EFFECT OF ISLAMIC FINANCIAL SYSTEM STABILITY ON ECONOMIC PERFORMANCE IN INDONESIA: EVIDENCE FROM DYNAMIC FACTOR MODEL AND NARDL APPROACHES

Abstract

This study constructs the financial stability indexes of Islamic and conventional banking systems for Indonesia using the dynamic factor model. Both stability indexes are then linked to economic performance in Indonesia by employing a nonlinear autoregressive distributed lag (NARDL) model. We contribute to the literature by investigating the possibility of asymmetric linkages between both financial system stability indexes and economic performance. The financial stability indexes constructed and a broad range of macro-financial variables can capture the 2008-2009 global financial crisis and the 2020-2021 COVID-19 pandemic crisis periods. The most significant results posit that positive and negative shocks in Islamic financial stability in the long run increase and decrease economic performance, respectively. However, the financial stability of conventional banks is negatively associated with economic performance in the long run. The quantile regression results also demonstrate that Islamic financial stability is statistically significant throughout all quantiles in promoting economic performance. It plays a greater role at lower quantiles and diminishes when the economic performance has been achieved at a high level. However, the conventional banking stability is a negative and significant determinant of economic performance throughout all quantiles. Results highlight that the stability of the financial system especially the Islamic financial system deepening would enhance economic performance.