Abstract:
The present study attempts to assess the impact of three important dimensions of diversification (income, product and geographic) on banks’ financial stability using panel data of 184 banks from 11 Islamic countries namely Bahrain, Kuwait, Indonesia, Malaysia, Oman, Pakistan, Qatar, Saudi Arabia, Turkey, UAE and Yemen for the period from 2006 to 2017. The study has also taken into consideration the moderating role of bank size and contagion risk in shaping diversification-stability nexus, which is considered relatively ignored research area in corporate finance literature. This study adopts a two-step analysis to examine the impact of diversification on the banking sector’s financial stability. First, a novel Financial Stability Index is constructed and put into the analysis along with traditional stability indicator of Z-Score. Then, the study uses the Herfindahl Hirschman Index as a proxy for diversification to explore the influence of income, product and geographical diversity on banks’ financial stability. Secondly, the study uses the system GMM framework and finds that income diversification plays a significant role in enhancing banking financial stability. While, geographical diversification within the home country enhances financial stability by providing risk reduction benefits. Further, pure Islamic banks are found to be more financially sound than pure conventional banks. In addition, the role of geographical diversification and income diversification on stability helps in understanding the networks through which income and geographical diversification can help deepen the financial systems. Further, bank size and contagion risk plays a significant moderating role in shaping the linkage between bank diversification and financial stability showing that benefits from diversification are dependent on bank size and reduced in the presence of contagion risk. The study contributes to the enduring debate on the inclusion of different non-financial services into banking portfolios with a view to enhancing their resilience to losses as well as bankruptcy risk. These results have important policy implications for banking regulators to enhance financial stability through bank diversification strategies.
