Efficiency in Islamic vs. Conventional Banking: The Role of Capital and Liquidity

Abstract

We show that higher capital and liquidity ratios increase the efficiency of conventional and Islamic banks. Using conditional quantile regressions, we further show that the effect is stronger for highly efficient, small, highly liquid, and highly capitalized conventional banks. We also find that more capitalized and liquid banks were more efficient during the 2008/2009 financial crisis and the Arab Spring. Our findings support the view that the constraints imposed by Sharia'a law, may widen the efficiency gap between the two bank types, at the expense of Islamic banks. Furthermore, our findings suggest that the efficiency of conventional banks not only depends on bank capital and liquidity, but also on the level of bank efficiency while the relationship is inconclusive for Islamic banks. These findings provide insight into how capital and liquidity can shape bank efficiency. It suggests that higher capital and liquidity buffers serve a constraint on policymakers and may function very differently depending on the level of bank efficiency.

Keywords: Islamic banking, Capital, Liquidity, Efficiency, Conditional quantile regressions

JEL Classification: G21, G28, G29