Islamic Banking and Finance: Fundamentals and Contemporary Issues

Financial Distress and Bank Failure: Relevance for Islamic Banks

reserve banks on account of early withdrawals by depositors in response to
changes in inter-temporal relative returns obtainable from the bank and from
elsewhere (say asset markets). These are closer to the first generation models
discussed above pertaining to category 1. (ii) There are models that explain
bank failures (bank runs) arising from game situation between depositors and
the bank with inefficient equilibrium. The inefficiency arises when there is a
coordination failure among the depositors and they loose confidence in their
bank.^6 These are closer to the second and third generation models of category
1 discussed above but pertain to individual bank failures.

5. Causes of Financial Distress—Policy Oriented Classification

In this paper we want to approach the subject with policy perspective in
identifying the causes of financial distress and banking crisis, and highlight
the differences and similarities in importance of these causes for Islamic
banks. We therefore take a more basic (fundamental) approach of listing the
causative factors and comparing the relevance of each for Islamic banking.

Fundamentally, four important economic agents take part in shaping the
banking environment; namely, the government, the central bank or the
supervising authority, banks themselves and bank customers be they
depositors or clients who borrow.

Figure 1: Four Types of Economic Agents - Shapers of the Banking

Environment

Banks

(^) Central
Bank
Regulators
Customers