The impact of <i>Shariah</i> financial screening on default risk: a comparative study of US firms

What the paper says

Purpose This study aims to investigate the relationship between financial Shariah screening rules (i.e. leverage and cash ratios) and the default risk of Shariah-compliant (SC) versus non-Shariah-compliant (NSC) firms. This study’s analysis focuses on S&amp;P 500 constituents from 2002 to 2022. Design/methodology/approach This study estimates a dynamic panel model using the two-step generalized method of moments to address endogeneity concerns. The model examines the association of leverage and cash holdings with default risk, measured by the Merton (1974) model, for SC and NSC firms. A set of standard control variables is included in the analysis. Findings This study’s results reveal a fundamental divergence in default risk drivers. Higher leverage is associated with a significantly greater increase in default risk for NSC firms than for SC firms, a difference that is both statistically and economically significant. Conversely, cash holdings show a stronger negative association with default risk for SC firms. This core finding is robust across model specifications. The authors also find that Shariah compliance is linked to crisis-contingent resilience. During the Global Financial Crisis, SC firms were buffered from the risks of high leverage, an advantage that diminished in the COVID-19 pandemic. Furthermore, the Shariah governance structure is associated with an enhanced protective role of cash, especially for SC firms with weak ESG performance. Research limitations/implications These findings offer investors a risk-based rationale for using Shariah-compliance to build crisis-resilient portfolios. Furthermore, within SC portfolios, cash holdings are linked to risk mitigation in firms with weaker ESG profiles. For regulators, they provide evidence of how Islamic finance’s leverage constraints can be informative for macroprudential policies, suggesting that ethical principles are associated with tangible stability benefits. Originality/value This study provides the first comprehensive comparison of default risk dynamics between SC and NSC US firms. We contribute a novel, crisis-contingent theory of financial resilience, showing that Shariah compliance is linked to insulation from leverage risk during financial crises (GFC), an advantage that moderates during broader economic shocks (COVID-19). Furthermore, we reveal that Shariah governance is connected to a stronger protective role of cash against default risk, specifically for firms with weak ESG performance, an effect absent in conventional firms.