Diversification and nonlinear credit cyclicality in dual-banking systems

Purpose This study aims to investigate whether diversification stabilizes bank lending over the business cycle, with a particular focus on differences between Islamic and conventional banks in dual-banking systems. Design/methodology/approach Using a dynamic panel of 65 banks from the Gulf Cooperation Council between 2008 and 2021, the analysis uses the system generalized method of moments estimator to examine the effects of loan and income diversification, measured using inverse Herfindahl–Hirschman Index (inverse HHI) indicators, on credit cyclicality. Findings The results reveal a nonlinear, inverted U-shaped relationship between GDP growth and credit expansion. Conventional banks remain procyclical throughout the cycle, while Islamic banks are procyclical mainly during downturns. Income diversification supports overall credit growth but increases procyclicality in highly diversified conventional banks. Loan portfolio diversification reduces procyclicality in both bank types, particularly at moderate diversification levels. Research limitations/implications The study focuses on Gulf Cooperation Council banks and may not generalize to other banking systems. Future research could explore broader regional contexts and alternative diversification measures beyond inverse HHI-based measures. Practical implications Policymakers should consider institutional and portfolio differences in macroprudential frameworks, encouraging loan diversification while carefully monitoring the systemic risks of income-based expansion. Social implications This study shows how diversification strategies influence credit stability over the business cycle in dual-banking systems. By identifying when loan diversification dampens procyclicality and when income diversification may amplify it, the findings inform macroprudential policy design aimed at reducing excessive credit contractions. In bank-based economies, a more stable credit supply supports the continuity of investment and the resilience of small businesses. The results also contribute to a more balanced understanding of Islamic and conventional banking models, highlighting that financial resilience depends on portfolio structure rather than institutional form alone. Originality/value This study offers novel evidence on the nonlinear and bank-type-specific effects of diversification on lending cyclicality, providing policy-relevant insights for dual-banking systems.