Prospect theory and risk-taking behavior: an empirical investigation of Islamic and conventional banks

The paper aims to explain the risk taking in Islamic and conventional banks from a behavioral prospect as proposed by Kahneman and Tversky (1979) and Tversky and Kahneman (1992). We used the thermal optimal path (TOP) method to test the prospect theory predictions on a sample of 128 Islamic and conventional banks operating in 13 Middle Eastern and North African (MENA) countries. We found significant correlation coefficients for each measure of the returns, except with the IINTL measure for conventional banks, which is situated below the target and the ROE measure for Islamic banks, which is situated below the target and conventional banks, which is located above the target. Indeed, in the areas of a loss below the target level, the correlation coefficient results are positive for the ROE, ROA and IINTL measures for both Islamic and conventional banks, suggesting an excessive risk-taking behavior. Furthermore, empirical results revealed that unlike the return measures, all the other measures, except the EQTA measure for conventional banks situated above the target, are significant. The results also indicated that for the areas below the benchmark, positive correlation coefficients are obtained for all the risk measures for conventional and Islamic banks except for the LLPTL measure. In fact, these results have several implications for policymakers and banks’ regulators who better supervise the banking system. Moreover, these results show how bank managers behave facing the risk.