Exploring the Impact of Real Sector Shocks on Islamic Banking in Pakistan: A VECM Approach

By Salman Ahmed Shaikh and Tahir Suleman

Abstract

A distinguishing feature of Islamic banking is the use of real assets in financing operations. The requirement to use real assets makes manufacturing sector an important market for Islamic banking financing operations. Manufacturing sector in Pakistan has had to cope up with surge in oil prices due to slack in domestic oil production and rise in imported oil prices. In this study, we use quarterly data for the period 2006-2016 and apply Vector Error Correction Model (VECM). We want to find how external shocks to the economy and shocks to international crude oil price and manufacturing output affects financing, non-performing loans and profitability of the Islamic banking industry. Our results indicate that a shock in large scale manufacturing index has an increasing effect on financing and investments, while a shock in exchange rate has a declining effect. Moreover, our findings reveal that a shock in large scale manufacturing index has an amplifying effect on non-performing loans, but a shock in exchange rate does not affect non-performing loans by much. We also show that a shock in oil price has a dampening effect on non-performing loans. Finally, for profitability, our analysis highlights that a shock in exchange rate and international oil price has a declining effect on ROE, whereas a shock in LSM index enhances profitability.