Does Capital Adequacy Moderate the Credit-Risk Effect of Profit-and-Loss-Sharing Financing in Islamic Banks? (Frontiers in Applied Mathematics and Statistics)

Summary

• The paper develops a contract-level risk-mitigation framework across ten Islamic financing instruments.p.1
• It tests whether regulatory capital adequacy dampens the link between profit-and-loss-sharing financing share and non-performing financing, using a quarterly six-country panel.p.1
• The final sample covers Indonesia, Kuwait, Malaysia, Oman, Pakistan and Saudi Arabia; Bahrain, Turkey and the UAE were excluded for not reporting the contract-type breakdown.p.4
• The interaction coefficient point estimate is 0.12, with a standard error of 0.085 and a 95% confidence interval of approximately −0.05 to +0.29.p.5
• A true coefficient of about 0.24 would be needed to be detected with 80% power at the 5% level.p.5
• Excluding Diminishing Musharakah from the PLS aggregate gives an interaction coefficient of −0.033, p = 0.841, N = 250.p.6

Key insights

1. Islamic financing risk is often analyzed as one undifferentiated category despite large differences in how ownership, control and loss are allocated across contracts.p.1
2. Certain private commercial Musharakah exposures attract a 400% risk weight under the prudential treatment.p.3
3. The lagged interaction becomes −0.1336 (p = 0.062), directionally consistent with the hypothesis but not treated as support.p.7
4. The models explain little of the within-country variation in changes in NPF (within R2 of 0.02–0.06).p.9
5. The results are best read as reflecting limited estimation precision, compatible with a true effect close to zero.p.9
6. Bank-level studies with larger cross-sections, such as one covering 63 banks, do detect significant nonlinear relationships between PLS financing and credit risk.p.7