Impacts of Bank-Specific and Macroeconomic Risks on Growth and Stability of Islamic and Conventional Banks: An Empirical Analysis from Pakistan

Abstract

The implications of bank-specific risks and macroeconomic risks on the growth, profitability, and stability of Islamic and conventional banks are examined and compared in this article. The study also investigates whether corporate governance mitigates the effects of both bank-specific and macroeconomic risks on Islamic and conventional banks' development, profitability, and stability. For the period 2007-2019, we examined a panel data set of 22 banks in Pakistan, including both Islamic and conventional banks. We discovered considerable evidence that both bank-specific risks and macroeconomic risks have negative effects on the growth, profitability, and stability of Pakistani banks using a dynamic panel data estimator, the two-step Generalized Method of Moments (GMM) approach. Furthermore, the findings show that bank-specific and macroeconomic risks have different consequences in both types of banking. The impacts of liquidity risk, operational risk, capital risk, inflation risk, and exchange rate risk are higher for Islamic banks than for conventional banks. Conventional banks, on the other hand, are more vulnerable to credit risk and interest rate risk. Finally, the findings show that good corporate governance reduces the negative consequences of both categories of risks on bank development, profitability, and stability. This is true for Islamic and conventional banks alike.

1. Introduction

Banks play a significant role in the smooth operation of a country’s economy. Financially stable banking is considered a prerequisite for sustainable economic development. The banking sector performs the important function of economic acceleration and financial intermediation by transforming deposits into productive investments. Typically, banks operate in a highly uncertain environment (Al-Tamimi & Obeidat, 2013). They are exposed to several risks like credit, market, liquidity, reputational, operational, and compliance/regulatory risk, which may adversely affect bank performance. The effects of various types of risks on banks’ growth, profitability, and stability are critical for evaluating the overall performance and success of banks.

The study of the performance and stability of the banking sector is of good interest to researchers and policymakers in both developed and underdeveloped countries. Specifically, after the financial crises 2007/2008, the evaluation of these variables has gained dynamic attention among researchers and becomes a growing concern for bank supervisors and regulators (Ali & Puah, 2018). For instance, Rashid and Jabeen (2016) identified bank-specific, macroeconomic, and financial factors affecting bank performance in Pakistan. They documented that reserves, overheads, and operating efficiency are significant indicators of conventional banks’ (CBs) performance, whereas, deposits, market concentrations, and operating efficiency are the important factors in explaining the Islamic banks’ (IBs) performance. Additionally, interest rates and variation in GDP negatively affect the performance of both types of banks. Another study conducted by Rashid and Khalid (2017) provides evidence of the differential influence of interest and inflation rate volatility on the performance of Islamic and conven-tional banks in Pakistan. Al-Homaidi et al. (2018) showed that bank-specific determinants such as liquidity, capital adequacy, bank size, deposit, leverage, asset quality, operating efficiency, asset management, and leverage are highly significant to bank profitability. Further, macroeconomic factors like interest rates, GDP, inflation, and exchange rates have significant and negative effects on bank profitability. Moreover, Ali and Puah (2018) demonstrated that credit risk, bank size, funding risk, and liquidity risk are significant determinants of bank profitability and stability. Shair et al. (2019) reported the negative impact of insolvency risk, credit risk, and competition and the positive effect of liquidity risk on the profitability of Pakistani banks. Dao and Nguyen (2020) reported the negative influence of operational risk and capital adequacy ratio and positive effect of credit risk on banks’ profitability in Asian developing countries.

In addition to bank-specific and macroeconomic determinants, corporate governance (CG) is considered an important determinant for improvement in bank performance. The execution of good CG is most significant because it nurtures a culture of integrity and leads to sustainable and positive performing business. Further, CG provides signals to the market about the good management and performance of an organization and effective alignment of the interest of management with other stakeholders (Rustam & Narsa, 2021). Effective and sound CG implementation reduces idiosyncratic and systematic risk and plays a vital role in developing the culture of openness and transparency, and controlling the agency issues. Moreover, CG increases profit, market value, sales growth, and decreases costs of doing business (Zagorchev & Gao, 2015), and enhances the market capitalization of corporations.

The previous empirical works mainly investigated the determinants of profitability and stability, whereas the analysis of banking growth is quite limited. Secondly, limited attention was given to exploring the impact of numerous kinds of risks on banks’ growth, profitability, and stability of both types of the banking system (Islamic & conventional), comprehensively. Third, no one studied the moderating role of corporate governance in the relationship between various risks and banking growth, profitability, and stability. Few studies have attempted to determine the influence of bank-specific risks on profitability and stability in different countries and at the regional level (Al-Tamimi et al., 2015; Ali et al., 2019). These studies explored only the impact of a few bank-specific risks. Hence, it is noticeable that our study is different than previous empirical works in several ways. 1) We determine the effect of the most important bank-specific and macroeconomic risks on the growth, profitability, and stability of IBs and CBs in Pakistan. 2) We compare the effect of bank-specific and macroeconomic risks across IBs and CBs. 3) We examine whether corporate governance moderates the effect of bank-specific and macroeconomic risks.

2. Literature Review

2.1. Bank-Specific Risks

The bank-specific risks have a substantial effect on the performance of the bank. Tabari et al. (2013) examined the impact of liquidity and credit risk on the performance of Iranian banks during the sample period 2003–2010. They concluded that both liquidity risk and credit risk have a negative relation while capital, size, GDP, and inflation have a positive relation with bank performance. Al-Tamimi, et al. (2015) investigated the relationship between different financial risks and the performance of IBs operating in GCC covering the period of 2000–2012. They reported that only operational and capital risk has a significantly negative impact on the IB’s performance. Haque and Wani (2015) inspected the sample of Indian banks for 2008–2013. Their results provided evidence that capital risk, credit risk, and solvency risk are statistically significant, while interest rate and liquidity risk do not prove any substantial impact on performance.

Ghenimi et al. (2017) evaluated the influence of liquidity and credit risk on bank stability while observing the sample of MENA region banks covering the sample period 2006–2013. Their estimation results provided sound evidence that the interaction of both types of risk causes bank instability, and individually both forms of risk have extensive influence on stability. Olalekan et al. (2018) inspected the effect of financial risks on Nigerian bank’s profitability. They concluded that liquidity risk has positive but insignificant, credit risk has significantly negative, while capital risk has positive impacts on bank profitability. In the same way, Alsyahrin et al. (2018) scrutinized the influence of financing, operational, and liquidity risk on the financing of Indonesian Islamic banks covering the period of 2012–2016 and reported that all these risks significantly influence the financing. Similarly, Puspitasari et al. (2021) examines the sample of rural banks in Indonesia for the period 2009–2018. They concluded that market risk, credit risk and operational risk have vital impact on the default risk of rural banks.

H1: Bank-specific risks have negative effects on the growth, profitability, and stability of IBs and CBs.

2.2. Macroeconomic Risks

It is widely argued that unanticipated variations in macroeconomic variables can cause global effects on firm fundamentals like investment opportunities, cash flow, and risk-adjusted discount factors. Moreover, macroeconomic variables like unemployment, economic growth, exchange rates, inflation, and interest rates significantly affect the price of risky assets (bonds, stock, derivatives, and currencies) through several channels. The academicians considered inflation is the most critical indicator that has a substantial effect on the performance of a bank. The effect of inflation is contingent on whether the inflation is unanticipated or anticipated. In the case, it is anticipated, banks adjust their interest rate on loans and increase revenue faster than that of costs. Thus, inflation positively affects profitability. On the opposite side, if inflation is unanticipated, costs of banks may increase faster than revenue because the bank is lethargic in adjusting its interest rates, consequently inflation adversely affects profitability (Talbi & Bougatef, 2018).

Inflation determines the withdrawal behavior of depositors. Inflation diminutions purchasing power, where depositors tend to withdraw more funds from their bank accounts and spend immediately to guard themselves against further monetary value decline. Therefore, banks are exposed to financial instability. Likewise, foreign exchange is the important detriment contributing to international banking, and exclusive of foreign exchange international banking would be impossible as banks involved in the settlement of international payment and receipt. The appreciation of exchange rates causes an increase in bank deposits. For instance, the economy becomes more productive and competitive, importers and exporters gain more returns from their business, and hence they will deposit more money in bank accounts (Solarin et al., 2018). On the other hand, superfluous volatility in exchange-rate worsens the financial and economic stability and persuading banking crises.

Interest rate risk is considered to be the main cause of bank insolvency. Interest rates are a regular element of routine banking activities and an important source of profitability. However, it should be maintained within the prudent level, otherwise, it will lead to interest rate risk (BCBS, 2004). The cause of interest rate risk is the common banks’ features like lending for long period and borrowing short, which leads to maturity mismatch or re-pricing mismatch of liabilities and assets (Zainol & Kassim, 2012). Banks’ assets, liability, and off-balance sheet items are highly sensitive to variations in the interest rate (Ramlall, 2018) and thus affects the profitability of a bank through the influence on net interest margin.

Rashid and Khalid (2017) scrutinized the effect of real interest and inflation rate uncertainty on solvency and profitability of IBs and CBs in Pakistan over the period 2008–2015. The authors explored that both variables and their volatility have differential impacts on the solvency and profitability of IBs and CBs. Additionally, interest rate uncertainty has positive, whereas inflation rate uncertainty has negative effects on IBs solvency. Similarly, Al-Homaidi et al. (2018) explored that variations in the exchange and interest rate have negative while the inflation rate has a significant positive impact on the Indian commercial banks.

H2: Macroeconomic risks have negative impacts on the growth, profitability, and stability of IBs and CBs.

2.3. Risk Difference Across IBs and CBs

Islamic and conventional banks play similar functions of financial intermediation, but the nature and structure of products offered by Islamic banks are substantially distinct from that of conventional banks (Obaidullah, 2005). The possible reason is the compliance of Islamic banks’ operations with the golden rules of Islamic law (restriction of interest, speculation, gambling, Gharar (uncertainty), investment in illegal sectors, the purchase and sale of debt contract, derivative products, and profit-taking without real economic activity). These precise rules suggest the existence of specific financial products for IBs, the requirement for tangible assets, considering value creation from a pluralist perspective, and new affiliation between debt holders, shareholders, and managers.

The intermediation role of Islamic banks is centered on asset and risk sharing, whereas conventional banks’ intermediation function is primarily based on debt and risk transfer. As a result, the risk exposure of both types of banks differs. IBs are exposed to unique risks (displaced commercial risk, Shari’ah non-compliant risk, rate of return risk, and equity investment risk) as well as risks (credit, liquidity, operational, transparency, and legal risks) that are similar to those faced by CBs, but their implications differ due to the unique nature of IBs. In general, it appears that IBs are at a higher risk than CBs.

Srairi (2009) reported that IBs are exposed to several additional unique risks besides the basic risks faced by CBs. The additional risks may be due to their distinctive structure of liability and asset, compliance to Shari’ah requirement, and the prohibition of granted return or deposit insurance. Additionally, the reasons may be the unfamiliarity and lack of experience with all financial techniques, ban on the practice of derivatives for the use of hedging, restricted access to collateral, and recovery complications (Kabir et al., 2015). Debt-based contract made by IBs should be based upon real trade (to take and give delivery). Thus, IBs operations must be linked with the real economy, decreasing speculative trading, and avoiding derivatives and high leverage which may lead to economic instability. Moreover, under the debt-based contracts once the loan is granted then IBs are not allowed to sell the debt to any third party as the selling of debt is restricted under the rules of Shari’ah. Due to these constraints, IBs faces fewer risks related to transactions (Zainol & Kassim, 2012).

H3: Bank-specific and macroeconomic risks affect differently the growth, profitability, and stability of IBs and CBs.

2.4. Moderating Role of Corporate Governance

Sound corporate governance in banks helps to reduce financing costs and can lower the investor’s investment risk (Al-Farooque et al., 2007). Effective CG promotes stability and tolerates accurate performance monitoring, and hence reduces perceived risk (James-Overheu & Cotter, 2009). CG endorses a fair return to investors, efficient and careful resources allocation within a firm, brings better management, and enhances corporate efficiency and performance (Tai, 2015). Moreover, it reduces the level of risk and enhances the level of performance (Maurya et al., 2015). Efficient CG encourages top management to oversee the organizational resources efficiently and effectively and hence promotes transparency and accountability in an organization (Mulyadi, 2018). On contrary, the weak structure of CG triggers high levels of default risk and financial instability (Ballester et al., 2020).

In the literature, several research studies rationalized the relationship between corporate governance attributes, performance, and risk. Cornett et al. (2010) evaluated the mechanism of CG and US banks’ performance. They reported that good CG such as higher pay-for-performance sensitivity, more board independence, and higher insider ownership demonstrate positive affiliation with banks’ performance during crises. Similarly, Peni and Vahamaa (2012) documented that strong CG practices significantly mitigated the adverse impact of financial crises on bank performance and stock return, while examining the impact of CG on the performance of US banks. Chang et al. (2015) evaluated CG as a moderator in the connection between performance and risk. They reported that CG plays a role as a risk shield and companies where superior CG attributes exist report low levels of risk and high levels of performance. Moreover, Al-Gamrh et al. (2018) examined whether CG reduces the influence of risk and leverage on firm performance during and after crises. The study concluded that CG mitigates the negative impact of risk and leverage on firm performance after crises. In addition, Permatasari (2020) stated that the implementation of good CG practices has influences on bank risks, and banks with different governance ratings revealed differences in operational risk, liquidity risk, and credit risk.

H4: Corporate governance moderates the effect of bank-specific and macroeconomic risks on the growth, profitability, and stability of IBs and CBs.

3. Methodology

This study investigates a panel data set of Islamic and conventional banks operating in Pakistan over the period 2007–2019. The corporate governance, bank-specific risks, and control variables data are gathered from the annual reports of each bank. The macroeconomic risks and country-specific control variables data are taken from the published annual reports of the State Bank of Pakistan. We use the dynamic panel data estimator (the two-step system GMM method) for data analysis. The advantage of the two-step system GMM is that it eliminates the time-invariant unobservable bank-specific fixed effects by taking the first difference of each underlying variable. Further, it overcomes endogeneity problems in the regressors and controls the heterogeneity across individual banks.

3.1. Empirical Models

We estimate various empirical models to fulfill the purpose of the study. The baselines models represented in Equations (1), (2), and (3) are developed to observe the effects of both categories of risks on growth, profitability, and stability.

G_it = α + X_itβ + λBR_it + γMR_t + ε_it       (1)

P_it = ∅ + Yitβ + λBR_it + γMR_t + μ_it       (2)

S_it = δ+ Z_itβ + λBR_it + γMR_t + ν_it       (3)

G_it is the growth, P_it is the profitability and S_it is the stability of i bank at time t. α,⌀ and δ are the intercept, and ε_it, μ_it and ν_it are the error term. BR_it denotes bank-specific risks that are credit risk, liquidity risk, capital risk, and operational risk. MR_it denotes macroeconomic risks that are inflation risk, exchange rate risk, and interest rate risk. β, λ, and γ represent the coefficient of control variables, bank specific risks, and macroeconomic risks. X_it, Y_it and Z_it are the vector of control variables where X_it includes bank size, tax ratio, and cost efficiency, Y_it includes bank size, deposit, and saving, while Z_it takes in bank size, asset structure, and financial development.

Next, we examine the effects of both types of risks across IBs and CBs. Hence, we interact with two dummies in the baseline models. D_i ^IB and D_i^CBare dummy variables for IBs and CBs, respectively. D_i ^IB and (D_i^CB) take value 1 if the underlying bank is Islamic (conventional), if not, equal to 0. All other variables are as described in Equations (1), (2), and (3). The extended models are as follows.

G_it = α^IB + γ^CB + X_itβ + λ^IBBR_it × D_i^IB + λ^CBBR_it × D_i^CB + γ^IBMR_t × D_i^IB + γ^CBMR_t × D_i^CB + ε_it       (4)

P_it = ∅^IB + ∅^CB + Y_itβ + λ^IBBR_it × D_i^IB + λ^CBBR_it + D_i^CB + γ^IBMR_t × D_i^IB + γ^CBMR_t × D_i^CB + μ_it       (5)

S_it = δ^IB + δ^CB + Z_itβ + λ^IBBR_it × D_i^IB + λ^CBBR_it + D_i^CB + γ^IBMR_t × D_i^IB + γ^CBMR_t × D_i^CB + ν_it       (6)

Another purpose of our study is to evaluate whether corporate governance moderates the effect of both categories of risks on the growth, profitability, and stability of IBs and CB. Hence, the interaction term between corporate governance index (CG_it) and risk indicators are included in the bassline models.

G_it = α^IB + α^CB + X_itβ + λ₁^IBBR_it × D_i^IB + λ₂^CBBR_it × D_i^CB × CG_it + λ₃^CBBR_it × D_i^CB + λ₄^CBBR_it × D_i^CB × CG_it + γ₁^IBMR_t × D_i^IB + γ₂^IBMR_t × D_i^IB × CG_it + γ₃^IBMR_t × D_i^CB + γ₄^IBMR_t × D_i^CB × CG_it + ε_it       (7)

P_it = ∅^IB + ∅^CB + Y_itβ + λ₁^IBBR_it × D_i^IB + λ₂^CBBR_it × D_i^IB × CG_it + λ₃^CBBR_it × D_i^CB + λ₄^CBBR_it × D_i^CB × CG_it + γ₁^IBMR_t × D_i^IB + γ₂^IBMR_t × D_i^IB × CG_it + γ₃^CBMR_t × D_i^CB + γ₄^CBMR_t × D_i^CB × CG_it + μ_it       (8)

S_it = δ^IB + δ^CB + Z_itβ + λ₁^IBBR_it × D_i^IB + λ₂^IBBR_it × D_i^IB × CG_it + λ₃^CBBR_it × D_i^CB + λ₄^CBBR_it × D_i^CB × CG_it + γ₁^IBMR_t × D_i^IB + γ₂^IBMR_t × D_i^IB × CG_it + γ₃^CBMR_t × D_i^CB + γ₄^CBMR_t × D_i^CB × CG_it + + ν_it       (9)

3.2. Measurement of Variables

Banks’ growth is measured by the index of asset growth, deposit growth, and loan/financing growth. The term loan growth is for CBs, while financing growth is for IBs. Profitability is measured by the index of three proxies: Return on the asset, return on equity, and net interest/mark-up margin. Stability is measured by the Z-score. Z-score is the return on asset plus book value of equity to asset ratio divided by the standard deviation of return on asset. Explanatory variables consist of bank specific risks and macroeconomics risks. Bank-specific risks include credit risk, liquidity risk, operational risk, and capital risk. Credit risk is measured by the index of three proxies: non-performing loan to gross advances, provision against advances to gross advances, and nonperforming loan write-off to provision against advances. Liquidity risk is quantified by two proxies: current asset to total deposit and current asset to total asset. Operational risk is calculated by the index of three proxies consisting of admin expense to non-markup/interest income, non- markup/interest expense to total income, and admin expense to profit before interest and tax. Capital risk is computed by the ratio of total capital to the total asset.

Macroeconomic risks include inflation risk, exchange rate risk, and interest rate risk. Observing the moderating impact of corporate governance attributes, we construct the indexes of bank-specific risks, macroeconomic risks, and corporate governance attributes by applying the principal components analysis (PCA) technique. This study takes board size, independent directors, CEO duality, frequency of board meetings, risk management committee, and audit committee as attributes of CG (Table 1).

Table 1: Description of Variables

4. Empirical Results

4.1. Descriptive Statistics

For IBs and CBs, Table 2 shows descriptive statistics such as mean, standard deviation (SD), lowest value, and maximum value of variables. In comparison to CBs, we notice that IBs have a higher rate of growth on average. CBs, on the other hand, are more profitable on average than IBs. While the Z-score (stability) statistics show no significant differences between the two groups of institutions. Further- more, CBs have a larger average mean value of credit risk proxies than IBs. Unlikely, IBs had greater mean values for liquidity risk, operational risk, and capital risk proxies than CBs. When it comes to bank-specific control factors, CBs have a higher mean value for bank size, tax ratio, and total deposit than IBs. IBs, on the other hand, have a better average cost efficiency and asset structure than their traditional equivalents.

Table 2: Descriptive Statistics: Islamic Versus Conventional Banks

4.2. Estimation Results

4.2.1. Estimation Results: Full Sample

Table 3 shows the estimation results for the entire sample. Lagged growth, lagged profitability, and lagged stability all have positive and significant coefficients. This shows that the values of all dependent variables are stable. Panel A shows that the credit risk coefficient value is significant and negative at the 1% significant level in all three models: growth, profitability, and stability. This indicates that credit risk has a negative impact on a bank’s growth, profitability, and stability. Similarly, liquidity risk has a negative impact on growth, profitability, and stability. In terms of profitability and stability, the findings are in line with the findings of Ghenimi et al. (2017) and Hassan et al. (2017).

Table 3: Estimation Results-All Banks

Standard errors are in parenthesis. ***p < 0.01, **p < 0.05, *p < 0.1.

We find significant and negative coefficients in all models when looking at operational risk. As a result, operational risk has a negative impact on bank growth, profitability, and stability. Our findings are consistent with prior research by Al-Tamimi et al. (2015) and Alsyahrin et al (2018). Similarly, all of the models’ capital risk coefficients are significant and negative. In the case of the profitability model, our findings are in line with Mousal et al. (2018). In all models that look at macroeconomic risks, the coefficient value of all risks is negative and considerable. It indicates that changes in the rate of inflation, the exchange rate, and the interest rate hurt banks’ growth, profitability, and stability. Rashid and Khalid (2017) and Al-Homaidi et al. (2018) both came to similar conclusions.

Depositors’ purchasing power may deteriorate as a result of inflation. To safeguard themselves from further monetary depreciation, depositors withdraw their funds from banks for immediate expenditure. This will reduce bank l total deposits, resulting in financial instability. Furthermore, due to interest rate fluctuations, debt costs may overtake banks’ asset revenue. Furthermore, interest rate volatility affects the market value of elements in a bank’s balance sheet, and thus directly affects the bank’s net worth. Overall, the results of the estimations support our hypothesis that bank-specific and macroeconomic risks have a considerable negative influence on bank growth, profitability, and stability.

We discover that bank size has a positive impact on growth, profitability, and stability when control variables are taken into account. Larger banks, according to the findings, have stronger growth, profitability, and are more stable. This is in line with Ali and Puah (2018) and Shair et al. (2019). Similarly, we find that cost efficiency has a positive impact. It means that cost-effective banks develop faster. Unlikely as it may seem, the tax ratio’s coefficient is negative and significant. This means that higher taxes stifle bank expansion.

Deposit is positively and statistically significant to bank profitability, according to the profitability model. It suggests that banks with higher deposit are more likely to invest and make profit. Unlikely as it may seem, the saving coefficient is negative and significant. Savings resulted in a reduction in bank investment, which harmed the banks’ profits. Furthermore, the coefficient values in the stability model show that asset structure and financial development have positive and significant influences.

The diagnostic tests are shown in Panel B of Table 3. Overall diagnostic test results support the instruments’ validity, indicating that it is resilient and has a lower number of groups than the total number of groups in the sample. The Hansen J-test estimates do not provide any indication that the null hypothesis should be rejected (There are no over identifying restrictions in a statistical model). In addition, the Arellano and Bond tests show that the residual are free of 2nd order serial correlation.

4.2.2. Results for IBs Versus CBs

The estimation results for IBs versus CBs are shown in Table 4. Credit risk has significant and negative effects on both types of banks’ growth, profitability, and stability, according to the estimated value of credit risk. The data, however, demonstrate that IBs have a lower credit risk than their traditional equivalents. The reason for this is that IBs do not provide mortgage or asset-backed loans. Mortgage loans are widely regarded as the primary cause of financial disasters. Second, Islamic law forbids the use of securitization, which protects IBs from defaulting loans. Finally, a business partnership agreement between banks and borrowers may reduce credit risk exposure by addressing adverse selection issues, reducing information asymmetry, and facilitating a better understanding of borrowers’ creditworthiness.

Table 4: Estimation Results: IBs Versus CBs

Standard errors are in parenthesis. ***p < 0.01, **p < 0.05, *p < 0.1.

We find a strong negative sign for liquidity risk for both IBs and CBs when we look at the coefficient value of liquidity risk in all three models, however, the coefficient values are greater in the case of IBs. The reason for this could be that Islamic banks do not have access to a wide range of liquidity instruments and other popular conventional financial tools such as options and contracts to control their liquidity risk. Due to the presence of Gharar (uncertainty) and interest, Islamic law prohibits the usage of options and derivatives.

We see a negative and significant impact of operational risk on growth, profitability, and stability for both types of banks based on the estimation results. IBs, on the other hand, have greater coefficients than their traditional equivalents. The explanation for this could be that IBs are exposed to additional operational risk as a result of Shari’ah non-compliance. In this case, the bank does not recognize the earnings and, as a result, the bank profit is reduced. Second, in non-profit and loss financing modes such as leasing contracts, IBs take ownership of the assets and all associated risks until the contract is completed. Furthermore, due to the complexity of the IB model, IBs of a younger age and smaller size may have a higher cost structure, heavier administration, and operating costs, resulting in increased operational risk. For both IBs and CBs, we are likely to find negative capital risk coefficient values in all models. However, the results denote that IBs are more exposed to capital risk rather than CBs.

In all three models, we discover a negative sign of inflation risk when we look at the estimation value of macroeconomic risks. In the case of IBs, however, inflation risk has a greater impact on growth, profitability, and stability. The explanation for this could be that IBs are more involved in real estate transactions, which are heavily influenced by inflation. We also find that exchange rate risk has negative and significant effects on growth, profitability, and stability. The calculated value of the coefficient indicates that in the case of IBs, exchange rate risk has a bigger influence. When we look at the impact of interest rate risk on IBs, we find that it has an insignificant effect. In the case of CBs, however, we observe a significant and negative coefficient.

It is generally accepted that Islamic law prohibits Islamic banks from offering predefined fixed interest rates on deposits and charging any sort of interest on loans. The overall findings show that bank-specific and macroeconomic risks have differing effects on Islamic and conventional banks’ development, profitability, and stability. The reason for this is that the structures of conventional and Islamic banks are vastly different. Islamic banks operate under Islamic Jurisprudence rules, which prohibit any transaction based on interest, gambling, short selling, Gharar (uncertainty) in contracts, and debt selling. Asset-based (non-participatory) contracts such as Ijarah, Salam, Istisna, and Murabaha, and equity-based (risk sharing) contracts such as Musharaka and Mudaraba are the two main types of contracts offered by Islamic banks.

4.2.3. Moderating Role of Corporate Governance

Table 5 displays the results of the estimation of corporate governance’s moderating influence in determining the effects of bank-specific and macroeconomic risks on growth, profitability, and stability. Where Panel A denotes the estimation values of variables, allowing us to compare the effects of both types of risks across IBs and CBs before and after interaction terms are included in models. Panel B delves into diagnostic testing that indicates model validity.

Table 5: Moderating Role of Corporate Governance

Table 5: (Continued)

Standard errors are in parenthesis. ***p < 0.01, **p < 0.05, *p < 0.1.

The lagged growth, lag profitability, and lag stability coefficient values suggest that banks with more growth, profitability, and stability in prior years will have more growth, profitability, and stability in subsequent years. In all models, the coefficients of both categories of risks are negative and significant for both types of institutions. However, before and after the addition of interaction variables in the models, the predicted coefficients of both categories of hazards are different. The coefficients of both categories of risk fall after interaction terms are included in the models. In addition, we find that corporate governance has a positive and significant impact on both types of banks’ growth, profitability, and stability when we look at the estimations. The impacts of interaction terms (BSR × CGI and MER × CGI) on growth, profitability and stability are also positive and significant in both types of banks. As a result, corporate governance appears to mitigate the negative effects of both types of risks on both types of banks’ development, profitability, and stability. The reason for this could be that corporate governance fosters strong relationships with shareholders and the stock market, as well as maintains the trust and confidence of investors and depositors, allowing the bank to allocate resources carefully and attract more deposits, capital, and investment. CG also ensures accountability and transparency, as well as effectively monitoring the banks’ management, investment, lending, and borrowing. It also uses a risk management framework to manage and diversify risks. Further, it reduces mismanagement, corruption, fraud, and financial expenses in the long run.

Panel B of Table 5 shows the importance of diagnostic tests in confirming the overall validity of models. The AR (2) value and P-value indicate that the residuals have no 2nd order autocorrelation. In all models, the J-tests demonstrate that the number of instruments is fewer than the group, indicating that there is no over-identifying limitation in the instruments.

5. Conclusion

In this paper, we examine and analyze the effects of bank-specific and macroeconomic risks on Islamic and conventional bank development, profitability, and stability in Pakistan from 2007 to 2019. We also look at the function of corporate governance as a moderator in determining the impact of both types of risks on growth, profitability, and stability for both types of banks. The study found that both bank-specific and macroeconomic risks had a negative impact on both types of banking systems’ growth, profitability, and stability. Furthermore, the research shows that these sorts of risks have varied consequences on different types of institutions. Islamic banks were exposed to much higher liquidity, operational, capital, inflation rate, and currency rate risk, whereas conventional banks were exposed to significantly more credit and interest rate risk. Corporate governance practices, on the other hand, play a significant role in reducing the effects of both types of risks in both types of banks.

This research has significant implications and suggestions for a wide range of stakeholders, including bank executives, policymakers, regulators, and investors. Our findings help stakeholders gain a better grasp of the many forms of bank-specific and macroeconomic risks that negatively impact bank operations. For bank management to recognize problems quickly and make speedy improvements, as well as to be safe and sound from financial crises, effective risk management and implementation of excellent corporate governance procedures are required. The risk management department of a bank is expected to fulfill its duties diligently to not only reduce risks but also improve the bank’s overall performance. Regulators should develop regulations and internal control systems that effectively manage various risks while maintaining an acceptable level of overall risk. Furthermore, the regulator must be aware of the structural variations between IBs and CBs to develop risk management policies and strategies tailored to each kind of banking system.

In the context of Pakistan, this study only examined conventional and Islamic banks. Future research could focus on a cross-country investigation of risks and their impact on bank performance. In the relationship between risk and performance, the moderating influence of bank ownership structure, institutional quality, and country governance can also be investigated.