It is generally argued that Islamic banks are safer than conventional banks. The prime reason is that their product structure is essentially asset-backed financing, while conventional banks rely heavily on leveraging, which was considered one of the main causes of the 2008 global financial crisis. This paper examines the riskiness of Islamic and conventional banks during the 2008 global crisis by measuring overleveraging, defined as the difference between actual and optimal debt. This research conducted empirical analysis on the overleveraging of 20 banks (10 conventional and 10 Islamic banks) from five different countries, namely, Bahrain, Kuwait, Malaysia, the United States, and the United Kingdom. The analysis is double-folded: on the one hand, the results in this paper suggest that excess debt, rather than the mere holding of debt, was the reason behind the severe financial meltdown in 2007–2009; on the other hand, this paper shows that Islamic banks, in most of the countries in context, performed better during the recent crisis, but were subject to the second-round effect of the global crisis around the years of 2011–2013.

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We develop an empirical model of bank capital structure to study the impact of large oil shocks on overleveraging of banks which presents severe challenges for banks’ balance sheet management. The measure of overleveraging builds on the Stein (2012) model by adding a jump-diffusion component that captures the jump size and intensity of predictors such as oil prices and political instability. Overleveraging is derived and estimated for a sample of six banks in three oil-producing countries and Western countries using the Markov Chain Monte Carlo (MCMC) method, for the years 2006-2016. The estimation of the optimal debt shows that most of the banks in this context had a high optimal debt around 2008, overlapping with the oil price shock. In addition, most of the predictors, namely oil prices and political instability factors proxied by terrorism, political corruption, and military expenses, regularly appeared in volatility and jump intensity factors.

This paper addresses if and how excess debt can be considered as an early warning signal for banks and takes an additional dimension by comparing the excess leverage between Islamic and conventional banks in Indonesia before, during, and after the Global Financial Crisis (GFC). To do so, this research develops an empirical model of banks’ capital structure and optimal and excess debt, and it conducts an empirical analysis on the overleveraging of eleven conventional and Islamic banks in Indonesia. Results show that all banks became vulnerable to the GFC in 2007–2009 while credit build-up, i.e., overleveraging, started in 2005. However, for most of the banks in the sample, Islamic banks performed better and leveraged less prior to the GFC, which made them more resilient to the crisis.

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