Islamic Banking and Firm Performance: Costs, Benefits, and Lessons from the Global Financial Crisis

Abstract:
The roles played by Western-oriented banks in creating and exacerbating the Global Financial Crisis invite investigation of alternative banking arrangements. The dual-banking system in Turkey allows us to obtain a better understanding of Islamic banks in resolving the two fundamental finance problems — transferring funds from savers to borrowers and efficiently allocating those funds among competing borrowers. We are particularly concerned with the effects of that resolution on real activity by non-financial firms. Islamic banking relations are analyzed in terms of secular, Western-oriented, finance concepts. Islamic banking relationships attenuate financial frictions and shift risk from firms to banks (where risk can be borne more efficiently). The extent to which these features of Islamic banking relationships affect firms and improve or impair real economic performance are evaluated empirically. With a unique dataset of 100,000 firm/year observations, we document the advantages of an Islamic banking relation in normal times in terms of increasing investment and expanding the size of the firm. During abnormal times, we find that firms with an Islamic banking relationship investment less, suggesting the dark side of an Islamic banking relationship. Religiosity is an important factor in the adoption decision by firms for an exclusive Islamic banking relationship. We use this ”instrument” to re-examine the sensitivity of investment and firm growth to an Islamic banking relationship. Propensity score matching estimates confirm our previous findings.