Impacts of Inflation and Interest Rate Uncertainty on Performance and Solvency of Conventional and Islamic Banks in Pakistan

Abstract

This paper examines the effects of inflation and real interest rate uncertainty on the performance and solvency of banks in Pakistan. It also examines whether the effect of both types of uncertainty differs for conventional and Islamic banks. Annual data covering the period 2008-2015 for a sample of 25 banks are used to carry out the empirical analysis. Generalized Least Square (GLS) estimator is applied to overcome the problem of heteroscedasticity. The results indicate that several bank-specific variables are important in determining the performance and solvency of banks operating in Pakistan. The results also show that these variables have considerable differential impacts on the financial performance and solvency of both conventional and Islamic banks. With regard to the effects of macroeconomic variables, the results show that the rate of inflation, the interest rate, and their volatility also have quite different effects on the performance and solvency of conventional and Islamic banks. We find that although neither inflation nor interest rate uncertainty significantly affect the solvency of conventional banks, the solvency of Islamic banks is significantly affected by both types of uncertainty. Specifically, we find that inflation uncertainty has a negative, whereas, the uncertainty associated with the real interest rate has a significant positive impact on the solvency of Islamic banks. However, both types of uncertainty have a statistically insignificant effect on the financial performance of both conventional and Islamic banks in Pakistan. Providing significance evidence on the bank-specific empirical determinants, our analysis helps bank managers to improve their banks’ financial performance and solvency. Further, our findings are helpful for understanding how the financial performance and financial soundness of conventional and Islamic banks are determined during periods of heightened inflation and real interest rate uncertainty.