1. Introduction

While Islamic Finance has gained substantial prominence in the past decade, little is known about the potential risks it presents as an asset class. While there have been some Islamic banks that were about to collapse (see Henry and Wilson, 2004), there have been no large scale collapses of Islamic banks nor have there been any financial crises sparked by the fall of Islamic banks. Yet, if the share of Islamic finance grows at its current rate (15% by some estimates, Ainley et al., 2007), it is likely that the stability of Islamic banks will become an increasingly important topic of discussion by both bank analysts and central bankers.

However, with the exception of a few studies, there has been little substantial research conducted to ascertain the impact of the differences between Islamic and conventional banks considering the unique operating constraints and contracts employed by Islamic banks. More importantly, there has been little systematic empirical analysis of Islamic banks and their potential risk implications on an individual bank level. This study attempts to shed light on the differences in financial stability/risk between Islamic and conventional banks utilising the z-score as a measure of financial stability/risk. Utilising a sample of approximately 37 Islamic banks and 150 conventional banks from across 17 countries, the study provides an analysis of the determinants of financial stability.

Previous empirical literature has only considered financial stability differences between Islamic and conventional banks based on size effects or the relative share of Islamic banks in the banking market (Cihak and Hesse, 2008). The research does not address the Islamic bank specific endogenous factors that might lead to variations in financial stability and therefore fails to explain why there may be variation potentially arising out of the contractual structures utilised by Islamic banks.