Does capitalization enhance efficient risk undertaking?

Abstract

Purpose In light of the current debate on bank capital requirements, the purpose of this paper is to investigate the relative impact of capitalization on risk‐taking efficiency in Islamic and conventional banks. The author tests whether changes occurring to the capital structure of such different types of intermediaries unevenly affect their behaviour in terms of risk‐taking efficiency. Design/methodology/approach The paper conducts an empirical analysis using data for the period 2001‐2011 by means of both standard regression methods and stochastic cost frontier techniques. Findings Results provide evidence that more capitalized Islamic banks are associated to less risky positions in terms of their asset structure. In particular, the latter exhibit higher liquidity standards and a lower incidence of non‐performing loans compared to other banks. This has delayed positive effects on profitability and no substantial impact on efficiency. On the other hand, highly capitalized conventional banks tend to shift from more traditional lending activities to investment in other (profit generating) assets. Such strategy increases profitability and efficiency, although raising impaired loans. Research limitations/implications This study does not address potential endogeneity concerns that might affect the variables at stake, hence mainly providing indications in terms of correlation between phenomena rather than causality. Practical implications The analysis has important practical implications when considering capital adequacy as a regulatory tool for managing the risk of Islamic banks' activity, following principles similar to those recommended by the Basel committee. Originality/value The original contribution of the paper to the literature consists of comparing the effects of capitalization in different types of banks, and results can be usefully exploited by policymakers wishing to tailor banking regulation on the specific model of banking they are entitled to regulate.

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