The Effect of Market Power on Stability and Performance of Islamic and Conventional Banks

Bank-level panel data are used to test the effects on risk and returns, of market power, banking and bank-environment activities with respect to a total of 175 Islamic and conventional banks in 12 Middle Eastern countries. By incorporating the traditional SCP and the RMP hypotheses, I assess the relatively high bank returns in Islamic banking system. The results indicate that Islamic banking systems are generally biased toward the RMP hypothesis, but there is evidence that supports the traditional SCP paradigm in conventional banks. I find that interest rate spreads appear to present conventional banks with a trade-off between risk and returns. Off-balancesheet activities increase bank profitability and stability for both markets. Furthermore, most of other bank-specific and macroeconomic variables such as capital adequacy, liquidity and cost efficiency are significant, although their impact and relation with profits and stability is not always the same for Islamic and conventional banks. Finally, in the extended dynamic model, the results show that profitability persists strongly, suggesting that a departure from a perfectly competitive market structure may be very substantial.