Impacts of monetary policy on credit supply of Islamic banks

Abstract

Knowing the transmission channels of monetary policy is important to effectively and successfully achieve the macroeconomic objectives of monetary policy. Indeed, after the 2007–08 financial crisis, we have a substantial amount of literature on the effectiveness and competence of the credit supply channel of banks. Nevertheless, we have very limited empirical evidence on the role of Islamic banks in the monetary policy transmission mechanism. This chapter therefore contributes to the literature by focusing on the role of Islamic banks in the monetary policy transmission process by exploring the differential impact of a monetary policy tightening on the credit supply of Islamic banks in the case of Pakistan and Malaysia and by investigating whether bank size and bank liquidity matter in formulating the effects of tight monetary policy. The dynamic panel data (aka system-GMM) estimator is used to overcome the issue of endogeneity and persistence. While estimating the effects of three alternative measures of monetary policy on banks’ credit supply, we include several bank-specific variables in the specification as control variables. The results provide strong evidence on the existence of credit supply cannel in both Pakistan and Malaysia, suggesting that Islamic banks significantly reduce their financing during episodes of monetary policy tightening. The results also suggest that the tightening of monetary policy more adversely affects the credit supply decisions of small-sized banks and less-liquid banks as compared to large-sized and more-liquid banks in both of the countries. Our findings suggest that there is a vital need to take into account the nature of Islamic banks and their size and liquidity positions while devising monetary policy instruments to efficiently manage credit supply in the economy and to successfully achieve the overall macroeconomic objectives of monetary policy.