Capital buffer and credit‐risk adjustments in Islamic and conventional banks

• Published date: 01 September 2019
• Author: Khemaies Bougatef,Fakhri Korbi
• DOI: http://doi.org/10.1002/tie.22022
• Date: 01 September 2019

RESEARCH ARTICLE

Capital buffer and credit-risk adjustments in Islamic

and conventional banks

Khemaies Bougatef

1

| Fakhri Korbi

2

1

Higher Institute of Computer Science and

Management of Kairouan, University of

Kairouan, Tunisia

2

Department of Finance, Paris-Sorbonne

University, CEPN, France

Correspondence

Khemaies Bougatef, Higher Institute of

Computer Science and Management of

Kairouan, University of Kairouan, Tunisia.

Email: khemaies_bougatef@yahoo.fr

The main purpose of this article is to empirically investigate the interactions between changes in

capital buffer and changes in credit risk, using panel data of Islamic and conventional banks

located in the Middle East and North Africa (MENA) region over the period 1999–2016. A nega-

tive two-way relationship between the changes in capital buffer and the changes in credit risk is

found for the two types of banks, that is, banks tend to decrease their capital buffers in

response to an increase in risk exposure and limit their risky activities in response to an increase

in their capital buffers. Dividing our period of study into three subperiods to assess the effect of

the last financial crisis 2007–08 on the adjustment process, we point out the negative bidirec-

tional relationship between the changes in capital buffer and the changes in credit risk of the

two types of banks is present for the three subperiods except the case of conventional banks

during the precrisis period. Moreover, we provide evidence that Islamic banks adjust their capi-

tal buffer in response to the changes in credit risk regardless of the existence or not of a deposit

insurance scheme. In contrast, the negative two-way relationship between the changes in capi-

tal buffer and the changes in credit risk in conventional banks is found only in countries without

deposit insurance schemes.

KEYWORDS

capital buffer, conventional banking, credit risk, Islamic banking, simultaneous equations

1|INTRODUCTION

Islamic banking differs from conventional banking in several ways. The

most important difference is the prohibition of the payment and the

receipt of interest. The Islamic banking system is essentially based on

profit-and-loss sharing (PLS) partnership rather than on traditional

interest-based intermediation (Ahmad & Hassan, 2007). Islamic banks

do not charge a fixed rate of interest on financing provided to their

customers but they are rather rewarded by receiving an agreed per-

centage of profit or bearing loss not due to misconduct or negligence.

This divergence between Islamic banking practices and conventional

banking counterparts requires the existence of specific regulatory

standards that take into consideration the composition of the assets,

that is, the PLS investments versus the non-PLS investments. In this

respect, Archer, Karim, and Sundararajan (2010) argue the displaced

commercial risk, which results from profit-sharing investment

accounts (PSIA), affects the Islamic bank's regulatory capital require-

ments. Daher, Masih, and Ibrahim (2015) provide evidence Islamic

banks employ their capital buffer to mitigate this unique risk. Errico

and Farahbaksh (1998) demonstrate the appropriate regulatory

framework for Islamic banks should give a greater importance to the

management of operational risks and information disclosure issues

compared to the case of conventional banks. However, the Basel

Committee on Banking Supervision (BCBS) did not consider Islamic

banks in its proposals (from Basel I to Basel III).

The Basel I accord was released in 1988 and was first implemen-

ted by the Group of Ten (G10) countries and later progressively by

other countries of the world. This first Basel proposal had as main

objective the enhancement of the soundness of the banking sector by

fixing a minimum regulatory capital ratio. The Second Basel accord

known as Basel II was developed in 2004 to supersede the Basel I

accord. It recommends maintaining a minimum capital adequacy ratio

(CAR) of 8% to guarantee the solvency of the bank in the case of

unanticipated losses and declines in asset values. The new regulatory

framework known as Basel III was developed after the last financial

crisis of 2007–08 to overcome some weaknesses in financial regula-

tion under Basel I and II. The Third Basel Accord requires the imple-

mentation of a countercyclical capital regulation. Henceforth, banks

are required to buildup adequate capital buffers outside periods of

financial distress to avoid the procyclical nature of lending.

DOI: 10.1002/tie.22022

Thunderbird Int. Bus. Rev. 2019;61:669–683. wileyonlinelibrary.com/journal/tie © 2018 Wiley Periodicals, Inc. 669