The Transmission of Monetary Policy Through Conventional and Islamic Banks

Abstract

We investigate the differences in banks' responses to monetary policy shocks across bank size, liquidity, and type-i.e., conventional versus Islamic-in Pakistan between 2002:Q2 and 2010:Q1. We find that following a monetary contraction, small banks with liquid balance sheets cut their lending less than other small banks. In contrast, large banks maintain their lending irrespective of their liquidity positions. Islamic banks, though similar in size to small banks, respond to monetary policy shocks as large banks. Hence, ceteris paribus, the credit channel of monetary policy may weaken when Islamic banking grows in relative importance.JEL Codes: E5, G2.

Banking Models and Monetary Transmission Mechanisms in Malaysia: Are Islamic Banks Different?

“…Finally, as noted by Zaheer et al . (), the lack of substitutable assets to Islamic financing may have further strengthened the effect of adverse shocks on Islamic financing. Thus, it is plausible that the lending channel working through the Islamic banking system would be more potent.…”

“…Accordingly, the transmission of monetary shocks through Islamic banks can be more potent. By contrast, the religious reasons underlying the use of Islamic financing services can potentially shield Islamic banks from monetary shocks (Zaheer et al ., ). This means that the lending channel can be weaker for the Islamic banks.…”

“…As noted by Zaheer et al . (), the Islamic banks may not view Islamic financing and securities to be substitutable. Moreover, the Islamic money markets are less developed and hence Islamic banks have limited access to alternative sources of funds other than deposits during adverse shocks (Farooq & Zaheer, ).…”

“…By contrast, Zaheer et al . () find that Islamic banks maintain their lending following monetary policy shocks for the case of Pakistan.…”

“…These include Ergeç and Arslan () for Turkey and Zaheer et al . () for Pakistan. In line with the Malaysian case, Ergeç and Arslan () reaffirm the sensitivity of Islamic financing to interest rate shocks.…”