Voluntary capital buffers and risk-taking in dual banking systems

This paper examines how the voluntary capital buffers, the excess capital that banks hold above regulatory minimum requirements, affect risk-taking in dual banking systems where Islamic and conventional banks coexist. We draw on insights from the Lucas tree theoretical framework and utilize data on 284 banks across 17 countries from 2000 to 2019, employing a two-step GLS. Our contribution lies in showing that, unlike mandatory requirements, voluntary capital buffers play a risk-mitigating role in dual banking systems, particularly for Islamic banks. The main takeaway is that voluntary capital buffers, unlike mandatory requirements, are stabilizing. Moreover, the stabilizing impact of voluntary buffers is more pronounced for smaller banks and in more competitive environments, highlighting the critical role of bank type, size, and market structure in the capital buffer-risk relationship. These findings challenge the one-size-fits-all approach to bank regulation and underscore the need for tailored capital policies that embrace institutional diversity. • We use the Lucas tree model to capture risk dynamics in dual banking systems. • Capital buffers reduce risk more for Islamic banks than conventional banks. • Competition strengthens the risk-reducing role of capital buffers. • Capital buffers reduce risks for small banks in competition but not for large banks. • Tailored regulations for Islamic and conventional banks enhance stability.