Is credit risk really higher in Islamic banks?

ABSTRACT This paper empirically explores the assertion that Islamic banks have higher credit risk than conventional banks. We give definitions, methods for identification and methods for management of credit risk for each Islamic financial tool. This risk is then calculated for nine Islamic banks and nine conventional banks using contingent claims analysis. Merton’s model, based on Black and Scholes’s option pricing formula, is used to measure the distance-to-default, DD, and the default probability, DP from 2005 to 2009. Islamic banks have a mean distance-to-default of 204, significantly higher than conventional banks (DD = 15). The mean default probabilities are 0.03 and 0.05, respectively. Cumulative logistic probability distributions are then used to derive default probability from distanceto- default. These results are more satisfying: the distribution of default probability has larger tails, responding to the criticism of the use of a normal distribution.