Empirical evidence of risk shifting in bonds and debt-basedsukuk
Authors: Hamzah Siti Raihana , Ismath Bacha Obiyathulla , Mirakhor Abbas , Abdul Kader Malim Nurhafiza 
Published: August 2018

PurposeThe purpose of this paper is to examine the extent of risk shifting behavior in bonds andsukuk. The examination is significant, as economists and scholars identify risk shifting as the primary cause of the global financial crisis. Yet, the dangers of this debt-financing feature are largely ignored – one needs to only witness the record growth of global debt even after the global financial crisis.Design/methodology/approachTo identify the signs of risk shifting existence in the corporations, this paper compares each corporation’s operating risk before and after issuing debt. Operating risk or risk of a firm’s activities is measured using the volatility of the operating earnings or coefficient variation of earning before interest, tax, depreciation and amortization (EBITDA). Using EBITDA as the variable offers one distinct advantage to using asset volatility as previous research has – EBITDA can be extracted directly from firms’ accounting data and is not model-specific.FindingsRisk shifting can be found in not only the bond system but also the debt-basedsukuksystem – a noteworthy finding becausesukuk, supposedly in a different class from bonds, have been criticized in some quarters for their apparent similarity to bonds. On the other hand, this study thus shows that equity feature, when it is embedded in bonds (as in convertible bonds) or when a financial instrument is based purely on equity (as in equity-basedsukuk), the incentive to shift the risk can be mitigated.Research limitations/implicationsGlobal awareness of the dangers of debt should be increased as a means of reducing the amount of debt outstanding globally. Although some regulators suggest thatsukukreplace debt, they must also be aware that imitativesukukpose the same threat to efforts to avoid debt. In short, efforts to ensure future financial stability cannot address only debts or bonds but must also address those types ofsukukthat mirror bonds in their operation. In the wake of the global financial crisis, amid the frantic search for ways of protecting against future financial shocks, this analysis aims to help create future stability by encouraging market players to avoid debt-based activities.Originality/valueThis paper differs from the previous literature in two important ways, viewing risk shifting behavior not only in relation to debt or bonds but also when set against debt-basedsukuk, which has been subjected to similar criticism. Indeed, to the extent that debts and bonds encourage risk shifting behavior and threaten the entire financial system, so, too, can imitationsukukor debt-basedsukuk. Second, this paper is unique in exploring the ability of equity features to curb equity holders’ incentive to engage in risk shifting behavior. Such an examination is necessary for the wake of the global financial crisis, for researchers and economists now agree that risk shifting must be a controlled behavior – and that one way of controlling risk shifting is by implementing the risk sharing feature of equity-based financing into the financial system.