Profitability and risk in Indonesian Islamic banks: do profit-loss sharing contracts matter?

Purpose The profit-loss sharing (PLS) contract is a fundamental financing contract of Islamic banks. Notably, Indonesian Islamic banks extend higher PLS financing compared to other countries. This study aims to examine the influence of PLS financing on profitability and financing risk in Indonesian Islamic banks, incorporating nonlinear relationships. Design/methodology/approach This study uses dynamic panel regression using a two-step system Generalized Method of Moments (GMM) to investigate the impact of PLS financing on return on assets (ROA) and nonperforming financing (NPF). Data from all Islamic banks in Indonesia from 2015: Q1 to 2020: Q4 are used. Findings The results indicate that PLS financing reduces ROA and enhances NPF. However, PLS financing demonstrates a U-shaped impact on profitability but has an inverted U effect on financing risk. These findings suggest that profitability improves when PLS financing reaches approximately 61.60% of total financing, while impaired financing decreases when PLS financing approaches 57.09% of total financing. Furthermore, market power, strong bank fundamentals and economic booms enhance profitability and lower financing risk. Originality/value This paper is the pioneering work to assess the nonlinear impact of PLS financing on profitability and financing risk, contributing novel insights to Islamic banking literature.