Islamic Banking and Bank Stability in Pakistan: Evidence from the Post-2021 Macro-Financial Stress Period

Abstract

This study analyzes the correlation between Islamic banking and bank stability in Pakistan in the period of macro-financial stress after 2021. The study is inspired by the serious deterioration in the macroeconomic scenario of Pakistan since 2021, which has led to high inflation, monetary tightening, exchange-rate pressures, fiscal vulnerabilities, external financing constraints and increasing uncertainty. The study creates a balanced panel of seven Pakistani banks (five conventional and two full-fledged Islamic banks) for a period of 2022–2024 using the financial information provided by the banks in their annual reports, PACRA and VIS financial summaries, stock exchange filings, and publications of the State Bank of Pakistan (SBP). The most important indicators of bank stability are based on accounting metrics, such as the Z-score, which uses ROA, EQUITY, and the volatility of ROA from 2020 to 2024. Based on empirical results, Islamic banks were found to be more profitable than conventional banks in the study period. The average ROA of Islamic Banks was 2.04% compared to 1.26% of conventional banks and average ROE was 40.17% and 23.31% respectively. The stability results give a more complicated result. Conventional banks' average Z-Score (M = 38.97, SD = 22.96) was significantly higher when compared to that of Islamic banks (M = 11.88, SD = 1.69). The difference between the two is statistically significant (t = 4.54, p < .001) and is confirmed by a non-parametric Mann–Whitney test (U = 90, p < .001). A robustness check excluding one conventional bank (United Bank Limited), which has an unusually low historical ROA volatility and therefore mechanically inflates its Z-score, was also performed; the direction and significance of the result did not change and was strengthened (t = 8.14, p < .001, Cohen's d = 2.96). It can therefore be concluded that the results do not support the proposition that Islamic banks were automatically more stable than conventional banks during the post-2021 period. The results, on the other hand, indicate that Islamic banks had a higher profitability, with also a lower variableness of profitability, leading to a lower distance-to-insolvency measure under the used Z-score specification. The findings are supported by overall macro-balance of the SBP that the Islamic banking industry remained well capitalized, liquid, able to handle asset quality and continuously expanded its balance-sheet. The study findings indicate that Islamic banking was resilient and that resilience cannot be confused with a higher bank-level Z-score for Islamic banking. The conclusions drawn have far-reaching implications for the risk management in Islamic banks, macroprudential regulation, liquidity management, and future development of Pakistan's dual banking system.

Keywords: Islamic banking, bank stability, Z-score, financial stability, macro-financial stress, Pakistan, conventional banking, profitability, banking risk.

https://doi.org/10.5281/zenodo.22734748