This paper investigates the effect of market structure, including some bank-specific variables and macroeconomic conditions, on the profitability of Indonesian Islamic rural banks. We apply the structure conduct performance (SCP) and the relative market power (RMP) hypothesis. Panel data comprising 142 Islamic rural banks from 2013Q1 to 2018Q4 are employed. This study breaks them apart, associated with the level of economic development consisting of Java as developed regions and outside Java as less developed regions. This study employs static and dynamic panel regression. The GMM method, however, is appropriate because of the dynamic nature of profitability. Our results confirm the SCP hypothesis and fail to support the RMP hypothesis. The higher market concentration allows Islamic rural banks to generate a significantly higher profit by conducting a collusive strategy. More interestingly, the collusive behavior may result in more profit for Islamic rural banks located in the developed regions than those in less developed regions. Evidence also highlights the importance of operating efficiency and impaired financing on profitability. High operating efficiency and low impaired financing can improve profit. Our results suggest that capitalizing market share by improving efficiency and optimizing financing contracts between PLS and non-PLS contracts also improve profit.

This paper investigates the impact of profit and loss sharing (PLS) contracts on non-performing financing of Islamic rural banks as Islamic small banks focus on small and medium enterprises at province level across country. Our study employs panel data, consisting of 142 Islamic rural banks and using quarterly data from 2013Q1 to 2018Q4, and splits them based on the bank’s size and geographical area. Both static and dynamic panel regressions are then applied. The results obviously indicate that a high proportion of profit and loss sharing contracts leads to high financing risk. The large Islamic banks encounter a higher non-performing financing stemming from profit and loss contracts compared to small Islamic banks. Profit and loss contracts also produce higher financing risk for Islamic banks outside Java, as those areas are less developed areas than Java itself. A more efficient Islamic bank is less financing risk. Income diversification lessens the impaired financing and, more particularly, large Islamic banks and Islamic banks located in Java much benefit by diversifying income and financing to lower financing risk. Our study suggests that Islamic rural banks may consider the optimal level of profit and loss sharing contracts to minimize financing risk.