Solvency and Liquidity of Islamic Banks Under Political Instability

Abstract

Political instability can lead to market uncertainty, volatile investor sentiment, and a shortage of liquidity provisions. It often disrupts economic growth, financial markets, and leads to cross-border effects. Moreover, weak institutional environments with poor contract enforcement and investor protection lead to a decline in investor confidence. Thus, political factors can easily shape the performance and development of the banking system. Using data from Islamic banks, this study employs System Generalized Method of Moments (GMM) to explore how different levels of political risk directly affects the capital adequacy and liquidity decisions of Islamic banks. Additionally, this study examines the role of capital markets in managing Islamic banks' liquidity and capital buffers, while also analyzing the impact of the COVID-19 pandemic on their capital and liquidity decisions. The sample includes 166 Islamic banks globally and covers a 7-year period from 2017 to 2023. Capital adequacy and liquidity ratios are crucial as they reflect a bank’s ability to absorb systematic shocks and sudden withdrawal demands, such as those caused by political instability. Compared to conventional banks, Islamic banks face unique challenges due to their geographic concentration, real-economy sensitivity, and regulatory dependencies. Results show strong persistence in capital and suggest slow capital adjustment speeds and adjustment barriers. Bank-level control variables such as profitability and size, provide evidence for the franchise value hypothesis and pecking order theory. Additionally, Islamic banks are well-capitalized in politically stable countries. The results also suggest that political stability matters less to capital decisions when capital markets are well-developed. Besides this, the COVID-19 pandemic adversely affected liquidity levels but had no significant impact on Islamic banks' capital levels. The study highlights how underdeveloped Islamic capital markets constrain Islamic banks’ ability to manage capital and liquidity effectively, particularly in maintaining adequate buffers and adapting to regulatory or market shifts. Given these challenges, regulators should focus on three key priorities: deepening Islamic capital markets to expand financial infrastructure, harmonizing regulatory standards to reduce transaction costs, and closely monitoring capital adjustment speeds to identify systemic barriers. These measures would strengthen banks’ capacity to absorb shocks while supporting the broader stability of the Islamic financial system in the long run.

Date of Award	2025
Original language	American English
Awarding Institution	HBKU College of Islamic Studies