Does a country’s external debt level affect its Islamic banking sector development? evidence from Malaysia based on quantile regression and markov regime switching

The importance of Islamic banking is recognized globally. Its development has become a matter of great interest for many economies. Initiatives such as establishment of institutions and regulatory framework in countries that are at the forefront of promoting Islamic banking, have been pursued, yet some stakeholders seem to suggest that Islamic banking development is in stagnation. This may be due to the fact that such initiatives have often ignored the macroeconomic environment in which Islamic banks operate. One such environment is the external debt levels of the country that hosts Islamic banks. The “debt overhang” theory suggests that huge debt levels discourage investment, and may lead to banking crisis. Other theories postulate that external debt provides liquidity which benefits the banking sector. Empirically too, conflicts exist in connection with the impact of external debt on the banking sector. While some findings report that external debts have effect on bank loan prices, others find banking crisis to be insensitive to external debt burden. This paper has two objectives; firstly, to investigate the impact of external debt on Islamic banking development, and secondly to find out whether the relationship between external debt and Islamic banking development is linear or non-linear. Analyzing ten years’ monthly data of Malaysia using VECM, Quantile Regression and Markov Regime Switching techniques, the findings tend to suggest that there exists a positive relationship between external debt and Islamic banking development, which seems to be non-linear. Under sound economic conditions, the impact of external debt on Islamic banking development is significantly positive, but the impact is insignificant during economic downturn and uncertainties.