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The development of Islamic banking has attracted global attention, particularly since the sub-prime crisis (2007–2008). Despite the establishment of institutions and regulatory framework in countries that are at the forefront of promoting Islamic banking, 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 level of a country in which Islamic banks operate. This paper makes an initial attempt to investigate firstly, 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. Analysing ten years’ monthly data using VECM, Quantile Regression and Markov regime-switching techniques, the findings tend to suggest that, (a) there is a positive relationship between the external debt levels and Islamic banking development and, (b) However, the relationship seems to be non-linear. Under stable economic conditions, external debt has a higher impact on Islamic banking development compared to those of economic downturns, crises, and increased financial uncertainties.

quantitative finance and economics

Does a country’s external debt level affect its Islamic banking sector development? Evidence from Malaysia based on Quantile regression and Markov regime-switching