The bank-lending channel of monetary policy transmission in a dual banking system: empirical evidence from panel VAR modeling

Abstract

This paper applied the panel VAR approach and the Impulse Response Functions to investigate the differences in the monetary transmission processes of Islamic and conventional banks using disaggregated bank-level data for Saudi Arabia over the period 2008Q1–2020Q4. Our findings show that: i) Islamic banks play a significant role in transmitting monetary policy decisions to the real economy through the balance sheet channel; ii) Islamic banks’ deposits are more responsive to oil price shocks than Islamic financing; iii) the reaction of Islamic banks to monetary policy and price shocks is relatively weaker than that of conventional banks, suggesting the existence of rigidities, such as excess liquidity, inertia in changing return rates, and the lack of funding and investment sources, and iv) the relatively significant responses of Islamic banks to various shocks make it easier for the Saudi central bank to achieve macroeconomic goals through monetary policy actions in a dual-banking system.

Keywords:

• Bank lending channel
• monetary policy transmission
• Islamic banking
• panel VAR

JEL classification:

• C33
• E44
• E52
• G21

PUBLIC INTEREST STATEMENT

This paper investigates the differences in the monetary transmission processes of Islamic and conventional banks using disaggregated bank-level data for Saudi Arabia. The main findings show that Islamic banks play a significant role in transmitting monetary policy decisions to the real economy through the balance sheet channel, and that their reaction to monetary policy and price shocks is relatively weaker than that of conventional banks, suggesting the existence of rigidities, and the lack of funding and investment sources.

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1. Our calculations from financial statements of Saudi banks.

2. The selected banks are Rajhi, Alinmaa, AlBaled, Aljazeera, NCB-AlAhly, Arab National Bank, Ryad Bank, Alawwal, The Saudi Investment Bank, Saudi Fransi BanK, Samba, and Saab.

3. Reserve money is narrowly defined as the monetary base, and it is the sum of currency outside banks and bank reserves.

4. Such financing is granted to customers without charging interest in order to be sharia-compliant. In Saudi Arabian Islamic banks, these methods fall mainly into four broad categories: Murabaha, Ijaraa, Istisnaa, and Musharakah. Murabaha is a financing agreement where the bank purchases a commodity or asset and sells it to the client at a price based on the purchase price plus a profit that is agreed with the client, meaning that the client is aware of both the cost and the bank’s profit. Ijaraa is an agreement whereby the bank, acting as a lessor, purchases or builds an asset for lease according to the request of the customer (the lessee), who agrees to lease the asset for a specified period for an agreed rent, and at the end of the period, ownership is transferred from the bank to the customer. Istisnaa financing is a financing agreement whereby the bank contracts the manufacture of a commodity with certain known specifications according to the client’s request. The client then becomes a debtor to the bank for the manufacturing price plus a profit. Musharaka is an agreement between the bank and a customer where the bank invests in a certain enterprise or the ownership of a certain property, ending with the customer acquiring the full ownership. Any profits or losses are shared per the terms of the agreement.

5. In Saudi Arabian Islamic banks, deposits comprise demand deposits and customers’ time investments based on the profit-sharing principle.

6. See Espinoza and Prasard (2012) and Alghaith et al. (2015).

7. In general, VAR models have been found to be an especially useful tool for estimating dynamic interactions between endogenous variables of interest. However, in empirical financial applications, sufficiently long data is typically a major constraint, and “the curse of dimensionality” frequently becomes a problem.

8. The GMM estimator was developed by Arellano and Bond (1991), Arellano and Bover (1995), and Blundell and Bond (1998) to tackle the endogeneity issue in the presence of unobserved fixed country effects.

9. This coefficient checks whether the overidentification restriction is rejected at the 5% significance level.

10. The results of estimated PVAR models are presented in the tables A1 to A4 of the appendix.

11. Boukhatem and Djelassi (2020a) argue that the four Saudi Islamic banks have, on average, lower loan-to-deposit ratios, much higher interbank ratios, and more comfortable liquidity ratios than conventional banks.

12. For more details about the weakness of the PLS mode of financing and the evolution of Islamic banking to a non-PLS system, refer to the work of Boukhatem and Djelassi (2020b).

13. A profit shock undergone by entrepreneurs will have a negative effect on the income of Islamic banks and the wealth of investment account holders (local risk). Since the depositors’ claims on banks are not guaranteed in nominal terms, decreases in the bank’s income will have a negative impact on the wealth of any depositors whose portfolio included a significant number of investment accounts. This structure may better resist shocks to the asset side of balance sheet because such shocks can be instantaneously absorbed by the liabilities side. This type of adjustment helps the stability of the banking system. In the case of the conventional banking system, there exists a dichotomy between assets and liabilities, and any shock that hits the assets side can generate instability (Boukhatem & Djelassi, 2020b).

14. Non-oil GDP, as a measure of output, can be considered as a proxy for domestic demand.

Additional information

Notes on contributors

Jamel Boukhatem

Jamel Boukhatem is full professor at the Faculty of Economic Sciences and Management of Tunis. His research focuses on monetary and financial macroeconomics. He has published papers in several indexed and high ranked Journals such as Emerging Markets and the Global Economy, Research in International Business and Finance, Journal of Applied Business Research, Bosra Istanbul Review, Annals of Financial Economics, Finance Research Letters, Quarterly Review of Economics and Finance, Quantitative Finance and Economics, Annals of Operations Research, Renewable and Sustainable Energy Reviews, International Journal of Economics and Financial Issues, Future Business Journal, and Heliyon Journal.