Investigating the Effects of Geopolitical Risk, Oil Price Shocks, and Banking Stability on Financial Stability in Iran Using the Kalman Filter Approach

Abstract

This study aimed to investigate the effects of geopolitical risk, oil price shocks, and banking stability on financial development in Iran. In terms of purpose, the study is applied research, while in terms of nature, it is descriptive–analytical and classified as an ex post facto study. The statistical population comprises the Iranian economy, and the study period covers 1986–2024. In this study, financial development was measured using the ratio of bank credit extended to the private sector to gross domestic product (GDP), and the effects of oil price shocks, economic policy uncertainty, geopolitical risk, banking stability, bank profitability, and trade openness on financial development were examined. Oil price shocks were extracted using an autoregressive moving average model and an exponential generalized autoregressive conditional heteroskedasticity model. In addition, the economic policy uncertainty index was calculated by combining fluctuations in monetary, fiscal, and exchange-rate policies, inflation, and economic growth using the Hodrick–Prescott filter and principal component analysis. The banking stability index was also calculated based on the logarithm of the Z-score, incorporating capital adequacy, return on assets, and the standard deviation of return on assets. Given the possibility that the coefficients may vary over time, the research model was formulated within a state-space framework and estimated using the Kalman filter approach. The results of the Phillips–Perron test indicated that the study variables were nonstationary at level but became stationary after first differencing; therefore, all variables included in the model were integrated of order one. The Johansen–Juselius cointegration tests also confirmed the existence of a long-run equilibrium relationship among the model variables. Based on the Hansen test, the null hypothesis of parameter stability was rejected, indicating that the model coefficients varied over time and confirming the necessity of using the Kalman filter approach. The results obtained from estimating the state-space model showed that oil price shocks, economic policy uncertainty, and geopolitical risk had negative and statistically significant effects on financial development in Iran. The final coefficients of these variables were estimated at 0.072, -0.015, and -0.025, respectively. Accordingly, increased uncertainty arising from oil price volatility, instability in economic policies, and intensified geopolitical risks reduces financial development by increasing investment uncertainty, weakening public confidence, raising financing costs, shortening decision-making horizons, and reducing participation in formal financial markets. In contrast, banking stability, bank profitability, and trade openness had positive and statistically significant effects on financial development. The final coefficients of these variables were 0.094, 0.129, and 0.031, respectively. Therefore, strengthening banks’ loss-absorption capacity, improving asset quality, increasing the efficiency and profitability of the banking system, and expanding trade can enhance financial intermediation capacity and the provision of financial resources to the private sector. Examination of the time-varying coefficients further indicated that the magnitude and direction of the effects of the investigated factors were not constant across different periods.