Cushion hypothesis and credit risk: Islamic versus conventional banks from the MENA region

Conventional banks are 'indirectly' allowed to take more risk under the shadow of sovereign guarantees. Banks commit moral hazards as any major banking crisis will be 'cushioned' by deposit insurance and bailed out using the taxpayer's money. This study offers an alternative explanation for the determinants of banks' credit risk, particularly those from the Islamic regions. Although conventional banks and Islamic banks may share state and social cushioning systems, Islamic banks are strictly prohibited by moral and religious principles from gambling with depositors' funds, even if there is a cushion available to bail them out. However, banks belonging to collective societies, such as those in the MENA area, may be inclined to take more risks due to the perception of having a larger safety net to protect them in the event of failure. We analyse these theoretical intersections by utilising a dataset consisting of 320 banks from 20 countries, covering the time span from 2006 to 2021. Our analysis employs a combination of Ordinary Least Squares (OLS), Fixed Effects (FE), and 2-step System-GMM methodologies. Our analysis reveals that Islamic banks are less exposed to credit risk compared to conventional banks. We contend that the stricter ethical and moral ground and multi-layer monitoring system amid protracted geopolitical and post-pandemic crises impacting Islamic countries contribute to the lower credit risk. We examine the consequences for credit and liquidity management in Islamic banks and the risk management strategies employed by Islamic banks, which can serve as a valuable reference for other banks.