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Advances in Social Sciences Research Journal – Vol. 11, No. 11

Publication Date: November 25, 2024

DOI:10.14738/assrj.1111.17840.

Alsulmi, F., Mahmood, R., & Sapar, R. (2024). The Effects of Credit, Liquidity, and Operational Risks on GCC Bank Financial Stability:

Moderating Role of Board Size. Advances in Social Sciences Research Journal, 11(11). 191-207.

Services for Science and Education – United Kingdom

The Effects of Credit, Liquidity, and Operational Risks on GCC

Bank Financial Stability: Moderating Role of Board Size

Fatima Alsulmi

Putra Business School,

University Putra of Malaysia, Selangor, Malaysia

Rosli Mahmood

Putra Business School,

University Putra of Malaysia, Selangor, Malaysia

Resul Sapar

Putra Business School,

University Putra of Malaysia, Selangor, Malaysia

ABSTRACT

This paper examined the impact of three types of bank risk: credit, liquidity, and

operational risk on bank financial stability. It also examined the moderating role of

board size and board frequency meetings. It also investigated the macroeconomic

factors such as GDP growth and inflation and their influence on bank financial

stability. A sample of listed banks in GCC stock exchanges from 2014 to 2022 using

a panel data analysis. The findings highlighted that credit and operational risk

significantly impact a bank's financial stability, but liquidity risk is unrelated to the

bank's financial stability. In addition, GDP and the Covid-19 pandemic had a

negative impact on bank financial stability. Board size significantly moderates

relationships between credit risk, operation risk, and bank financial stability.

Keywords: Risk, Financial Stability, Governance, GCC.

INTRODUCTION

Over the past ten years, the term “financial stability” has come to represent a crucial role that

central banks and other public bodies play. Although financial stability has only recently been

used, central banks have long been concerned about banking stability. Over the past 30 years,

several issues have arisen in commercial banking and other areas of the financial sector

worldwide. These issues are primarily attributable to poor risk management by commercial

banks and other players during financial market deregulation. This example demonstrates the

need for strong regulation by strong regulators to maintain stability in the commercial banking

sector [1].The financial stability of a system is when lenders, such as banks and other financial

markets, can offer households, societies, and businesses the funds required to contribute,

invest, and grow in the economy, even in unfavourable events or shocks [2]. Although it is

challenging to define and quantify bank stability, a banking system can be considered unstable

when there is an excessive fluctuation in assets or during a crisis [3].

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Advances in Social Sciences Research Journal (ASSRJ) Vol. 11, Issue 11, November-2024

Services for Science and Education – United Kingdom

GCC refers to the Gulf Corporation Council, founded in 1981 in Abu Dhabi and consists of six

countries: the Kingdom of Saudi Arabia, the Sultanate of Oman, the United Arab Emirates, the

State of Bahrain, the State of Qatar, and the State of Kuwait. Furthermore, they agreed on a

cooperative framework that would unite the six countries to achieve unity through

coordination, integration, and interconnection among the Member States in all fields. They have

unique relationships, shared characteristics, and comparable systems based on the Islamic

religion, belief in a shared destiny, and shared objective [4-6].

In the Gulf Cooperation Council (GCC) countries, there are two primary types of banking

systems: Islamic and conventional. Several countries, notably the GCC, use a dual banking

system in which Islamic banks coexist with traditional banks. The division of banks into Islamic

and conventional categories derives from how these institutions carry out their primary

intermediation services, which include collecting deposits, making loans, and, on the other

hand, paying (charging) interest or returns. Structure, regulators, international standards such

as capital requirements, and corporate governance in GCC banks [7-9].

The banking sector has experienced instability at different times in the past. A bank's financial

stability is commonly measured by the bank z-score ratio, which uses the sum of ROA and the

equity-to-asset ratio (EAR) by the standard deviation of ROA. Over the past 15 years, the return

on equity (ROA) has been dropping throughout the area, with the GCC region experiencing a

worse decline than emerging market economies (EMs). Data indicates that ROAs decreased on

average from 2006 to 2020 in all GCC countries. Leverage increased widely in all areas.

Increased leverage resulted in increased debt expenses, as seen by the interest coverage ratio,

which has decreased significantly since 2007. This can lead to a decline in banks' asset quality

and the materialization of contingent liabilities [10].

Combining certain factors of the banking environment with crucial external variables has led

to the stability of the banking sector in the GCC region [11]. A recent report by IMF (2022)

highlighted how the banking sector in GCC countries is vulnerable even with the government.

The double shock of COVID-19 and oil prices in 2020 exacerbated these vulnerabilities further,

even though monetary and fiscal policy support helped cushion their impact. Although not

critical, profitability, debt service, liquidity, and revenue have declined - translating into fewer

buffers to cope with the subdued demand and low capital expenditure levels.

THEORETICAL BACKGROUND

The theory of financial intermediation was adopted by Diamond and Dybvig [12]. This theory

serves two essential functions: facilitating risk transfer and managing the intricate web of

financial instruments and markets. Additionally, this theory can explain banks’ inherent risks

and their role as a source of returns [13]. According to Diamond and Dybvig [12], banks can

only achieve stability if there is a match between their liquidity and assets. According to

Kashyap, Rajan [14], banks function as financial intermediaries, acquiring assets using funds

obtained through deposits, equity issuance, or bonds. This banking model suggests that banks

facilitate financial transactions and drive economic growth. A particular focus of the theory of

financial intermediation is the role banks play in vetting and supervising borrowers during the

loan process [15]. factors that affect bank financial stability examined factors such as credit

risk, liquidity risk, and Operational risk [16, 17]. These risk factors are linked to FIT because

the central concept of FIT, which pictures banks as intermediates, can disrupt the

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Alsulmi, F., Mahmood, R., & Sapar, R. (2024). The Effects of Credit, Liquidity, and Operational Risks on GCC Bank Financial Stability: Moderating

Role of Board Size. Advances in Social Sciences Research Journal, 11(11). 191-207.

URL: http://dx.doi.org/10.14738/assrj.1111.17840

intermediation process by limiting banks' capacity to extend credit or fulfil their duties to

creditors and depositors.

Based on the agency theory assumptions, it can be inferred that larger boards may negatively

affect board dynamics, leading to decreased efficiency and effectiveness. Poor communication,

coordination problems, and limited flexibility in the decision-making process are potential

challenges that larger boards may face [18]. The agency theory is one of the main theories in

the governance framework [17]. The theory addresses agency problems arising from the

conflict of interest between the firm’s management, board, shareholders, and any party

interested in the firm. The agency problem is heightened by the failure of shareholders to

monitor senior managers successfully. Within the banking sector, senior managers' present and

future wage opportunities may be influenced by the banks' future successes or long-term

sustainability [19]. It also demands the formation of board sub-committees, risk management,

and internal control systems to observe managerial attitude [17, 20].

LITERATURE REVIEW AND HYPOTHESIS DEVELOPMENT

Financial Stability

The term financial stability of the financial system can be used when extreme volatility, stress,

or crises are absent. Narrowly, it can be defined if the financial system can function well

compared to the overall economy; it involves how smoothly the complex relationship between

financial markets, infrastructures, and institutions [21-23]. Banking industry stability is

highlighted by the strong profitability of their operations and enough liquidity, showing that

banks have a balanced structure of assets and liabilities [24]. Nevertheless, due to the poor

quality of their capital, assets, and liabilities and the aggressiveness of their loan strategy,

raising credit risk and, consequently, the likelihood of losses, banks’ financial stability may be

compromised in the medium future. The financial stability of developed and emerging nations,

however, differs significantly. For instance, economic progress, regulatory frameworks, and

institutional quality can all affect how well private credit can increase financial stability.

Additionally, depending on the economic environment, currency price variations can affect

financial stability [25-27]. Specifically, emerging economies may have weak early warning signs

than advanced economies, reflecting the unique challenges and risks faced by these economies.

Gulaliyev, Ashurbayli-Huseynova [28] highlighted that identifying the factors depends on

various factors, such as the nature of the research questions, the types of data available, and the

specific characteristics of the variables being used or location.

Credit Risk

Credit risk is described by Supervision and Settlements [29] as “the potential that a bank

borrower or counterparty will fail to meet its obligations following with agreed term credit risk

management aims to maximize a bank’s risk-adjusted rate of return by maintaining credit risk

exposure within acceptable parameters.” Financial institutions typically face credit risk on the

asset side of the balance sheet. Haron and Hock [30] claimed that there may be credit risk when

the bank buys the goods and then sells them to the client for a profit. Credit risk arises,

nevertheless, if a customer breaches their delivery-related commitments. A bank must accept

credit risk since it exists to receive deposits and extend credit [1, 31, 32]. By far, the most

significant risk that banks confront is credit risk, and more than any other risk, the success of

their operations depends on precise measurement and effective management of this risk [33].

Scholars found that credit risk harms and reduces a bank’s stability and affects bank survival