The Impact of Islamic Financing Modes on Bank Profitability in Islamic Banks of Pakistan: The Mediatory Role of Credit Risk, Capitalization and Cost-Efficiency

This research study examines profitability factors in Pakistani Islamic banks by assessing how different financing approaches affect bank financial outcomes. We contend that financing models affect performance directly, as well through credit risks, capital levels, and cost efficiency. This research seeks to address existing gaps in the literature regarding how these factors work together within Pakistan's Islamic banking sector. Research data about seven major Islamic banks between 2013-2023 was obtained through quantitative analysis of annual financial reports. The banking performance is measured through Return on Assets (ROA) and Return on Equity (ROE). The research investigates three main financing approaches including Profit-Sharing Financing (PSF) which includes Mudharbah, and Musharkaha, Profit-Margin Financing (PMF) which includes Murabaha, and Ijarah, and Istisna (IST). The direct effect of these three approaches on ROA and ROE, as well as on Credit Risk (CR), Capital Adequacy Ratio (CAR), and Cost Efficiency (CE) was measured. Furthermore, the onward effect of CR, CAR, and CE is assessed on both ROA and ROE. The results showed that Profit-Sharing Financing negatively affects both ROA and ROE. However, Profit-Margin Financing generates a positive effect for both metrics. Istasna seems to positively affect ROE, but its impact on ROA remained inconclusive. Similarly, PSF positively affects CR, and CE, whereas PMF seems to have a negative effect on both. IST doesn't seem to have any significant effect on both CR and CE. Moreover, the effect of all three financing on CAR and its onward effect on ROA and ROE remained inconclusive. CR doesn't seem to have any significant effect on both ROA and ROE. However, CE seems to positively affect ROE, but not ROA. The research implies that Pakistani Islamic banks should achieve optimal financial strategy balance through enhanced PMF usage and better cost control systems. The authors suggest implementing better risk management systems alongside stronger capital reserves to enhance profitability as well as financial stability. The results of this study advance the understanding of profitability in Islamic banks operating in emerging markets while providing useful knowledge for Islamic finance policymakers and executives as well as researchers in this field. Future academic studies should analyze the extended effects of these financing structures along with the way fintech contributes to profit growth.