Please cite this article in press as: Saeed, M., Izzeldin, M., Examining the relationship between default risk and efﬁciency in Islamic and conventional banks. J. Econ. Behav. Organ. (2014), http://dx.doi.org/10.1016/j.jebo.2014.02.014 ARTICLE IN PRESS G Model JEBO-3301; No. of Pages 28 Journal of Economic Behavior & Organization xxx (2014) xxx–xxx Contents lists available at ScienceDirect Journal of Economic Behavior & Organization j ourna l h om epa ge: w ww.elsevier.com/locate/jebo Examining the relationship between default risk and efﬁciency in Islamic and conventional banks  Momna Saeed ∗ , Marwan Izzeldin Department of Economics, Lancaster University Management School, Lancaster University, UK a r t i c l e i n f o Article history: Received 15 November 2012 Received in revised form 7 August 2013 Accepted 14 February 2014 Available online xxx JEL classiﬁcation: C33 G21 D240 Keywords: Islamic banking Banking efﬁciency Stochastic Frontier Analysis Default risk Merton’s model Panel VAR a b s t r a c t We examine 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. To the best of our knowledge this is the ﬁrst study to consider the efﬁciency–default risk paradigm in a comparative setup which includes IBs. Efﬁciency and default risk are measured using the Stochastic Frontier Approach and distance to default (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, for CBs and for the GCC is such that a decrease in default risk is associated with lower efﬁciency levels. With the single exception of IBs, the causality from proﬁt efﬁciency to default risk is inversely related for all categories. For CBs, the trade-off between efﬁciency and risk is evident. The absence of a trade-off for IBs suggests that efﬁciency and default risk are plausible early warning indicators of IB instability. These ﬁndings could be of relevance to regulators in countries where both banking system co-exist. © 2014 Elsevier B.V. All rights reserved. 1. Introduction The recent ﬁnancial crisis remains as a stark reminder of the need to monitor the health of the banking industry. An increase in the tendency to default remains a good indicator of riskiness in banks; and this has gained much attention given the association of defaults with ﬁnancial instability (Porath, 2004). There are only two studies of note: Koutsomanoli- Filippaki and Mamatzakis (2009) and Koetter and Porath (2007) provide comprehensive evidence on the causality between efﬁciency and default risk.  This paper has beneﬁted from comments by Abdelhaﬁd Benamraoui, Meryem Duygun, Gerry Steele and an anonymous referee. We also thank partic- ipants at the 2012 IFABS Conference on Rethinking Banking and Finance: Money, Markets and Models in University of Valencia, Spain, and the discussant and participants at the JEBO Islamic Finance Conference 29th September to 1st October 2012 for valuable suggestions. Financial support from Gulf One Investment Bank, Bahrain, is gratefully acknowledged. We thank Jullian William for providing us with the MATLAB routines to calculate D-to-D. We would also like to thank Lea Zicchino and Inessa Love for providing the codes for panel VAR estimation. ∗ Corresponding author. Tel.: +44 01524592930. E-mail address: m.saeed@lancaster.ac.uk (M. Saeed). http://dx.doi.org/10.1016/j.jebo.2014.02.014 0167-2681/© 2014 Elsevier B.V. All rights reserved.