forward the hypothesis that Islamic banks ought to have been at
least partially immune to the subprime crisis. Moreover, empirical confirmation of whether or
not this partial immunity exists, and at the same time of severe instability in conventional
banks, would also corroborate the hypothesis that Islamic and conventional banks are subject
to structurally different risks.

3. Methodology

3.1 Sample
The sample was put together from several sources:
- A list of banks available on the internet. 7
- A list of quoted Islamic banks provided by the Bankscope database.
- Personal investigation through banks websites.

Several problems came to light when putting together the sample. Firstly, there is
confusion between Islamic banks and other Islamic financial institutions, or between Islamic
banks and conventional banks offering Islamic products. Therefore, it was necessary to carry
out detailed research on the websites of the various institutions and stock markets in question.
Secondly, although widely used, the Datastream database is not exhaustive. Many markets
are not covered. Thirdly, many Islamic banks were only quoted very recently, and a sufficient
history of data was not available. After taking into account these constraints, the initial sample
(34 Islamic banks and 36 conventional banks) was reduced to 14 Islamic banks and 14
conventional banks (Table 1). Conventional banks were chosen as far as possible from the
same markets as Islamic banks.

7
http://www.learnislamicfinance.com/Human-Resources.htm

6
 Table 1 - Sample composition

Islamic banks Conventional banks

Name of bank Country Name of bank Country
ABU DHABI ISLAMIC BANK UAE AHLI UNITED BANK EGYPT Egypt
AL RAJHI BANK Saudi Arabia BANK OF KW.& THE MDE. Kuwait
AL ARAFA BANK Bangladesh BANK OF SHARJAH UAE
BAHRAIN ISLAMIC BANK Bahrain BURGAN BANK Kuwait
BANK ALJAZIRA Saudi Arabia COMMERCIAL BANK INTL. UAE
DUBAI ISLAMIC BANK UAE COMMERCIAL BK.OF KUWAIT Kuwait
FAISAL ISLAMIC BANK OF
EGYPT Egypt COML.INTL.BANK Egypt
ISLAMI BANK BANGLADESH Bangladesh DUTCH BANGLA BANK Bangladesh
ISLAMIC BANK OF BRITAIN UK EASTERN BANK Bangladesh
KUWAIT FINANCE HOUSE Kuwait GULF BANK OF KUWAIT Kuwait
MEEZAN BANK Pakistan MASHREQ BANK UAE
QATAR INTL.ISLAMIC BANK Qatar NATIONAL BANK OF BAHRAIN Bahrain
QATAR ISLAMIC BANK Qatar NATWEST UK
SHARJAH ISLAMIC BANK UAE NIB BANK Pakistan

3.2 Data
The various banks’ share prices were gathered via Datastream. The number of
observations and the periods in which they were made are summarised in Table 2.

Table 2 - Number of observations and start and end dates

Name of index Start date End date Number of observations

CBRA 18/07/05 17/07/07 522

CBRP 18/07/07 17/07/09 523
IBRA 18/07/05 17/07/07 522
IBRP 18/07/07 17/07/09 523
CBRA: Commercial Banks Return Ante
CBRP: Commercial Banks Return Post
IBRA: Islamic Banks Return Ante
IBRP: Islamic Banks Return Post
Note: Ante – before the crisis; post – during the crisis.

The subprime crisis hit the financial markets on 18 July 2007 when brokerage firm
Bear Stearns announced that two of its hedge funds, which had invested massively in
subprimes, had lost virtually their entire value (US$ 1.5bn). This event came after 10 July,
when rating agency Moody’s had downgraded 399 subprime securities issued by Citigroup,
Morgan Stanley, Merrill Lynch and Bear Stearns. On 19 July, Standard & Poor’s announced

7
that it was downgrading 418 securities linked to subprime lending. For calculation purposes,
18 July was selected as the date on which the subprime crisis began to affect the financial
markets.

An index was then calculated for each subsample. The calculation method was
borrowed from the DJIA index (Dow Jones Industrial Average) and the Japanese Nikkei 225
index. It is based on an arithmetic mean. While the simplicity of the method used to calculate
this index may be criticised (with share prices considered to be weighted by price), it meets
our objective of reflecting market movements.

Returns are calculated using the following formula:

Rt = ln (Pt / Pt-1) (1)

Where Pt and Pt-1 are the values of the index at t and t-1 (Floros, 2008).

3.3 Measuring volatility

The volatility of returns on shares quoted on the stock market is used to measure the
stability of banks. The GARCH method (generalised autoregressive conditional
heteroskedasticity) was used to estimate this volatility.

Illing and Liu (2003) set out three alternative measures of financial stress: the standard
measure, the refined measure and the GARCH method. They observed that the GARCH
method provided the best measure of stress on capital markets. They calculated the
probability of type I and type II 8 errors for each of the three alternatives. The GARCH
method has the lowest values, at 17% and 21% of errors respectively.

Let yt equal the return on a share or portfolio between t-1 and t; and let Ft-1 be the
information held by investors at t-1. In this case, the best estimate of the value of the return
and its volatility is the expected value of yt for a given value of Ft-1; and the variance of yt for
a given value of Ft-1. These are respectively denoted: mt = E (yt Ft-1) and ht = Var (yt Ft-1).
Therefore, the unexpected return is εt ≡ yt – mt (Engle and Ng, 1993). The value of εt is a
measure of the impact of information between t-1 and t. A negative (positive) value means
that the information was bad (good) news. The size of the difference between yt and mt gives
an idea of the significance of the news between t-1 and t. (Engle and Ng, 1993).

Engle (1982) modelled conditional variance (volatility) ht as a function of the residual

ε. This is the ARCH (p) model (autoregressive conditional heteroskedasticity) with p past
periods:

8
A type I error is the probability of the measure failing to report a high stress event. A type II error is the
probability of the measure mistakenly reporting a false high stress event.

8
 p
ht = ω + ∑
i =1
α i ε t2− i (2)

Where α 1……p, and ω are constant parameters. The model for one period is:

h t = ω + α ε t2− 1 (3)

In other words, volatility depends on the residual (of information) from a single past
period.

Bollerslev (1986) brought the ARCH model into widespread use. He modelled
conditional variance as a function of the residual εt and of the volatility of past periods, using
the following GARCH (p, q) formula:
p q
ht = ω + ∑
i =1
α iε 2
t−i + ∑i=1
β i ht−i (4)

The model for one period is as follows: GARCH (1, 1):

h t = ω + α ε t2− 1 + β h t − 1 (5)

ω, α and β are constant parameters.

The previous two models are said to be symmetrical, i.e. the sign of the error (or
residual) εt has a neutral effect on conditional variance since ε is squared in the model. The
leverage effect 9 has been identified as a phenomenon in share prices (Black, 1976; French and
al, 1987). Bad news (where the residual is negative) causes the amplitude of volatility to
increase more than good news (where the residual is positive). As a result, symmetrical
models (ARCH and GARCH) become ineffective in capturing this effect. They do not reflect
the reality of market movements in share prices.

Engle and Ng (1993) tested various asymmetric volatility forecasting models. They
demonstrated that the one that most effectively models returns is GJR-GARCH (so named in
reference to its designers Glosten, Jagannathan and Runkle, 1993). The formula for GJR-
GARCH (1, 1) is as follows:

h t = ω + β h t − 1 + αε 2
t −1 + γ S t−− 1ε t2− 1 (6)

9
Also known as the asymmetric effect.

9
Where S t− = 1 if ε t < 0, S t− = 0 elsewhere, ω, α, γ and β are constant parameters.

When the residual is negative, volatility is impacted by two terms in the equation that
includes the residual. The Exponential-GARCH model (Nelson, 1991) also gives good results
in the case of violent shocks. The E-GARCH (1, 1) model may be expressed as follows:

log h t = ω + α g ( z t − 1 ) + β log( h t − 1 ) (7.a)

g ( z t −1 ) = θ z t −1 + γ [z t −1 − E z t −1 ] (7.b)

ε
z t −1 = t −1
(7.c)
h t −1

2
E Ζ t −1 = if Ζ t ~ Ν (0,1) .
π

Where ω, α, γ, θ and β are constant parameters.

Table 3 sets out descriptive statistics for the indices and their returns. All four series
have positive skewness, which means that the right tail of the distribution is longer. The
kurtosis values are higher than 3 for return series; the distributions are somewhat sharp with
thicker tails than a normal distribution, especially for conventional banks. This is said to be a
leptokurtic distribution.

10
 Table 3 - Descriptive statistics
Conventional banks
Index Return
Mean 129.215922 0.0008171
Standard deviation 75.3408637 0.05452031
Variance 5676.24574 0.00297246
Kurtosis 1.95741978 400.393463
Skewness 1.15404551 4.48111551
Minimum 56.2778571 -1.05979934
Maximum 689.974286 1.24924625
Number of observations 1,045 1,044
Islamic banks
Index Return
Mean 63.0439583 0.00050753
Standard deviation 13.0716717 0.01396366
Variance 170.868601 0.00019498
Kurtosis -0.64542225 3.62967294
Skewness 0.54923783 0.77647507
Minimum 42.0442857 -0.04731397
Maximum 96.84 0.07353794
Number of observations 1,045 1,044
Note:
- Skewness measures the asymmetry of series’ distribution around the mean.
- Kurtosis measures the flatness of series’ distribution.
- For a normal distribution, the value of the skewness coefficient is zero and that of kurtosis is 3.

Tests of ARCH effects (or heteroskedasticity tests) can be used to detect any
correlation between the squares of residuals. The following were used:
• Q-statistics (Box Pierce, Ljung Box, etc.): autocorrelation tests on the ε2t
• LM (Lagrange multiplier) tests for the absence of autocorrelation on ε2t

In both cases, the null homoskedasticity hypothesis is rejected for large statistical
values. Table 4 sets out the results of ARCH effect tests.

Table 4 - Results of ARCH effect tests

Test
Index ‡
Q (12) LM† (12)

CBR (235.8426)* (356.4308)*

IBR (123.8673)* (76.8838)*
‡
Ljung-Box statistic for the twelfth order of autocorrelation on the squares of the residuals.
†
Lagrange multiplier statistic for the twelfth order of autocorrelation on the squares of the residuals.
*
Significant at 1%.
CBR: Commercial Banks Return
IBR: Islamic Banks Return

11
 The null homoskedasticity hypothesis is rejected for both series of returns (Islamic and
conventional banks). There is indeed a temporal dependence between the squares of the
residuals. Consequently, both series of returns can be used to study the behaviour of volatility
during the periods covered by the study.

4. Results and discussion

The parameters of the E-GARCH and GJR-GARCH models were estimated by the
FIML (full information maximum likelihood) method using the Marquardt-Levenberg
iterative minimisation method. Table 5 sets out the estimated models for the various periods.
The t-values of parameters are reported in parentheses.

Table 5 - Results of estimates

RESULTS OF ESTIMATES

Commercial banks

E-GARCH (1,1) before the crisis:

log h t = - 0.6505 + 0.2811 g ( z t − 1 ) + 0.9225*** log( h t − 1 )
(- 3.54 )
* ** ***
(5.36 ) ( 43.49 )
⎡ 2 ⎤
g ( z t − 1 ) = 0.3373*** z t − 1 + ⎢ z t − 1 − ⎥
( 2.70 )
⎣ π ⎦
Log L = -1535.60779

E-GARCH (1,1) during the crisis:

log h t = - 4.4887* * * + 1.8720 * * * g ( z t − 1 ) + 0.3464* * * log( h t − 1 )
(- 18.26 ) (35.50 ) (9.30 )
⎡ 2 ⎤
g ( z t − 1 ) = 0.4820* * * z t − 1 + ⎢ z t − 1 − ⎥
(8.41 )
⎣ π ⎦
Log L = - 1037.32876

GJR-GARCH (1,1) before the crisis:

h t = 0.000011 + 0.784893 h t − 1 + 0.09823 ε t2− 1 + 0.138768 S t−− 1 ε t2− 1
(3.01 )
* **
( 21.06 )
** *
( 2.49 )
** **
( 2.42 )
Log L = - 1533.057

GJR-GARCH (1,1) during the crisis:

h t = 0.003448 + 0.031944 h t − 1 − 0.00621 ε t2− 1 + 0.146804 S t−− 1 ε t2− 1
(3.44 )
** * (0.12 ) (- 0.11 ) (1.35 )
Log L = - 725.9778

12
Islamic banks
E-GARCH (1,1) before the crisis:
log h t = - 0.18712* + 0.143707 g ( z t − 1 ) + 0.978495* * * log( h t − 1 )
(- 1.93 ) (3.51 )
***
(89.45 )

⎡ 2⎤
g ( z t −1 ) = - 0.25929 z t − 1 + ⎢ z t −1 − ⎥
(-1.59 )
⎣ π ⎦
Log L = - 1604.32

E-GARCH (1,1) during the crisis:

log h t = - 2.7035* * * + 0.5948* * * g ( z t − 1 ) + 0.6757* * * log( h t − 1 )
(- 4.02 ) (6.35 ) (8.50 )
⎡ 2 ⎤
g ( z t − 1 ) = - 0.0418 z t − 1 + ⎢ z t − 1 − ⎥
(- 0.50 )
⎣ π ⎦
Log L = - 1477.25434

GJR-GARCH (1,1) before the crisis:

h t = 3.124E * - 6 + 0.906721 h t − 1 + 0.105113 ε t2− 1 − 0.06755** S t−− 1ε t2− 1
(1.87 ) ***
( 25.75 ) * **
( 2.96 ) (- 2.36 )
Log L = - 1603.976

GJR-GARCH (1,1) during the crisis:

h t = 0.000047 + 0.490266 h t − 1 + 0.425194 ε t2− 1 − 0.10449 S t−− 1 ε t2− 1
(3.19 )
* ** ** *
(5.06 ) (3.92 )
** * (- 0.99 )
Log L = - 1477.123
Note:
- t-values in parentheses
- (*) Significant at 10%; (**) significant at 5%; (***) significant at 1%
- The γ parameter was standardised to 1 in the case of E-GARCH (1, 1)

Before the crisis, for conventional banks, the GJR-GARCH model provides a better
explanation of volatility (higher LogL). During the crisis, the GJR-GARCH model continues
to have a higher LogLikelihood value, but β, α and γ are not significantly different from zero.
Moreover, the parameters of E-GARCH are all significant at a threshold of 1%. This proves
that there was a strong leverage effect during the subprime crisis. E-GARCH model is more
adequate to capture the effects of extreme shocks (Engle, R. F. and Ng. V., 1993).

Before the crisis, for Islamic banks, the GJR-GARCH model better captures the effects
of volatility. All its parameters are significant, and γ is negative. The leverage effect was
present during this period but in a special manner. Bad news decreases the conditional
variance of 0.06755 S t−−1ε t2−1 . It reflects, probably, the confidence of the investors in this

industry. During the crisis, the same model (GJR-GARCH) gives a higher value for LogL.
Unlike for conventional banks, all parameters are significant at a threshold of 1% with the

13
exception of γ. Bad news had, a priori, no effect on conditional variance of Islamic banks
during this period.

The models selected for conventional and Islamic banks are therefore GJR-GARCH
(1, 1), E-GARCH (1, 1), GJR-GARCH (1, 1) and GJR-GARCH (1, 1) respectively.

Table 6 sets out estimates of conditional variance for both types of banks during the
two periods.

Table 6 - Statistical estimates of conditional variance

Standard
Mean Min Max Skewness Kurtosis
deviation
CBRVA 0.00021814 0.0002319 6.03736E-05 0.002233557 3.873260219 20.71956772
GJR-GARCH

CBRVP 0.00402576 0.00956427 0.00343884 0.22230189 22.8589017 522.684732

IBRVA 0.00015152 0.00011013 4.5612E-05 0.00061981 1.83337738 3.35186671
IBRVP 0.00026216 0.00024644 9.3107E-05 0.00189288 3.4059951 14.5810102
CBRVA 0.0002026 0.00017485 4.5398E-05 0.00157013 3.26690694 14.9173218
E-GARCH

1020.56593 23329.388 0.00011633 533524.684 22.8691879 522.999835

CBRVP
(0.44225272)* (9.23115816)* (0.00011633)* (210.612519)* (22.7028211)* (517.687535)*
IBRVA 0.00014862 0.00010065 3.7616E-05 0.00055806 1.70164835 2.9333773
IBRVP 0.00024797 0.00019774 7.299E-05 0.00200038 3.88984337 23.4548915
Notes:
- CBRVA: Commercial Banks Return Volatility Ante
- CBRVP: Commercial Banks Return Volatility Post
- IBRVA: Islamic Banks Return Volatility Ante
- IBRVP: Islamic Banks Return Volatility Post
*
Without outlier (03/21/2008).

Before the crisis, Islamic banks showed volatility of 0.00015152, versus 0.00021814 for
conventional banks, with standard deviations of 0.00011013 and 0.0002319 respectively.
Conventional banks were therefore more volatile during that period. However, volatility was
low for both types of bank. It explains the confidence of investors in the markets in general
during that period.

During the crisis, the volatility of Islamic banks rose to 0.00026216, with a standard
deviation of 0.00024644. For conventional banks, volatility increased violently to 1020.56593
(0.44225272 without outlier), with a standard deviation of 23329.388 (9.23115816 without outlier)
and a maximum value of 533524.684 (210.612519 without outlier). The volatility of Islamic banks
increased by a factor of 1.73 during the financial crisis. That of conventional banks increased
by a factor of 4,678,491 (2,027 without outlier) during the same period. The volatility of
conventional banks was 3,892,912 (1687 without outlier) times that of Islamic banks during
this period.

14
 The value of skewness was positive for both types of banks during both periods (Table
5). The distributions are skewed to the left relative to the mean, and their right tails are longer.
The value of kurtosis is higher than 3 for both types of banks during both periods. The
volatility distributions are sharper and the tails thicker than in a normal distribution. They are
leptokurtic. The difference between Islamic and conventional banks lies in the fact that the
latter have a much higher coefficient. Their conditional variances are more concentrated
around the mean than is the case for Islamic banks. The conditional variance of Islamic banks,
which was low before the crisis, increased moderately during the crisis.

These results corroborate both the hypothesis that Islamic banks were at least partially
immune to the subprime crisis and the underlying hypothesis that Islamic banks are not
subject to the same risks as conventional banks – although, due to their links with the real
economy, they do eventually suffer the consequences of the subprime crisis.

5. Conclusion
The increasing importance of Islamic banks within the international financial system
calls for their stability to be examined. This study empirically observed the specific nature of
their risks at the time of the 2007 banking crisis – a specific nature which rendered them
largely immune to its consequences. However, this does not mean that Islamic banks are
exempt from risk, and prudential management methods suited to conventional banks may not
be applied to them indiscriminately. The risks specific to Islamic banks should therefore be
characterised and risk management tools be developed accordingly.

15
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