Impact of banking regulation on risk and efficiency in Islamic banking

Abstract

PurposeThis paper aims to examine whether bank regulation, supervision and monitoring enhance or impede technical efficiency and risk‐taking behaviour of Islamic banks across the globe.Design/methodology/approachTechnical efficiency scores are calculated using the data envelopment analysis (DEA) model while simultaneity between banks' supervision and regulation on risk and efficiency estimates are calculated using the seemingly unrelated regression (SUR) approach.FindingsThe author's results suggest that regulations and strict monitoring of banking operation, and higher supervisory power of the authorities, increase the technical efficiency for Islamic banks. The opposite effect is observed in the case of risk‐taking behaviour of Islamic banks, with higher restrictions resulting in a reduction in risk taking of Islamic banks.Research limitations/implicationsThe Basel II & Basel III guidelines suggested that stricter regulations and supervision could hamper banking efficiency. The existence of a powerful supervisory body could also lead to the inefficiency of banks. The DEA scores from this paper suggest that this may not necessarily be the case, especially as Islamic banks appear to be technically efficient in stricter regulatory conditions.Originality/valueA message that emerges from this analysis is that there is a strong link between Islamic bank technical efficiency and risk‐taking behaviour with the Central Bank regulatory and supervisory policies. It is also conclusive that the Islamic banking system works well within a stricter regulatory environment.