STRESS TEST FOR ISLAMIC AND CONVENTIONAL BANKS USING SENSITIVITY SCENARIO TEST: Evidence from Qatari Banking Sector

Abstract

The objective of the paper is to assess the resilience of the banking sector in Qatar to shocks assumed to three risk types, namely, credit risk, interest rate risk and foreign exchange risk. Additionally we divide the banks in the sample into two groups by business model (i.e. 5 conventional banks, and 3 Islamic banks) and try to capture the impact of these shocks on each group of banks applying the same procedures as those followed for the whole banking sector. To achieve this we attempt to examine potential implications on the banks’ capital adequacy ratio (CAR) in the case that banks have increased their provisioning to reflect loan quality deterioration, short-term interest rate has increased by 1.5% and the exchange rate of Qatari riyal against major currencies has depreciated. To this end, we apply a sensitivity stress test under which we assume that the presumed shocks to the three risk types materialize simultaneously and independently over the period from 2006 to 2010. The impact of shocks on the banking sector and the two groups of banks is expressed as post-shock capital adequacy (CAR) ratio ( tier 1 capital relative to risk-weighted assets) compared to pre-shock (baseline scenario) capital adequacy ratio. The difference between these ratios has also been disintegrated into its component of each risk type to assess the size of impact of each risk type on the capital adequacy ratio. Besides, we compare post-shock CAR with Qatar Central Bank's minimum requirement for capital adequacy ratio of 10%, and Basel II directives, which mandate a minimum capital adequacy ratio of 8 %. Finally, we estimate the capital needs for the whole banking sector and each group of banks whenever post-shock CAR ratio happen to fall below any of the two minimum ratios required. The paper reveals that the overall pool of risk for the banking sector as a whole and for the conventional banking sector has declined whereas it increased for the Islamic banking sector. It further finds that the weight of individual risk type has remained unchanged in the period under analysis. in terms of overall impact on capital adequacy ratio, while credit risk continues to have the biggest impact there hardly has been any impact resulting from an increase in short term interest rates by 1.5% or exchange rate depreciation against foreign currencies other than the US$. In addition, Islamic banks appear to be more exposed to credit risk compared to conventional banks as the impact of credit quality would have been severer on Islamic banks as compared to conventional banks. Besides, Islamic banks seem to have assumed higher credit risk post the global crisis in 2008 compared to before the crisis.

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