Risk-adjusted efficiency and corporate governance: Evidence from Islamic and conventional banks

Previous studies have compared the efficiency of Islamic banks with their conventional counterparts using a common efficiency frontier and ignoring risks, in spite of the two bank groups operating under different technological, market and institutional conditions. We overcome this issue by estimating efficiency using the stochastic meta-frontier model for a large international sample, and show that compared to conventional banks, Islamic banks are 4 percentage points more cost efficient, but 17 percentage points less profit efficient on a risk-adjusted basis. For both bank types, higher bank risk reduces cost efficiency but increases profit efficiency, implying that risks contribute more to generating revenues than inflating costs. Having a stronger Shariah supervisory board is conducive to improving Islamic banks' profit efficiency. Our findings are robust to accounting for potential endogeneity in the governance-efficiency relationship.