Effect of Geopolitical Risk, Oil Price Shocks, and Banking Stability on Financial Stability in Selected Islamic Countries: Emphasizing Profitability and Trade Volume

Abstract

The present study employs a Bayesian Panel Vector Autoregression (BPVAR) approach to empirically investigate balance-sheet sustainability and financial stability in selected Developing Eight (D-8) countries, namely Iran, Türkiye, Pakistan, Bangladesh, Indonesia, Malaysia, Egypt, and Nigeria, over the 2013–2024 period. Financial stability is measured using the ratio of bank credit extended to the private sector to gross domestic product (GDP), while fluctuations in the price of Iranian Heavy Crude Oil are extracted using an asymmetric EGARCH specification. To more accurately control for and measure policy interventions in the financial structure, a composite and locally adapted Economic Policy Uncertainty (EPU) index is developed using the Hodrick–Prescott filter and Principal Component Analysis (PCA), based on monetary, fiscal, and exchange-rate variables as well as the macroeconomic variables of growth and inflation. The results indicate that the interest rate has the largest weight in the construction of this composite index. Examination of variable stationarity using the Levin–Lin–Chu test indicates that all variables are stationary at level, while the Kao panel cointegration test confirms the existence of a long-run equilibrium relationship among the variables. Model evaluation using the Limer test indicates that the panel-data structure is preferable to the pooled estimation method. After determining an optimal lag length of one, the dynamic relationships within the model are estimated. The findings obtained from estimation of the Panel VAR system show that structural oil-price shocks, geopolitical risks, and economic policy uncertainty exert negative and statistically significant effects on the financial stability index of the selected Islamic countries. Sudden capital outflows during periods of geopolitical tension, disruptions to international trade networks, cost-push inflation resulting from supply shocks, and the imposition of structural budget deficits on governments are among the most important transmission channels through which these fluctuations affect financial-system resilience, thereby intensifying credit and liquidity risks within the banking network. By contrast, improvements in the bank stability index, increases in return on assets as an indicator of profitability and internal efficiency within the banking sector, and expansion of foreign trade volume, representing greater economic openness, exert positive and statistically significant effects on financial stability in these countries. The estimated error-correction coefficient is -0.09, indicating a moderate speed of adjustment toward long-run equilibrium and the dynamic stability of the system; approximately 9% of short-run deviations are corrected each year. Analysis of impulse response functions further confirms that the response of financial stability to shocks originating from the explanatory variables is dynamic and that the effects of these shocks gradually dissipate over time. Finally, the structural stability test based on inverse characteristic roots shows that all roots lie inside the unit circle, confirming the required mathematical stability of the model.