Islamic bank incentives and discretionary loan loss provisions

• We examine whether Islamic banks utilize loan loss provisions differently from conventional banks.
• Our results show that Islamic banks provide lower provisions than their conventional counterparts.
• We find an inverse relationship between profit distribution management and loan loss provisions.
• Results are sensitive to whether such management is for benefit or detriment of investment depositors.
• There is a need for more thorough supervision and improved disclosure for investment accounts.

The objective of this paper is to ascertain whether there are significant differences in the loan loss provisioning behaviour of Islamic banks as compared to conventional banks. We proposed that loan loss provisioning will be linked to the extent of profit distribution management. The results suggest that Islamic banks consistently record lower loan loss provisions. However, the association between profit distribution management and loan loss provisioning is mixed. The overall results tend to suggest that there is an inverse relationship between profit distribution management and loan loss provisions. The results also suggest that there are differential effects depending on whether the profit distribution management is for the benefit or the detriment of investment depositors. If there is a surplus of asset returns over profit distributions (positive profit distribution management), it is observed that Islamic banks increase their loan loss provisions. However, this result does not extend to the full sample containing both Islamic and conventional banks. Further, there is no effect where the profit distribution management is for the benefit of investment depositors.