Interplay of Institutional Quality, Efficiency, and Stability in The Islamic Banking Sector of Malaysia

Abstract

Malaysia’s institutions, regulations, and policies affect the performance of the Islamic banking sector. Nevertheless, it also influences the cost of financial intermediaries, which is linked to bank efficiency. Hence, banking performance is affected by the cost of financial intermediaries. This study examines institutional quality, efficiency, and financial stability in the context of the Malaysian Islamic banking sector with the addition of interaction terms 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 (government effectiveness, regulatory quality, and the rule of law) influences Islamic banking performance. Based on the interaction terms, government effectiveness and regulatory quality have a negative and statistically significant impact on ZROA due to Islamic banks’ inefficiency. Conversely, government effectiveness and regulatory quality positively and statistically influence financial stability, as measured by NPLs. As for the rule of law, financial stability based on ZROA can be achieved in a strict environment when Islamic banks are inefficient.