Bank capital and portfolio risk among Islamic banks

• DOI: http://doi.org/10.1016/j.rfe.2017.03.004
• Published date: 01 September 2017
• Author: Murat K. Munkin,Syed Abul Basher,Lawrence M. Kessler
• Date: 01 September 2017

Review of Financial Economics 34 (2017) 1–9

Contents lists available at ScienceDirect

Review of Financial Economics

journal homepage: www.elsevier.com/locate/rfe

Bank capital and portfolio risk among Islamic banks夽

Syed Abul Bashera, Lawrence M. Kessler b, Murat K. Munkinc,*

aDepartment of Economics, East West University, Plot No-A/2, Aftabnagar Main Road, Dhaka 1219, Bangladesh

bBoyd Center for Business & Economic Research and Department of Economics, University of Tennessee, Knoxville, TN 37996, USA

cDepartment of Economics, University of South Florida, 4202 East Fowler Avenue, BSN 3426, Tampa, FL 33620-5500, USA

ARTICLE INFO

Article history:

Received 30 June 2015

Received in revised form 27 May 2016

Accepted 13 March 2017

Available online 29 March 2017

JEL classification:

C11

C32

G21

G28

Keywords:

Islamic banks

Asset risks and total capital

Panel data with endogenous treatment

MCMC

ABSTRACT

Minimum capital requirements are often implemented under the notion that increased capital improves

bank safety and stability. However, an unintended consequence of higher capital requirements could arise if

increasing capital induces banks to invest in riskier assets. Several researchers have examined this relation-

ship between bank capital and risk among conventional banks, and interest around this topic has intensified

since the 2007–2008 financial crisis. However, the findings are rather mixed. Moreover, very few studies

have focused on Islamic banks, which differ greatly from their conventional counterpart’s due to their need

to be Shariah-compliant. In this paper a sample of 22 Islamic banks is analyzed over a seven year period

from 2007 to 2013. The empirical approach is fully parametric and Bayesian utilizing techniques developed

by Kessler and Munkin (2015) and building on previous banking research by Shrieves and Dahl (1992) and

Jacques and Nigro (1997). Some evidence is found suggesting that increases in total capital positively affect

the levels of asset risks among Islamic banks.

© 2017 Elsevier Inc. All rights reserved.

1. Introduction

Banks maintain a minimum capital requirement because it pro-

vides a buffer against negative shocks and acts as insurance against

the risk of insolvency. However, the financial crisis of 2007–2008

exposed the fact that many of the world’s largest banks held insuffi-

cient capital and were not able to cover all of their losses. This appar-

ent mismatch between the ‘minimum regulatory capital require-

ment’ and its resulting impact on ‘bank solvency’ has promoted

an intense debate among policymakers, bankers, and academics on

the question: “how much capital should banks hold in order to

cover their potential losses?” In most countries, the minimum cap-

ital requirement is 8% of risk-weighted assets, and is expected to

夽We are grateful to the participants of the 2012 Islamic Finance Conference in

Birmingham for comments and suggestions for improvements. The valuable input of

our discussant Marwan Izzeldin has much improved the paper. We also thank Kabir

Hassan for his input which he provided at earlier stages of this research.

*Corresponding author.

E-mail addresses: syed.basher@gmail.com (S.A. Basher), lkessler@utk.edu

(L.M. Kessler), mmunkin@usf.edu (M.K. Munkin).

increase to 10.5% under the Basel III accord (Basel Committee on

Banking Supervision, 2010).1As of today, the debate is still active on

how much capital banks should hold.

Capital requirement can be a double-edged sword. While

increased capital enhances bank safety, it might induce a bank to

assume greater risks. If the latter effect outweighs the former, even

well-capitalized banks may face the risk of insolvency. There is

a large literature in financial economics studying the relationship

between risk-taking and the capitalization of banks. The theoretical

literature suggests that risk and capital decisions are simultaneously

determined and interrelated.2For instance, Gennotte and Pyle (1991)

show that an increase in the capital requirement may induce a bank

to simultaneously decrease the size of its portfolio and increase its

asset risk in hopes of earning higher returns. Diamond and Rajan

(2000) offer a model that simultaneously rationalizes the asset and

the liability sides of banks. They show that while greater capital

1Table 1 provides an overview of the capital requirements under Basel II and

Basel III.

2The literature is vast and comes to contradicting results. For a survey of the

theoretical and empirical literature, see Stolz (2007).

http://dx.doi.org/10.1016/j.rfe.2017.03.004

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