Does a one-size-fits-all approach to financial regulations alleviate default risk? The case of dual banking systems

Abstract

Financial regulations are developed to curb financial and economic fragility costs without undermining the economic contributions of banks to economic development. To understand the impact financial regulations have on reducing the financial fragility of banks we use the probability-of-default of banks as a proxy for bank failure. After analyzing data collected from 15 countries with a dual banking system for the period 2000–2015, we find convincing evidence that not all financial regulations have risk-reducing benefits for banks and the impact of financial regulations on default risk is not the same for conventional banks (CBs) and Islamic banks (IBs). The empirical evidence suggests that regulations that lessen overall default risk have a greater impact on IBs while those increasing default risk have a greater impact on CBs. Based on our findings we recommend that regulators should consider the different natures of CBs and IBs and tailor financial regulations to suit these operationally distinct financial intermediaries.