Relationship Between Musharakah, Credit Risk, and Profitability in Pakistan's Islamic Banks

Abstract

The most significant and theoretical link between credit risk and Islamic banks' profitability ratio (ROE) has been determined due to the special nature of Musharakah (cost-in-low) financing. This study aims to determine how credit risk affects Islamic banks' profitability ratio (ROE). Data was obtained from (2018-2022), from the yearly reports of selected Islamic banks in Pakistan. The data analysis found that measures for the end of Musharakah size financing (MSF) (0.0220) and Musharakah Non-Performing ratio (MNPR) (0.03706) significantly impact return on equity. Study results show a strong and positive correlation between ROE and the Musharakah Non-Performing Ratio (MNPR). Based on the findings, it was concluded that the economic support of Musharakah (diminishing) generally increases the return on equity (ROE) of Islamic banks. Therefore, this research suggests Islamic banks need to increase their support for Musharakah (diminishing) to overcome the high credit risk exposure. Based on the findings of this study, Islamic banks can design and implement policies to reduce credit risks while improving their financial performance. Furthermore, this research can help Islamic banks improve their profitability ratio by reducing credit risk.