Risk sharing vs risk shifting: a comparative study of Islamic banks

Purpose This study aims to compare the use of risk-sharing and risk-shifting contracts (RSFCs) in Islamic banks using a triple grouping of conservative, moderate and liberal Islamic banks based on the Khaled Khandelwal (KK) model. Six fundamental Islamic contracts are used in this study, namely, Mushãrakah, Mudãrabah, Murãbaha, Salam, Ijãrah, Istisnã. Mushãrakah and Mudãrabah represent profit and loss sharing contracts (i.e., risk-sharing contracts – RSHCs), whereas Murãbaha, Salam, Ijãrah and Istisnã represent RSFCs. This study extends the previous studies by addressing an issue that has been neglected in the literature. The extent to which the two groups of contracts are used is extremely important because of its effect on the valuation of Islamic banks and on their earning quality. Design/methodology/approach This study aims to analyze, using descriptive statistics and inferential statistics, the use of RSHCs and RSFCs made by 72 fully Islamic banks, using a sample that includes banks in most of the countries where Islamic banks are present. Only fully Islamic Banks were considered, that is, banks that are essentially mainstream banks; therefore, banks that include only a specific line of Islamic products, often called the Islamic Window, were excluded. The total number of the sample was 118, but the study was restricted to 72 banks due to the availability of time series data covering the period of study, 2007 to 2015. Findings The study documents that over the period 2007 to 2015 the moderate banks have better distribution and balance of RSHCs and RSFCs than the conservative and liberal banks. The conservative banks are found to depend greatly on RSFCs, whereas the liberal banks are found to depend almost completely on RSFCs. Unexpectedly, the conservative banks have not shown a noticeable improvement over the period of analysis on their level of reliance on RSHCs. The results show that there is a significant difference in the percentage income distribution of the two contracts between the moderate banks and the conservative banks and between the moderate banks and the liberal banks. However, no significant difference was found between the conservative banks and the liberal banks. Originality/value The study uses an alternate rating model for Islamic financial institutions. The study examined the issue of risk sharing and risk shifting contracts usage in banks for a long period of nine years and at a global level and with an additional dimension of three categories of Islamic Banks based on the KK model.

Designing Bankers’ Pay: Using Contingent Capital to Reduce Risk-Shifting Incentives

Including contingent convertible bonds (coco) in the capital structure of a bank affects the sensitivity to risk of its equity-based compensation. Such risk-shifting incentives can be reduced if the coco bonds are well-designed. Similarly, we show that compensating executives with well-designed coco bonds can also reduce risk-shifting incentives. In practice, however, most coco bonds have characteristics that result in both stock and coco compensation having large sensitivities to changes in asset risk — equity-based compensation encourages executives to increase risk, coco compensation to reduce risk. We show that a pay package combining both stock and coco can practically eliminate risk-shifting incentives and that it can be implemented with a bank’s preexisting coco bonds.