Impact of Shariah Compliance on Financial Performance of Islamic Banks: Evidence from Pakistan
Abstract
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Despite the remarkable growth of the Islamic banking industry over the past
few decades, its Shariah legitimacy is still debated. In this regard, most of
the pronouncements of Shariah scholars are deduced from secondary
sources of Islamic jurisprudence which are open to diverse interpretations.
In general, the well-known Islamic legal maxim “Al-Kharaj bil Dhaman”
suggests that each Shariah compliant business should be exposed to some
kind of risk. Arguably, while pursuing the goal of profit maximization,
Islamic banks offer such risk free modes of financing that undermine their
Shariah legitimacy. In this context, some studies explored the relationship
between Shariah compliance and profitability. These studies mostly
reported mixed findings because they measured Shariah compliance using
irrelevant or limited proxies. In light of these findings, the purpose of the
current study was to revisit this relationship by applying a more
comprehensive proxy to measure Shariah compliance of Islamic banks. To
this end, it analyzed unbalanced panel data extracted from the annual reports
(2008-2020) of five full-fledged Islamic banks operating in Pakistan.
Applying the robust fixed effect model, it found a significant positive
relationship between Shariah compliance and financial performance,
suggesting that better Shariah compliance leads to improved financial
performance.
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