How diversification shapes full-fledged Islamic bank Stability? A causal inference approach

The banking literature has long debated the effect of diversification on financial stability, yielding inconclusive results. This ongoing debate arises from two main limitations, namely a primary focus on conventional banks, which overlooks the distinct risk-sharing principles of Islamic banks, and the widespread assumption of linear relationships, disregarding essential threshold effects. Departing from traditional econometric approaches, this study employs a causal inference framework to reveal how diversification's effects on Islamic banks' stability fundamentally reverse across intensity levels. Our analysis demonstrates a critical dichotomy: while moderate diversification enhances stability, excessive diversification undermines it. Utilizing aggregate-level data from 13 countries (2013Q4–2022Q4), we employ the generalized propensity score-dose response function (GPS-DRF) approach, which effectively captures curvilinear relationships between diversification and stability. Our findings, which remain robust across multiple tests, indicate a non-linear and asymmetric relationship with moderate diversification enhancing stability, whereas excessive diversification undermines it. These findings provide actionable insights for financial practitioners and policymakers, with significant implications for Islamic banking regulation and risk management strategies.