Loan Quality, Cost Efficiency, and Corporate Earnings in Islamic Banking

We investigate how Islamic banking alters the paradigm of the banking system, affecting the loan performance, cost efficiency, and corporate earnings of Islamic banks. The conceptual analysis shows how Islamic banking helps to improve the quality of bank assets by instituting a partnership or non-partnership contract in the banking business on the one hand, and escalates the cost of banking operations on the other side due to the additional operational hurdles, which triggers higher earnings uncertainty in Islamic banking than in conventional banking. The global evidence from 23 countries confirms that, due to the high operational costs, the earnings of Islamic banks are more uncertain even though they perform well in loan operations. Therefore, we conclude Islamic banking trades-off between the reduction of credit risk and escalation of business risk.