Capital decision of Islamic and conventional banks in high-income and middle-income countries: an interaction effect of cost efficiency

Banks must maintain adequate capital at all times; the importance of this cannot be overstated. This has become a crucial aspect of bank operations that helps ensure financial stability by safeguarding depositors and building trust in the banking system. The current study investigates the capital decision of Islamic and conventional banks in High-Income and Middle-Income (HIMI) countries from 1995 to 2024. With the absence of endogeneity, the analysis utilizes a static model involving 2,072 unbalanced panel data points taken from 10 HIMI countries spanning from 30 years. The final estimation employs a random effects model using cluster standard errors to address both heterogeneity and serial correlation. Interestingly, cost efficiency emerges as playing a pivotal role in influencing the relationship between bank diversification and capital level. The interaction effect is evident in the individual models of conventional banks, High-Income countries, and Middle-Income countries. High efficient banks are found to reduce their capital level when diversification activities increase. However, the relationship becomes positive for low cost-efficient banks in High-Income countries, implying that stronger capital buffers are maintained when diversification increases. Following the trade-off theory, Islamic and conventional banks in HIMI countries are found to reduce their capital level to support bank growth. Nevertheless, the moral hazard issue of being ‘Too Big to Fail’ (TBTF) is prevalent for both the conventional bank and High-Income country models. This validates the lack of market discipline among larger banks due to the belief that they are TBTF. In another notable finding, the capital decision of banks is influenced by the institutional characteristics and different income group level. Banks operating in High-Income countries reveal to hold significantly higher capital level than those banks in Middle-Income countries. In particular, Islamic banks in both High-Income or Middle-Income (HIMI) countries are revealed to significantly hold lower capital than conventional banks in HIMI countries. Despite this, during crises, the capital level of banks in High-Income countries is significantly higher than non-crisis period. The study recommends that the relevant regulatory bodies to coordinate the existing capital regulation with the distinct institutional characteristics and economic environment of the country. Greater emphasis should be placed on bank growth, whereby both Islamic and conventional banks need to strengthen their capital level as they expand. The study suggests banks to strategically strategize their diversification activities depending on the cost efficiency level to enhance the capital level. Above all, central banks should strengthen regulatory oversight, especially on larger conventional banks and those larger banks operating in High-Income countries, to mitigate the domino effect that could arise from the moral hazard of TBTF. Furthermore, it is equally important for banks to embrace the risk absorption hypothesis when engaging in high-risk activities to maintain bank stability and mitigating the impact of future shocks. Overall, the study contributes to the existing literature and regulatory practice by demonstrating the role of cost efficiency in shaping more effective capital risk management strategies, thereby supporting both regulators and banking institutions in strengthening capital adequacy and overall financial stability.