Systemic risk, competition, and governance in alternative financial systems

This thesis comprises of three research studies based on assessing the systemic stability of the alternative financial systems in countries where both conventional financial institutions (CFIs) and Islamic financial institutions (IFIs) operate alongside. The first study compares the systemic risk levels of CFIs and IFIs. In particular, it analyses the cross-systemic linkages between the two distinct financial models and identifies the most resilient financial sector. The second study analyses the level of competition between the two financial models and its impact on the systemic stability. The third study examines how different features of the dual (Shariah and corporate) governance model in Islamic financial institutions determine their systemic risk. These studies use a sample of 376 financial institutions from 12 countries that have both conventional and Islamic finance presence (250 CFIs and 126 IFIs) over the period 2000-2019. These studies lead to important findings and implications for the regulators and supervisors of the dual financial institutions and reflect on instilling the systemic financial stability in the financial economy.

The first study investigates the systemic risk of the full, conventional and Islamic financial sectors. Using the ΔCoVaR as the measure of systemic risk, we find that the systemic risk of one type of financial system arises due to the distress of the other type. This answers "how cautious" should one (e.g. conventional) financial system be from the other (e.g. Islamic). More specifically, the conventional financial system is more systemic towards the Islamic whereas the latter transmits lower systemic spillovers towards the former. Additionally, the Islamic financial system appeared more resilient and less contagious during and after the global financial crisis of 2008. Hence, the inclusion of the Islamic financial institutions complementing the conventional ones, could foster an overall financial stability in the economies where both financial systems operate.

In the second study, we examine the empirical relationship between competition (proxied by Lerner index) and systemic risk (captured through ∆CoVaR) of conventional and Islamic financial institutions using dynamic GMM panel vector autoregressive (pVAR) technique. This approach allows for controlling the potential sources of endogeneity that are inherent in the competition-risk relationship. We find significant evidence that competition undermines the systemic financial stability. Moreover, our results show that on average, the systemic risk of conventional financial institutions is higher than Islamic financial institutions and IFIs depict higher market powers than CFIs in the dual sector. By extending our analysis towards the cross sector estimations, we found that the market structure of the minority/Islamic business models can diminish the systemic risk of the commercial sector. This study significantly contributes to a better understanding of systemic stability among the diversified financial industry driven by the competition levels, by providing empirical evidence from an emerging market characterised by the largest dual financial sector in the world. A series of robustness tests confirms our results and the relationship holds during the expansive as well as recessive moments of the economy.

The third study investigates the impact of dual-governance framework comprising Shariah (Islamic law) and conventional corporate governance on the systemic risk of 126 IFIs. We argue that little attention has been given to the role of dual governance system and systemic risk, despite a strong link between conventional corporate governance and risk-taking behaviour of financial institutions, in general. We measure dual-governance through a set of Shariah supervisory and corporate governance variables. Additionally, we introduce novel proxies comprising external Shariah audit and cross-institution/cross-country Shariah supervisors to comprehend the Shariah governance. Our results show that smaller Shariah supervisory boards (SSBs) with financial expertise/education and performing an external Shariah audit are associated with lower systemic risk. Moreover, cross-institution SSB members appointed in the same country further contribute towards lowering the systemic risk levels together with smaller and independent boards, lower CEO power and enhanced audit quality. Our results are robust to alternative estimations, systemic risk measures and proxies for usual controls.