Conventional vs Islamic banking and macroeconomic risk: Impact on asset price bubbles

This paper examines how the liability side of Islamic banks is impacted by the risk in the macro economy. The paper first develops theoretical models for conventional and Islamic banks. For conventional banks, we argue that during periods of rising risk in the economy, investors with higher risk aversion prefer bank deposits as a haven compared to other asset classes, causing conventional banks to be flushed with excess liquidity, which is then disposed of in the form of risky loans. This may create asset price bubbles and a further increase in the overall risk of the economy. For Islamic banks, we build a theoretical model with a religious conscious customer base who demands products with religious compliance. The increased self-regulatory environment faced by Islamic banks on the backdrop of religious compliance helps reducing the influx of liquidity and conversion into risky loans during periods of heightened macroeconomic shocks. Using bank-level data from 20 Muslim-dominated countries for the period from 2000 to 2015, we test the propositions of our theoretical model. We find that the macroeconomic risk has a significant, positive impact on conventional bank deposits, while its impact on Islamic banks' deposits is either negative or significantly lower than their conventional counterparts.