Is credit risk really higher in Islamic banks?

Boumediene, Aniss. The Journal of Credit Risk; London Vol. 7, Iss. 3,  (Fall 2011): 97-129.

Abstract
TranslateAbstract

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 distanceto-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 distance-
to-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. [PUBLICATION ABSTRACT]

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Headnote

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 distanceto-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 distance-
to-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.

INTRODUCTION

Islamic banks, like their counterparts in conventional finance, obtain profits by providing facilities to
their customers. However, unlike conventional banks, they do not lend money, except in one case
(qard hasan), where the bank lends money to customers who are in difficulty. This lending, which, of
course, is interest-free, is an aspect of the bank's social activities.

In order to earn profits, a typical Islamic bank uses many tools. These tools can be classified into two
groups: cost-plus tools (murabahah, ijarah, istisna', salam, etc) and investment tools (mudarabah,
musharakah). Over the course of each contract underlying these tools, Islamic banks take many
risks, but the major one is credit risk (in mudarabah and musharakah this risk is called "capital
impairment risk" (Islamic Financial Services Board (2005a))). Credit risk can be defined as the
probability that a counterpart of a contract will fail to fulfill its engagements, either as a one-off or
completely.

It is usually argued that Islamic banks have higher levels of credit risk than their counterparts in
conventional finance, based on the fact that Islamic banks do not have the appropriate risk
management tools to deal with such risk. Furthermore, Islamic banks have a hybrid status because,
while they are supposed to be commercial banks, they use mudarabah and musharakah, which are
actually direct investments. In the literature, almost all contributions establish the above assumption
analytically. How et al (2005) measure credit risk in Islamic and conventional banks. However, this
study was limited to Malaysia only. They used the proportion of allowance for loan loss to total
assets as a proxy for credit risk. However, to the best of the author's knowledge, there are no
empirical works that deal explicitly with the identification of credit risk in each Islamic financial tool,
measuring this risk for Islamic banks and comparing it with conventional banks. This modest
contribution attempts to fill this gap.

This paper is organized as follows. Section 1 deals with the identification and mitigation of credit risk
in Islamic banks' tools. Section 2 describes how credit risk is measured. Section 3 presents the
model and data, and Section 4 presents the results and gives a discussion.

1 CREDIT RISK IN ISLAMIC BANKS

Musharakah, mudarabah, istisna', salam, ijarah and murabahah are the main contracts used by
Islamic banks for providing facilities to their customers. A second possible classification for these
contracts could be to distinguish between non-debt-creating Islamic modes of financing
(musharakah and mudarabah) and debt-creating modes (all others) (Kahf (2005)). A third possible
classification would be to distinguish original Islamic modes of financing (musharakah, mudarabah,
istisna' and salam) from "reshaped" modes of financing (ijarah and murabahah) (Uthmani (2002)).
Before attempting to identify credit risk in these tools, it is interesting to note the contentious debate
regarding the degree of acceptability of these contracts from scholars. There exist two main opinions
on the subject. The first opinion is that if Islamic banks respect the rules of Shari'ah in their contracts,
"reshaped" modes of financing are not less Islamic than the original ones (El-Gamal (2000)). The
opposite opinion says that ijarah and murabahah are not ideal modes of financing and should be
utilized only when and where the original modes cannot be used. Moreover, "murabahah is only a
device to escape from interest" (Uthmani (2002)) . Musharakah and mudarabah are based on the
profit and loss sharing (PLS) principle, which is why they are the most required modes of financing.
When utilized, these two instruments do not create debt in the society at a whole, and the profit is
shared more equally between capital and labor.

The latter arguments have been put forward by researchers who do not necessarily have a
connection to the Islamic finance industry. Ordody de Ordod (2001), for example, demonstrates that
what guarantees economic equilibrium, and full employment, is an "infinite individualized a posteriori
rate" rather than a referenced, pre-fixed rate of interest. This economic analysis substitutes the
traditional IS plot, where the intersection of the two curves ("I" for investments and "S" for savings)
gives a rate of interest at equilibrium, with a plot where the two curves are identical and increase
with the augmentation of the expected rate of return. Ordody de Ordod (2001) argues that it is the
rigidity of the rate of interest to fluctuations that causes disequilibrium and inflation. Shiller (2003)
advances the idea that subjecting borrowers to conventional fixed nominal interest rates on their
debts leads to the problem of personal bankruptcy. He suggests a linking of repayment terms to
income. This practice would perform a risk management function and reduce the number of
bankruptcies.

An analysis of credit risk in each instrument mobilized by Islamic banks and a description of the way
to manage it now follows.

1.1 Musharakah1

The bank enters into a partnership with one or many partners (whether customers or not).
Musharakah is derived from a commercial relation in Fiqh called shirkat-ulamwal. This contract
constitutes a part of a more general concept widely known in Fiqh: that of shirkah. For the
musharakah to be valid, a profit-sharing ratio (PSR) must be defined before commencing business.
Profits, for each partner, are a fraction of the actual profit of the project. It cannot be a percentage of
the amount invested, nor a lump sum. The PSR can be equal to the percentage of the partner's
participation in the capital. It can also be higher depending on whether or not the partner is a
sleeping partner. However, unfortunately, if there is loss, it is shared between the partners according
to the ratio of their participation in the partnership. Moreover, if all partners have agreed to incur a
debt during the course of the business, the portion of loss not covered by the liquidation of assets is
shared on a pro-rata basis between them. This is the case because the liability of partners in
musharakah is unlimited. Participation in a partnership can be with money, and it can also be with
illiquid assets. In the latter case, the value of the contribution to the investment is defined on a
market-value basis.

There is no credit risk in musharakah. In fact, what the bank can lose in case of failure is the capital
that it provided. Here, the credit risk is actually "capital impairment risk" as mentioned before. Unlike
their conventional counterparts, and in order to invest in musharakah, Islamic banks mix their own
capital with the amount of (special) investment accounts. These accounts are managed through the
PLS principle. Then, both stockholders and investment account holders know that they can lose the
amount invested at any moment. Furthermore, the bank has the right to manage or monitor the
partnership. In the case where the bank remains a sleeping partner while explicitly stipulating
management rules, any loss due to negligence or misconduct is borne by its instigator. On the other
hand, partners in musharakah are logically selected according to their integrity, honesty and good
reputation. It rejects "defaulter" clients.

The fact is that anxiety over investing in a project, where the profit is only known ex post, can often
prevail. It is argued that there is always a risk of loss due to economic factors, unlike conventional
systems, where a fixed rate of return is always guaranteed. Two arguments can be formulated
against this affirmation: Islamic banks study the achievability of every project with due diligence;
secondly, portfolio diversification and higher returns (since they are not tied to any referenced rate)
will absorb any loss (Uthmani (2002)).

1.2 Mudarabah

Mudarabah is a special case of partnership. It is a contract between two parties, rabb-ul-mal

(provider of funds) and a mudarib (user of it). Mudarabah is an original business relation where
capital and labor are treated in the same way and have the same importance. Labor and capital are
put together from different parties to make profit. There are some conditions on the validity of
mudarabah: like musharakah, PSR must be defined before starting the business. In the case of loss,
each partner loses what he has provided: the supplier of funds loses his money and the mudarib
loses the hard work he has devoted to the project. Liability in mudarabah is limited to the funds
provided unless some debt is incurred during the course of business with the agreement of both
parties. If the mudarib is convicted for negligence or misconduct, he is liable to rabb-ul-mal for the
loss caused by his actions. Unlike musharakah, rabb-ul-mal remains a sleeping partner; it does not
have the right to participate in the management of the project. If this condition is not respected, the
contract of mudarabah is broken, as the contract loses its specificity; it is no longer a mudarabah
and will resemble an ijarah contract. During mudarabah, ownership of the assets remains with the
provider of funds; the mudarib cannot claim any percentage in the appreciation of the market value
of assets. The remuneration of the mudarib comes from the proportion of the real profit due to him,
neither from perception of fees nor salary or remuneration.

The contract of mudarabah is clearly based on trust between the partners and it is more efficient in a
human society with a high or very high level of faith (including religious faith). However, there are
many difficulties associated with implementing this type of contract in the real world. Before
concluding the contract, there is a high probability of adverse selection. Riskier projects can be
selected because they promise higher returns, or a candidate can hide some risks in the project
presented. Asymmetric information, after the conclusion of the contract, will lead to moral hazard.
The mudarib can, for example, increase the level of expenses in immaterial benefits in order to take
more profits than was agreed.

There are some solutions to the problems cited above (adverse selection and moral hazard). Instead
of entering, on a mudarabah basis, into a large project at one time, it might be better to subdivide the
project into small projects and to conclude a mudarabah for each of them, one after another. If there
is risk of moral hazard, the bank stops doing business with the mudarib and tries to find another
partner. In this case, the loss will not be very significant. In addition, the mudarib has no incentive to
behave falsely because he will lose the remaining contracts. Secondly, Islamic banks accept
investment accounts on a mudarabah basis. What permits depositors to do so (to some extent) is
their trust in the bank and its management. In the same way, Islamic banks can only use mudarabah
with highly reputed companies. If the contract is sufficiently large, there could be a coalition of
Islamic banks dealing with such companies. In the case of misconduct, the mudarib would lose not
only his work, but also his reputation in the market. The latter loss can be called a "reputational risk"
incurred by the mudarib. However, the most interesting solution is the combination of mudarabah
and musharakah in the same contract. After the conclusion of mudarabah and the agreement on the
PSR, the mudarib can add some money to the project on a musharakah basis with a second PSR
agreed with this musharakah. The addition of capital to the project from the mudarib is clear proof of
the quality of the project, and of the mudarib 's truthful intention (see Uthmani (2002) for an example
of a combination of mubarabah and musharakah). A further solution is the use of "incentive
compatible contracts", which can reduce moral hazard and adverse selection (see Khan and Ahmed
(2001) and, for a more detailed approach, Ahmed (2002)). Finally, El-Gamal (2006, p. 122) states
that if the conditions of mudarabah are violated, the contract can be converted into ijarah. Profits are
then assigned to the mudarib and the entrepreneur receives a wage for his efforts.

1.3 Salam

A salam contract is an agreement between two parties. One of them agrees to provide specific
goods at a future date while the other party agrees to pay its price in full at the conclusion of the
contract (the payment can be delayed for a maximum of three days, not exceeding the time of
delivery of the commodity, but it should not be an amount already loaned to the seller2). At the time
of the conclusion of the contract, the commodity is not in the ownership and possession of the seller,
whether it exists or not. For a salam contract to be valid, it is necessary to identify precisely the
quantity (weight or measure) and quality of the goods to be delivered. It is also compulsory to fix the
place and the time of delivery (it can be a fixed date, or tied to the upcoming of an event whose
happening is certain, or a period of time like harvest).3 There is no minimum period between the
moment of the conclusion of the contract and time of delivery. If the buyer puts a condition in the
contract that the object of delivery must come from a particular origin (field, farm, etc) the contract of
salam is void. A salam contract cannot be canceled unilaterally (Akkisidis and Khandelwal (2008)).

In this type of contract, credit risk is present when there is a default on delivery of the commodity. If
default is only temporary, the bank can wait until the commodity is available or break off the contract
and get its money back if the other party is not in a situation of hardship.4 During the conclusion of
salam, Islamic banks are allowed to take a security (guarantee5, mortgage, etc) from the other party.
The guarantor will be asked to deliver the same commodity. Otherwise, the price of the mortgage
can be used either to buy the commodity in the market or to recover the funds advanced (Uthmani
(2002)) . At the time of delivery, the bank has the right to ask the other party to exchange the
commodity with another commodity of the same value.6 Default on delivery can be caused by a high
fluctuation in price at the end of the contract. In that case, the other (dishonest) party might prefer to
default, sell the goods in its possession and reimburse the amounts advanced from the bank. A
clause can be added to the contract to prevent this kind of behavior: above an acceptable level of
price fluctuation, the bank compensates the provider of the commodity. This clause, called band al-
ihsân (beneficence clause), is common in Sudan (Khan and Ahmad (2001)). Unlike istisna', a penalty
clause is not available in salam, because the price paid is considered as a loan until delivery of the
commodity.7

Islamic banks have no intrinsic need to remain in possession of the commodities. They usually enter
into a parallel salam. After the conclusion of the first salam contract, the bank enters into a second
salam, as a seller, with a third party. The bank undertakes to provide the same commodity as the first
salam contract. The price in the second contract is higher than the first contract (which constitutes its
profit margin) and a time of delivery after that of the first contract or at the same date. It is necessary
that the two contracts remain independent. If the other party in the first contract fails to deliver the
object, the bank is bound to deliver the commodities to the other party in the second salam. The
strategic advantage of Islamic banks is that they can regroup commodities of the same kind from
many salam contracts agreed with small sellers, and sell them in one large parallel salam (for
example, to a foreign buyer) . If a parallel salam is not feasible, the bank may receive a unilateral
promise to buy, from another party, at a higher price than that of the salam (Uthmani (2002)). Selling
back the commodity to the seller at a higher price is riba, adding to the fact that it will become a
"buy-back" contract (Uthmani (2002)).

1.4 Istisna'

Istisna', in Arabic, means "order to manufacture". A party asks another party (the manufacturer) to
make an object that is unavailable in the market, using materials provided by the manufacturer. The
price of istisna' can be paid in advance, or at any time agreed upon between both parties. It can also
be paid in full at the time of delivery or in installments at defined periods. The contract can be
canceled unilaterally before the manufacturer has started to make the object and after the party
canceling the contract has informed the other party. The contract of istisna' should specify the time of
delivery8 More precisely, fixing the time of delivery is not an essential part of istisna'. However, the
purchaser can define a maximum date of delivery after which the price due will decrease daily; he
(the purchaser) can also, in that case, refuse the object manufactured or pay the price (Uthmani
(2002)).

Like salam, the bank does not need the manufactured object. It enters into a parallel istisna ' in order
to satisfy the need of one of its customers or partners (third party) . The credit risk in istisna' can be
one of two kinds. It can be a failure to deliver, in which case the contract of istisna' can contain a
penalty clause (band al-jazâa) to overcome counterparty risks (Khan and Ahmad (2001)), unless the
failure is due to factors beyond the control of the manufacturer.9 An example of a penalty clause is
when the bank ties the time of delivery to the price (reverse relation) : the price is decreased by a
certain amount each day. The compensation received must cover the actual loss suffered by the
bank, monetary or not, and all gain that was certain, but not already made.10 The bank can also
give part of the price of istisna' to the manufacturer, at the beginning (or end) of each stage of the
manufacturing process. At the same time, it retains a security or collateral (Ayub (2007)). If the
manufacturer is no longer able to fulfill its engagement, the bank covers its expenses from the
security. Another option (which needs confirmation) is that the banks replace the defaulted
manufacturer with another one on the basis of the first istisna' contract.

A second difficulty can arise if the purchaser in a parallel istisna' defaults on paying the due
installment or the price in full. In such a situation, the bank has the right to retain the title of the
manufactured object (or any other asset owned by the purchaser) as a security until the last
payment is received (Uthmani (2002)). The bank can also appoint an agent as a debt collector on a
wakâlah (agency contract) or a ju'âlah (service contract) basis.11 Like salam, a penalty clause is not
available when the party that ordered the manufacture fails to pay the price because it is considered
as a loan. 12

1.5 Ijarah

Ijarah as operated by Islamic banks is very similar to "financial leasing" in conventional finance. The
difference between the two concepts is that, in the former, the proprietorship of the object of the
lease remains with the bank (the lessor). The asset is on its balance sheet until the end of the period
of lease (Sundararajan and Errico (2002)). What is transferred is its usufruct. Moreover, the transfer
of the ownership from the lessor to the lessee is not automatic at the end of the contract. The second
transfer is an independent transaction, as explained below. The consequence of this difference is
that all liabilities related to the proprietorship of the asset are supported by the bank ("nonroutine"
maintenance repairs (El-Gamal (2006)) and takaful insurance is included if required). The lessee
cannot be made liable for a loss caused by factors beyond his control (Uthmani (2002)). However,
the lessee must compensate the lessor for any harm caused to the leased asset by his misuse or
negligence. If the object has lost the function for which it was leased, in the normal way of utilization,
and no repair is possible, there are at least two views. Either the bank must replace it (Khan (1991)
and Islamic Financial Services Board (2005a)), or the contract is terminated on the day the loss
occurs (Uthmani (2002)) and the lessor's entitlement to rent discontinues (Kamali (2007)).

The rental has to be defined before starting the lease period (which is the date of delivery of the
leased asset to the lessee) for the whole agreed period of the contract. In long-term leasing,
however, the rental can be increased by a specified amount periodically. Alternatively, the lease can
be concluded over a shorter period and the parties can renegotiate a new rental at the end of each
period. It is possible, in some conditions, to tie the rental to a benchmark, but this is not a universal
rule (Uthmani (2002)). Unlike sale contracts, one particularity of ijarah is that it can be concluded at a
future date, with the condition that the rent will be due after delivery of the asset (Uthmani (2002)).
The termination of the lease contract cannot be effective without mutual consent, unless one of the
terms of the contract is broken. The lessee can, with the lessor's permission, sublease the leased
asset. All jurists are unanimous on the permissibility of collecting a rent that is less than or equal to
the rent in the original lease, but they diverge if the "subrent" is higher (Uthmani (2002)). The lessor
can ask the lessee to provide a security and/or a guarantee, justified on two grounds: rental is
considered as a debt and the leased asset is given to the lessee as a trustee (Ayub (2007)).

As pointed out previously, ijarah and the transfer of an asset's ownership to the lessee at the end of
the contract are two different transactions. If this transfer is a precondition to the conclusion of the
contract of leasing, it is not allowed by Shari' ah. However, ijarah wa iqtina' allows the transfer of
ownership at the end of the contract. The bank promises unilaterally, in parallel with the conclusion
of the contract of ijarah, to sell (at a predetermined price) the asset, or to give it as a gift to the
lessee at the end of the contract on the condition that the lessee has paid all due rents. This promise
is binding on the bank, but not on the lessee. In the case where the asset is given as a gift, a
contract can be concluded in parallel with the contract of ijarah instead of a promise. Other options
for the transfer of ownership are that the bank gives a choice to the lessee to buy the asset at the
market price at the end of ijarah. It also provides the option to buy it at any time, on the condition that
a new contract of sale is concluded. The price could be the market price or could be agreed at the
time of sale.13

Ijarah wa iqtina' is also called ijarah muntahia bittamleek. One contradiction found in the literature
should be mentioned: a rental paid in ijârah muntahia bittamleek implicitly includes the cost of the
asset which serves to buy the leased asset. If this asset is no longer operational, the Accounting and
Auditing Organization for Islamic Financial Institutions (AAOIFI) recommends that the bank refunds
to the lessee the difference between the rent agreed and a prevailing rental for the same asset
(because the lessee hoped to become the owner of the asset) (Ayub (2007)). The Islamic Financial
Services Board (2005a) adopts the same attitude. It recommends that the bank refunds the
additional amounts (capital payments) included in the ijarah muntahia bittamleek lease rentals,
above the amount equal to a rental found in an operating ijarah for the same asset. However, this
poses a problem. It goes against the spirit of ijarah, because the part of rental paid for taking
ownership in the future has no contractual justification. In other words, the lease and transfer of
ownership are mixed together; they are no longer independent. It seems that this arrangement more
closely resembles a diminishing musharakah.

Credit risk in ijarah occurs when defaults on payment of rent occur, either at individual times, or
completely. In this case, the bank can put a clause in the contract stipulating that if default on
payment occurs, the lessee will be forced to pay a penalty to a charitable fund maintained by the
bank (Uthmani (2002)). This clause, however, should be utilized only if the lessee is not in real
difficulty. If the lessee is honest and can anticipate that he will become a defaulter, he can (with the
permission of the bank) sublease the asset, with rent going directly to the bank. If the leased asset is
in high demand in the market, the bank can cancel the lease contract unilaterally, because the
lessee has contravened a term of the agreement. It can then lease the object to another client.

Another source of credit risk that can emerge is as follows. While ijarah is a binding contract that
must have a defined and determined period - and taking into account that it can be concluded now
and executed at a future date - the customer, after informing the bank that he wants to lease an
identified asset, can change his mind and cancel the lease. The bank will find itself with an asset
purchased with no return. To overcome this type of problem, the bank can, in a first step, disburse an
arbun (down payment) to the supplier of the asset for a specified time limit. Once it is convinced of a
customer's engagement, it purchases the asset. It can also appoint the lessee as an agent to buy
the asset on its behalf, khiyâr-al-shart 14 (option by stipulation) can also be used when the bank
purchases the asset, khiyâr-al-shart should be used only by way of exception, for a maximum of
three days. If this option is present in the contract of purchase of the asset, according to the Shari'
ah, the price is not paid in full.15 In the lease contract, khiyâr-al-shart can be stipulated (not
exceeding three days) by either of the parties, or both of them (Kamali (2007)). In such cases, the
bank either purchases the leased asset with a "reverse" khiyâr-al-shart, or waits until the expiration
of the three days.

1.6 Murabahah

Unlike musharakah and mudarabah, murabahah is not really a financing tool. Murabahah as used by
Islamic banks today is a combination of different contracts in accordance with Fiqh muamalat. It was
introduced in order to satisfy the needs of contemporary Muslims, namely, to buy a house or a car,
and to circumvent the recourse to ribawi loans.16 However, it can be used for any valuable
commodity. In its purest form, though, murabahah is merely a contract of sale where the cost is
known by the buyer, and he agrees to add on top of this cost a certain amount as a profit to the
seller. Otherwise, if the cost is hidden, the transaction is called musawamah.

For murabahah-lil-amir-bi-al-shira' ("contemporary" murabahah) to be Shari' ah compliant, it is

necessary to respect the order of the following operations. For example, the customer promises to
buy a house from the bank, and the bank promises to sell it to the customer. The agreement
includes a specification of an agreed ratio of profit added to the cost (Uthmani (2002)). If it is
specified that each party is bound by its promise, it becomes like a forward sale and then becomes
void. Only one party must be bound by its promise; the promise of the other party remains
nonbinding.17 The binding nature of the promise is effective if there were some liabilities incurred by
the other party based on the promise.18 The bank buys the house from a third party. Once it takes
possession of it, it informs the customer, who then makes an offer to the bank to buy the house. The
bank accepts the offer, and the ownership is transferred to the customer. The second sell is almost
always done on a bai' mu' ajjal basis, ie, the price is deferred and paid in installments. The price,
which has become a debt, cannot be increased if a payment is delayed. The bank is at liberty to
discount, if it wishes, the full price in case of early reimbursement, on the condition that it must not
be agreed between the two parties during the conclusion of the contract.19 If, for some reason, a
direct purchase is not possible, the bank can appoint a third party, or the customer, as its agent to
buy the commodity.

Credit risk in murabahah can emerge in two ways. First, a customer can cancel his option to buy the
commodity after the bank has engaged itself in some actual liabilities. As mentioned in the previous
paragraph, the Organisation of the Islamic Conference Fiqh Academy, AAOIFI and most Islamic
banks treat the promise to buy as binding on the customer (Khan and Ahmed (2001)). Thus,
according to the resolution of the Islamic Fiqh Academy, a court of law can enforce the customer to
fulfill his engagement; otherwise, he will be liable for any actual loss caused to the bank (including
monetary loss but not the opportunity cost (Uthmani (2002))). When the bank purchases the
commodity, the contract of sale may include a khiyâr-al-shart not exceeding three days. In that case,
if the customer defaults on his promise to buy, the bank returns the commodity to the seller (without
specifying the delay of three days) (see Obaidullah (2002) and Al-Bashir (2005)). If there is a delay,
for example, between purchase by the bank and delivery to the customer for imported goods from
abroad (Islamic Financial Services Board (2005a)), the bank can pay an arbun in first phase to its
supplier, and terminate the deal when goods are available and the customer has not defaulted. Or, if
the bank is in "constructive possession" of the commodity, it can receive an arbun from the customer.
It is lawful because an arbun is only available during the period of sale,20 after the phase of
muwa'adah.

A second source of credit risk is the late payment of installments or complete default of payment.
Firstly, the bank can ask for a security. If the security is the commodity itself, the mortgage becomes
applicable as soon as ownership is exchanged. If it is another object, the mortgage can be given to
the bank, before actual sale, after the price of the murabahah is determined (Uthmani (2002)). It is
preferable that the bank takes the commodity sold as a mortgage if there is a risk that the customer
will sell it to generate cash once its ownership has been obtained. Tawarruq21 is almost prohibited
and banks should encourage qard hasan to respond to the cash needs of the customers.22 Islamic
banks must avoid tawarruq as much as possible, because it can be harmful to their operational
management. Secondly, the customer can supply a guarantee from a third party. The guarantor will
be liable to the bank if a default on payment occurs. Thirdly, the bank can add a clause in the
murabahah agreement stipulating that, in case of default on payment at the due date, the buyer
must pay a certain amount to a charity fund maintained by the bank, unless it has been established
that he is in real difficulty. Furthermore, the bank can add a clause stipulating that, if default occurs in
reimbursing one installment, the remaining installments are due immediately, unless the purchaser is
in a situation of distress (the wealth owned by the purchaser in case of distress should be sufficient
only for his original needs).23 Like istisna', the bank can appoint a debt collector.

As will be seen later, a high level of default on the asset side of a bank's balance sheet affects a
bank's liquidity both directly and indirectly. In order to diminish its exposure to shortage of liquidity,
the bank can enter into a "reverse murabahah" (Kahf (2006)). When it purchases the commodity
from the supplier, the bank pays the supplier on a bai' mu' ajjal basis and then sells the item to the
customer.

1.6.1 Diminishing Musharakah

In order to reduce the weight of murabahah in the field of Islamic banks, diminishing musharakah
can constitute an alternative mode of financing. At first, the bank enters into a co-ownership with the
client, and leases its shares to him. Shares of the bank are divided into equal parts; the client
promises to purchase these parts periodically. This promise is compulsory for the partner but not for
the bank. At each period, the client (after informing the bank that he wants to buy a part of its share
and the bank accepts) pays an amount divided into two parts: rent (which decreases with the
decrease of shares of the bank) and the price for one unit of bank shares. The price of sale of each
part is fixed at the moment of the sale, at the market price, or any other price agreed between the
two parties at that moment.24

Since diminishing musharakah is a combination of contracts, credit risk can appear on several
different levels. In a leasing contract, the bank can deal with default on payment of due rents using
the tools identified above. If the partner defaults on purchasing the bank's parts of ownership, he can
be dealt with in a court of law, based on his promise. But if he is unable to do so, the bank can sell
them to a third party with the approval of the Shari' ah board (Akkisidis and Khandelwal (2008)). If
default occurs on both contracts, the bank cancels the lease and sells its parts of ownership to a
third party (or leases these parts only, which can be a strong deterrent to defaulter partner failing to
fulfill his obligations).

2 MEASURING CREDIT RISK

Credit risk, as defined before, is the probability of default (DP) in fulfilling engagements, at one time
or overall, by the other party.

Credit risk (the risk of counterparty failure) is so important for banks that the 1988 Basel Committee
on Banking Supervision's standards on capital requirements were mainly established to deal with
this risk. Default risk covers over 80% of risks in an average bank's banking-book asset portfolio.
Hence, it is the cause of 80% of the cases of bank failure (Khan (2003)). It is unanimously agreed in
the literature that credit risk is the most important risk for banks (see Mohd Arrifin et al (2009); Khan
and Ahmad (2001); Basel Committee on Banking Supervision (1988); How et al (2005); and Elgari
(2003)).

As previously mentioned, credit risk is the principal cause of bank failure (Iqbal and Greuning
(2008)). The Basel Committee on Banking Supervision also reports that weak credit risk
management practices and poor credit quality continue to be a dominant cause of bank failures and
banking crises worldwide (Mohd Arrifin et al (2009)). Defaults (by customers) can trigger liquidity,
downgrade and other risks. Therefore, the level of a bank's credit risk adversely affects the quality of
its assets in place (Khan and Ahmad (200 1)) . Operationally, a bank fails when its cash inflows from
repayments of credits, sales of assets in place and mobilization of additional funds fall short of its
mandatory cash outflows, deposit withdrawals, operating expenses, and meeting of debt obligations
(Khan and Ahmad (2001)). Credit quality problems can result in bank insolvency (How et al (2005)).

As in conventional banks, credit risk is the most dominant source of risk in an Islamic bank
(Sundararajan (2007)). It is usually argued that Islamic banks face higher credit risk than their
conventional counterparts. Islamic banks (not Islamic banking, which is based on partnership,
leasing and sale), in their present form, face higher (credit) risk than conventional banks because
they do not have sufficient Shari' ahcompliant tools for dealing with debt-based contracts in
comparison with conventional banks (Elgari (2003)). While investment depositors bear part of banks'
direct credit risk through PLS modes,25 these modes may also increase (in theory) the overall
degree of risk on the asset side of a bank's balance sheet, causing the bank risks that are normally
borne by equity investors (Sundararajan and Errico (2002)). However, in regard to minimum capital
requirements, Islamic banks and conventional banks have qualitatively similar credit risk (Kahf
(2005)).

Arguments against the robustness of Islamic banks for dealing with higher credit risk are based only
on theoretical inference. Empirically, to the best of the author's knowledge, there is no proof for such
arguments. On the other hand, it can be argued that credit risk is lower in Islamic banks than (or, at
least, is the same as in) conventional banks.
On the asset side, firstly, while Islamic modes of financing appear riskier (because it is antonymic for
a bank to deal directly in commodities and bear risk of ownership), Islamic banks have sufficient risk
management tools to prevent default. Furthermore, PLS modes of financing musharakah and
mudarabah (as argued above) do not bear credit risk. The level of credit risk does not depend on the
difference between conventional and Islamic modes of financing. Rather, it depends on the types of
customers and the types of choices they make (Elgari (2003)). Even murabahah (which is
extensively used by Islamic banks and is a "borderline" (Uthmani (2002)) tool) is, from a credit risk
management perspective, not different from loans (Elgari (2003)). Secondly, unlike conventional
banks, Islamic banks' assets are more diversified and are not mostly composed of loans. These
assets are connected to different parts of economic sectors, which provides a natural way of
diversifying risk to Islamic banks.

On the liability side, bearing in mind that investment accounts are managed through mudarabah,
conventional banks are more leveraged than Islamic banks. Fewer liabilities are due at maturity by
the latter than by the former. Obviously, conventional banks are more vulnerable to credit risk than
Islamic banks. In addition, investment protection reserves, pioneered by Jordan Islamic Bank,
protect capital and investment deposits from any risk of loss, including default (Khan and Ahmad
(200 1)).

Default probability and distance-to-default are used to estimate credit risk levels in Islamic and
conventional banks. This methodology has the advantage of being neutral to the specificity and size
of each bank.

Default probability depends directly on the quality of assets at maturity, which depends (as explained
above) mostly on credit risk levels. Bad quality of assets leads to insolvency and default, especially
in the banking sector, because of the high degree of leverage present in it. This methodology is
useful for banks as a means of identifying their credit risk level and the quality of their assets. Credit
risk also affects depositors and investment account holders directly They face the risk that the bank
will not honor requests for withdrawals at face value (El-Hawary et al (2004)). It is useful for them to
identify the level of credit risk that they are subjected to when they put their money in the bank. In
other words, it allows investment account holders to choose the best pair (risk, return26), and it
allows deposit account holders to estimate the probability of loss of their money27

3 METHODOLOGY AND DATA

3.1 Methodology
It is assumed (see, for example, Merton (1974) and Vasicek (1984)) that the market value of banks'
total assets, V, follows a geometric Brownian motion:

... (3.1)

where µ^sub v^ is the instantaneous expected rate of return on the assets per unit time, σ^sup
2^^sub v^ is the instantaneous variance of the return per unit time, and dz is a standard Wiener
process.

The liability side of a bank's balance sheet is made up of equities and total liabilities. If E represents
the market value of equities and D represents total liabilities (debt on the bank28), according to
contingent claims analysis (CCA) (Black and Scholes (1973) and Merton (1974)), at maturity T, if V >
D, shareholders will pay off the debt and receive (V - D). But if the market value of assets is lower
than the value of the debt, owners of the bank choose to go bankrupt (because of limited liability)
and debt holders take control of the bank. In other words, the value of the bank's equity, at maturity,
equals:

E = max(0; V-D) (3.2)

The market value of equities, E, can be perceived as a call option that shareholders have on the
market value of assets, V, with a strike price equal to the value of the debt, D, and a maturity, T. The
current market value of equities can be expressed, using the Black and Scholes (1973) option
pricing formula, as:

... (3.3a)

where N(d) is the cumulative normal density function:

... (3.3b)

... (3.3c)

where σ^sub v^ is the instantaneous standard deviation of the rate of return on the value of the
assets of banks (ie, asset volatility, which is assumed to be constant).

According to Ronn and Verma (1986), in the Black and Scholes option pricing formula (see Appendix
B), the risk-free rate of interest only enters into the factor with which the strike price is discounted, ie,
it is only the present value of debt that is relevant for calculation. Furthermore, since, in the context
of the bank, the face value of the debt is the present value of the exercise price, the interest rate will
not appear in the formula. This methodology is also followed by Lehar (2005) and Elsinger et al
(2006), among others. Two facts support this assumption. First, deposits are insured, and their
present face value is therefore guaranteed at maturity. Second, uninsured liabilities constitute only a
small portion of the total liabilities of a bank.

It should be mentioned that it is this assumption (face value of debt being the present value of the
strike price) that permits the use of the option pricing formula for Islamic banks, since Islam does not
recognize time value of money in a transaction when both sides of this transaction are constituted of
money.

Shari' ah does not prevent any estimation, mental calculation or expectation of the return by either
party [in an investment]. But it considers all these like an illusion that must not be exchanged for a
real increment accruing to either party until the investment process actually produces an increment,
then the shares belonging to the owner and user of funds become real facts (Kahf (1994)).

Equity is dividend protected since it is the recipient of dividends. For this reason, it is modeled as a
fully dividend-protected call (Ronn and Verma (1986)). Dividends therefore do not appear in
Equation (3.3).

The value of the debt, D, can be extracted from a bank's balance sheet, and the value of equity, E, is
the market capitalization. But the market value of assets, V , and its volatility, σ^sub v^, are
unknown. In order to compute these two variables, another equation is needed in order to have two
equations with two unknowns.

According to Merton (1974), the dynamics of the security E, whose market value is a function of V
and T, can be written in stochastic differential form as:

... (3.4)

where µ^sub E^ and σ^sup 2^^sub v^ are the instantaneous expected rate of return on this security
and variance, per unit time. dz^sub E^ is a standard Wiener process.

E(V, T) gives a functional relationship between µ, s and dz in (3. 1) and (3.4). By Ito's lemma:

... (35)

Comparing terms in (3.4) and (3.5), we have:

... (3.6 a)
... (3.6b)

or:

... (3.6c)

Therefore:

... (3.7)

Equations (3.3) and (3.7) are used to calculate the market value of assets and its volatility.

3.1 .1 Calculation of distance-to-default and default probability

The probability of default is the probability that the market value of assets will fall below the value of
debt at maturity T. Put formally:

... (3.8)

If G = In V, then, from Ito's lemma:

... (3.9)

Since µ^sub v^ and σ^sub v^ are constant, G = In V follows a generalized Wiener process. ... are its
constant drift and constant variance rate, respectively. The change in In V between time zero and
time T is normally distributed, with mean (...)T and variance σ^sup 2^^sub v^T (Hull (2009)).

Then, change In V from t = 0 to t = T:

... (3.10)

with:

... (3.11)

The default probability becomes:

... (3.12)

After rearranging:
... (3.13)

From (3.11), it can be seen that e has a standard normal distribution N(O, 1). Therefore:

... (3.14)

The default probability for a bank in Equation (3.14) is a function of the distance between the current
market value of assets and the face value of its liabilities (V^sub 0^ /D) adjusted for the expected
growth in asset values ... relative to asset volatility σ^sub v^ (Hillegeist et al (2004)). This distance is
called distance-to-default. Being normalized by asset volatility, it is the number of standard
deviations a firm lies from default (total liabilities in this paper) (Chan-Lau et al (2004)).

Thus:

... (3.15)

... (3.16)

The order of the computation is executed as follows. Equations (3.3) and (3.7) are used to estimate
the market value of assets and their volatility (V and σ^sub v^). The results obtained allow the
expected rate of return on assets (µ^sub v^) to be estimated. Then, distance-to-default (DD) and
default probability (p^sub T^) are calculated using Equations (3.15) and (3.16).

3.2 Data

The empirical study was performed for a sample of nine Islamic banks and nine conventional banks
(see A. 1 for the name and location of banks). Default probability and distance-to-default are
calculated for five years, from 2005 to 2009 inclusive, for each bank.

Table 1 shows the methodology of calculation for each variable used in the computation.

3.2.1 PLS liabilities

For Islamic banks, liabilities managed through PLS are excluded. Profit and loss sharing liabilities
include investment accounts, saving accounts and wakalah deposits (for the latter two, only those
managed through PLS were excluded: the cases of Abu Dhabi Islamic Bank for both types of
accounts and Dubai Islamic Bank for saving accounts) . Profit equalization provisions (PEP) were
also excluded since they focus on profit not yet distributed to investment account holders and so are
not really liabilities of the bank (this applies to Dubai Islamic Bank only) . Islami Bank Bangladesh
retains an investment depreciation reserve in its liabilities. This was also excluded because such
reserves are not a liability because, by definition, losses are shared between partners and then
absorbed.

3.2.2 Annualized volatility

Annualized volatility is calculated as follows (Hull (2009, pp. 282-283)). Given:

... (3.17)

where r^sub i^ denotes the daily return on stock price and pr,- denotes the stock price at the end of
day i = 1,2,...,n. Annualized volatility is then estimated as:

... (3.18)

where b denotes the number of observations in one year (number of trading days). For the sample
this varies between 260 and 262.

3.2.3 Time to maturity

Maturity T is assumed to be one year. This choice is made due to the fact that the boundary
condition for the value of the equity as a call, ie, E = max(0; V-D) comes into effect at the time of the
audit. It is therefore reasonable to argue that the time until next audit should be the proper value of
maturity (Ronn and Verma (1986)).

3.2.4 The expected rate of return on assets

As noted in Equation (3.1), µ^sub v^ is the instantaneous expected rate of return on the assets per
unit time. If we consider 1 unit of time = 1 year, V^sub i^ and V^sub i+1^ are the market value of
assets in times i and (i + 1), then µ^sub v^ becomes the expected rate of return on assets per
annum. Then:

... (3.19)

The actual values of assets obtained from Equations (3.3) and (3.7) are used to calculate a
(realized) proxy of µ^sub v^.

It should be mentioned that the expected rate µ^sub v^ should not be confused with the actually
realized continuously compounded rate of return on assets (drift rate) defined in Equation (3.9),
which equals (...) included in the calculation of DD. This difference is due to the lognormal
distribution property of assets.

4 RESULTS AND DISCUSSION

4.1 Results

Table 2 on the facing page reports distance-to-default and default probability for each bank in the
sample from 2005 to 2009.

The results in Table 3 on page 1 19 show that Islamic banks are further from default than
conventional banks (mean distance-to-default is equal to 204 and 15, respectively). Default
probability (3.5% and 5.7%, respectively) is thus higher for conventional banks, which reflects higher
credit risk. However, this probability is abnormally high for both types of banks. This is, without
doubt, due to the recent financial crisis that began in July 2007. But the difference between
conventional and Islamic banks is that conventional banks were directly affected by the crisis.
Islamic banks were immunized from the subprime crisis but have probably been affected due to the
impact of the crisis on the real economy (Boumethene and Caby (2009)). This can be seen from
Table 2 on the preceding page. Out of nine conventional banks, eight had a plummeting distance-to-
default from 2007 to 2008, but only three out of nine Islamic banks experienced this.

A Wilcoxon rank-sum test29 (equivalent to a Mann- Whitney U -test) was performed to evaluate
whether or not the difference in the distance-to-default between groups of banks is statistically
significant for the period analyzed.

The results show that the mean distance-to-default for Islamic banks is significantly higher than the
mean distance-to-default for conventional banks at the 10% level (pvalue equal to 0.0807 or 8.07%).
Thus, in response to the question posed in the title of this paper, credit risk is significantly lower in
Islamic banks than in conventional banks.

These results are consistent with those of How et al (2005) concerning Malaysian banks. They found
that banks with Islamic financing have significantly lower credit risk than those without such a
financing method. Furthermore, off-balance-sheet activities (the use of derivative contracts and the
ratio of documentary credits to total assets) and the extent of securitization (risk mitigation) are not
significant explanatory variables for the credit risk of Malaysian banks. Credit risk is explained only
by the category of the bank (Islamic or not) and the bank's size (negative correlation).
This study can be criticized on two grounds. Firstly, the default point for firms is, actually, between
total liabilities and short-term liabilities. This is why some studies have set the default point as the
sum of total short-term liabilities and half long-term liabilities. However, in the context of banking, this
approach is inconsistent, because banks' liabilities are, for the most part, constituted from demand
deposits. These deposits are volatile and correlated with many economic and financial factors, chief
among them the good financial health of the bank. Therefore, demand deposits can be long-term
liabilities or immediately claimed liabilities in the case of a bank run. A second criticism can be made
with regard to the use of a normal distribution for the transformation of distance-to-default to default
probability. For example, a bank with a distance-to-default of about four will have a default probability
of around zero. This means that this bank should be better in quality than an entity with a rating of
AAA (Kealhofer (2003)). Table 4 shows the correspondence between default probability and the
ratings of Standard & Poor's and Moody's.

Ratings are subdivided into two categories: investment grade and below investment grade. For
Standard & Poor's, for example, AAA, AA, A and BBB constitute the first category (Crouhy et al
(2006)). Using an empirical distribution of default rates (based on past defaults), a bank with a
distance-to-default of about four actually has a default probability of 0.5% (Kealhofer (2003)) or 1%
(Crosbie (2003)). In both cases, this bank will be downgraded from above AAA to below investment
grade (Kealhofer (2003)). The empirical distribution of default rates has larger tails than a normal
distribution (Crosbie (2003)). However, the question is whether a distribution based on past defaults
in some locations can be available in others. Unless a more adequate statistical distribution has
been formally defined to convert distance-todefault to default probability, it would be wiser to use
distance-to-default as a default predictor (see the explanation given below). For this reason, a test of
the statistical significance of the difference between Islamic and conventional banks was carried out
using distance-to-default.

4.2 From scoring to default probability

The logit model uses a cumulative logistic probability distribution to transform a score Y into a
probability (Bessis (2010)). Defining ? as the default probability:

... (4.1)

As defined in Equation (3.15), DD is a complete and unbiased indicator of firm vulnerability, since it
captures the impact of three major determinants of default risk: earnings expectations, leverage and
asset risk. Distance-to-default (and then default risk or default probability) increases with the
decrease of leverage and/or increase of earnings expectation, which increases an asset's value.
Distance-to-default decreases with the increase of an asset's volatility (Chan-Lau et al (2004)). The
difference between companies is present in their asset values, their volatilities and capital structures,
all incorporated in distance-to-default. Thus, the latter can be used as an ordinal measure of a
company's default risk (Kealhofer (2003)). Based on these arguments, if we consider distance-to-
default as a score, using the logit model, this score can be converted into a default probability for
banks.

A cumulative logistic probability distribution was used to convert distance-todefault to default

probability, renamed DPiogu, for the sample of banks, as follows:

... (42)

Contrary to G, a high distance-to-default means greater robustness to default. Table 5 on the next
page reports such default probabilities. The results are more interesting to study than those obtained
with normal probability. Almost all nil probabilities have disappeared and have been replaced by
higher values. For example, zero default probability, under normal distribution, equals 0.01% for
Commercial Bank International under the logistic distribution for 2007 (DD = 8.58). At the sample
level, default probability is still higher for conventional banks at 0.0717394, in comparison with
Islamic banks, for which it is 0.0442560. More generally:

If DD > 0 [arrow right] DP^sub logit^ > DP^sub normal^

If DD < 0 [arrow right] DP^sub logit^ < DP^sub normal^

If DD = 0 [arrow right] DP^sub logit^ = DP^sub normal^ = 0.5 ?G 50%

In other words, the cumulative logistic probability distribution has larger tails than a cumulative
standard normal distribution. The plots in Figure 1 on page 124 and Figure 2 on page 124 for
conventional banks, and in Figure 3 on page 125 and Figure 4 on page 1 25 for Islamic banks show
the difference between the two distributions based on results found in the empirical study.

4.3 The concept of limited liability

The method used to calculate credit risk developed so far is only valid if it is assumed that bank's
shareholders have limited liability. The maximum that they can lose, in case of bankruptcy, is their
share in the capital. This concept is widely accepted in civil and common law. However, in Islamic
law it is not as readily assumed. The standard situation is that if shareholders (partners in a
musharakah) agree to incur a debt, on behalf of the enterprise, they are all responsible for its
reimbursement.

Uthmani (2002) has made some ijtihad30 on the subject. Some ideas from his work now follow.
Uthmani claims that limited liability has no express mention in the original sources of Islamic Fiqh.
This concept is based, in present-day business practices, on the concept of "juridical personality". A
company, for example, has the capacity to sell and purchase to become a debtor and a creditor, to
sue and be sued. These capacities are shared with a "natural person". Consequently, if the company
becomes insolvent, creditors will liquidate the company's assets and recover their claims. But if this
is not sufficient, they incur a loss without the possibility of claiming compensation from shareholders.
Contrary to limited liability, the concept of "juridical personality" is present in Islamic jurisprudence.
Thus, the validity of limited liability can be derived by inference. Uthmani gives five antecedents in
jurisprudence that cover all aspects of limited liability. These antecedents are waqf, baitul-mal, joint
stock, inheritance under debt and the limited liability of the master of a slave. All of them lead to the
legitimacy of limited liability in Islamic law. But this concept should only be applied to public
companies and to sleeping partners (who have no understanding of the day-to-day business) in
private companies and partnerships.

5 CONCLUSION

Credit risk is present in conventional and Islamic banks. The difference between the two types of
banking is that the latter includes investment tools fueled by investment accounts that are managed
using the PLS principle. This provides a powerful and compliant securitization to Islamic banks. It
has been empirically demonstrated in this paper that Islamic banks have lower credit risk than
conventional banks. The problem of management of this risk by Islamic banks is not due to a
shortage of risk management tools. As demonstrated in Section 1 , there are many techniques
available that are Shari'ah compliant. The core problem is the inclination to manage this risk like
conventional banks do. This is inconsistent because contracts in the two types of banks are not of
the same nature. The solution is somewhere else: in the strict applicability of Islamic contracts and a
deep knowledge of their mechanisms, as well as the options that they offer.

APPENDIX A: NAME AND LOCATION OF BANKS INTHE SAMPLE

Kuwait Finance House has not disclosed the amount of investment accounts in its balance sheet nor
in the annual report since 1994. In order to appreciate the value of those accounts, the percentage
of their value in total deposits has been calculated from 1980 to 1993 (apart from 1990, where there
was no financial data). The mean of this percentage, during these years, is 85.55% of total deposits
with a standard deviation of 3. 15%. The mean was a basis for the calculation of the amount of
investment accounts in total deposits from 2005 to 2009 for this bank.

On July I1 2007, the Kuwait Real Estate Bank (incorporated in 1973) was renamed to Kuwait
International Bank to exercise its business as an Islamic bank. Before that, it ran parallel operations
(Islamic and conventional).

In December 2009 the Bank of Kuwait and the Middle East obtained the final approval of the Central
Bank of Kuwait for its conversion to an Islamic bank.

Footnote

1 For an accurate and comprehensive definition of different financing tools, the interested reader is
referred to Uthmani (2002).

Footnote

2 Resolution 85 of the ninth Session of the Islamic Fiqh Academy held in Abu Dhabi (UAE) in 1415
AH/1995 CE.

Footnote

3 See footnote 2.

4 See footnote 2.

5 Only by a third party as a benevolent act and on the basis of a service charge for actual expenses
(Khan and Ahmed (2001)).

6 See footnote 2.

7 See footnote 2.

Footnote

8 Resolution 65 of the seventh Session of the Islamic Fiqh Academy held in Jeddah in 1 4 12 AH/ 1
992 CE.

9 See footnote 8.
10 Resolution 109 of the twelfth Session of the Islamic Fiqh Academy held in Riyadh in 1421
AH/2000 CE.

Footnote

11 See Khan and Ahmad (2001). A debt-collection agency has also been recommended by the
Islamic Financial Services Board (Islamic Financial Services Board (2005a))

12 See footnote 10.

Footnote

13 Resolution 110 of the twelfth Session of the Islamic Fiqh Academy held in Riyadh in 1421
AH/2000 CE.

Footnote

14 See Obaidullah (2002) and Al-Bashir (2005) for an extensive discussion on khiyâr al-shart.

15 Mohamed Ali Elgari commenting upon Al-Bashir and Al-Amine (2005).

16 Reimbursement of these loans consists of capital and interest, the rate of which is known at the
conclusion of the contract.

Footnote

17 Resolution 40-41 of the fifth Session of the Islamic Fiqh Academy held in Kuwait in 1409 AH/1988
CE.

18 See footnote 17.

19 Resolution 64 of the seventh Session of the Islamic Fiqh Academy held in Jeddah in 14 12 AH/ 1
992 CE; Islamic Financial Services Board (2005a); and Uthmani (2002).

Footnote

20 Resolution 72 of the eighth Session of the Islamic Fiqh Academy held in Brunei Darussalam in
1414 AH/1993 CE.

21 A scenario in which, in personal financing, a client buys an item on credit from the bank on a
deferred payment basis and then immediately resells it for cash to a third party.
22 For more details, see resolution 179 of the nineteenth Session of the Islamic Fiqh Academy held
in Sharjah in 1430 AH/2009 CE.

23 Resolution 64 of the seventh Session of the Islamic Fiqh Academy held in Jeddah in 14 12 AH/1
992 CE.

Footnote

24 Resolution 136 of the fifteenth Session of the Islamic Fiqh Academy held in Masqat in 1425
AH/2004 CE.

Footnote

25 Investment deposits are managed through mudarabah between the bank and depositors; the
funds are utilized (mixed or not with bank's own funds) on the asset side to provide facilities through
all financing tools.

Footnote

26 It would be fair for an investor who believes in Islamic banks' essence to add - in addition to
material benefits - benefits earned from the choice to act in accordance with what he is convinced
by.

27 If demand deposits are insured (by government or other entity), this probability, for depositors, is
close to zero.

28 Off-balance sheet liabilities are not included in total liabilities.

Footnote

29A nonparametric statistic is used instead of a ¿-test because the four tests used for normality in
the SAS output (namely, Shapiro- WiIk, Kolmogorov-Smirnov, Cramer-von Mises and
AndersonDarling) reject the null hypothesis that DD values come from a normal distribution, for
Islamic and conventional banks, at the 1% level.

Footnote

30 An endeavor to formulate a rule on the basis of evidence found in the Islamic sources.

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AuthorAffiliation

Aniss Boumethene

Paris Institute of Business Administration, University of Paris I:

Pantheon-Sorbonne, 7 rue Guérin, 94220 Charenton-le-Pont,

Paris, France; email: a14919s@yahoo.com

Appendix

APPENDIX B

The Black and Scholes (1973) option pricing formula is presented as follows:

S: the stock price.

x: the strike price.

r: the short-term interest rate.

σ^sup 2^: the variance rate of the return on the stock.

t : the expiration date.