Bank lending channel in a dual banking system: Why are Islamic banks so responsive?

• DOI: http://doi.org/10.1111/twec.12507
• Published date: 01 March 2018
• Date: 01 March 2018

SPECIAL ISSUE ARTICLE

Bank lending channel in a dual banking system:

Why are Islamic banks so responsive?

Ahmet F. Aysan

1

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Mustafa Disli

2

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Huseyin Ozturk

3

1

Istanbul Sehir University, Istanbul, Turkey

2

Ghent University, Ghent, Belgium

3

Central Bank of the Republic of Turkey, Ankara, Turkey

1

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INTRODUCTION

The bank lending channel posits that central banks—at least in part—can control banking sector’s

ability to lend by adjusting the reserve supply via open market operations. On a contractionary pol-

icy, open market operations of central banks drain reserves and hence deposits from the banking

system. If banks are not able to find alternative sources of funding to compensate for this deposit

withdrawal, the supply of bank loans will decrease. Although this spillover chain is well estab-

lished for varying size (Kashyap & Stein, 1995; Stein & Kashyap, 2000), liquidity (Ashcraft,

2006; Stein & Kashyap, 2000) and capitalisation (Kishan & Opiela, 2000) of banks, there is still

lack of evidence on how this mechanism works for different bank types. Studying the monetary

transmission mechanism for different bank types is relevant because it may have different impacts

on bank lending. This is especially important to identify how effectively centr al banks can influ-

ence the level of reserves (deposits) and, as a consequence, bank lending (credits). In this study,

we empirically compare the bank lending channel in a dual banking system where Islamic and

conventional banks operate side by side. Since the bank lending channel incorporates the beha-

viour of customers and creditors in a single transmission mechanism, we will be able to unders tand

different behavioural patterns of both of these groups in different banking schemes.

Although Islamic and conventional banks fulfil similar intermediary roles, moral foundations of

Islamic banking make Islamic banks and their depositors distinct from those of conventional banks.

From a customer’s perspective, Islamic banks contribute to financial inclusion by attracting reli-

giously motivated customers into the system (e.g. Kumru & Sarntisart, 2016). Islamic banks may

represent a morally appealing alternative for those customers whose financial preferences are dri-

ven by religious beliefs. Religiosity also appears to be a major determinant for consumer choice

behaviour (Essoo & Dibb, 2004), irrespective of the religion the individual is attached to (see e.g.

Wilkes, Burnett, & Howell, 1986). For instance, Miller and Hoffmann (1995) report a negative

correlation between religiosity and attitudes towards risk at individual level. Similarly, Hilary and

Hui (2009) find that firms located in US counties with high levels of religiosity tend to exhibit

lower risk exposure as measured by the variances in returns on assets or equity. In a similar vein,

as argued by Abedifar, Molyneux, and Tarazi (2013), Islamic bank depositors are more sensitive

DOI: 10.1111/twec.12507

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©2017 John Wiley & Sons Ltd wileyonlinelibrary.com/journal/twec World Econ. 2018;41:674–698.

to bank performance and macroeconomic shocks and demonstrate greater withdrawal risk than

their conventional counterparts.

From the bank’s perspective too, whether or not having a religious affiliation might have an

influence on the willingness to supply credit. Since Islamic banks employ severa l unique financial

models and contracts, the customer portfolios of Islamic and conventional banks may substantially

vary. Further, recent research suggests that conventional banks put more weight on collateral in

their credit allocation decisions (e.g. Aysan, Disli, Ng, & Ozturk, 2016; Shaban, Duygun, Anwar,

& Akbar, 2014). Because of their opaque nature, especially the small and medium-sized enterprises

(SMEs) segment of the market seems to face credit constraints from this practice (Carpenter &

Petersen, 2002). Islamic banks, on the other hand, may be more attractive to SMEs since they sub-

stantially relieve collateral requirements by making use of murabaha

1

contracts. Moreover, in a

dual banking system, conventional banks are generally more established houses and have solid

relations with larger firms who have “hard”information. Islamic banks, which still hold marginal

shares in the banking systems, may fulfil SMEs’credit demand by relying on “soft”information.

Despite their strong growth, Islamic banks still do not hold a significant place in the banking

industry, which forces them to target the untapped SME market. Recent empirical results using

data from Indonesia (Shaban et al., 2014) and Turkey (Aysan, Disli, Ng, et al., 2016) show that

Islamic banks’willingness to finance SMEs is significantly higher than that of conventional banks.

However, given the growing body of evidence that small businesses are more exposed to economic

and policy shocks (see e.g. Berger & Udell, 2002; ECB, 2016; OECD, 2012), it can be argued that

Islamic bank lending is more sensitive to monetary and economic shocks.

Especially since the outbreak of the global financial crisis, Islamic banking has emerged as a

viable complementary scheme in the global banking system. Parallel to the rising visibility of the

Islamic banking sector, growing academic attention has resulted in a wide range of research foci.

A number of studies have focused on the efficiency differences between Isla mic and conventional

banks (e.g. Abdul-Majid, Saal, & Battisti, 2010; Samad, 1999; Srairi, 2010), while others have

documented operational differences between them (e.g. Beck, Demirg€

ucß-Kunt, & Merrouche,

2013; Daher, Masih, & Ibrahim, 2015; Elnahass, Izzeldin, & Abdelsalam, 2014; Ibrahim, 2016;

Iqbal, 2001). Another stream of research has explored the resilience of Islamic banks with the out-

break of the 2008 global financial crisis (Abedifar et al., 2013; Cih

ak & Hesse, 2010; Hasan &

Dridi, 2011; Rajhi & Hassairi, 2013). Closer to this study, there is a growing literature that exami-

nes the impact of monetary policy and several transmission channels in a dual banking environ-

ment. Among these studies, for instance, Sukmana and Kassim (2010) and Zulkhibri and Sukmana

(2016) examine, respectively, the behaviour of Malaysian and Indonesian Islamic banks in the

monetary transmission process. Both of these studies conclude that Islamic financial institutions

play a significant role in the monetary transmission. Zaheer, Ongena, and van Wijnbergen (2013)

study the differences of banks’responses to monetary shocks across bank size, liquidity and bank

type in Pakistan. They find that Islamic banks’reaction to monetary shocks is relatively limited

and conclude that the bank lending channel may weaken when Islamic banking grows in relative

importance. In line with the above-mentioned literature, this paper first separately examines the

presence of the bank lending channel for the transmission of monetary policy through Islamic and

conventional banks in Turkey. We then provide an in-depth discussion of the observed differences

and explore the potential reasons for this discrepancy by conducting additional exercises and

robustness checks.

1

In a murabaha contract, the bank buys a product on behalf of a client and resells the product to the same client with the

cost of the product and a mark-up (margin).

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