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Does Capitalization Enhance Efficient Risk Undertaking? A Comparison between Islamic and Conventional Banks

This paper investigates the relative impact of capitalization on risk-taking efficiency in Islamic and conventional banks. In particular, we test whether changes occurring to the capital structure of different types of banks unevenly affect their behavior in terms of risk-taking efficiency. Results, obtained both by regressions and a stochastic cost frontier analysis in the period 2000-2011 show that higher capitalized Islamic banks are associated to less risky policies in terms of their assets structure. In particular, they exhibit higher liquidity standards compared to other – less capitalized – Islamic banks. This corresponds to lower non-performing loans, leading to weak delayed positive effects on profitability and no substantial impact on efficiency. On the other hand, more capitalized conventional banks tend to shift from more traditional lending activities to investment in other assets, including off balance sheet items. Such policy provides higher profitability and profit efficiency although raising impaired loans. The analysis has important implications when considering capital adequacy as a regulatory tool for managing the risk of Islamic banks’ activity.