Examining the relationship between default risk and efficiency in Islamic and conventional banks

We examine the relationship between efficiency and default risk in Islamic banks (IBs) and conventional banks (CBs) in Gulf Cooperation Countries (GCC) and three non-GCC countries over the period 2002-2010. To the best of our knowledge this is the first study to consider the efficiency-default risk paradigm in a comparative setup which includes IBs. Efficiency and default risk are measured using the Stochastic Frontier Approach and distance to default (Merton's model) respectively. The existence of causality/reverse causality between the two is addressed via a panel Vector Auto Regression (VAR) framework. Our analysis shows that the relationship between profit efficiency and default risk banks across the sample, for CBs and for the GCC is such that a decrease in default risk is associated with lower efficiency levels. With the single exception of IBs, the causality from profit efficiency to default risk is inversely related for all categories. For CBs, the trade-off between efficiency and risk is evident. The absence of a trade-off for IBs suggests that efficiency and default risk are plausible early warning indicators of IB instability. These findings could be of relevance to regulators in countries where both banking system co-exist.