Macroprudential policy and financing behaviour in dual banking system: Bank-level evidence from Indonesia

The Islamic financial system has received a great deal of attention on issues related to financial stability in recent years. The proponents of Islamic finance believed that the Islamic financial system is theoretically and empirically proven to be more resilient toward financial crises than its conventional counterpart. The resilience and stability of Islamic banks stem from their distinctive features: the prohibition of interest, speculative transactions, and excessive risk taking activities. Shari’ah principles prohibit speculation and excessive risk taking because they led to detrimental impacts to the financial system and society. However, the Islamic financial system is still not immune to the crises, because the existing business model is akin to conventional banking and contains deviations from Shari’ah norms and objectives.

This paper provides a contribution to the macroprudential literature by examining the dual banking system regulation in Indonesia. Using a dynamic panel model, we examine the influence of a reserve requirement based loan-to-funding ratio (RR-LFR) on the financing behaviour of both conventional and Islamic banks from 2001 until 2015. The RR-LFR framework is formulated to mitigate systemic risks by considering the liquidity condition of the banking sector as well as preserving financial stability. Understanding the mechanism of macroprudential policy using a bank-level dataset improves the framework of macroprudential policies, particularly within a dual banking system. This study employs the system generalized method of moments (GMM) estimator proposed by Arellano & Bond (1995) and Blundell & Bond (1998), which is viewed to be superior in dealing with dynamic panel modelling. The dynamic GMM estimator is essentially an instrumental variable estimator that uses the lagged value of all endogenous regressors as well as lagged and current values of all strictly exogenous regressors as their instruments.

The findings suggest that the RR-LFR framework is effective in lowering lending activities of dual banking systems. However, when we disaggregate the RR-LFR impact into conventional and Islamic banks, the results suggest that the RR-LFR exerts more influence in managing credit expansion of conventional banks compared to Islamic banks. Further analysis to capture the impact of different categories of bank-specific characteristics and types of institutions shows that different groups of banks react to RR-LFR policy. For both conventional and Islamic banks, larger banks are more prone to macroprudential policy as compared to smaller banks, while public-owned banks are more vulnerable to change in macroprudential policy than foreign banks.