The Cyclical Behavior of Credit and Liquidity Risks on Bank Stability in MENA Countries with a Dual Banking System

Abstract

The purpose of this paper is to investigate whether credit and liquidity risks individually and/or jointly impact bank stability in the context of the dual banking system in the MENA region, and to check whether Islamic banks have different patterns in terms of the effect of the two risk categories on bank stability. Towards these goals, we estimate a dynamic panel model on a sample of 30 conventional banks and 14 Islamic banks from 9 countries covering the period 2004-2020, which is characterized by economic and political fluctuations and instability and includes the global financial crisis in 2008, the Arab Spring in 2011 and the COVID-19 pandemic in 2020. We found that the credit and liquidity risks impact individually and jointly bank stability. Our results also show that as banks are subject to more credit risk, they raise their risk-taking more during booms than during recessions, and as banks are subject to more liquidity risk, they take more risk during good economic times than bad ones. Additionally, controlling for Islamic banks, we find evidence that the negative effects of credit risk and liquidity risk on bank stability seem to be more pronounced for these types of banks. Our empirical results have valuable recommendations to risk managers and regulators. Firstly, the risk management unit of the banks should not only focus on illiquid or credit risky banks with the potential problem of instability, but also pay more attention to both risks jointly. Second, special attention should be paid to the risk management of Islamic banks since the effect of the two risk categories on their stability is more pronounced. Third, Islamic banks should launch research and development (RnD) programs to develop Islamic financial markets for better risk management. Fourth, the monetary policy authorities should consider both the quality of borrowers and bank liquidity in the formulation of monetary policy as channels through which they can conduct an effective monetary policyto attain the macroeconomic objectives of the policy. Finally, policymakers should consider the improvement of institutional structure, a well-functioning Islamic money market, and sound regulatory framework as prerequisites to make the banks more stable.