CHAPTER 1

INTRODUCTION

Background of Pakistan’s Banking Industry

The foundation of Pakistan's financial system is the banking industry, which is essential to
maintaining macroeconomic stability, directing money towards profitable ventures, and
encouraging savings. Over the last several decades, the business has experienced substantial
change, reflecting both local socioeconomic circumstances and worldwide financial trends.
Pakistan's banking sector is unique in that it consists of two distinct systems: the Islamic banking
system, which is based on Shariah principles of finance and forbids riba (interest) and gharar
(excessive uncertainty), and the conventional commercial banking system, which primarily uses
interest-based intermediation. These two sectors operate together to create a dual banking
system that serves a broad range of clients and financial requirements, hence defining the
features of Pakistan's financial [Link], M. (2011). Differences and similarities in
Islamic and conventional banking. International Journal of Business and Social Science, 2(2),
166–175. This research adopts a broad perspective on Pakistan's banking industry, concentrating
on the factors that influence credit risk in both commercial and Islamic banks between 2010 and
2024.

Evolution of Commercial Banking in Pakistan

In Pakistan, commercial banking has a lengthy institutional history. Only a few banks were left
to Pakistan after its independence in 1947, and the State Bank of Pakistan (SBP) was founded in
July 1948 to act as both the country's central bank and regulator. Although the industry grew
during the next decades, the government implemented comprehensive nationalisation in the
1970s, putting all banks under state control. Poor credit distribution, inefficiency, and a lack of
financial discipline were all results of this approach. Burki, S. J., & Niazi, G. S. K. (2010). The
banking sector reforms in Pakistan: A success story. The Lahore Journal of Economics, 15, 73–
97. Pakistan started a thorough banking sector reform initiative in the 1990s with a focus on
modernisation, privatisation, and liberalisation. In addition to strengthening corporate
governance standards and prudential rules, these changes allowed private local banks and foreign
institutions to re-enter the market. With the bulk of total assets, commercial banks currently
have a strong position in the financial industry. By the end of 2024, the total assets of the
banking system were estimated by the State Bank of Pakistan to be at PKR 53.7 trillion, with
traditional commercial banks accounting for the majority of this amount. Because of their focus
on trade financing, interest-based lending, deposit mobilisation, and government investments,
they are particularly vulnerable to shifts in inflation, interest rates, and sovereign borrowing
requirements (SBP, 2024).
Emergence and Growth of Islamic Banking
The rise in demand for financial services that adhere to Shariah coincided with the emergence of
Islamic banking. When the State Bank of Pakistan established a thorough regulatory and
supervisory framework in the early 2000s, Islamic banking—which had been modest and
experimental in the 1980s and 1990s—began to formally take off. The tenets of asset-backing,
risk-sharing, and avoiding speculative activity guide the operations of Islamic banks. Commonly
used financial arrangements include Ijarah (lease), Murabaha (cost-plus sale), Musharakah (joint
venture), and Mudarabah (trust-based partnership). Islamic bank deposits made up
approximately 22% of sectoral deposits by December 2024, while Islamic banking assets totalled
PKR 11.07 trillion by that same month, or around 20.6% of the whole banking industry (SBP,
2025).
With Islamic banks growing through both fully fledged Islamic institutions and Islamic
"windows" within traditional banks, the development trajectory has been strong. Furthermore,
this sector has gained more legislative momentum as a result of recent Federal Shariat Court
decisions and the government's declared goal of Islamizing the financial system by 2027.
Scholars and policymakers have also taken notice of Islamic banking's resilience to both local
and international shocks, although further research is needed to fully understand its distinct
credit-risk profile.
Commercial and Islamic banks are both subject to the same macroeconomic and financial
realities, although their divergent operating philosophies. With periods of poor GDP growth,
huge fiscal deficits, rapid currency depreciations, increased sovereign borrowing, and spikes in
inflation, Pakistan's economy has seen extremely difficult times from 2010 to 2024. For
example, in 2023, inflation reached one of its highest points ever—above 35 percent—which
significantly reduced family buying power and the ability of both individuals and companies to
repay debt (Pakistan Bureau of Statistics, 2024). In 2023, the State Bank of Pakistan responded
by increasing the policy rate to 22 percent, the highest level in the history of the nation's
monetary system. These macroeconomic factors have a direct impact on banks' loan portfolios by
increasing the likelihood of default, decreasing the value of collateral, and making risk
management procedures more difficult. During times of economic strain, non-performing loans
(NPLs) rise, compromising capital adequacy and profitability and endangering the overall
stability of the financial system. Despite having distinct structures, commercial and Islamic
banks are both required to handle these risks in the same economic climate.

Importance of Credit Risk Management

It is impossible to exaggerate the importance of credit risk management for the banking industry.
Since lending is the biggest operation for the majority of banks, credit risk—the potential for
borrowers to default on their debts is the most significant risk that banks face. The capacity of a
bank to precisely assess, track, and reduce credit risk is essential to its continued existence and
expansion. Basel Committee on Banking Supervision (2000). Principles for the Management of
Credit Risk. Bank for International Settlements. Weak credit-risk management can have systemic
effects for Pakistan, where financial intermediation is still comparatively low by international
standards. This can impede economic development, discourage investment, and restrict corporate
lending. In this sense, the credit-risk profile of banks is significantly shaped by macroeconomic
factors like GDP growth, inflation, and interest rates as well as bank-specific elements like
capital adequacy, asset quality, profitability, loan-loss provisioning, and bank size. In light of
these circumstances, this study looks at the factors that influence credit risk in Pakistan's banking
industry, encompassing both commercial and Islamic banks between 2010 and 2024.
This research acknowledges the presence of both systems in Pakistan's financial architecture by
using an inclusive sector-wide approach, in contrast to other studies that either solely focused on
Islamic banks or only examined conventional institutions. The study captures the interaction
between macroeconomic shocks and bank-specific characteristics across a broad sample of banks
by using panel data econometric approaches. Instead of contrasting the two systems, the goal is
to offer a cohesive knowledge of how credit risk changes throughout the industry, giving
regulators, legislators, and bank management useful information.
The introduction concludes by highlighting the significance of the banking industry in Pakistan's
economic growth, the concurrent ascent of commercial and Islamic banks, and the role that credit
risk plays in determining stability. To address a major gap in the literature and policy discussion,
this study examines the years 2010–2024, a period marked by both macroeconomic weaknesses
and growth prospects. It is anticipated that the results would strengthen regulatory supervision,
strengthen credit-risk management frameworks, and strengthen capital buffers, all of which will
support the stability and expansion of Pakistan's banking industry overall.

RATIONALE
Pakistan’s banks are vital to the economy, despite the fact that credit risk poses a serious threat.
Although commercial and Islamic banks operate in the same economy, their different methods of
conducting business put them at risk of different sorts of threats. Between 2010 and 2024,
Pakistan saw a rise in government debt, inflation, and currency issues, which made it harder for
individuals and companies to pay back their loans. Islamic banks have unique risks since they
use profit and loss sharing and forbid interest. Previous studies have primarily focused on a small
period of time or a single type of institution, leaving a gap. This study will look at the two sorts
of banks together over a long period of time. The outcomes will assist legislators and regulators
in improving credit risk management and promoting the stability of the banking sector.

PROBLEM STATEMENT
For Pakistan’s banking industry, credit risk is a major obstacle directly impacting financial
stability. Most previous research left a void by focusing on only one kind of bank or short time
spans. This study addresses that gap by looking at how commercial and Islamic banks of
Pakistan from 2010 to 2024 manage credit risk in light of both economic conditions and bank-
specific variables.

OBJECTIVE OF THE STUDY

The primary goal of this study is to investigate the elements that affect credit risk in Pakistan's
commercial and Islamic institutions over 2010–2024. More precisely, the study seeks:
1. Consider how macroeconomic factors including interest rate, inflation, and GDP growth affect
the credit risk of banks.
2. Consider how bank-specific characteristics including capital adequacy, asset quality,
profitability, loan loss provisioning, and bank size affect credit risk.
3. Compare how these elements together influence credit risk across commercial and Islamic
banks inside dual banking system Pakistan.
4. Offer insightful ideas for legislators, regulators, and bank management to enhance credit risk
management systems and guarantee financial stability.

HYPOTHESIS
Ha1: Credit risk in the Pakistani banking industry is greatly influenced by the Capital Adequacy
Ratio (CAR).
Ha2: In Pakistan’s banking sector, credit risk is strongly influenced by asset quality (AQ).
Ha3: Credit risk in Pakistan’s banking sector is significantly affected by Return on Assets
(ROA).
Ha4: The credit risk in Pakistan’s banking sector is greatly affected by Loan Loss Provision
(LLP).
Ha5: Credit risk in Pakistan’s banking sector is quite affected by Bank Size.
Ha6: In the Pakistani banking industry, credit risk is greatly affected by the interest rate.
Ha7: There is a significant impact of Inflation on credit risk in Pakistan’s banking sector.
Ha8: There is a significant impact of GDP Growth on credit risk in Pakistan’s banking sector.
 CHAPTER 2
LITERATURE REVIEW

The primary determinants of credit risk in commercial banks, as determined by the non-
performing loan (NPL) ratio, were examined by Naili (2022) in emerging countries. According
to the study, loan performance is significantly influenced by the state of the economy as a whole.
Banks deal with fewer bad loans while GDP growth is strong, but when inflation increases, loan
quality deteriorates and non-performing loans (NPLs) rise. Strong capital adequacy (CAR)
reduces credit risk at the bank level because banks with adequate capital are better equipped to
withstand financial shocks. Since profitable banks typically handle their loans more skilfully,
profitability, as indicated by ROA, also lowers NPLs. Because the study reveals that big and
small banks handle credit risk differently, bank size also matters. The findings are more
trustworthy because these results hold up consistently across several testing. Overall, the study
makes the case that lowering credit risk in commercial banks requires both robust bank
performance (capital and profitability) and economic stability (growth and inflation).
Using dynamic panel data, Louzis et al. (2012) looked at credit risk—NPLs—in Greek
commercial banks. GDP growth lowers NPLs; greater interest rates and unemployment raise
defaults. Bank specific criteria also count; lower profitability (ROA/ROE) and poorer
management increase credit risk; better banks provide better quality loans. The research shows
that internal bank health and broad economic circumstances together influence credit risk; hence,
capital ratios and loan to deposit ratios both count.
This study on 22 Sub-Saharan African countries examines nonperforming loans (NPLs) as a
measure of credit risk. GDP growth reduces NPLs; inflation raises them by exacerbating
borrower hardship. At the bank level, higher profitability (ROA) and stronger capital adequacy
(CAR) both reduce NPLs, making banks more resilient. The study generally underlines how
good bank performance and macroeconomic stability both help to determine credit risk
management.
This study examines the factors that affect non-performing loans (NPLs) in Barbados'
commercial banks between 1991 and 2015. It demonstrates that robust GDP development lowers
NPL ratios; a thriving economy leads to better credit quality. In the meanwhile, when borrowing
costs increase and job losses reduce repayment ability, increased interest rates and rising
unemployment both contribute to an increase in non-performing loans. The significance of a
bank's financial soundness is shown by statistics at the bank level, which shows that greater
profitability (ROA, ROE) and improved capital adequacy (CAR) help keep NPLs lower. NPLs
also tend to be lower for larger banks, indicating that they are better at managing credit risk. In
conclusion, the study emphasises how sound bank fundamentals (profit, capital, and size) and a
robust economy combine to reduce credit risk in Barbados's commercial banking industry.
Nonperforming Loans and Macro financial Vulnerabilities (IMF) Nkusu (2011) examines
nonperforming loans in advanced nations to demonstrate how credit risk is influenced by general
macroeconomic circumstances and bank health. The report identifies a distinct, recurring pattern:
NPL rates increase when GDP growth slows down; economic downturns lower borrower income
and increase defaults. Interest rate and inflation changes are also significant since unfavourable
real rate hikes and abrupt monetary tightening increase repayment obligations and NPLs.
Because undercapitalised or unprofitable banks have less capacity to absorb losses and deal with
declining credit quality, poorer profitability and smaller capital buffers (CAR) are associated
with more non-performing loans (NPLs) at the bank [Link] also highlights that the link is
reciprocal, as large non-performing loans (NPLs) can exacerbate economic stress and erode bank
lending. This research supports your theory by offering solid proof that the main factors
influencing commercial-bank credit risk are GDP, inflation/interest conditions, ROA, and CAR,
and that policymakers ought to keep a close eye on these metrics.
This study examines the factors that influence the growth or decline of non-performing loans
(NPLs) across several nations and financial institutions. It separates the causes into two
categories: macroeconomic variables (such as GDP growth, inflation, unemployment, and
interest rates) and bank-level factors (such as a bank’s size, capital strength, profitability, and
operational efficiency). According to the report, because they are better at managing credit risk,
banks with higher ROAs are often less likely to have problematic loans. NPLs are also decreased
by strong capital ratios (CAR), which demonstrate that banks with stronger buffers manage risks
more securely. In terms of the economy, NPLs are often lowered by faster GDP growth, but they
may also be raised by higher inflation or worse macroeconomic conditions. This argues that
controlling credit risk requires both a robust economy and banks that are managed properly
(profitability, capital, scale, and efficiency).
Using strong econometric approaches including fixed effects, random effects, and Ensuring
consistent results with GMM models. Results reveal that bank-level variables are very important:
banks with greater capital adequacy (CAR) and more profitability (ROE) do better at managing
NPLs; meanwhile, Acting as a protective cushion, loanloss provisioning (LLP) helps to reduce
defaults. Rising inflation lowers borrowers' repayment capacity, hence increasing credit risk on
the macroeconomic level, while stronger GDP growth enables repayment and so lowers NPLs.
These results taken together show that efficient management of credit risk in the banking
industry in Bangladesh calls for both sound internal bank procedures and a stable
macroeconomic environment.
This study examines the relationship between macroeconomic variables and credit risk in the UK
banking industry, with a focus on non-performing loans. To forecast when credit risk may
increase, the authors employ intelligent models. They discover that while rising prices put
pressure on borrowers, credit risk increases along with inflation. Additionally, persons who are
unemployed are less able to repay loans, which raises credit risk. Remarkably, reduced credit risk
is associated with larger national savings and higher national wealth (such as GDP per person).
This implies that banks have less problematic loans when the economy is expanding and
consumers are saving more. These findings demonstrate that national income, unemployment,
and inflation are crucial indicators of credit risk in banking.
Khanam, Hasan, and Afsar (2021) investigate the reasons for non-performing loans (NPLs) in 20
Bangladeshi commercial banks from 2009 to 2019. They examine both macro- and bank-level
variables using simple OLS regression. Macro economically speaking, they discover that GDP
growth dramatically lowers NPLs since borrowers are more likely to repay when the economy
expands. On the bank side, greater NPLs are associated with operational inefficiencies and
bigger banks, whereas lower NPLs are associated with better profitability and stronger capital
adequacy (CAR). These results unequivocally demonstrate the importance of a robust economy
and well-capitalized, well-managed banks in maintaining high loan quality and low credit risk.
From 2005 to 2017, Khan, Siddique, and Sarwar (2020) investigate the factors that contribute to
non-performing loans in Pakistani banks. Using panel data and regression models, they discover
that important bank-level variables such as income diversification, capital adequacy (CAR),
profitability, and operating efficiency all have a negative correlation with non-performing loans
(NPLs); in other words, the better a bank does, the fewer bad loans it has. Although economic
diversity and CAR also had detrimental impacts, they were not statistically significant.
According to the study, banks with higher levels of efficiency and profitability are better at
avoiding credit risk, which improves the health of their loan portfolios.
Based on 2007–2021 data, tested determinants of credit risk of Pakistani Islamic banks Loan loss
provisions were substantially raising credit risk (β=1.159, p< 0.01) in an OLS regression
analysis on four banks; capital adequacy ratios were decreasing it (β=-0.181, p< 0.05). The
research revealed Islamic banks' increased sensitivity to internal elements than to
macroeconomic factors. Its 15-year range, though, overlooked important events including
Pakistan's 2018 currency crisis. Researchers advised closer tracking of loan loss buffers since
they believe they represent 23% of credit risk variation in normal times. Though their work lays
a groundwork, it needs time extension to evaluate long-term trends.
Between 2004 and 2016, Akram and Rahman (2018) examined risk management in five
traditional and four Islamic Pakistani banks. By means of correlation analysis, they found
Islamic banks' asset quality exhibited an inverse relationship with credit risk (r=-0.42), opposite
to conventional banks (r=+0.38). The varied risk profiles of Sharia-compliant assets helped
explain this paradox. Analysis of the crisis phase of the study revealed that Islamic banks had
17% lower NPLs during the 2008 financial crisis. Although enlightening, the study omitted
changing regulatory policies enacted after 2016 that changed risk dynamics. Their results
highlight the requirement of Sharia-specific risk models.
Analysing Indonesian Islamic banks (2010-2016), Wiyono and Effendi (2018) found size-
dependent risk patterns. Bigger banks (assets > $1B) demonstrated higher sensitivity to financing
development (β=+0.15); smaller banks showed opposite relationships. Their most important
conclusion was that GDP growth had a negative effect (β=-0.09), hence implying the
countercyclical character of Islamic banks. Indigeneity was controlled for using GMM
estimation in the study; this approach was afterward employed in Pakistani investigations. Its
emphasis on Indonesia, though, restricts direct relevance to Pakistan's distinct market
arrangement. The study highlighted how institutional scale modifies risk aspects.
. Using Pooled OLS regression, (2021) investigated four Islamic banks for Pakistan (2008-2017).
While bank size did not affect credit risk, capital-level ratios (β=-0.33) and profitability (β=-
0.28) greatly lowered it. Their quantile regression showed that Islamic banks' capacity to
withstand crises derives from capital buffers as such effects doubled during crises. Laying out
that maintaining CAR above 12% reduces NPLs by 19% during crisis times gives the study
practical significance. Still, it ignored newer risk variables including digital financing. Their
work is still helping inside Pakistani Islamic banking circles.
Proposing the "Sharia Compliance Premium" model, Al-Wesabi and Ahmad (2013) investigated
22 GCC Islamic banks 2000-2010. They examined if LLP ratios explain 38% of variation in
credit risk, therefore raising risk by 0.63% for every 1% rise. When looking at financing types,
Murabaha agreements had 15% lower default rates than Musharakah. Its consequences for Gulf
banks were fundamental; for Pakistan's distinct economic circumstances, it required adaptation.
Research started methods for measuring Sharia-related risk premiums globalized today.
Bashir (2003) looked on Islamic banks in the MENA region Mudarabah and Musharakah include
profit-and-loss-sharing (PLS) contracts' risk-return tradeoffs. Results indicate that PLS-based
funding revealed lenders to 22% more risk than fixed-return financing with Murabaha, yet
produced 18% higher returns. The study identified Islamic banks' equity-based financing as
relying on capital buffers and rigorous borrower screening. However, the result cannot be used
today since the data used was from a pre-2008 era. Still, Islamic finance books reference Bashir's
risk-adjusted performance model.
In an IMF comparative study, Čihák and Hesse looked at the financial stability of 142
conventional and 18 Islamic banks across 20 nations. Using the Z-score approach to compare
insolvency risk, they found that Islamic banks were 15% more stable during crises. Their studies
revealed that due to asset-backed financing, Islamic banks were more stable in performance
under stress. Though authors warned that regulators might limit applicability by country, this
study greatly influenced Pakistan's Islamic Banking Act of 2015.
Examining the 2008 Pakistani financial crisis in 2009, noted an 18% increase in NPL for Islamic
banks; conventional banks saw a 27% rise. This suggested that Islamic banks were slightly more
resilient due in part to their Shariah-compliant asset mixes and low exposure to speculation.
Further analysis revealed that Islamic banks recovered slowly due to contract inflexibility and
little use of legal enforcement tools. These results later prompted the State Bank of Pakistan to
implement distinct capital regulations for Islamic banks in 2010.
Majeed and Zainab (2021) examine Islamic banks' and local Pakistani conventional banks' 2015–
2020 financial data. Average capital for Islamic banks was 15% more and average liquidity ratios
22% lower, suggesting a more risk-averse attitude. Islamic banks generated equivalent risk-
adjusted returns even with lesser liquidity. The research noted that macroeconomic elements
were excluded from consideration whereas a capital strength improved the credit risk
performance of Islamic banks. This limits its use for general risk modelling.
Using ARDL models, Farooq and Khan developed an Islamic Credit Risk Index for Pakistan and
showed that Islamic banks were 30% more responsive to inflation than typical banks. Islamic
finance's non-adjustable contract conditions and fixed profit rates produced this. The study
demonstrated very practical application and the State Bank of Pakistan adopted the index for
credit risk stress testing. Still, their model missed any interest rate impacts, making it less suited
for volatile economies.
Hassan and Dicle looked at Islamic banks in Turkey in 2017 to evaluate how Shariah control
affected credit risk. Centralized Shariah boards reduced non-performing loans (NPLs) by 12%
relative to banks with decentralized boards. They showed how regular religious monitoring
improves loan default risk and credit quality. The research also had direct policy use, with
evidence from it contributing to Pakistan's 2018 Shariah compliance framework reforms.
Researchers claim that while Turkey-specific, advantages of centralized control are also
applicable to Islamic banking industries with similar governance gaps.
In their 2009 study of Malaysia, Chong and Liu examined Islamic banks alongside conventional
banks to see how changes in interest rates affect credit risk. Their research found that fixed-profit
contracts made Islamic banks more resilient against rate shocks. They also discovered a delay in
risk transmission, though, which meant that Islamic banks were reactive only after a time lag
relative to conventional banks. They developed a transmission model later used by others in
studies on Pakistan. The study showed that Islamic banks are organized differently and that
traditional systems call for unique designs.
Global studies on 28 Islamic banks done by Abedifar and others in 2015 found that profit-and-
loss sharing (PLS) financing improved long-run stability. However, the banks with more
application of PLS contracts required more capital cushions to cushion against unexpected
losses. Basel III rules, which assert that capital adequacy is a top priority in Shariah-compliant
banking, were tested by the authors. The study showed that while PLS reduces capital risk, bank
and customer have great monitoring and risk-sharing needs. This guided global Islamic capital
norms.
Effendi and Wiyono investigated Indonesian rural Islamic banks, especially those funding
agriculture. Effective credit risk management in Indonesian rural Islamic banks depends on a
minimum capital adequacy ratio (CAR) of 15%. Relevant topics for rural Pakistan as well, they
suggested a two-factor model depending on borrower income stability and product seasonality.
Although grounded in Indonesia, this is a pertinent study for Pakistani banks engaged in rural
settings using Islamic microfinance products. They said that the rural credit risk of Islamic
banking requires alternative models and criteria.
Archer and Karim developed a theoretical framework in 2013 for readjusting capital risk weights
for Islamic financing devices like Mudarabah and Musharakah. They argued that conventional
risk models undervalued the volatility of equity-based contracts. They unveiled a revised version
for risk weight Islamic finance supervisory standards would finally apply. Their research guided
the Shariah-compliant product credit risk computation policies of the State Bank of Pakistan.
Though non-empirical, their model educated policymakers on the fact that Islamic banks' risk
profiles differed from those of conventional banks.

CHAPTER 3
RESEARCH METHODOLOGY
3.1 Research Design
Using panel data from 2010 to 2024, this research investigates the causes of credit
risk in the Pakistani banking industry. Sixteen to eighteen commercial and Islamic bank data
make up the sample. The influence of bank-specific as well as macroeconomic variables on
credit risk is assessed using regression analysis.

3.2 Data type

Examining the causes of credit risk in Pakistani banks, the study uses secondary panel
data from 2010 to 2024. To evaluate how internal and external elements affect credit risk, it takes
bank-specific indicators (CAR, AQ, ROA, LLP, bank size) and macroeconomic variables (GDP
growth, inflation, interest rate) into account.

3.3 Data Source

To guarantee reliability and correctness, the data for this research will be taken from
secondary sources. The main source will be the State Bank of Pakistan (SBP), especially its
annual publications and statistical bulletins, which offer official data on the banking industry.
Furthermore yearly financial statements of chosen Islamic banks in Pakistan will be used to
compile bank-specific information including asset quality, loan loss provisions, capital adequacy,
and profitability. Data will be gathered from world databases including the World Bank and IMF
to guarantee consistency for macroeconomic measures like GDP growth, inflation, and interest
rates. Ensuring that both bank level and country level influences on credit risk are recorded,
these combined sources will provide a thorough dataset spanning the years 2010 to 2024. Using
well-known, reliable data sources, this multi-source approach improves the study’s validity.

3.4 Time frame

Giving a 15-year window, the research spans 2010 to 2024. This duration has been
selected to capture both short-term variations and long-term trends in the drivers of credit risk in
Pakistani Islamic banks. It also covers major financial and economic events, therefore
guaranteeing that the study captures many phases of the banking and economic environment.

3.5 software
3.6 Dependent variable
Credit Risk(CR):
Credit risk arises from the potential that an obligor is either unwilling to perform on an
obligation or its ability to perform such obligation is impaired resulting in economic loss to the
bank.

3.7 Independent Variables

3.7.1 Capital Adequacy Ratio (CAR)
The Capital Adequacy Ratio (CAR) assesses the capital requirement based on the risks
faced by the banks.
3.7.2 Asset Quality (AQ)
Asset quality determines the robustness of financial institutions against loss of value in
the assets. The deteriorating value of assets, being prime source of banking problems, directly
pour into other areas, as losses are eventually written-off against capital, which ultimately
jeopardizes the earning capacity of the institution.
3.7.3 Return on Assets (ROA)
Return on Assets measures the percentage of profit of a company in relation to its overall
resources i.e. Assets. It measures how efficiently company is using its assets to generate earning.
3.7.4 Loan Loss Provisions (LLP)
A loan loss provision is an income statement expense set aside as an allowance for
uncollected loans and loan payments. This provision is used to cover different kinds of loan
losses such as non-performing loans, and customer bankruptcy.
3.7.5 Bank Size
Bank size This is the overall worth of the bank’s assets. Big banks are able to handle credit
risk more effectively because they possess more resource.
3.7.6 Gross Domestic Product (GDP)
GDP tells us about the growth of the nation. The higher the GDP, the more likely borrowers
can repay loans and at increased GDP, there’s less credit risk.
3.7.7 Interest Rate (IR)
Although Islamic banks do not charge interest, market interest rates influence them
indirectly through customer actions and competition.
3.7.8 Inflation
With a rise in inflation, prices go up. High inflation erodes the value of money, meaning
that people who have borrowed money may struggle to pay it back.