Determinants of credit risk of Islamic banking in a dual banking system: a case of selected Muslim countries

The level of credit risk of Islamic banking has generated a great deal of concern to the
banking regulatory authorities of many Muslim countries in the last few years. This study,
therefore, examined the determinants of the credit risk of Islamic banking within the dual
banking system of selected Muslim countries for the period 2007-2015. Autoregressive
distributed lag (ARDL) and Dynamic OLS were employed to investigate the existence of a
long-run relationship between the credit risk of Islamic banking and selected bank-specific
and macroeconomic variables. Hirschman-Herfindahl-Index (HHI) was also employed to
detem1inc the level of financing concentration by the banks. Evidence from ARDL indicates
the existence of a long-run relationship between the credit risk of Islamic banking and
financing-deposit gap, real income, money supply, interest rates, credit expansion, and
exchange rate in Malaysia, Indonesia and Bahrain. Similarly, evidence from HHI reveals the incidence of financing concentration by Islamic banks in these countries. Furthermore,
evidence from Dynamic OLS indicates the existence of a long-run relationship between credit risk and financing concentration in Islamic banking in Malaysia and Bahrain. The inherent risk in financing concentration patircularly in the household and consumer sectors indicates the presence of moral hazard in Islamic banking financing. The implication of the findings of the study suggests that the managements of Islamic banks and the relevant regulatory authorities need to further strengthen the existing credit risk management and monitoring strategies to prevent the incidence of the banking crisis and Islamic banking failure. The understanding of
the existence of moral hazard in financing concentration will also guide relevant stakeholders in Islamic banking to ensure that banks are not only Sharia-compliant but also ensure optimum financing portfolio mix that can guarantee the long-run interest of their stakeholders and the overall financial system stability.