Islamic Banks’ Capital Buffers: Unique Risk Exposures and the Disciplining Effects of Charter Values

In the aftermath of the recent financial crisis, the inherent linkages between banks’ capital buffers and risk took center stage as policy makers promoted a more resilient global banking system. The growing recognition of Islamic banking as a viable alternative-banking model warrants the need to investigate the overall susceptibilities of Islamic banks’ capital buffers to unique risks emanating from their operating environments. We examine this issue over the period 2005-2012 in the 18 countries where Islamic and conventional commercial banks coexist. We employ a panel model using dynamic Generalized Methods of Moments (GMM) on a data set comprising 128 commercial banks of which 44 are Islamic commercial banks. The search for alternative forms of prudential regulation over and above risk based capital guidelines has also shifted the attention of policy makers towards investigating the disciplining effects of banks’ charter values on capital buffers. We test this issue for Islamic banks, and whether the relationship varies as a function of the size of the charter as implied by theory. We employ the cross-section threshold approach suggested by Hansen (2000) for 101 publicly listed commercial banks in the same countries. To the best of our knowledge, this study is the first attempt to examine empirically the aforementioned issues for Islamic banks. This study is expected to expose shortcomings in capital adequacy guidelines and raises distinct policy implications with regards to the regulation and supervision of Islamic banks in countries where both bank types co-exist.