Market discipline and capital buffers in Islamic and conventional banks in the MENA region

Abstract

This paper examines the effectiveness of market discipline in motivating banks to mitigate their default risk by using capital buffers against adverse effects in portfolio risk. Using a large sample of 126 banks from 9 MENA countries from 2009 to 2014, we study whether support, funding, and risk disclosure motivate banks to hold larger capital buffers to cover potential portfolio risk or not; and whether it affects differently Islamic and conventional banking sectors. Our paper findings provide evidence of the contradictory effects of these factors on Islamic banks compared to conventional banks. While government support results in higher capital buffers, stronger market discipline resulting from uninsured liabilities and disclosure results in larger capital buffers. Most factors look effective only for the conventional banking industry and ineffective for the Islamic banking industry due to its risk-sharing characteristic. Our paper findings provide evidence of the effectiveness of market discipline mechanisms, especially for the conventional banking industry. Moreover, high government support reinforces the disclosure and uninsured funding effects, especially for conventional banks. Finally, competition minimizes bank’s risk incentives.