Is Credit Risk Really Higher in Islamic Banks?

Abstract

This article explores empirically the assertion that Islamic Banks have higher credit risk than Conventional Banks. A definition, identification and the way to manage credit risk are given to each Islamic financial tool. This risk is, then, measured on nine Islamic and nine Conventional Banks, using Contingent Claims Analysis (CCA). Merton’s model (1974), based on Black & Scholes’ (1973) option pricing formula, allowed the measure of the Distance-to-Default (DD) and Default probability (DP) from 2005 to 2009. Islamic Banks have a mean DD of 204 significantly higher than conventional Banks (DD = 15). Mean DP equals 0.03 and 0.05 respectively. Afterward, cumulative logistic probability distribution has been used to derive DP from DD. Results are more satisfying; the distribution of DP has larger tails which respond to the critic against the use of a normal distribution.