Determining the relationships between bank capital, credit risk, cost inefficiency and profitability in Islamic banks: a comparative analysis between before and after Global Financial Crisis

This study empirically determines the relationships between bank capital, credit risk, cost inefficiency and profitability in Islamic banks on a cross-country basis for the years between 2003 and 2012. Specifically the study aims to identify these relationships during the periods before and after the global financial crisis (GFC). Besides that, this study also determines the differences in these relationships in Islamic banks that operate in MENA and non-MENA regions. The extant literature on these relationships were concentrated largely in the conventional banks and have mixed conclusions. As the Islamic banks are subjected to Shariah – compliance, their financial instruments and operating system is different from conventional banks. Contrary to the general belief that Islamic banks were not affected by the effects of GFC due to its interest-free intermediation and profit-loss sharing system, evidences have indicated that both, Islamic and conventional banking systems, are equally vulnerable to financial shocks during extreme events. Using the yearly bank financial statement data collected from Bankscope database on 85 Islamic banks from 24 countries over a period of ten years, this study analyzed these relationships employing the appropriate regression techniques. The theoretical framework of this study used four main Islamic bank variables; bank capital, credit risk, cost inefficiency and profitability to determine the relationships between them, besides six other bank specific variables. The research methodology mainly used the panel data analysis in analysing the relationship between these variables. The findings of this study reveal that low capitalized Islamic banks take on more credit risk, cost inefficient Islamic banks take on more credit risk and highly risky (in terms of credit risk) Islamic banks were more cost inefficient for the periods before and after GFC and also in MENA and non-MENA regions. Another finding of this study reveals that, highly profitable Islamic banks take on less credit risk during the period before the GFC. However, the inverse was observed after GFC. Region wise, it is noted that highly profitable MENA region Islamic banks take less credit risk, while highly profitable non-MENA region Islamic banks take on more credit risk. The findings of this study also indicate that in Islamic banks, higher the bank capital, higher the profitability during both periods (before and after GFC) and also in Islamic banks that operate in MENA and non-MENA regions. Overall, this study found that the relationships between bank capital, credit risk, cost inefficiency and profitability in Islamic banks were generally similar during both the periods before and after the GFC. However, differences were noted in the directions of which cost inefficiency and profitability affects credit risk in MENA and non-MENA region. Cost inefficiency negatively affects credit risk of Islamic banks that operate in MENA region while the inverse is observed in Islamic banks that operate in non-MENA region. Profitability negatively affects credit risk of Islamic banks that operate in MENA region while the reverse condition is observed in Islamic banks that operate in non-MENA region