Essays in Islamic Banking, Institutional Quality, and Financial Development Outcomes

This thesis explores the implications of Islamic banking and institutional quality for financial inclusion, access to finance constraints of small and medium-sized enterprises (SME), and capital misallocation. Building on ideas from Islamic finance theory, institutional economics and political economy, the thesis comprises three separate but connected empirical essays. These essays rely on large-n cross-country datasets and instrumental variable (IV) estimation strategies to address endogeneity concerns and arrive at more credible causal inferences. The first essay studies the Islamic banking–institutional quality–financial inclusion linkages. The analysis exploits repeated cross-sectional data on nearly all countries covered by the World Bank’s Global Findex database over four survey waves (2011, 2014, 2017, and 2021) and estimation using Pooled OLS and IV models with the Muslim population share as an instrument for Islamic banking presence. I find that the presence of Islamic banking has a statistically significant positive effect on financial inclusion and this effect is contingent on both institutional quality and type of political regime. In countries with robust institutional frameworks, there is a larger positive effect of Islamic banking presence on financial inclusion and in non-democracies, the dynamics differ.

The second essay examines the constraints around access of SMEs to finance and the roles of Islamic banking and quality of institutions roles in determining access to finance obstacles. Based on firm-level data from the World Bank Enterprise Survey available for the period 2006-2022, I estimated ordered probit, multinomial logit, and instrumental variable models. The results show that presence of Islamic banking reduces access to finance obstacles for SMEs, while quality of institutions is effective as a moderating variable in this relationship. Islamic banking and institutional quality interact to yield further reductions in access to finance obstacles. The third essay considers the macroeconomic consequences of the rise of Islamic banking by analyzing its effect on capital misallocation as measured by the dispersion in marginal revenue product of capital (MRPK). Based on firm-level data from the World Bank Enterprise Surveys and the Pooled OLS and an instrumental variable estimation method I find that the impact of Islamic banking presence on misallocation of capital is negative and significant, and that the interaction of Islamic banking with quality of institutions produces a highly significant and negative effect.

Collectively, these three essays contribute to the growing body of literature on Islamic finance and development by providing rich empirical evidence on the channels through which Islamic banking and quality of institutions jointly drive such financial outcomes. The thesis has important policy implications for regulators, policymakers and development practitioners who seek to leverage Islamic banking as a tool for financial inclusion and efficient allocation of capital especially in developing and emerging economies.