Determinants of Islamic Banking Industry's Profitability In Pakistan for the Period 2004-2012

To explore how Islamic banking could be promoted in Pakistan, one of the crucial factors is exploring the factors that determine the profitability of Islamic Banking Industry (IBI). The studies on the determinants of Islamic banking growth focus on a number of such internal and external determinants. Because of not taking into account both internal and external factors simultaneously, most of the studies are subject to some biases. This study takes into account both internal and external determinants, empirically investigates the core determinants of growth of Islamic banking in Pakistan and evaluates the relative importance of internal and external factors in IBI's growth during the period 2004-2012. Quarterly unbalanced panel data have been used for nine Islamic banks: Five full-fledged Islamic banks and four standalone Islamic branches of conventional banks. Encompassing Approach and General to Specific (GTS) methodology have been used to select the most appropriate model. The study found that internal factors were relatively more important than external factors, because according to GTS approach, comparatively some external variables were found highly insignificant and were dropped. Internal factors like total assets, operating expenses over total assets, number of branches, capital ratio (total equity to total asset) and liquidity, and external factors like inflation and interest rate were significantly related to return on asset in both long run and short run while only inflation did not show any significant immediate impact on ROA in the short run. These findings propose that banks with high capital ratio are relatively more profitable. Efficient management of bank operations can enhance bank profitability. Islamic banks will have to improve their capability to predict inflation to adjust profit rates accordingly