Effect of Interest Rates and Bank Size on Profitability of Islamic Banks in an Interactive Model

Abstract

This paper is aimed at studying the role of interest rates and bank size along with other macroeconomic and firm-level factors in determining the Islamic bank's profitability. We also explored the intricate complementarities of these two factors in the relationship between Profitability and bank-level factors. Other macro variables like GDP, Inflation and Exchange rate were taken as control. We have used the interaction effect of Bank-level variables like spread, efficiency, default risk, capital adequacy, liquidity, and leverage which were taken as predictors on profitability. Profitability was measured by Return on Asset and Equity. Data from full fledge Islamic banks in Pakistan was taken during the period of 2006-2018. These Islamic banks included were Al Baraka Bank Pakistan Ltd, BankIslamiPakistan Ltd (BIPL), Dubai Islamic Bank Pakistan Ltd (DIB), and Meezan Bank Limited. The regression analysis shows there is a significant impact of macroeconomic indicators, bank-specific variables, and interaction effect of interest and size on the Islamic bank's profitability. The interest rate and exchange rate have a negative and significant impact on ROE. Whereas Asset Quality, Gearing, and Capital Adequacy seem to have a positive and significant effect on profitability. Bank specific variables such as credit risk, spread ratio, and size also seem to negatively affect profitability. With regards to interaction effect, both size and interest rate seems to complement the effect of Asset Quality, Credit Risk, Spread Ratio on Profitability. However, both size and interest rates have a negative complementary with gearing in predicting profitability. Therefore, this study will help the policymakers, regulars, and bank management to identify the key drivers of profitability so they can increase the profitability of Islamic Banks in Pakistan.