Impact of capital inflows on bank profitability: a comparative analysis of dual banking systems

Purpose Using data on 739 banks from 22 countries with a dual banking system from 2012 to 2019, this paper aims to examine whether capital inflows affect banks’ profitability in recipient countries. Design/methodology/approach The authors check the conjecture about the effect of capital inflows on the profitability of the host country’s banks by estimating the following regression: (1) where the dependent variable ( P ict ) refers to bank profitability, measured by either ROA or ROE for bank i , country c and year t . ROA is defined as the ratio of net profit to average total assets expressed as a percentage, which determines how efficiently a bank uses its assets to generate a profit. ROE is defined as the ratio of net profit to average total equity expressed as a percentage, which is a measure of increases in shareholders’ wealth. Findings The authors find that capital inflows are generally positively associated with bank profitability. However, cross-border capital inflows reduce the rate of return in Islamic banks relative to their conventional counterparts. When decomposing inflows by instrument, the authors find that the enhancing role of capital inflows on bank profitability comes mainly from debt inflows and borrowers; the authors observe that the documented results emanate mostly from the inflows to the financial sector. These results remain unchanged if holding a bank’s risk constant. Overall, foreign funds in the form of debt inflows targeting the financial sector can disproportionately improve the performance of commercial banks in recipient countries. Originality/value The paper is an original research project. The analysis contributes to the existing literature in several ways: the authors study whether the impact of capital inflows on bank profitability varies with the bank business model by looking at both the Islamic and conventional bank systems. The profitability of the banking system is an important catalyst for growth and stability. The authors also decompose capital inflows to recipient countries into their equity and debt components and study the differential impact of those components on the profitability of Islamic and conventional banks.