Diversification and bank stability: Role of political instability and climate risk

Abstract

Amid the changing regulatory environment, economic volatility, and environmental complexities, the banking industry has experienced significant transformation. In this scenario, diversification has arisen as a critical risk management approach. This research investigates the intricate dynamics between bank diversification strategy and stability, particularly concentrating on the influences exerted by political uncertainty and climate-related risks. Our study examines the effect of bank diversification strategies on bank stability by using a sample of 271 banks operating in the MENA countries during the period 2009–2020. We also analyze how political instability and climate risk impact the nexus between diversification and bank stability. Our results show that the impact of enhancing banking diversification on stability is mixed. The bank's income and assets diversification improve the bank's stability. In contrast, diversification benefits appear to be deteriorating with the increase in non-interest activities-the so-called 'dark side of diversification.' While political instability and climate risk significantly affect the bank's stability and reduce the benefits of the bank's diversification strategy. Furthermore, the impact of diversification on bank stability varies across banks due to differing size and market power levels. Notably, the adverse impact of bank diversification on stability is more pronounced in conventional and GCC countries than in Islamic and non-GCC countries. The study offers significant policy implications for bank regulators to identify measures needed to address the risks of climate change in the banking sector and improve the stability of banks.