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Examining the relationship between default risk and efficiency in Islamic and conventional banks

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  • Saeed, Momna
  • Izzeldin, Marwan

Abstract

We examine the relationship between efficiency and default risk in Islamic banks (IBs) and conventional banks (CBs) in Gulf Cooperation Countries (GCC) and three non-GCC countries over the period 2002–2010. To the best of our knowledge this is the first study to consider the efficiency–default risk paradigm in a comparative setup which includes IBs. Efficiency and default risk are measured using the Stochastic Frontier Approach and distance to default (Merton's model) respectively. The existence of causality/reverse causality between the two is addressed via a panel Vector Auto Regression (VAR) framework. Our analysis shows that the relationship between profit efficiency and default risk banks across the sample, for CBs and for the GCC is such that a decrease in default risk is associated with lower efficiency levels. With the single exception of IBs, the causality from profit efficiency to default risk is inversely related for all categories. For CBs, the trade-off between efficiency and risk is evident. The absence of a trade-off for IBs suggests that efficiency and default risk are plausible early warning indicators of IB instability. These findings could be of relevance to regulators in countries where both banking system co-exist.

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  • Saeed, Momna & Izzeldin, Marwan, 2016. "Examining the relationship between default risk and efficiency in Islamic and conventional banks," Journal of Economic Behavior & Organization, Elsevier, vol. 132(S), pages 127-154.
  • Handle: RePEc:eee:jeborg:v:132:y:2016:i:s:p:127-154
    DOI: 10.1016/j.jebo.2014.02.014
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    1. repec:eee:riibaf:v:42:y:2017:i:c:p:1401-1412 is not listed on IDEAS
    2. Abedifar, Pejman & Hasan, Iftekhar & Tarazi, Amine, 2016. "Finance-growth nexus and dual-banking systems: Relative importance of Islamic banks," Journal of Economic Behavior & Organization, Elsevier, vol. 132(S), pages 198-215.
    3. repec:eee:ecmode:v:64:y:2017:i:c:p:513-523 is not listed on IDEAS
    4. Sorwar, Ghulam & Pappas, Vasileios & Pereira, John & Nurullah, Mohamed, 2016. "To debt or not to debt: Are Islamic banks less risky than conventional banks?," Journal of Economic Behavior & Organization, Elsevier, vol. 132(S), pages 113-126.
    5. repec:eee:finsta:v:34:y:2018:i:c:p:12-43 is not listed on IDEAS
    6. repec:eee:finsta:v:31:y:2017:i:c:p:18-44 is not listed on IDEAS

    More about this item

    Keywords

    Islamic banking; Banking efficiency; Stochastic Frontier Analysis; Default risk; Merton's model; Panel VAR;

    JEL classification:

    • C33 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Models with Panel Data; Spatio-temporal Models
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • D24 - Microeconomics - - Production and Organizations - - - Production; Cost; Capital; Capital, Total Factor, and Multifactor Productivity; Capacity

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