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Maintaining financial stability has always been one of the most important economic aims. The literature related to financial stability shows the effect of variables like financial development and financial liberalization on financial instability. However, some conflicting results have been reported about the direction of this impact. Accordingly, the purpose of this study is to investigate the effect of various factors on financial instability with an emphasis on the variables of financial development and financial liberalization in developing countries. The financial instability index calculated by the PCA approach and annual observations from 2005 to 2019 is employed. The research model is estimated using the System-GMM. The results indicate that financial development in developing countries has a positive effect on financial instability and exacerbates it due to the lack of correspondence between the goals of policymakers and the realities of financial markets in such countries. Moreover, the positive impact of financial liberalization on financial instability is obtained representing that following fiscal policies implemented in countries with developed financial markets is not working in developing countries. Thus, financial decision-makers in these countries must adopt stabilization policies in accordance with the characteristics of their financial markets. In addition, the results confirm the negative impact of the government size on financial stability in developing countries, emphasizing the reduction of government presence and the development of the private sector in these markets.

Keywords: Financial instability, financial development, financial liberalization, government size, PCA, SGMM

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