Abstract

     Our investigation of 46 conventional and 22 Islamic banks from the Gulf Cooperation Council (GCC) countries during 2008–۲۰۲۱ reveals that sectoral diversification effects on stability are nonlinear and different for the two bank types. While Islamic banks’ stability is worsened only by moderate levels of diversification, conventional banks’ stability is enhanced by high levels and impaired by low levels of diversification. Furthermore, diversification acted as a stabilizer during the global financial crisis but exacerbated the adverse effects of the Covid-19 pandemic. Although regulators usually call for bank diversification, our results imply that it can be a double-edged sword.

Introduction

     Due to dependence on oil and gas revenue and their price plunge caused by the Global Financial Crisis (GFC) in 2008, the governments of the Gulf Cooperation Council (GCC) countries started introducing various policies aiming at developing diversified real and financial sectors.1 While oil and gas production still represents over 40% of the GDP in GCC countries, with the exception of Bahrain and UAE, (Esam, 2021) shows that there has been significant diversification away from hydrocarbon revenue since 2010 in all GCC countries, particularly in Saudi Arabia, UAE and Bahrain. Given the low development of capital markets and non-bank financial institutions in these countries, banks play a pivotal role in assisting the execution of these national diversification policies by providing financing to support investments in the existing and ‘new’ sectors. The proponents of diversification in banking would see this as an opportunity for banks to spread their loans and financing2 across different sectors and thus reduce bank default, liquidity, and bankruptcy risks (Diamond, 1984; Demsetz and Strahan, 1997; Rose and Hudgins, 2006), vulnerability to economic downturns and financial crises (Tabak et al., 2011; Doumpos et al., 2016), and become safer and more stable (Saunders and Walter, 2012). On the contrary, the opponents of diversification would argue that banks are better off by focusing on a single sector or a few sectors as that allows them to leverage their screening and monitoring knowledge and expertise in these sectors and thus reduce the unnecessary complexity, agency problems, overhead expenses (Klein and Saidenberg, 2010), earnings volatility (DeYoung and Roland, 2001), and write-downs and write-offs (Jahn et al., 2013) that usually come with diversification.

Discussion and conclusion

     Against the backdrop of the GCC countries’ ongoing economic diversification policies and banks being the primary financiers of the projects brought about by these policies, we investigate (i) if and how diversification of loans and financing across economic sectors impacts the stability of GCC banks, (ii) if the effects are the same on conventional and Islamic banks, and (iii) if diversification helps banks navigate smoothly through economic downturns such as the 2008 global financial crisis and the ongoing Covid-19 pandemic.

     anks navigate smoothly through economic downturns such as the 2008 global financial crisis and the ongoing Covid-19 pandemic. Analyzing a unique panel dataset of 46 conventional and 22 Islamic banks, we find that there is no one-strategy-fits-all even within these seemingly similar countries. Diversification effects on bank stability are nonlinear and different for Islamic and conventional banks. While Islamic banks’ stability worsens at moderate levels of diversification, conventional banks’ stability thrives at high levels and erodes at low levels of diversification. Given that the diversification measure is an inverse measure of concentration, this means that a high concentration of loans on one or a few economic sectors also benefits conventional banks. Lastly, we observe a temporal dimension of our results which suggests that diversification supported bank stability against the destabilizing effects of the global financial crisis but amplified the adverse effects of the Covid-19 pandemic.