Optimizing Resilience: Impact of Credit Risk Management on Financial Performance in Islamic Banking

Abstract

This study examines the intricate relationship between financial performance and credit risk management in Islamic banking, focusing on the ripple effects of key risk indicators. Employing a semi-experimental methodology, we analyzed annual financial data from five top-performing Islamic banks in Pakistan listed on the Pakistan Stock Exchange (PSE) over the period (2019–2023). Using Ordinary Least Squares (OLS) regression, this research evaluates the impact of Non-Performing Financing (NPF) and Assumed Financial Risk (AFR) on Return on Assets (ROA), a primary metric of financial performance. The findings shows that NPF negatively and significantly impacts ROA (β1 = -0.0655, p < 0.05), underscoring the importance of robust credit risk management practices. Conversely, AFR demonstrates a positive and significant influence on ROA (β2 = 0.00025, p < 0.05), suggesting effective risk assumption strategies enhance profitability. Co-integration tests indicate no long-term equilibrium relationships among ROA, NPF, and AFR, yet random effects regression underscores a significant correlation between credit risk management (CRM) and Islamic banks' performance. The results highlight that Islamic bank conduct meticulous risk evaluations to mitigate adverse effects of credit risks, safeguard depositor equity, and enhance financial outcomes. The study concludes that strategic management of credit risk particularly minimizing NPF and optimizing AFR can significantly boost financial performance. These findings hold critical implications for policymakers and stakeholders aiming to strengthen the resilience and profitability of Islamic financial institutions.