Contributing role of regulatory compliance and Islamic operations in bank risk: evidence from Pakistan

Purpose - This study aims to estimate the regulatory compliance impact on the risk of banks operating in Pakistan. The direct and indirect regulatory compliance of conventional banks with Islamic operations in terms of risk from 2009 to 2017 are estimated. Design/methodology/approach - This study used a two-step system generalized method of moment (GMM) (dynamic panel) to examine the relationship between regulatory compliance, Islamic operations and the bank risk and tested the direct and indirect impacts of regulatory compliance and Islamic operations on the said risk. Findings - Regulatory compliance has a significant and positive relation with bank risk, whereas the Islamic bank operations have a significant and negative relationship. Thus, regulatory compliance creates pressure on banks, but the Islamic operations of conventional banks reduce this pressure in direct and indirect ways. Practical implications - Per the policy of State Bank of Pakistan (SBP), banks shall pursue Islamic operations to reduce regulatory pressure and widen their scope. The results suggest that regulatory compliance creates pressure on bank risk irrespective of the type of the bank. Thus, the SBP should seek the appropriate measure for this occurrence. Originality/value - To the best of the authors’ knowledge, this work is the very first study that has considered the unique Islamic operations of conventional banks and estimated its impact on risk. Moreover, this work examined two types of bank risk instead of employing stability and market measure. This research is also the first to implement a two-step system GMM for the methodology.