Capitalization Requirements, Efficiency and Governance: A Comparative Experiment on Islamic and Western Banks

Abstract

The profit and loss sharing principle that is peculiar to Islamic banks reformulates the allocation of risk between shareholders and depositors. In this work we focus on monitoring as a determinant of bank efficiency, under the assumption that equity is a better device than deposits for reducing excessive risk undertaking. Since in Islamic banks depositors are closer to stockholders in terms of residual claiming on profits, the positive relationship between capitalization and efficiency should in principle be weaker in than in their Western counterparts. Results, obtained by means of a stochastic cost frontier analysis on samples of European-15 and Islamic banks during the period 1996-2002, show that the ratio of equity to deposits negatively affects inefficiency in both types of banks, but this effect is considerably undersized in Islamic banks as compared to European ones, thus providing a justification to the reluctance that has accompained the proposal of capital coefficient revision for Islamic banks in accordance to Basel I and II Agreements.

Keywords: Islamic Banks, Capital, Governance

JEL Classification: G21, G32