1. Introduction

Bank failures threaten the economic system as a whole. Therefore, it is crucial to predict bank financial failures in order to prevent or minimise the negative effects on the economic system. Due to this, the present paper analyses whether the wellknown Altman Emerging Market Z-score model can predict bankruptcy and at the same time measure the financial performance of Islamic banks in the GCC countries. This empirical analysis examines 14 Islamic banks in the GCC countries – consisting of 4 Islamic Banks in UAE, 4 Islamic banks in Bahrain, 2 Islamic banks in Qatar, 2 Islamic Banks in Saudi Arabia, and 2 Islamic Banks in Kuwait – during the period 2005-2010. This is significant since the study also looks at the impact of the global financial crisis on the performance of Islamic banks.

First, let us look at the variety of definitions of failure. Amongst the earliest definitions of failure is that of Beaver (1968). He defined failure as the inability of a firm to pay its financial obligations as they mature. Blum (1974), in his work, stressed that a firm which falls into any one of the categories defined by him is considered as failed. These events are: the inability to pay debts as they fall due, entrance into a bankruptcy proceeding, and an explicit agreement with the creditors to reduce debts.

According to Altman (1993), failure, insolvency, default and bankruptcy are four different terms and they all mean that a business is in distress. Bankruptcy may be the worst case scenario for certain companies, but default also can cause problems to business stakeholders. Some studies therefore do not try to predict bankruptcy, but failure instead. Altman (1993) mentioned that failure, insolvency, default and bankruptcy can be defined in different ways. Failure in economic terms means that a business has a rate of return on invested capital that is significantly and continuously lower than that of similar investments, which means that the company cannot meet its obligations to the shareholders. In other words, it simply means that the company cannot give enough return on its shares. Insolvency, on the other hand, can be divided into two categories: technical insolvency and insolvency in a bankruptcy sense. Technical insolvency is more concerned with the short term obligations of the company and can be temporary. Otherwise, insolvency in a bankruptcy sense is worse than technical insolvency because it means that something is problematic with the business in the longer term, which normally happens when the total liabilities are bigger than the total assets (Mous, 2005). Default happens when a company cannot meet its obligations to the creditors. For example, a company fails to pay the periodical interest or settle a debt when it is due. When this happens it is a serious sign that the company is in trouble, though it may not lead to bankruptcy. Finally, bankruptcy occurs when a company files for bankruptcy. These definitions give a clear distinction between each category and make it easier for the researcher to distinguish between failed and non-failed companies based on the above criteria.