The Role of Stress Tests in Enhancing Bank Transparency: A Comparative Study of Islamic and Conventional Banks

Abstract

Abstract The global financial crisis highlighted the crucial role of stress tests in evaluating a bank’s resilience to severe economic shocks. Accordingly, the purpose of the study was to examine the contribution of stress tests to credit risk in terms of hedging banking opacity and improving financial resistance against negative shocks in MENA countries, observed for the period from 2012 to 2022. Furthermore,, this study explores the impact of stress tests on enhancing bank transparency, particularly within the contexts of Islamic and conventional banking systems using the Panel-VAR and GMM approach. A conceptual framework is established to explain the connection between stress testing and bank transparency, emphasizing on the mechanisms through which stress tests can promote greater disclosure and accountability. A comparative analysis of stress testing practices across both banking sectors reveals similarities and distinctions in scenario selection, modeling techniques, and disclosure practices. In-depth case studies of Islamic and conventional banks illustrate the practical application of stress testing in fostering transparency. These results show that stress tests produce information about credit risk exposure and about the real conditions of financial institutions. Therefore, more transparency on bank losses and risks would have also enabled bank regulators to focus more attention on financial institutions and react early to take “corrective measures”. Policy recommendations are drawn to enhance the effectiveness of stress testing in promoting transparency and financial stability within both Islamic and conventional banking sectors. This study contributes to a deeper understanding of stress testing’s role in fostering a more resilient and stable financial system.