Assessing the Stability and Resilience of Islamic Banks through Stress Testing under a Standardized Approach of the IFSB Capital Adequacy Framework

Stress testing is an essential risk management tool that helps financial institutions to identify, assess and mitigate risks in their businesses. Stress tests have been and are an excellent tools for understanding the plausible impact of a “what-if scenario” in the banking industry. The global financial crisis has placed the spotlight squarely on stress tests. Though Islamic banks operate within the similar financial environment, their balance sheet composition calls for different treatment in stress testing. Stress testing work has been extensively discussed by the international framework such as of Basel Committee on Banking Supervision and Committee of European Banking Supervisors and is reflected in the IMF work as well. However, the existing literature on stress testing is either mostly from conventional banks perspective or is dominated by the qualitative nature from an academic perspective. There is significant gap in the literature to address the specificities of Islamic banks and the stress testing implications. This paper explores this gap. The paper develops a stress testing matrix – a step-by-step approach, which is used as a benchmark for simulating solvency stress tests for Islamic banks, followed by a stylised numerical example through a tractable Excel-based framework for solvency stress testing. The paper highlights various implications and relationships arising out of solvency stress testing for Islamic banks, including the vulnerability of Islamic banks under defined scenarios, demanding appropriate immediate remedial actions by the Islamic bank on future capital resources and capital needs. The paper notes that stress testing for risk management in Islamic banks seems to be an underdeveloped area where much work at all levels, including by supervisory authorities and market players, is required. Thus, it is hoped that the findings of the paper provide preliminary discussion on developing a comprehensive toolkit for the Islamic banks similar to what is developed by the IMF FSAP programme. © Author