Banks’ stability-efficiency within dual banking system: a stochastic frontier analysis

Purpose – The purpose of this paper is to examine and compare the market power and the efficiency-stability of Islamic and conventional banks in the MENA zone and South East Asia during the 2005-2012 period. Design/methodology/approach – The author applied an empirical approach in two steps. First, the author estimates the Lerner indicator, which is a measure of competition. Then, this measure is regressed and other explanatory variables on the banking “stability-efficiency” are derived simultaneously from the estimation of a stability stochastic frontier. Findings – The author concludes that increased competition in the Islamic banking sector promotes the overall banking stability. Besides, whether there is a low or high competitiveness, the size of an Islamic bank is positively related to financial stability. However, large conventional banks operating in market with limited competitiveness become more involved in the risk behavior. The author concludes that capitalization has a positive effect on stability only in case of low competitiveness. Originality/value – The originality of this research lies in the application of the stochastic frontier approach (SFA) on the Z-score indicator. This methodology enables to take into account the differences between the current and the optimum stability that each bank can achieve, thus creating a new measure of financial stability called “efficiency-stability”.