Regulation, banking competition and risk-taking behavior in the MENA region: policy implications for Islamic banks

Abstract

Purpose This paper aims to investigate the impact of regulation and market competition on the risk-taking Behaviour of financial institutions in the Middle East and North Africa (MENA) region. Design/methodology/approach The empirical framework is based on panel fixed effects/random effects specification. For robustness purpose, this study also uses the generalized method of moments estimation technique. This study tests the hypothesis that regulatory capital requirements have a significant effect on financial stability of Islamic and conventional banks (CBs) in the MENA region. This study also investigates the moderating effect of market power and concentration on the relationship between capital regulation and bank risk. Findings The estimation results support the view that capital adequacy ratio (CAR) has no significant impact on credit risk of Islamic banks (IBs), whereas market competition does play a significant role in shaping the risk behavior of these institutions. This study report opposite results for CBs – an increase in the minimum capital requirements is followed by an increase in a bank’s risk level, which has a negative impact on their financial stability. Furthermore, the results support the notion of a non-linear relationship between banking concentration and bank risk. The findings inform the regulatory authorities concerned with improving the financial stability of banking sector in the MENA region to set their policy differently depending on the level of concentration in the banking market. Research limitations/implications This study contributes to the literature on the effectiveness of regulatory reforms (in this case, capital requirements) and market competition for bank performance and risk-taking. In regard to IBs, capital requirements are less effective in requiring IBs to adjust their risk level according to the Basel III methodology. This study finds that IBs’ risk behavior is strongly associated with market competition, and therefore, the interest rates. Moreover, banks operating in markets with high banking concentration (but not necessarily, low competition), will decrease their credit risk level in response to an increase in the minimum capital requirements. As a result, these banks will be more stable compared to their conventional peers. Thus, regulators and policymakers in the MENA region should restrict the risk-taking behavior of IBs through stringent capital requirements and more intense banking supervision. Practical implications The practical implications of these findings are that the regulatory authorities concerned with improving banking sector stability in the MENA region should proceed differently, depending on the level of banking market concentration. The findings inform regulators and policymakers to set capital requirements at levels that would restrict banks from taking more risk to increase their returns. They are also important for bank managers who should avoid risky strategies in response to increased regulatory pressure (e.g. increase in the minimum required capital level of 8%), as they may lead to an increase in the level of non-performing loans, and therefore, a greater probability of bank default. A future extension of this study will focus on testing the effect of bank risk-taking and market competition on the capitalization levels of banks in the MENA countries. More specifically, this study will investigates if banks raise their capitalization levels during the COVID-19 pandemic. Originality/value The analysis of previous research indicates that there is no unambiguous answer to the question of whether IBs perform differently than CBs under different competitive conditions. To fill this gap, this study examines the influence of capital regulation and market competition (both individually and interactively) on bank risk-taking behavior using a large sample of banking institutions in 18 MENA countries over 14 years (2005–2018). For the first time in this line of research, this study shows that the level of market power is positively associated with the level of a bank’ insolvency risk. In others words, IBs operating in highly competitive markets are more inclined to take a higher risk than their conventional peers. Regarding the IBs credit risk behavior, this study finds that market power has a limited impact on the relationship between CAR and risk level. This means that IBs are still applying in their operations the theoretical models based on the prohibition of interest.

Bank performance before and during the COVID-19 crisis: Does efficiency play a role?

“…We also present some estimates for the Lerner index and Boone indicators for the sample countries included in the analysis. In line with Mateev et al ( 2022a , b , c ), we do find “a significant difference in the level of market power as measured by the Lerner index and Boone indicator between the two samples. The overall Herfindhal-Hirschman index (HHI) is 0.20, which is considered “moderately concentrated” for all countries in the sample, with the mean difference strongly significant at the 1% level of significance” (p. 13).…”

“…Our results in Table 2 support previous research findings on banks in the MENA region (Haque, 2019 ; Mateev and Bachvarov 2021 ; Mateev et al 2022a , b , c ). Table 2 confirms the Mateev et al ( 2022c ) finding; “when we compare the insolvency risk (measured by distance to default, or Z-score) between the two groups of banks, we find that CBs are much less risky than IBs (2.70 vs. 2.13). Moreover, we observe that IBs have higher credit risk measured by non-performing loans to gross loans (NPL/GL) ratio” (p. 10).…”

“…The banks’ financial stability issue during the COVID-19 pandemic also attracted growing interest among the academic community. Extant research “supports the notion that during the financial crisis, capital responses to the risk-taking behavior of banks are not similar to the normal economic conditions” (Mateev et al 2022a , b , c , p. 2). Moudud-Ul-Huq ( 2021 ) finds “that higher capital promotes banks’ financial stability by lessening the risk, and higher risk impedes capital growth.…”

“…We use unbalanced panel data for 225 banks in the MENA region obtained from Bureau van Dijk’s Bankscope database and the annual reports of the sample banks. Following Mateev et al ( 2022c ), we use “other secondary data sources such as the World Bank's World Development Indicators (WDI), International Financial Statistics, and annual reports of the central banks to collect macroeconomic data” (p. 6). The analysed period is extended to 15 years and represents the years for which financial and accounting data are available for each bank in the MENA countries.…”

“…A recent study by Li et al ( 2021 ) investigated “the effect of the COVID-19 pandemic on the relationship between the use of non-interest income and bank profit and risk and reported, “that noninterest revenue sources are positively related to performance but inversely related to risk” (p. 1). The study recommends banks “follow a portfolio diversification approach during the pandemic that can be beneficial for banks expanding beyond the traditional lending sources of income” (Mateev et al 2022c , p. 4). However, on the negative side, when banks move to non-interest income sources, they face higher credit risk (NPL) and more income instability (Ammar and Boughrara 2019 ).…”