Effects of financial liberalisation on the financial stability : a comparative analysis between Islamic banks and conventional banks in Malaysia

Abstract

As a financial intermediary the banking sector plays a critical role mobilizing funds between the surplus and shortage units . However, the global financial market has experienced a marked change as a result of the shift from financial repression to financial liberalisation. Such a shift led to the flow of capital across borders and the financial sector development. Competition and deregulation of interest rate are the two mechanisms of financial liberalisation. The effect of financial liberalisation on financial stability can be passed through or mediated by these two mechanisms. In Islamic banks, the mediating effects may differ from those of conventional banks due to the Shariah constraints. A liberalised banking sector prompted commercial banks to intensify risk-taking activities, which ultimately could affect the financial stability adversely vis-a-vis the survival of smaller banks. This study, therefore aimed to analyse the mediating role of competition and interest rate in the relationship between financial liberalisation and financial stability in Malaysian conventional and Islamic banks. As the sample period of this study covered the periods of two financial crises, namely the 1997 Asian Financial Crisis and 2008 Global Financial Crisis this study further investigated such mediating relationships prior, during and after the said financial crises. Using the PLS-SEM method, the empirical results showed that financial liberalisation significantly affected financial stability of conventional and Islamic banks. Likewise, competition and interest rate significantly mediated the link between the financial liberalisation and financial stability. Meanwhile, competition was the only significant mediator between financial liberalisation and financial stability before and during the 2008 Global Financial Crisis. This research extended the financial liberalisation theory, structure-conduct-performance theory, competition fragility view and competition stability view in predicting financial stability by investigating the mediating role of the two financial liberalisation mechanisms. This study found that the competition fragility view holds conventional and Islamic banks when competition mediates the relationship that will affect financial stability. The government need to intervene to preserve the financial stability when there is a competition . It also can be concluded that this study has an implication for policy makers and the banking industry. As for Islamic banks, they need to preserve their stability in the financial liberalisation setting with the mediation for both competition and interest rate. Lastly, competition and interest rate needs to be set at the best possible level so that financial stability can be well preserved especially for Islamic banks that are abide by the Shariah. An area of novelty offered by the study lies in examining the mediating variables of competition and interest rate between the financial liberalisation and financial stability by comparing between the Islamic and conventional banks.