What Drives the Profitability of Islamic Banks?: Insights from Indonesia Using the Vector Error Correction Model (VECM) Approach

Abstract

This study examines the influence of various Islamic financing mechanisms – mudarabah, murabaha, musharakah, liquidity, and financing risk – on the profitability of Islamic banking institutions in Indonesia from 2011 to 2020. Utilizing a quantitative approach, the research aims to thoroughly assess both the short-term and long-term effects of these variables on the dependent variable, Islamic banks’ profitability. The analysis is based on panel data from the Indonesian Islamic banking sector during the specified period and employs the vector error correction model (VECM) method for data analysis. The outcomes of the estimation tests indicate that each of these variables significantly impacts the return on assets (ROA) of Islamic banks in Indonesia, both in the short and long term, throughout the given period. The findings reveal that changes in mudarabah, murabaha, musharakah, non-performing financing, and financing-to-deposit ratio have led to measurable responses in the ROA of these institutions. This study offers valuable insights into the relationship between Islamic financing components and the profitability of Islamic banks in Indonesia, contributing to a deeper understanding of the financial dynamics in this sector over the past decade. Keywords: Islamic banks, Islamic financing, profitability, VECM