Investigation of credit risk-performance relationship in Islamic banks in Pakistan

Abstract

Pakistan financial sector was influenced by the 2007-08 global financial crises (GFC), particularly its banking industry suffered the most. Both conventional banks, as well as, Islamic banks showed serious concerns of not having proper risk management systems to desist from the vulnerabilities of crises. Out of six, two full-fledged Islamic banks could not absorb the GFC’ shocks and resultantly, one of them was dissolved, while the other amalgamated. To know the extent, of which the GFC affected the Islamic banks’ credit risk that ultimately deteriorated the performance of one-third of Islamic banks in Pakistan, this study was motivated to analyze the GFC impact on the credit risk and performance relationship in Islamic banks. The study therefore, investigates the relationship between performance and credit risks and impact of GFC on this relationship of all full-fledged Islamic banks operating in Pakistan during the period 2002QII-2012QIV. On the basis of Islamic banks’ quarterly published data, Seemingly Unrelated Regression (SUR) model is applied for the analysis of unbalanced panel data at aggregate banks level and at the individual bank level. This study is not only attempts to present a comprehensive analysis to investigate the credit risk-performance relationship of Islamic banks in Pakistan’ at both the aggregate and individual banks’ levels, but also explores the GFC impact on this relationship during three periods of the crises, pre-crisis period 2005-07, the crisis period 2007-09 and the post-crisis period 2009-12. The findings reveal that size, funding cost, regulatory capital, risk weighted assets and risky sector financings have significant relationships with profitability, liquidity and financing variables of Islamic banks’ performances, both at aggregate bank level and individual bank level. The study also confirms the negative relationship between credit risk predictors and performance variables of Islamic banks in Pakistan. Further, the results exhibit that the GFC impact on this relationship found to be more influential during the crisis period as compared to the pre-crisis period and post-crisis period. This happened because of the unavailability of risk evasion measurements with Islamic banks in Pakistan. The findings suggest several policy implications: Firstly, Islamic banks’ should develop early warning systems to desist from vulnerabilities of such crises in future. Secondly, serious attention should be given by banks taking into account those performance variables that have significant relationships with the credit risk. Thirdly, Islamic banks need to develop sustainable systems to examine the worthiness of borrowers that help reduce the default risks. Fourthly, regulator should conduct periodic reviews on the quality of financing disbursed to borrowers to enhance the confidence of the general public in Islamic banking. Finally, regulator should ensure the effectiveness and implementation of its existing policies to prevent banks from financing/disbursements to risky sectors. A cross country study is recommended to develop generalized conclusion.