The regulations–risk taking nexus under competitive pressure: What about the Islamic banking system?

Abstract

Does market power condition the effect of bank regulations and supervision on bank risk taking? We focus on three regulatory tools: capital requirements, the restriction of activities, and official supervisory powers. Employing 10 years of unbalanced panel data on 123 Islamic and conventional banks operating in the Middle East and Asia, we arrive at the following conclusions. First, banking market power strengthens the negative impact of capital regulation on bank risk taking. Second, our empirical results suggest that the negative effect of activity restrictions on stability is diminished when banks have greater market power. Finally, we do not find strong evidence that the negative effect of supervisory power on banks’ risk taking is conditioned by their competitive behavior. In further analysis, we differentiate between Islamic and conventional banks regarding their competition, as well as their risk behavior. The results differ according to the banking business model. These findings could be useful for bank regulators in light of the accomplishment of Islamic banks’ regulatory framework. Indeed, the adoption of Basel III represents a significant regulatory challenge, given that it does not take into account the specificities of Islamic banks.