Relationship between capital, risk and efficiency

Purpose – This paper aims to investigate the relationship between capital risk and efficiency of Islamic and conventional banks operating in Bangladesh. In this pursuit, the research attempts to answer these questions: do inefficient banks assume more risk? Is there any major difference between Islamic and conventional banks in terms of efficiency and risk taking behavior? Design/methodology/approach – The study collects various bank-level data from the audited financial statements of Islamic and conventional banks for the period of 2001 to 2011. Collected data are analyzed using Stochastic Frontier Analysis for efficiency estimation and Seemingly Unrelated Regression (SUR) approach for assessing the relationship between capital, risk, and efficiency. Findings – Analysis of data shows that conventional banks are more efficient in managing cost than Islamic banks. Moreover, the SUR results show that the relation between capital and efficiency are bidirectional and negative, whereas the relation between capital and risk is also bidirectional but positive for Islamic banks. On the other hand, risk and efficiency are positively related, and the result is bidirectional for conventional banks. Research limitations/implications – The research concentrates on private-commercial banks as proxy for conventional banks. State-owned banks including specialized banks and foreign commercial banks are excluded from the sample due to various anomalies in reporting of financial data. Practical implications – There is a lot of room for Islamic banks to increase productive efficiency because cost efficiency of Islamic banks is less than that of the conventional banks. This can be attributed to the relative small size of Islamic banks in Bangladesh. Because there exists a positive relationship between size and efficiency for Islamic banks, they can concentrate on increasing their size to capitalize on economies of scale. Moreover, the analysis shows that inefficient conventional banks assume higher risk which conforms to moral hazard hypothesis. Therefore, regulatory authorities should discourage banks from exercising such practice for the greater stability of the overall banking system in Bangladesh. Originality/value – A good number of studies is available in the existing literature that compares the performance of Islamic and conventional banks in the case of Bangladesh. However, very few studies are found that examine the relationship between capital, risk and efficiency. Therefore, the research is new for the selected area. As a result, the research is expected to contribute to the existing literature by providing new information.