Examining the relationship between default risk and efficiency in Islamic and conventional banks in the GCC and three non-GCC countries

This paper examines 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. Efficiency and default risk are measured using Stochastic Frontier Approach (SFA) and Distance to Default (D-to-D) (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, CBs and GCC is such that a decrease in default risk is associated with lower efficiency levels. With the exception of IBs, the causality from profit efficiency to default risk is inversely related across all categories. For CBs, the trade-off between efficiency and risk is evident. The absence of a trade-off in IBs suggests that efficiency and default risk are plausible early warning indicators of IBs instability.