Purpose This study aims to investigate the effect of environmental, social and governance (ESG) strategies on non-performing loans (NPLs) in Islamic banking operations in emerging markets. Design/methodology/approach The research utilizes a random effect regression model to analyze a cross-country dataset from the Refinitiv Eikon database, including 26 Islamic banks across 10 emerging economies. The final sample includes 121 bank-year observations, over 12 years from 2012 to 2024. Sensitivity analyses and two-stage least squares (2SLS) regressions are also checked for robustness against the baseline model. Findings The results indicate a positive and significant association between ESG performance and NPLs in Islamic banks. ESG pillar-level analysis reveals that this relationship is driven by the environmental and social dimensions, which suggests that engagement of both dimensions, often characterized by higher upfront costs, longer investment horizons and exposure to a higher-risk borrower segment, may elevate short-term credit risk if not accompanied by adaptive risk management practices. In contrast, the governance pillar in Islamic banks appears to be more compliance-oriented and less directly linked to credit risk. Research limitations/implications The study is limited to Islamic banks in emerging markets, so the results may not be generalizable to conventional banks or financial institutions in developed economies. Future research could explore the underlying mechanisms driving this relationship and consider longitudinal analysis. Practical implications The findings suggest that ESG strategies, if not well-integrated into risk assessment frameworks, may inadvertently weaken credit quality. Policymakers and Islamic bank management should reassess ESG implementation to align with financial stability objectives. Originality/value This study provides novel empirical evidence on the unintended consequences of ESG engagement in Islamic banking, providing valuable insights for regulators and practitioners in emerging markets who are aiming to optimize ESG integration without compromising financial soundness.
Tumewang et al. (Tue,) studied this question.