Credit Risk of Islamic Banking and Macroeconomic factors in a Dual Banking System: Evidence from Malaysia.

Abstract

Understanding the effects of the macro-economic environment’s dynamics on the credit risk of Islamic banking in a dual banking system is imperative to the efficiency and stability of the Islamic banking industry. This study empirically investigates the effects of macroeconomic factors on the credit risk of Islamic banking in an economic and financial environment where conventional and Islamic banking systems operate under different statutory and regulatory environments such as the case in Malaysia. The study employs Dynamic Ordinary Least Squares (DOLS) Cointegration Modelling Approach using data from 2007 to 2022. The study finds a significant negative long-term relationship between the Islamic banking credit risk and economic growth (GDP). A positive and significant long -run relationship was found between credit risk of Islamic banking and the conventional interest rate. Foreign currency exchange rate and inflation did not show long-run relationship with the credit risk of Islamic banking in Malaysia. The findings of this study further underscore the need for understanding the effects of the macroeconomic factors not only on conventional banks, but also on the Islamic banking system. Of significant importance is the effect of conventional interest rate having positive long-run relationship with Islamic banking. Findings of this study are expected to benefit not only Islamic bank managers but equally of importance to regulatory authorities, financial analysts and policy makers both in government and business..