Environmental, social and governance aspects have increasingly shaped banking processes, with numerous studies highlighting their influence on financial performance and stability across the banking sector (Demirgüç-Kunt et al. 2024). Recently, researchers have explored how diversity, inclusion and sustainable practices affect ESG performance and bank stability. Globally, Arnone et al. (2024) examine incorporating ESG aspects in banking processes and find that ESG adoption not only enhances stability but also supports banks’ roles as ESG investment facilitators and risk managers. The study underscores the necessity of adapting regulatory frameworks to support ESG-aligned business models, thus ensuring sustainable growth in the sector. Additionally, the ability of ESG indicators to predict bank risk is emphasised by Citterio and King (2023), who find that integrating ESG measures in parallel with conventional financial indicators enhances the ability to predict bank distress. Their study advocates for ESG factors to be incorporated into predictive models and regulatory frameworks, as they significantly reduce the misclassification of distressed banks as stable. Sendi (2024) further examine market responses to ESG, finding that financial markets are increasingly internalising ESG performance, with regional variations across Europe, the Americas, Oceania and Asia. This study underscores the evolving investor recognition of ESG’s impact on bank valuation. Elnahass et al. (2021) find that global banking stability was negatively influenced by the COVID-19 pandemic. A study of 1090 banks across 116 countries showed that the outbreak led to poor financial performance and stability indicators. This effect was seen in different regions, countries and forms of banks, including conventional and Islamic banks. However, in the second quarter of 2020, there were indications that bank stability was improving.

In the European context, Saïdane and Ben Abdallah (2020) investigate the two-way connection between bank stability and sustainability, discovering that sustainability enhances stability, while stability poses a challenge to maintaining environmental and governance sustainability. Bouattour et al. (2024) also analyse ESG’s influence on bank stability in Europe, finding a nonlinear relationship moderated by digital transformations. This study identified that higher ESG performance correlates with reduced bank fragility in the digital era, particularly within European banks. Di Tommaso and Thornton (2020) find that low risk-taking is connected with high ESG scores in European banks but may lower overall bank value – a finding that underscores the trade-off between risk reduction and value preservation.

Xie et al. (2022) look at the impact of the global epidemic on the sector of banking in emerging Asian economies from Quarter 1, 2016 to Quarter 2, 2021. Different regression models were used for the study. The results showed that bank performance is positively related with gross domestic product (GDP) and bank size before and during the pandemic. However, during the epidemic, GDP and bank size had less of an effect on banking performance than it was previously. The study also discovered that the banking sector in Asian emerging nations was greatly impacted by the epidemic of COVID-19. Karim et al. (2022) examine the effects of rules related to sustainable banking in Pakistan from 2006 to 2020, especially during COVID-19. Their results show positive effect on bank characteristics like profitability and market return. Pakistani banks improved in various areas during the pandemic, indicating the effectiveness of sustainable banking regulations. Financial stability plays a crucial role in moderating the connection, guaranteeing useful sustainable banking operations and reduced default risk. In this context, Abbas et al. (2024) show that economic freedom aggravates banks’ risk-taking for Japanese banks, thus increasing their stability. They argue that while economic freedom can foster a competitive and efficient banking environment, it may also encourage riskier financial practices if not properly regulated. Azmi et al. (2021) analyse ESG’s effect on bank value in emerging economies, finding a nonlinear connection: bank value is increased by moderate ESG activity, while high levels show diminishing returns. Weber and Oni (2015) observe no significant link between sustainability practices and NPLs in Bangladeshi banks, suggesting that contextual factors may moderate the ESG-stability relationship. Moreover, environmental initiatives in particular improve cash flows and reduce the cost of equity but do not impact debt costs, aligning with both stakeholder and trade-off theories. Further, by examining the nonlinear effects of ESG factors, Yin et al. (2024) find a U-shaped connection between firm ESG performance and financial technology in China, where digital finance initially suppressed but later promoted ESG goals. Their findings emphasise the purpose of technology transformation in facilitating ESG improvements and the importance of regulatory environments in moderating these effects.

Tumewang et al. (2024) analyse the connection between diversity, inclusion and ESG performance in Islamic and conventional banks, revealing that a diverse and inclusive workplace significantly enhances ESG outcomes. Notably, this effect was stronger in Islamic banks, indicating the unique alignment of ESG goals within Islamic banking structures. Similarly, Alghafes et al. (2024) study ESG aspects’ effect on financial outcomes among Islamic banks in GCC countries, finding that governance and social factors positively affected financial metrics, although environmental factors had a less immediate impact. In a similar regional context, Shome et al. (2023) conduct a bibliometric review of banking literature in GCC countries and identified research gaps in risk-taking, systemic stability and performance, providing a guide for future studies on ESG and stability in the region. Mateev et al. (2024) examine how, during COVID-19, efficiency of markets and intensity affect the stability of the banking sector, the data from 575 banks in Middle East and North Africa (MENA) countries are used while efficiency enhances performance and stability, market intensity has a detrimental impact on profitability during the epidemic, market intensity – rather than efficiency – determines bank stability and Islamic banks with higher efficiency perform better during the pandemic compared to conventional banks. Table 2 A1 in Online Appendix 1 summarise a list of key empirical studies on the topic.

Table 4 exhibits the regression results. The table shows four estimated models, with column (1) showing the regression results using the aggregate ESG score as a proxy for banks’ ESG performance. The remaining columns (2–4) replicate the same regression for individual ESG factors. The results remain consistent across the four models, where ESG, environmental and governance factors show a significant negative effect on bank stability. However, the social factor is insignificant in this context. In addition, the lagged dependent variable LZscore (−1) is significant and positive across all models, which indicates the persistence of bank stability overtime, and the diagnostics tests affirm the validity of the estimation results.

The findings are consistent with the strand of the literature that suggests that the integration of ESG into banking practices may incur high initial costs that compromise banking stability (Athari et al. 2024; Chiaramonte et al. 2022; Do et al. 2024). As opposed to this result, some empirical evidence show that high ESG scores are associated with lower bank risk-taking and enhanced stability (Di Tommaso & Thornton 2020). In this context, Chiaramonte et al. (2022) argue that while the favourable benefits of bank stability are eventual, previous empirical evidence suggests that it takes time until these benefits are reaped, and banks may incur a substantial cost before the positive effect threshold is reached. Moreover, Do et al. (2024) and Athari et al. (2024) stress that investment in ESG demands the deployment of extensive amounts of human and capital resources, which adversely affects the value of the firm. Therefore, while adopting ESG may ensure long-run benefits for the banks, it may exert negative short-term effects on banks value and risk.

Moreover, the economic freedom index (EF) is only found significant in model (3), with a positive coefficient that indicates a favourable effect of the economic freedom on banking stability. The results align with the recent evidence provided by Adam et al. (2024) and Defung and Yudaruddin (2022), who report a positive effects of economic freedom on banking stability in sub-Saharan countries and Indonesia, respectively. For instance Adam et al. (2024) demonstrate that higher levels of economic freedom are associated with increased bank stability, showing that liberalised economic environments can enhance financial institutions’ stability.

The bank-specific variables show mixed results. For instance, bank size (Size) has a significant positive coefficient only in model (1), which indicates that larger banks have enhanced stability. This results ultimately supports the ‘concentration-stability hypothesis’, which posits that larger banks with higher concentration enhances banks stability because of lower competition (Beck et al. 2013; Calice & Leonida 2018). In this context, Adusei (2015) finds that larger banks in Ghana exhibit lower banking stability. The income diversity variable (Income_diversity), which represents how much of the bank’s income is generated from no-interest sources, is insignificant in all models. This is an indicator that the banks in the region are heavily dependent on interest income from traditional banking activities. This result confirms the previous findings of Abuzayed et al. (2018), who report insignificant effect of non-interest income on bank stability in the GCC countries.

On the other hand, macroeconomic variables are deemed to be significant factors affecting banking stability. To begin with, the coefficients of inflation are negative and significant across all models. This indicates that higher inflation erodes stability of banks in the GCC region. The results correspond to the literature, which suggests that while inflation increases the interest margin, it also erodes banks’ profitability due to heightened levels of credit risk (Adusei 2015; Mabkhot & Al-Wesabi 2022; Pak & Nurmakhanova 2013). Similarly, the coefficient of GDP growth are positive and significant suggesting that better economic conditions are reflected in improved bank stability. Sendi (2024) argues that inclusion of ESG activities during good economic conditions greatly enhance banks stability.

In Table 5, we re-estimate the regressions with the COVID-19 variable, by including a dummy variable to account for the COVID-19 pandemic period, whereas it takes the value of 1 for years 2020–2022 and 0 otherwise. By and large, the results remain consistent with the main results reported in Table 4. The estimated coefficient of COVID-19 is negative and highly significant in all models, which is interpreted by the damaging effects of the pandemic on bank’s stability. The findings are consistent with the previous literature (Al-Habashneh et al. 2023; Shabir et al. 2023; Broadstock et al. 2021). Demirgüç-Kunt et al. (2021) stress that the pandemic is threatening banking system stability as it exhausts lenders’ buffers and erodes assets’ quality.