Abstract
This study examines the interplay among institutional quality, efficiency, and financial stability in the Malaysian Islamic banking sector with a special emphasis on the interaction between efficiency and institutional quality. The sample comprises 16 Islamic banks from 2012 to 2020. The indicators for financial stability are Z-score based on return on assets (ZROA) and non-performing loans (NPLs). The system generalized method of moments (GMM) is employed to overcome the potential endogeneity issue in our regression. The findings show that institutional quality (i.e. government effectiveness, regulatory quality, and rule of law) influences Islamic banking performance. Based on the interaction model, government effectiveness and regulatory quality have a negative and statistically significant impact on ZROA. Conversely, government effectiveness and regulatory quality positively and statistically influence financial stability, as measured by NPLs. As for the rule of law, financial stability (i.e., ZROA) can be achieved in a strict environment when Islamic banks are inefficient.
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