Bank stability dynamic: uncovering pathways with structural equation modeling (SEM)

Purpose Bank stability is vital to maintaining a resilient financial system and a healthy economy. Unlike conventional banks, Islamic banks cannot use interest-bearing instruments, compelling them to adopt alternative financial strategies to manage liquidity while remaining Shariah-compliant. This study aims to investigate the factors influencing the stability of Islamic banks, which operate under Shariah principles and emphasize risk-sharing. Islamic banks face unique liquidity management challenges due to the prohibition of interest-bearing instruments, necessitating alternative financial strategies. Design/methodology/approach This research uses partial least squares structural equation modeling (PLS-SEM) to analyze the relationship between bank-specific factors (term deposits, asset quality, Islamic contracts, profitability) and macroeconomic factors, with liquidity risk as a mediator, on bank stability. Data from the annual reports of listed banks in Malaysia, covering 2010–2023, were analyzed. Findings The results highlight that asset quality and economic conditions significantly impact bank stability, while liquidity risk mediates the relationship between term deposits, Islamic contracts, profitability and bank stability. The study’s findings underscore the importance of effective liquidity management and the development of Shariah-compliant liquidity instruments to enhance the stability of Islamic banks. Research limitations/implications These insights are crucial for regulators, investors and policymakers to mitigate risks and promote sustainable financial growth. Practical implications This study contributes to the existing literature by providing empirical evidence on the determinants of Islamic bank stability, specifically incorporating liquidity risk as a mediating factor. Originality/value Unlike previous research that primarily focuses on conventional banking models, this study uses PLS-SEM to capture complex interrelationships among bank-specific and macroeconomic factors within the unique framework of Islamic finance.