How Financial Leverage Differs Between Conventional and Islamic Banks: A Dynamic Model Perspective of Banking Sector in Pakistan

Abstract

This study addresses the dynamic aspects of financial leverage in banking sector in Pakistan. Using theoretical and empirical insights, it aims to highlight the differences in leverage between Conventional Banks (CBs) and Islamic Banks (IBs). The study works with dynamic model (System GMM) to explore the existence of target leverage and variation in the speed of adjustment across CBs and IBs. In accordance with dynamic framework, the study observes the dynamics of the association between the exogenous variables and financial leverage. Study is deviation from textbook theory of bank capital and has embraced with sophisticated model to illustrate that the banks optimize and adjust their capital structure with environmental shocks and financial variations. Looking into very dynamic nature of environment, the study reports that in CBs the economic shocks and financial variations adjustment time tends to maintain adjustments in 1.88 years while IBs tend to maintain it in 0.82 year. Moreover, variations are found about the impacts of economic growth, inflation and sectoral nature in both Islamic and conventional banking. It will help policy makers in financial markets as well as mangers of both IBs and CBs by providing insights about dynamics of leverage. Systemic financial reforms after the global financial crisis and financial digital landscape are advised for banking industry that stress the development of hedging doctrines for deposits and deposit income. Therefore, there is a strong need to revisit hedging doctrine and risk management models for the banking sector in Pakistan that is relatively sluggish.

Do Peer Banks Affect Islamic Bank Financial Leverage Decisions?

“…Bank-level control variables are (1) SIZE, measured by the Logarithm of Total Assets (Hameed et al, 2019); (2) ROA, which is Return on Assets (Guizani, 2021); (3) NPF is Non-performing Financing (Erülgen, Rjoub, & Adalıer, 2020); (4) FDR is Financing to Deposit Ratio (Allen & Powell, 2013;Fauziah & Iskandar, 2015); and (5) LIQ, which is Liquid Assets to Total Deposits (Al-Mutairi & Naser, 2015;Pervin & Noreen, 2018). The country-level control variables are (1) GDP is GDP growth (Hameed et al, 2019); (2) INF is the inflation rate (Ahadifar et al, 2021); and (3) EXC is the USD exchange rate (Ahadifar et al, 2021).…”

“…Banks and financial firms are also highly levered compared to non-financial firms. These differences in leverage reinforce the importance of systematically exploring the financial sector's leverage as the non-financial sector (Hameed et al, 2019). Previous research has indicated that a company's financial decisions are not only influenced by the circumstances of the company itself but are also determined by other companies' behavior (peer effect).…”