Impact of the Islamic Modes of Finance on the Profitability of Islamic Banking Sector in Pakistan

Abstract

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The persistence of Islamic finance in any economy is arguably essential to
address the economic needs of the society. The golden principles of Islam
that is, profit and loss sharing, honesty, and doing business keeping in view
the welfare of the people can play a vital role in alleviating poverty. The
primary objective of the current study is to investigate empirically the impact
of the Islamic modes of finance and their contribution in enhancing
profitability. For this purpose, time series quarterly data ranging from
2014Q1-2020Q4 of the Islamic modes of finance (including Sukuk) were
used to find their impact on the profitability of the Islamic banking sector as
measured by Return on Asset (ROA). The ARDL and bounds cointegration
approach were used to examine the level relationship among the underlying
variables. The results provided strong evidence of a long-run equilibrium
relationship. The results also showed that Murabaha, Musharaka, Istisnaa,
and Diminishing Partnership have a prominent positive and significant
impact on ROA. However, the impact of Murabaha on profitability remains
significantly higher as compared to the other modes of finance. The second
most important determinant of profitability is Musharaka, followed by
Istisnaa. The estimated value of error correction term showed a significant
adjustment towards the long-run equilibrium. These findings may help the
managers of Islamic banks in allocating funds to different modes and
portfolios for optimal returns. They may also have a big impact on the ability
of policymakers to create policies appropriate for interest-free windows and
branches. Moreover, they would allow Islamic banks to retain their
competitive edge and improve the quality of their services.