^Do ESG Practices Improve Asset Quality? Evidence from Islamic and Conventional Banks in OIC Countries^ Fajar Dysna Kurniawan (a*), Mamduh M Hanafi (b)
a) Master of Science in Management, Faculty of Economics and Business, Gadjah Mada University [at]fajardysnakurniawan[at]mail.ugm.ac.id
b) Department of Management,Faculty of Economics and Business, Gadjah Mada University
Abstract
This study investigates the impact of Environmental, Social, and Governance (ESG) practices on the asset quality of banks within the dual banking systems of Organisation of Islamic Cooperation (OIC) countries, where both Islamic and conventional banks operate concurrently. Rooted in Stakeholder Theory, ESG practices are expected to enhance asset quality by aligning bank operations with broader stakeholder interests and promoting responsible lending behavior. Complementarily, the Resource-Based View suggests that ESG adoption can be a source of strategic advantage, enabling banks to better manage long-term credit risks and sustain superior asset quality. However, this relationship is unlikely to be uniform across all institutions. The study introduces financial performance as a moderating variable, recognizing that highly profitable banks may pursue aggressive lending or cost-cutting strategies (e.g., reduced loan monitoring) that dilute the benefits of ESG on asset quality, an idea consistent with the ^skimping hypothesis.^ Through this lens, financial performance may either reinforce or weaken the positive ESG to asset quality linkage depending on managerial orientation and strategic behavior.
Employing an unbalanced panel dataset of Islamic and conventional banks across selected OIC countries from 2009 to 2024, the study applies fixed-effects panel regression to control for unobserved heterogeneity. Asset quality is proxied using ratios such as non-performing loans to total loans, while ESG performance is measured via standardized ESG scores from Refinitiv. Financial performance is captured through indicators such as return on equity. Findings from this research are expected to provide nuanced insights into how internal bank dynamics, particularly profitability interact with sustainability practices in shaping asset quality outcomes. The study offers important implications for policymakers, bank managers, and regulators seeking to align financial stability with responsible banking through ESG integration, especially in emerging markets with dual banking systems.
