Audit quality, risk exposure and financial performance: a dynamic panel study of islamic banks

Abstract

This study aims to examine the relationship between risk exposures and financial performance in Islamic banks and evaluates how external audit quality moderates this relationship. The analysis is based on a panel dataset comprising 1,411 bank-year observations from 100 Islamic banks across 30 countries between 2002 and 2023. Seven core risk dimensions are analyzed both individually and in aggregate form. The models use Pooled Ordinary Least Squares, Fixed Effects and System Generalized Method of Moments estimators to account for unobserved heterogeneity and endogeneity. Audit quality is proxied by the presence of Big-4 audit firms. Higher levels of aggregated risk are consistently associated with lower financial performance. Operational and credit risks exert the most adverse effects, while liquidity risk shows a positive association with profitability, due to the unique liquidity management strategies in Shariah-compliant banking. Audit quality exhibits a differentiated moderating role, amplifying the financial impact of certain risks (e.g. credit, liquidity) while dampening the effects of others (e.g. return volatility). The study provides an empirical analysis of how risk exposures, both individually and collectively, affect Islamic banks’ performance, incorporating the conditional influence of external audit quality. It offers practical insights for strengthening audit governance and risk oversight mechanisms in Islamic financial institutions.