We investigate the reasons for the growing demand for Islamic banking internationally, and examine the relative economic performance of Islamic banks compared with conventional banks in managing their capital buffers and liquidity. Using data for the period 2000–2012 for 104 Islamic and 619 conventional listed and non-listed banks spread across 22 countries with both these types of banks, and using standard statistical methodology for archival data analysis, we find that religious, political, and socio-legal factors, rather than economics alone, play key roles for Islamic banks in attracting depositors. Governed by Islamic (Shariah) laws, these banks cannot lend money and charge interest. Depositors are not debt holders as in conventional banks, but investment partners that share in the risk, or profit-loss sharing (PLS), with the bank. As Islamic banks have no debt holders, and depositors self-select to bank with Islamic banks, economic theory suggests a reduced need for excessive (less productive) liquidity buffers. However, we find that Islamic banks maintain significantly higher liquidity buffers than their conventional counterparts. A main contribution of our study is to highlight the fact that standard economic measures alone may be inadequate to assess the performance of Islamic banks.
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