Climate risk and Islamic bank stability

Abstract

Purpose Extreme and recurring climate hazards may pose risks to the stability of banking industry, including Islamic banks. Therefore, this study aims to explore the effect of climate risk on the stability of Islamic banks. Design/methodology/approach We used unbalanced panel data from a sample of 60 Islamic banks drawn from 16 countries over 10 years (2013–2022). Based on regional distribution, 32 banks are in West Asia, 14 banks in South Asia, 12 banks from Southeast Asia and 2 banks from Africa. We employed the feasible generalized least square (FGLS) regression as the primary major regression model. Besides, a two-step system generalized method of moments estimator was applied for the results’ robustness check as well as evaluated subsample analysis using FGLS model. Findings The findings revealed that climate risk has a significant negative effect on Islamic bank stability. By examining the components of climate risk, the results confirmed that exposure to climate risk and adaptive capacity significantly decreased ZSCORE (implying an increase in insolvency risk). However, sensitivity to climate risk heightened credit risk (CR), while adaptive capability mitigated CR in the sampled Islamic banks. Research limitations/implications We utilized only a sample of 60 full-fledged Islamic banks operating in 16 countries in Asia and Africa between 2013 and 2022. However, we did not delve into the climate risk implications of various Islamic banking products and contracts. Practical implications The findings will be useful to regulators and managers. It informs local regulators and international regulatory bodies to develop unified local and international frameworks for climate risk stress-testing for Islamic banks. The study recommends that Islamic banks’ managers should set financing limit for industries prone to climate risks to avoid excessive risk exposure. Moreover, Islamic banks should streamline climate risk governance (through risk management departments and Shari’a supervisory board [SSB]) and embed climate mitigation conditions depending on climate risk exposure of Islamic financing contracts. Originality/value This study contributes to literature on Islamic finance sustainability as previous studies focused mainly on conventional banks excepting few studies that explore Indonesian Islamic banks and MENA dual banking. In addition, this study decomposes the climate risk index to assess the specific impacts of climate risk components on Islamic bank stability. This is advantageous because exposure and sensitivity amplify instability, while adaptive capacity should enhance stability. However, this study exposes the weakness of adaptive capacity that requires adequate funding to safeguard Islamic bank from climate impacts.