The Effect of the International Bank Lending Channel and Exchange Rate on Islamic Bank Credit: Empirical Findings from Indonesia

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Open economies’ banking systems are prone to financial stability issues and global crises. Most financing to the private sector is channeled through bank credit, and Islamic banking is expanding worldwide. This study’s novelty compared to previous studies is investigating whether the international bank lending channel, measured by foreign interest rate changes, and exchange rate dynamics influences domestic Islamic bank credit vis-à-vis conventional bank credit. In Islamic banking, transactions based on interest are prohibited and hence should not influence Islamic bank credit. Employing the NARDL framework, this study found that Islamic bank credit is negatively related to foreign interest rates. In addition, Islamic bank credit is found to be more significantly affected by the international bank lending channel than conventional bank credit. Furthermore, the exchange rate negatively influences domestic Islamic bank credit more significantly than conventional bank credit. The findings are in contrast with parts of the literature, which insinuates that Islamic banking is immune to weaknesses of conventional banking system. For recommendations, in formulating policies aimed at financial stability, authorities must consider the international bank lending channel, exchange rate dynamics and take into account the different relationships these variables have with Islamic, and conventional bank credit.