Capital Adequacy Ratios, E ¢ ciency and Governance: a Comparison Between Islamic and Western Banks

The pro\u85t and loss sharing principle that is peculiar to Islamic \u85nance reformulates the allocation of risk between stakeholders. Since in Islamic banks depositors are closer to stockholders in terms of residual claiming on pro\u85ts, the relationship between capitalization requirements and the performance of banks should in principle be weaker than in their Western counterparts. In this paper we \u85rst explore the nexus between capital-ization and bank e ¢ ciency, no matter the type of bank (Islamic and/or Western). Second, we compare the relative impact of capitalization on the e ¢ ciency of di¤erent types of banks in order to provide evidence on the determinants of possible discrepancies. 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 de-posits negatively a¤ects ine ¢ ciency in both types of banks, but this e¤ect is considerably undersized in Islamic banks as compared to European ones. This supports the reluctance that has accompained the proposal of capital adequacy ratios for Islamic banks in accordance to Basel Agreements