Deciphering Macroeconomic Threads: Unraveling their Impact on Credit Risk in Banks

Abstract

The notion of risk is commonly understood by an individual, and its importance has been emphasized as a crucial instrument in the process of decision-making, especially in cases where it is possible to quantify and value a variety of situations. However, the changes in the global financial landscape have increased the vulnerability of Islamic banking institutions to risks. Therefore, the present study examines the determinants of credit risk in Islamic banks. The study uses secondary data from 5 full-fledged Islamic banks and 10 Islamic windows from the period from 2010 to 2022 in Pakistan. This study employed the Generalized Method of Moment (GMM) estimation technique to count the heteroskedasticity and potential endogeneity issue that is avoided in the OLS regression. The results of this study stated that an increase in gross domestic product and exchange rate has a positive and significant relationship with credit risk in Islamic banks. On the other side increments in inflation, unemployment rate, and government debt spur the ratio of credit risk in Islamic banks. Moreover, we find that bank size plays a moderating role in between macroeconomic factors and credit risk in Islamic banks. The findings of this will benefit the management and regulatory authority to assess the macroeconomic factors that greatly impact the credit risk in Islamic banks.