How Quality of Institutions Shape the Expansion of Islamic Finance

The Arab Spring is expected to enhance the weak quality of institutions in MENA countries. We show in this paper how these changes can contribute to favor the expansion of Islamic finance by analyzing the role of quality of institutions on cost efficiency of Islamic and conventional banks. We measure cost efficiency of banks on a wide dataset of banks from 17 countries in which Islamic and conventional banks coexist. We find that Islamic banks have lower cost efficiency than conventional banks, which can hamper their expansion, as greater costs are associated with higher prices. However better quality of institutions reduces the gap in efficiency between Islamic and conventional banks. Moreover we find that, if Arab countries can increase the quality of institutions, Islamic banks will not suffer from a disadvantage in efficiency relative to conventional banks. Thus, our main conclusion is that the Arab Spring can favor the development of Islamic finance by improving the quality of institutions.