Does Environmental, Social, and Governance Performance Reduce Credit Risk? Evidence from Islamic and Conventional Banks in the Gulf Cooperation Council

This study examines whether environmental, social, and governance (ESG) performance reduces credit risk in Gulf Cooperation Council (GCC) banks over 2014–2025, and whether this relationship differs between Islamic and conventional banks. Using loan-loss provision (LLP) ratios as the primary credit risk proxy, we estimate two-way fixed-effects panel regressions and, as the primary specification, a two-step System GMM estimator for 43 banks across six GCC countries (258 bank-year observations). Our results are threefold. First, accounting for profit persistence and endogenous capital accumulation through System GMM reveals a significant negative aggregate ESG–credit risk relationship absent from static fixed-effects estimates, directly supporting the credit risk reduction hypothesis. Second, pillar decomposition identifies the social score as the primary driver, while governance and environmental scores are individually insignificant in the full sample. Third, split-sample GMM estimates reveal that Islamic bank credit risk dynamics are structurally distinct: profitability (ROA) suppresses provisioning approximately 1.2 times more powerfully than in conventional banks, loan intensity disciplines rather than amplifies credit risk under Sharia asset-backed financing, and lagged provisioning exhibits a mean-reversion pattern unique to the profit-and-loss sharing model.