Regulation, ownership and bank performance in the MENA region: Evidence for Islamic and conventional banks

Highlights

• We investigate the effect of regulation and ownership on bank profitability in the MENA region.

• We find that the effect of regulation is reinforced in banks with high level of ownership concentration.

• Regulatory measures have a significant influence on the profitability of CBs, whereas this effect is insignificant for IBs.

• However, regulatory effects depend on the type of ownership prevailing in IBs but not in CBs.

Abstract

This paper investigates the impact of regulation and ownership on the performance of banks in 19 countries in the Middle East and North Africa (MENA) region. We test the hypothesis that the effect of regulation on bank profitability depends on the type of ownership structure. The public and private views of bank regulation are also tested along with the interaction of bank regulation and ownership. We find regulation measures to have a strong influence on bank profitability, whereas ownership structure seems to play a limited role in explaining bank performance in the MENA region. The results support the private view of bank regulation and suggest that capital requirements and private monitoring when interacted with ownership concentration exert a strong influence on bank profitability. When the analysis is done separately for conventional and Islamic banks, we find that the impact of bank regulations though strongly significant, does not depend on the type of ownership structure prevailing in conventional banks. In contrast, regulatory effects seem to be important drivers of profitability of Islamic banks. Therefore, it is very important for policy makers in these countries not to treat the two types of banks identically when setting up and implementing bank regulations especially during the COVID-19 pandemic.

Introduction

This study investigates the impact of bank regulation and ownership on the performance of banks in the countries that belong to the Middle East and North Africa (MENA) region. The financial markets are unique in the MENA region as compared to the rest of the world given the stronger reliance on bank finance, and the higher level of governance ownership in banks, especially in the oil exporting countries (Haque and Brown, 2017). Therefore, investigating the issue of the impact of regulation and ownership on bank performance in this region is an important contribution to the existing literature. More specifically, we address the following two questions: (i) Is the effect of regulation and ownership on bank profitability significant? (ii) How different is the impact of bank regulation and ownership on the profitability of conventional and Islamic banks?

Prior literature reports that the occurrence of the recent global financial crisis significantly affected market competitiveness and bank risk taking, which in turn influenced bank performance and stability (Soedarmono et al., 2013). Moreover, the banking sector reforms and initiatives in the post-crisis period such as increased capital stringency and more intense banking supervision altered risk-taking behavior and efficiency of banks across the world (Haque and Brown, 2017, Bace and Ferreira, 2020, Yang et al., 2019). Despite the ongoing debate on the importance of regulatory reforms, there are limited empirical studies that examine the impact of bank regulation (in particular, Basel II Capital Accord regulations) on bank risk and performance in the MENA region. The adoption of the Basel II requirements in the MENA region was intended to align bank regulation with the level of sophistication of a country's financial system (Rocha et al., 2011).

A study by Mohseni-Cheraghlou (2012) reports a 92% regional compliance with Basel II provisions in relation to the disclosure of off-balance sheet items and risk management framework. Previous research reports that MENA countries have made substantial progress in relation to higher provisioning rates, tightening of personal loans, and the disclosure and sharing of credit information by financial institutions via “public credit registries or private credit bureaus” (Ayadi and De Groen, 2013). Moreover, the supervisory authorities of a number of GCC countries tend to have greater independence, even though they cannot replace management or to declare a bank insolvent. Other major challenges for the region include weak political power of the central banks, poor enforcement of regulatory guidelines, and a lack of effective supervision with limited supervisory expertise (Rocha et al., 2011). Therefore, the introduction of Basel II guidelines on bank capitalization, official supervisory power, and market discipline had strong policy implications for the MENA countries.¹

Despite the importance of financial reforms, there are still a limited number of studies that examine the influence of regulation and/or ownership on bank performance in the MENA region (see e.g., Sassi, 2013; Haque and Brown, 2017). The primary purpose of this paper is to determine whether the impact of regulation and ownership on bank performance is different between conventional banks (CBs) and Islamic banks (IBs). We also investigate the relationship between bank regulation and the type of ownership structure prevailing in each banking system. The analysis of this issue becomes more important at least for two reasons: (i) IBs have become systemically relevant as they grow and increasingly interact with CBs that are systematically important, (ii) the lack of understanding of how the regulatory policy should be shaped to better reflect the governing principles of Islamic banking. To fill in this gap, we estimate the impact of regulation and ownership on bank profitability of a sample of 308 banks (226 CBs and 82 IBs) in 19 countries in the MENA region, over a period of eleven years (2005–2015). We find that regulatory measures and ownership do have a differential impact on IBs. Therefore, it is very important for policy makers as regulators not to treat the two types of banks identically when setting up and implementing bank regulations.

We contribute to the empirical literature in several ways. Prior literature focusing on the MENA region investigates the impact of regulation on the efficiency of banks and finds that capital regulations have a positive effect on bank efficiency (Chortareas et al., 2012; Barth et al., 2013), whereas the impact of activity restrictions on efficiency is negative. An opposite effect of capital regulations and activity restrictions is reported by Pasiouras et al. (2009) and Sassi (2013). However, the effect on bank profitability is unknown. To fill in this gap, we test the public and the private views of bank regulation along with the interaction of bank regulation and ownership. We find that in line with the private interest view, official supervisor power and capital restrictions decrease the level of profitability of a bank; however, activity restriction and private monitoring have an opposite effect. Second, previous research reports that the effect of regulation may depend on the type of ownership of banks in the MENA region but the evidence is very limited (see e.g., Haque and Brown, 2017). Our analysis provides further support to the hypothesis that ownership structure has a strong impact on the relationship between regulatory measures and bank profitability. We find that the interaction effects are significant only for ownership concentration. More specifically, the effect of capital regulation (private monitoring) when interacted with ownership concentration leads to a negative (positive) effect on bank profitability.

Third, the question of whether the effect of regulation and ownership is different between conventional and Islamic banking has not been investigated so far. Our analysis shows that regulatory measures have a significant influence on the profitability of CBs, whereas this effect is insignificant for IBs (except for capital regulations). When regulatory measures are interacted with ownership type, the interaction effect is insignificant in the sample of CBs (except for ownership concentration). In contrast, we find strong evidence that this effect depends on the type of ownership structure prevailing in IBs, and is more pronounced for government banks and banks with high level of foreign ownership. Finally, our paper extends the empirical literature on regulation and ownership by focusing on the response of banks in the MENA region for an extended period before and after the crisis. Previous research reports contradicting results. While Amba and Almukharreq (2013) find no evidence in support of the common view that Islamic banking has better weathered the recent financial crisis, Belanès et al. (2015) reports a slight decline in Islamic bank efficiency further to the subprime crisis just like their conventional peers all over the world. We find a significant crisis effect only for IBs. When the observation period is divided into pre- and post-crisis periods, the analysis shows that regulatory measures have a significant influence on CBs both in the full sample period and the post-crisis period, whereas in the sample of IBs, the regulatory effects are more pronounced in the pre-crisis period.

This paper tries to fill in two major gaps in the existing empirical literature. The first gap is related to the issue of whether the effect of regulation depends on the type of ownership structure of banks in the MENA region. In a previous study, Haque and Brown (2017) examine how ownership and bank regulations individually and interactively influence the efficiency of banks in the MENA region. They find bank regulation to have a positive effect on cost efficiency in the post global crisis period and full sample period, suggesting improvements in the post-crisis period. However, their analysis reaches inconclusive evidence in regards to the effects of ownership and bank regulation on profit efficiency. Furthermore, the research is silence about the differential impact of regulation on the performance of IBs. Our analysis reveals that the influence of Basel II regulation and ownership on bank profitability is significantly different between the two banking systems in the MENA region. More specifically, the relationship between regulatory measures and ownership structure is reinforced only in the sample of IBs. The second gap is related to the impact of regulatory reforms on bank performance before and after the Global Financial Crisis (GFC), and whether this impact is different between IBs and CBs.² The previous studies (see e.g., Olson and Zoubi, 2016) that examine the effect of GFC on the performance of CBs and IBs in the MENA region find that IBs were more profitable and more financially stable than CBs prior to the GFC; however, as the crisis spread to the real economy in 2009, IBs noticeably underperformed compared to CBs. However, none of them has focused on the effects of regulation and ownership on the performance of the two banking system, before and after the crisis. To the best of our knowledge, we are the first to analyze this issue. We find that regulatory measures have a significant influence on CBs both in the full sample period and the post-crisis period. However, in the sample of IBs, regulatory effects are more pronounced in the pre-crisis period, but appear to be weak and therefore to improve in the post-crisis period.

The policy implications of our findings are that regulators and policy makers in the MENA region should carefully tailor the banking reform initiatives such as capital stringency and more intense banking supervision that may restrict risk-taking behavior and improve the efficiency of banking systems in these countries. The contribution of our paper is also related to the growing empirical literature that studies the economic impact of the pandemic on bank performance. For example, Demirguc-Kunt et al. (2020) analyze bank stock prices around the world (including the MENA region) to assess the impact of the COVID-19 pandemic on the banking sector. Using a global database of policy responses during the crisis, the paper also examines the role of financial sector policy announcements on the performance of bank stocks. The results show that the impact of prudential measures (which deal with the temporary relaxation of regulatory and supervisory requirements, including capital buffers) appeared to be limited, except in countries that are not part of the Basel Committee, where such policy initiatives have a negative impact on bank returns. In line with this finding, our paper suggests that regulators should require a more disciplined approach in bank lending decisions and building a sufficient capital conservation buffer to limit the impact of downside risk from depletion of capital buffers which is perceived to be significant during the pandemic.

The paper proceeds as follows. In section 2 we present the main findings of our analysis of the existing literature and formulate our hypotheses. In Section 3, we introduce the data set and the methodology that we use. In Section 4, we examine the effect of regulation and ownership on bank performance while controlling for bank-level characteristics and country macroeconomic conditions. Section 5 presents robustness checks and alternative specifications. We conclude in Section 6.