Tail dependence risk exposure and diversification potential of Islamic and conventional banks

ABSTRACT

This paper undertakes a rolling window comparative analysis of risks for portfolios consisting of GCC Islamic and conventional bank indices. We draw our empirical results by employing canonical, drawable and regular vine copula models, as well as by implementing a portfolio optimization method with a conditional Value-at-Risk constraint. We find evidence of higher riskiness in the group of Islamic banks relative to the group of conventional banks across each of the financial rolling window scenarios under consideration. Specifically, a greater negative (nonlinear) tail asymmetric dependence is observed in the pairs of Islamic banks’ relationships. The results also show that the optimal portfolio model supports a clear preference towards the group of conventional banks in regard to risk minimization and diversification benefits.

KEYWORDS:

• Islamic and conventional banks
• vine copulas
• conditional Value-at-Risk
• nonlinear dependence risk
• portfolio diversification

JEL CLASSIFICATION:

• C32
• G11
• G15

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

¹ A detailed explanation of the connection between the theorem of Sklar (1959) and the vine copula models implemented in this paper can be found in Brechmann and Schepsmeier (2011).

² Only the Kendall tau matrix for the r-vine is displayed. The Kendall tau matrices for the d-vine and c-vine can be provided upon request to the corresponding author.