Impact of capital adequacy requirement on performance and efficiency of Islamic and conventional banks in OIC member countries

Capital adequacy plays an important role in overseeing banks’ activities. It is used as a buffer to ensure banks have sufficient amount of capital against unexpected losses or adverse shock that could lead to bank failure. The impact of capital adequacy requirement on banks’ performance is in fact an ongoing issue and the issue is still growing with a lot more gaps to be filled in especially in Islamic banking. This study proposes to fill this gap by analysing and comparing 52 Islamic banks (IBs) and 186 conventional banks (CBs) in 14 Organization of Islamic Cooperation (OIC) member countries for the period of 1999 and 2009. It takes into account the performance and efficiency of the bank with the implementation of Basel Accord in these countries. The three main objectives of this study are: to examine the impact of capital requirement using two different measurements; to examine the relationship between capital requirement and banks’ lending and borrowing and the effect of capital crunch; and to ascertain the relationship between the Capital Adequacy Ratio (CAR) and bank efficiency and factors determining their cost and profit efficiency. Leverage ratio and author’s own measurement of risk-based capital is used to examine the two different measurements. Based on the findings the risk-based ratio is always higher than leverage ratio in all banks studied. The Estimated Generalized Least Squares (EGLS) regression model is used in the model to estimate capital requirement and the growth of banks’ deposits and loans. For this objective, four main hypotheses tested using multiple regression analysis which takes CAR and other bank specific variables and macro economic variables as the control variables. The empirical evidence of this study supports the notion that bank capital requirement has impacted the borrowing and lending of IBs and CBs in the sample. There is a strong positive relationship between the bank capital level and the growth of deposit and loan for both IBs and CBs. However, this study produces mixed results in the capital crunch effect. Even though the test shows the importance of capital supply on the banks’ borrowing and lending activities in both IBs and CBs, the effect of capital crunch can only be concluded on IBs. Next, this study analyzes the effect of the requirement CAR on the bank cost and profit inefficiency. Four main hypotheses are tested to analyze the mean efficiency using Stochastic Frontier Approach (SFA) obtained from a translog Cobb-Douglas cost and profit function which uses deposits and loans as the bank’s outputs. The banks’ cost of capital, cost of fixed assets and cost of labor are used as the input prices. The findings suggest that CBs are better than IBs in terms of profit efficiency but they are similar in cost efficiency. On the other hand, tests on low capitalized banks and high capitalized banks conclude that on average, CBs are more efficient (cost and profit efficiency) than IBs in 14 countries except for one test on high capitalized banks using risk-based capital where the IBs are better in both cost and profit efficiency than the CBs. The determinant of bank efficiency is tested using Tobit regression model. It is found that CAR has an impact on the profit efficiency in both IBs and CBs but it does not show any impact on IBs’ cost efficiency except when leverage ratio is used as capitalization measurement. Other bank specific variables such as bank total loan over total assets, bank liquidity, bank profitability and size of the bank has also impacted the banks’cost and profit efficiency. However, the impact of macroeconomic variables provides mixed results on IBs’ and CBs’ cost and profit efficiency. Overall, this study has significantly contributed to filling in the gap in the field of banking particularly by using IBs as the main example and samples from 14 OIC member countries which have not been done earlier. Another contribution to the literature is on the author’s own measurement of CAR based on Basel II measurement and to compare it with leverage ratio that is published in the Bankscope database. This study reveals practical implication to the regulators on issues regulating the banking industry internationally mainly in setting up the CAR for IBs in their countries.

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