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ISSN : 1598-7248 (Print)
ISSN : 2234-6473 (Online)
Industrial Engineering & Management Systems Vol.21 No.2 pp.168-182
DOI : https://doi.org/10.7232/iems.2022.21.2.168

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

Taufiq Carnegie Dawood*, Alamsyah Alwi, Rustam Effendi, Muhammad Abrar
Fakultas Ekonomi dan Bisnis, Universitas Syiah Kuala, Indonesia
Fakulti Ekonomi dan Pengurusan, Universiti College Bestari (UC Bestari), Malaysia
School of Social Science, Universiti Sains Malaysia, Fakultas Ekonomi dan Bisnis, Universitas Syiah Kuala, Indonesia
Fakultas Ekonomi dan Bisnis, Universitas Syiah Kuala, Banda Aceh, Indonesia
*Corresponding Author, E-mail: taufiq.dawood@unsyiah.ac.id
March 4, 2020 ; June 17, 2021 ; December 27, 2021

## Abstract

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.

## 1. INTRODUCTION

Open economies’ banking systems are prone to issues related to financial stability and global crises. Changes in monetary policy stance, which resulted in alterations of policy rates of large, developed nations, had a significant impact on the financial and banking sector of other countries. Prior to 2017, as the world economy was recovering from global financial crises of 2008 and 2012, developed economies were in the path of gradual monetary policy tightening. This development caused a rise in foreign interest rates faced by developed and developing open economies. However, The United States’ recent macroeconomic policy changes tend to loosen the Federal Funds Rate (Conti-Brown, 2018). This development would lower foreign interest rates for other open economies. The oscillations of foreign interest rates due to changes in the monetary policy stance of developed countries would have significant spill-over effects on the domestic financial systems of other open economies—particularly their banking sectors.

Global financial crises had shown the importance of financial system stability for macroeconomic soundness. Triggered by sharp depreciation of the domestic currency, developing countries in East Asia suffered severely from the East Asia financial crisis of 1997, which caused substantial fall in GDP and large unemployment hikes (Dwyer et al., 2013). Furthermore, the financial crisis caused sharp poverty increase, including in Indonesia (Dhanani and Islam, 2002). Similarly, financial stability is important for developed economies. The sub-prime mortgage-backed securities debacle in the United States, which triggered the 2008 global crisis, shown that financial stability issues have significant ramifications to the real sector (Rey, 2016).

Financing is key for all businesses, and banks hold prominent position in providing credit to private businesses and households. Approximately 75 percent of developing countries’ credit to the non-financial private sector are supplied by the banking sector in 2018. While in advanced economies, roughly 49 percent of total financing was channeled through bank credit (See table A.1 in Appendix A). This suggests that bank credit dynamics have significant implications towards the stability of the financial system (Hofmann, 2004).

Islamic banking is an important and rapidly growing segment of the banking sector. However, Islamic banks are distinct from conventional banks. According to Khan et al. (2021), the fundamental essence of Islamic banks is to promote the culture of risk-sharing (i.e., profit and loss sharing), which does not involve transactions based on interest, uncertainty, or speculation. In addition, Islamic banks focus on financing the real sector part of the economy which complies with the halal Islamic principle. Similarly, according to Rashid et al. (2020), Islamic banking, in principle, is different in nature and composition of assets and liabilities as compared to their conventional counterparts. Unlike conventional banking, Islamic banking is based on the prohibition of interest on bank deposits and credit. Furthermore, Islamic banking activities are based on the concept of profit and loss sharing on both the assets and liabilities side.

Due to the different operating procedures between Islamic and conventional banks, there is a set of literature which insinuates that Islamic banking is relatively immune to the weaknesses of the conventional banking system. Hasan and Dridi (2011) in a cross-country study found that Islamic banks’ credit and asset growth performed better than did that of Conventional banks’ in 2008–2009, contributing to financial and economic stability. Similarly, Rahim and Zakaria (2013) found that during the global financial crisis, when various sources of bank income was adversely affected, Islamic banks remained stable as opposed to the conventional banks. Likewise, Sorwar et al. (2016) found Islamic banks to be less risky than conventional banks; and especially so during the global financial crisis. Furthermore, Mohammed and Muhammed (2017) deduced that Islamic banking is not only safer than conventional banking, but it can safeguard the national economy during a period of crisis. While the results from Erfani and Vasigh (2018) suggest that Islamic banks overall were more financially solvent as compared to commercial banks.

However, there are studies which found that Islamic banks are not less riskier than conventional banks. Mokni et al. (2016) found that conventional banks are more stable than Islamic banks in the MENA area during the period 2002-2009. While Mahdi and Abbes (2018) found that the Global financial crisis had a significant impact on the capital, risk and liquidity of both conventional and Islamic banks. In similar light, Lassoued (2018) found that Islamic banks are much more susceptible towards credit and insolvency risk and they in general have a lower degree of stability compared to that of conventional banks. Furthermore, Aysan and Ozturk (2018) found evidence which conflict with some of the findings that indicated Islamic banks as natural stabilizers in the banking systems. While, Haddad et al. (2021) found that conventional banks are more solvent than Islamic banks during a financial stable period.

Islamic banking has become increasingly important in Indonesia and worldwide. Indonesia is the largest Muslim country in the world and in addition to conventional banks, it relies on the Islamic banking system, also known as the dual banking system. Islamic banking in Indonesia initialized by the establishment of Bank Muamalat Indonesia in 1992 (Syathiri et al., 2020). Loan contracts in the Islamic banking system often termed Islamic financing, are different from loan contracts of conventional banks, where each Islamic banks’ credit must comply with basic rules of lending and borrowing stipulated by Islamic law. For instance, Islamic law strictly prohibits any transactions involving interest (riba) in loan contracts (Majid, 2016). In September 2003, total Islamic bank credit in Indonesia amounted to USD 337 million, which constituted only 1.2 percent of total bank credit in Indonesia. By December 2018, it subsequently grown by 66 times and constituted 6.32 percent of the total bank financing in Indonesia (Figure 1). In a global context, a dual banking system was first implemented in Malaysia in 1983 (Mohammed et al., 2018). It has since expanded to other countries, even nations where the Islamic faith is not dominant among its citizens (Abedifar et al., 2016).

Although the Islamic principles strictly prohibit interest rates, research on relationships between domestic interest rates and Islamic bank credit and deposits is growing. Kassim et al. (2009) studied domestic monetary policy impact on Islamic and conventional banks in Malaysia. Similarly, Yusof et al. (2009) explored the effects of domestic monetary policy shocks on Islamic and conventional bank deposits in Malaysia and Bahrain. Ergeç and Arslan (2013) explored domestic interest rates impact on Islamic and conventional banks in Turkey and Zaheer et al. (2013) analyzed domestic monetary policy effects on Islamic and conventional banks in Pakistan. Additionally, both Hasin and Majid (2015) and Akhatova et al. (2016) evaluated the importance of Islamic banking on monetary transmission in Malaysia. Louhichi and Boujelbene (2016) examined the impact of domestic interest rates on Islamic bank credit in The Middle East and North African (MENA). While Zulkhibri and Sukmana (2017) studied the effect of domestic monetary policy on the dual banking system in Indonesia.

Changes in the monetary policy stance of a developed foreign country affects the foreign interest rate have implications for domestic financing in other economies. This mechanism is known as the international bank lending channel. According to Albrizio et al. (2020), the international bank lending channel is a transmission mechanism on how changes in the monetary policy stance of a developed country spill over to the rest of the world. This article found that an increase in funding costs (foreign interest rate) following an exogenous monetary tightening in a developed foreign country, leads to a statistically and economically significant decline of domestic bank lending in other countries.

There are a growing number of studies analyzing whether the international bank lending channel, as measured in changes of foreign rates of interest of a developed country, affects domestic conventional bank credit in other countries. Bruno and Shin (2015) analyzed US monetary policy effects on cross-border capital flows through US global banks in foreign countries. Dawood (2018a) studied the impact of foreign interest rate on domestic conventional bank credit in developing countries and also the impact of foreign interest rates dynamics on domestic conventional bank credit in Indonesia (Dawood, 2018b). Morais et al. (2019) analyzed the effect of US and European monetary policy on domestic conventional bank credit in Mexico. Lindner et al. (2019) studied effects of the US, UK and Euro Area’s monetary policy on domestic conventional bank credit in Germany and Austria. Gajewski et al. (2019) investigated US monetary policy’s effect on domestic conventional bank credit in Chile, Korea and Poland. Hills et al. (2019) explored monetary policy effects of the US, Europe and Japan on conventional bank credit of major financial centers. Auer et al. (2019) evaluated US, Euro Area and UK monetary policy effects on domestic conventional bank credit in Canada and Switzerland. While Bräuning and Ivashina (2019) studied US monetary policy effect on domestic conventional bank credit in emerging market economies. However, these studies are limited only to conventional bank credit. To the best of the authors’ knowledge, no analysis has been performed on this topic for Islamic bank credit. This is a novelty of the current study compared to previous research.

There is a growing literature that discusses the effect of exchange rate changes on conventional bank credit. Zanforlin (2011) studied the effect of exchange rate changes on domestic conventional bank credit on a panel study of 91 countries. Similarly, Magud and Vesperoni (2015) analyzed the effect of the exchange rate change on conventional bank credit in a panel study of 179 countries. Likewise Eickmeier and Ng (2015) explored the effect of exchange rate on conventional bank credit in a panel of 33 developed and emerging economies. While Cesa-Bianchi et al. (2018) conducted a panel study of 50 developed and emerging countries on the effect of the exchange rate and conventional bank credit. Finally Avdjiev et al. (2019) investigated the influence of exchange rate changes on domestic conventional bank credit to the private sector in a panel of 34 emerging market economies. Yet, previous research on this topic is mainly focused on conventional bank credit, and to the best of our knowledge there is yet a comparison study of the effect of the exchange rate on Islamic bank credit versus conventional bank credit. This serve as another novelty of the current paper compared to existing studies.

Given that there is currently no study which analyzes whether the international bank lending channel and the exchange rate affect Islamic bank credit in the domestic economy, this study fills this gap by analyzing whether the international bank lending channel and the exchange rate affect the movement of Islamic bank credit in the domestic economy, by exploring data for Indonesia. This issue is relevant since Islamic banking is rapidly developing around the world (Abedifar et al., 2016), and understanding what macroeconomic variables governs Islamic bank credit is at the forefront for policymakers concerned with financial stability in the domestic economy.

## 2. LITERATURE REVIEW

There is extensive literature that analyzes the effect of domestic interest rates on domestic conventional domestic bank credit and finds a negative relationship between the two variables. This literature falls under the topic of bank lending channel transmission mechanism of monetary policy, pioneered by Bernanke and Blinder (1992) and was explored through various angles. For US data, these papers found that a rise in the US monetary policy rate caused a fall of US conventional bank credit (for example, see Vera, 2012). Some recent extensions of this topic in other countries are Altunbas et al. (2010) which found that an increased domestic interest rate reduced domestic conventional bank credit in the Euro Area. Jiménez et al. (2014) found that a rise in the domestic interest rate due to domestic monetary policy contraction by the Bank of Spain reduced Spanish bank credit. Ciccarelli et al. (2015) found that a domestic monetary contraction resulted in a fall of bank credit in the Euro Area. In developing countries, Abdul Karim et al. (2011) found that conventional bank credit in Malaysia is negatively related to the policy rate of Bank Negara Malaysia. Bhatt and Kishor (2013) found that a monetary contraction by the Reserve Bank of India resulted in a drop in Indian conventional bank credit. Similarly, Mahathanaseth and Tauer (2019) found that domestic interest is negatively related to domestic conventional bank credit in Thailand.

Although Islamic banking principles strictly prohibit transactions involving interest rates and thus should have no effect on Islamic bank credit and deposits, there is a growing literature that explores the relationship between domestic interest rates and Islamic bank credit and deposits. However, the findings of this literature are mixed. Kassim et al. (2009) found that a rise in Malaysian interest rates decreased domestic Islamic bank’s credit. Furthermore Ergeç and Arslan (2013) found that domestic interest rates affected Islamic bank credit in Turkey. While Hasin and Majid (2015) found a negative long-run relationship between domestic interest rates and Islamic bank credit in Malaysia. In a similar light Akhatova et al. (2016) found that Islamic bank credit in Malaysia responded to monetary contractions by Bank Negara Malaysia. In addition, Aysan et al. (2018b) found that domestic Islamic bank deposits are more responsive to domestic interest rate dynamics compared to their conventional counterpart, and increases in domestic interest rates cause domestic Islamic bank deposits to rise. In contrast, Zaheer et al. (2013) found that domestic Islamic bank credit was not sensitive to domestic interest rates in Pakistan. Similarly, Zulkhibri and Sukmana (2017) found that the monetary policy rate of Bank Indonesia had no significant effect on domestic Islamic bank credit in Indonesia.

There are growing studies that analyze the relationship between changes in foreign rates of interest due to changes in the monetary policy stance of a developed foreign country and domestic credit from conventional banks in other countries. This set of studies falls under the international bank lending channel transmission mechanism (Ongena et al., 2021). However, the analysis of this issue is still not conclusive. Dawood (2018b) found that changes in foreign interest rates had a negative effect on Indonesian conventional bank credit. While Morais et al. (2019) found that a rise in the foreign interest rate due to US monetary policy tightening resulted in a fall in domestic conventional bank credit in Mexico. Gajewski et al. (2019) discovered that foreign interest dynamics are negatively related to domestic conventional bank credit in Chile, Korea, and Poland. Hills et al. (2019) found that foreign interest rate changes affected domestic conventional bank credit negatively in the UK and Hong Kong. While Bräuning and Ivashina (2020) found that foreign interest rates rises caused a fall in domestic conventional bank credit in emerging markets economies. However, Auer et al. (2019) found that a rise in foreign interest rates increased domestic conventional bank credit in Switzerland but had no effect on bank credit in Canada. As a note, the current literature on the international bank lending channel transmission mechanism only focus on conventional banks. To the best of our knowledge, there is currently no study which analyzed this issue in the context of Islamic bank credit.

Studies found that an exchange rate depreciation reduced domestic conventional bank credit. A panel study (Zanforlin, 2011) found that an exchange rate depreciation reduced domestic conventional bank credit. Similarly, Magud and Vesperoni (2015), in another panel study, found that a depreciation of the exchange rate was followed by a fall in domestic conventional bank credit to the private sector. Eickmeier and Ng (2015) found appreciation of the exchange rate resulted in a rise in domestic conventional bank credit in a panel of 33 developed and emerging economies. A panel study of 50 developed and emerging countries Cesa-Bianchi et al. (2018) found that an appreciation of the exchange rate and increased the volume of domestic conventional bank credit. Similarly, in a panel study of 34 emerging market economies, Avdjiev et al. (2019) found that a US Dollar appreciation (thus a depreciation of another country’s currency) resulted in a fall of domestic conventional bank credit to the private sector in the other country.

Although there is growing research which investigates whether the international bank lending channel and the exchange rate affects conventional bank credit in the domestic economy, to the best of the authors’ knowledge, there is currently no study that investigated whether the international bank lending channel and the exchange rate affects domestic Islamic bank credit, and compare it with conventional bank credit. Thus, there is a need to fill this gap in the literature by investigating whether these two external factors determine the movements of Islamic bank credit in the domestic economy.

## 3. METHODOLOGY

This paper employs a non-linear autoregressive distributed lag (NARDL) model. The purpose is to analyze possible non-linear cointegrating relationships (Maulana et al., 2021). In particular, employing the NARDL embeds the possible asymmetric relationship between foreign interest rate and bank credit; whether the relationship is similar between a rise in foreign interest rates with that of a fall. The NARDL is the non-linear extension of the autoregressive distributed lag (ARDL) framework. The ARDL framework was proposed by Pesaran et al. (2001). The ARDL is used to analyse long-run and short-run relationships and is applied to data with different degrees of integration (Rasoolizad and Rasoolizadeh, 2019).

The NARDL framework used in this analysis consists of seven variables of monthly Indonesian data from January 2004 to July 2018. The data span was chosen based on data availability. The variables are gross domestic product (GDP) (industrial production index as proxy), money supply (MS) (M2 as proxy), the nominal exchange rate between the Indonesian Rupiah and US dollar (ER), domestic interest rate (DR), foreign interest rate (FR) (Federal Funds rate as proxy), inflation (CPI) (Consumer Price Index as proxy), Islamic Bank Credit (ISC) and Conventional Bank Credit (CC). Data on “GDP” was obtained from the OECD database, MS, ER, DR, CPI and CC from Bank Indonesia, ISC was obtained from The Indonesian Authority of Financial Services (OJK), while FR from The Federal Reserve Economic Database (FRED). DR, CPI, FR, MS, and CC are measured in percentage points, while other variables are written in natural logarithms. The choice of variables is an extension of Imran and Nishat (2013) research by adding foreign interest rates and replacing conventional bank credit with Islamic bank credit.

There are several steps to the ARDL. Initially, a unit root test is performed to determine the degree of integration of variables. This step is followed by estimating co-integration (long-run relationship) between macroeconomic variables on bank credit. Extending the work by Imran and Nishat (2013) by adding foreign interest rates and Islamic bank credit in place of conventional bank credit, equation (1) represents Islamic Bank Credit (ISC) as a function of all other variables in the current study.

(1)

The coefficients in Equation (1) only yield long-run effects. The dynamic error correction model (ECM) representation with foreign interest rate and Islamic bank credit is derived from the ARDL model through linear transformations (Banerjee et al., 1993). Following Banerjee et al. (1993), the ECM representation which combines short-term and long-run relationships, is presented in equation (2).

(2)

The NARDL model is constructed as follows. The ARDL model in equation (2) assumes all variables have symmetric effects on bank credit. The NARDL relaxes this assumption by allowing a foreign interest rate rise to have different effects on bank credit than a fall in foreign interest rate (Maulana et al., 2021). Following Bahmani-oskooee and Saha (2016), we separate between foreign interest rate (FRPOS) rise and fall (FRNEG) by using cumulative sum. Cumulative sum is computed by introducing two different measures: one for foreign interest rate hikes and the other for a fall. To calculate the cumulative sum, first form the time series , then form two series by replacing negative values with zeros, compute the partial sum of positive values . Then replace positive values with zeros, compute the partial sum of negative values , where $F R j +$ and $F R j −$ denote positive and negative values respectively. Given FRPOS and FRNEG, transform equation (2) to obtain NARDL specifications in equation (3).

(3)

According to Shin et al. (2014), the bound testing approach of Pesaran et al. (2001) can be applied to equation (3). The next step is to ascertain co-integration by using the Bound test proposed by Pesaran et al. (2001). Finally, investigate the stability of the model by performing the cumulative sum of recursive residuals (CUSUM) and residual squares (CUSUMSQ).

## 4. RESULTS AND DISCUSSIONS

### 4.1 Stationarity Tests (Unit Root Test)

A stationary test is performed to determine the degree of integration of data in order to ensure the appropriateness of the NARDL method. Following Bahmani-oskooee and Saha (2016), stationary tests employed in this study is the Augmented Dickey-Fuller (ADF) Test. The test results show that the requirements for the NARDL are satisfied. Table 1 shows that foreign interest rates (FR), inflation (CPI) and money supply (MS) are stationary at levels. While GDP, the logarithms of the nominal exchange rate between Indonesian Rupiah and the US dollar (ER), domestic interest rates (DR) and the logarithms of Islamic bank credit (ISC) are non-stationary at levels, but are stationary at the first difference. These results imply that (FR), (CPI), and (MS) are integrated of order zero (I(0)), while all the other variables are integrated of order one (I(1)). Differences in orders of integration confirm the appropriateness of the NARDL framework for the analysis (Pesaran et al., 2001).

### 4.2 Estimation Results

Prior to performing the estimation of the NARDL model, the suitable lag length must be selected. Following Imran and Nishat (2013), the selection criteria of optimal lags for the NARDL is the Akaike Information Criterion (AIC).

Foreign interest rate (FR) change, due to change of monetary policy stance of a developed foreign country is negatively related to domestic Islamic bank credit (ISC). Using the Federal Funds Rate, the monetary policy instrument of the Federal Reserve of the United States, Table 2 shows that there is a significant negative long-run relationship between the foreign interest rate (FR) and domestic Islamic bank credit (ISC), in the case of the foreign interest rate rise. The argument of this result is as follows. Since there is no literature that discussed the effects of the international bank lending channel on Islamic bank’s credit, we amend the argument of the international bank lending channel for credit for conventional banks. In this channel, a monetary contraction in a foreign economy that increases foreign interest rates reduces the liquidity of funds available for bank credit in the foreign economy (Morais et al., 2019). Given the domestic economy is an open economy with an international flow of funds to and from the economy, increases in foreign interest rates cause the number of foreign funds channeled as bank credit to the domestic economy to decrease (Auer et al., 2019). In addition, a rise in foreign interest rates would also induce capital outflow from the domestic economy, which leads to a reduction of liquidity available to domestic banks to extend bank credit (Dawood, 2018a). Furthermore, according to Aysan et al. (2018a), depositors in both Islamic and conventional banks respond to interest rate changes. When Islamic bank depositors’ opportunity costs rise due to changes in interest rate differentials due to a rise in foreign interest rate (Zanforlin, 2011), they do not hesitate to withdraw deposits. While Aysan et al. (2018b) found that Islamic bank credit is more highly dependent on bank deposits than conventional bank credit. In sum, a rise in foreign interest rates due to the monetary contraction of a developed foreign country resulted in a fall of domestic bank deposits and thus a reduction of domestic Islamic bank credit.

The negative long-run relationship between foreign interest rate results seems to contradict the basic principles of Islamic banking of interest rates prohibition. However, the argument for this result is that borrowers of Islamic bank credit do not necessarily adhere to Islamic banking principles around prohibited interest rates (riba). Islamic banks’ businesses cater to a wide range of depositors and borrowers (Abedifar et al., 2016). Furthermore, bank customers in an open economy with a dual banking system, such as in Indonesia, have the choice between taking credit from Islamic banks, from conventional domestic banks, or even from foreign banks. Furthermore, there are cases where depositors have the choice of depositing their funds in either Islamic banks or conventional banks. Thus if there is an increase in interest rates due to the profit-loss- sharing principle of Islamic bank deposits, depositors may have the incentive to switch their deposits from Islamic banks to conventional banks Yusof et al. (2009), Zainol and Kassim (2010), or even to foreign banks. This would reduce the amount of liquidity available for banks to extend loans. Such incentive is also evident in the case of a foreign interest rate hikes which alter interest rate differentials (Zanforlin, 2011), causing Islamic bank depositors to transfer their funds to other banks, or even abroad (capital outflow) (Aysan et al., 2018a). The capital outflow decreases deposits and liquidity available to Islamic banks, and since Islamic bank lending is highly dependent on deposits (Aysan et al., 2018b), Islamic bank credit falls.

Using alternative measures for foreign interest rates also reveals a negative long-run relationship between foreign interest rates and Islamic bank credit. As a robustness check, an alternative foreign interest rate (the overnight LIBOR) was used in the analysis. Results in Table 2 shows that the findings of a negative long-run relationship between foreign interest rates vis-à-vis Islamic bank credit still holds.

However, the foreign interest rate has a positive long-run relationship with domestic conventional bank credit. As a comparison, we examine the effect of foreign interest rates on conventional bank credit using similar NARDL model specification, with conventional bank credit data transformed to growth rates (instead of levels) to ensure that the variable is integrated of order 1 (a condition required to apply the ARDL and NARDL method). The results show that foreign interest rates have a significant positive long-run relationship with domestic conventional bank credit. This result indicates that a rise in foreign interest rate caused a decline in liquidity due to the fall of credit originating from foreign conventional banks’ operating in the domestic economy (Morais et al., 2019). The decline of credit from foreign banks is offset by an increase in credit from conventional domestic banks (Bräuning and Ivashina, 2019). In addition, given that firms have sufficient time to adjust their balance sheet, they would substitute away from the costlier foreign conventional banks’ funding to credit originating from conventional domestic banks. Ultimately, the rise in foreign interest rates causes an increase of credit from conventional domestic banks (Dawood, 2018a).

Domestic interest rate is negatively related in the long run-with conventional bank credit, but not with Islamic bank credit. As shown in Table 2, there is a significant negative long-run equilibrium relationship between domestic interest rates (DR) and conventional bank credit. This result is in line with the findings of (Bernanke and Blinder, 1992) and numerous others scholars in various countries for example (Vera, 2012;Altunbas et al., 2010;Jiménez et al., 2012;Jiménez et al., 2014;Mahathanaseth and Tauer, 2019). However, although the sign is also negative, the long-run relationship between the domestic interest rate (DR) and Islamic bank credit is not significant. This finding is in line with the results of (Zaheer et al., 2013) and (Zulkhibri and Sukmana, 2017). The argument of this result is that there was dramatic expansion of deposits and liquidity into Islamic banks within the sample period. In turn, this rapid increase in liquidity dampens the responsiveness of Islamic bank credit towards changes in domestic interest rates (Zulkhibri and Sukmana, 2017).

The exchange rate (ER) affects both Islamic and conventional bank credit negatively, and the effect on Islamic bank credit is much larger than on conventional bank credit. As shown in Table 2, a currency depreciation results in a fall in both Islamic and conventional bank lending. Surprisingly, the effect of exchange rate (ER) change on Islamic bank credit is approximately 90 times larger than the effect on conventional bank credit. This result, plus the result that domestic Islamic bank credit is significantly influenced by the international bank lending channel, raises questions about parts of the previous literature, which insinuates that Islamic banking is somewhat immune to the weaknesses of the conventional financial system that plague conventional banks (for example see Hasan and Dridi, 2011;Rahim and Zakaria, 2013;Sorwar et al., 2016;Mohammed and Muhammed, 2017;Erfani and Vasigh, 2018). Particularly in relation to external economic factors. This would also have important implications for policy.

Finally, the findings confirm that Islamic bank credit is co-integrated with foreign interest rate. The result in Table 2 from the error correction representation of the ARDL model shows that the error correction term coefficient is negative (-0.031 for Islamic bank credit using the Fed Funds Rate) and is significant at a 1 percent level of significance. This magnitude indicates that the long-run equilibrium relationship is stable, in the sense that any disequilibrium is temporary and gets corrected over the period of time with the speed of correction is 3.1 percent per month for Islamic bank credit.

### 4.3 Stability Test

The model used in the analysis is shown to be stable. To test the stability of the model, the CUSUM test and the CUSUMQ test were employed. The CUSUM and CUSUMSQ tests was developed by Brown et al. (1975) was applied. This test, which shows whether short- and long-term coefficients obtained from the ARDL model are stable, indicated parameter stability with a five percent confidence interval. The results of the tests are shown in Figures 2, 3 and 4. Figure 2 show that the CUSUM and CUSUMQ graphs for Islamic bank credit with the Federal Funds rate as the foreign interest rate. As shown, the CUSUM and CUSUMQ graphs are within the five percent confidence interval (red line) which signifies that the Non-linear ARDL is stable (Pesaran et al., 2001).

As a robustness test, the CUSUM test and the CUSUMQ is applied to the Non-linear ARDL model which replaced the Federal Funds rate with an alternative foreign interest rate (the overnight LIBOR). Figure 3 also show that both the CUSUM and CUSUMQ graphs are within the five percent confidence interval, signifying that the Non-linear ARDL with the overnight LIBOR is stable.

Finally, the CUSUM and the CUSUMQ tests are applied the Non-linear ARDL for the conventional bank credit. As shown in Figure 4, both the CUSUM and CUSUMQ graphs are within the five percent confidence interval (red line), signifying that the Non-linear ARDL is stable.

## 5. DISCUSSIONS

The purpose of this study is to investigate whether the international bank lending channel, measured by dynamics of foreign interest rate, influences domestic Islamic bank credit in an open economy with a dual system of conventional and Islamic banking. In the Islamic banking system, transactions involving interest rates are strictly prohibited and thus should have no influence on Islamic bank credit. In addition, this analysis explores whether the exchange rate has a significant effect on domestic Islamic bank credit and compares it with domestic conventional bank credit. These issues are of significance based on two reasons. Firstly, the financial system of open economies is highly interconnected and influenced by developments of foreign macroeconomic variables and the monetary policy stance of foreign developed economies. With respect to global financial crises, this interconnectedness would have important implications about the stability of the domestic banking system and the real sectors of open economies. Secondly, Islamic banking has expanded around the world, even in countries where a majority of its citizens are not Muslims. This implies that the Islamic segment of the banking sector has increasing importance in determining the stability of the domestic banking and financial sector.

Islamic bank credit is affected by the international bank lending channel and by fluctuations in the global economy. Employing the Non-linear ARDL method and monthly data for Indonesia, this study found a long-run negative relationship between foreign interest rate and Islamic bank credit, in particular when there is a foreign interest rate hike. This result still holds even when an alternative foreign interest rate is used in the analysis. This result shows that Islamic bank credit in an open economy with dual banking system is not spared from movements of foreign interest rates and thus is prone to the international bank lending channel and global economic fluctuations. These findings should be considered by policymakers in charge of overseeing the stability of the banking and financial system, particularly in open economies with a dual banking system such as Indonesia. Since recent global crises spawn from risk that occurred due to the instability of the financial system, and since bank credit is still the most important source of financing (especially in developing countries), caution is required when formulating policy to mitigate the negative effects of foreign interest rates dynamics on domestic Islamic bank credit and the overall domestic bank credit.

In addition to the negative effect of foreign interest rates on domestic Islamic bank credit, we found that the international bank lending channel affects domestic Islamic bank credit more significantly than domestic conventional bank credit. According to Aysan et al. (2018a), this is because depositors in both Islamic and conventional banks respond to changes to opportunity cost. When Islamic bank depositors’ opportunity costs rise due to changes in interest rate differentials because of a rise in foreign interest rate (Zanforlin, 2011), they do not hesitate to withdraw deposits. In addition, Aysan et al. (2018a) found that the relationship between changes in opportunity cost and deposits is more significant for Islamic banks than for conventional banks. While Disyatat (2011) found that bank deposits are less important in determining conventional banks’ credit as compared to the banks’ balance sheets. However, Aysan et al. (2018b) also found that Islamic bank credit is more highly dependent on bank deposits than conventional bank credit. Because deposits fall by more in Islamic banks than conventional banks in the event of a foreign interest rate rise. And since Islamic financing is more highly dependent on deposits for lending than conventional bank credit (Aysan et al., 2018b), Islamic financing falls more than conventional banks credit because of the foreign interest rate rise.

The study also found that Islamic bank credit is more prone to a rise in foreign interest rates than a fall. According to Lassoued (2018), the reason why Islamic banks' credit is significantly more affected by a rise in foreign interest rate than a fall (the asymmetric result) is that operating under the Shariah principles, some Islamic financial products require additional credit risk on practicing banks due to non-standardized financial contracts, different manners of financing, and complexity in risk management. As a result, a risk-avoiding borrower may choose an Islamic banking institution given the opportunity to share any losses with the bank (Hasan and Dridi, 2011). In addition, since the Islamic banking institutions share their losses with depositors, they may face withdrawal risk (Siddiqui, 2008). For instance, Lassoued (2018) found that Islamic Banks are less liquid than conventional banks as they maintained higher loans to deposits ratio and are more heavily weighted towards loans than conventional banks. In addition, because Islamic banks are less liquid, they focus on financing the real sector part of the economy which comply with the halal Islamic principle and are not involved in transactions based on interest, uncertainty, or speculation (Khan et al., 2021). Hence Islamic banks have relatively limited securities to choose from to dampen against external shock compared to conventional banks. Therefore, due to the relatively limited security choices available to Islamic banks, a foreign interest rate hike might force an Islamic bank to reduce their loans. Conversely, due to the problem relating to the Profit-Loss-Sharing financing scheme, focus on financing the real sector, which complies with the halal Islamic principle and the relatively limited security choices available to Islamic banks (Khan et al., 2021) implies that they have relatively limited security choices to dampen positive external shocks such as an inflow of funds from abroad. Given the structure of Islamic banking just mentioned, a fall in foreign interest rate would increase Islamic bank’s financing less significantly compared to the magnitude of a fall in Islamic bank credit caused by a rise in foreign interest rate.

Islamic bank credit should not be viewed as homogenous to conventional bank credit, especially with respect to foreign interest rate dynamics. In contrast to Islamic bank credit, the results found that foreign interest rate has a positive long-run relationship with conventional bank credit, particularly in the case of foreign interest rate hikes. The finding highlights that both conventional and Islamic bank credits in an open economy are affected by the international bank lending channel. Plus, the direction of the relationship of foreign interest rate with Islamic bank credit differs from that of conventional bank credit. This implies that in formulating measures of intervention in an open economy with a dual banking system, these two types of bank credit should not be viewed in unison when faced with foreign interest rate dynamics. In light of the finding, policies concerning the stability of the banking sector and the financial system should be carefully formulated to take into consideration the different directions of relationship that foreign interest rates have on conventional bank credit on one hand, and Islamic bank credit on the other. Such measures would enhance the effectiveness of policies aimed at achieving and sustaining domestic financial and banking system stability in an open economy with a dual banking system.

The results of this article also show that domestic Islamic bank credit is more highly affected by changes in the exchange rate than domestic conventional bank credit. The reason for this is that the appreciation of the exchange rate has been associated with changes in cross-country interest rate differentials and increases in domestic liquidity (Zanforlin, 2011). In addition, exchange rates alter the relative values of domestic and foreign collateral goods, and thus, they affect total financing available to a country. Furthermore, Cesa-Bianchi et al. (2018) found that exchange rate appreciations contribute to fueling an (international) credit supply increase by inflating the value of collateral in the domestic banks. While Avdjiev et al. (2019) found that Exchange rate fluctuations could influence conventional bank credit in the domestic economy by affecting borrowers’ balance sheets. Furthermore, there is an additional effect of the depreciation of the domestic currency on domestic credit via the interest rate differentials. A currency depreciation alters the interest rate differentials across countries, which in turn reduces liquidity and deposits available to all banks in the domestic economy (Zanforlin, 2011). While, Aysan et al. (2018a) found that the effect of changes of opportunity cost, through the interest rate differentials, on deposits is higher for Islamic than for conventional banks. This implies that the change in deposits due to a depreciation of the exchange rate is larger for domestic Islamic banks than conventional banks. And since Islamic banks are highly dependent on deposits for credit provision as compared to conventional banks (Aysan et al., 2018b), an exchange rate depreciation affects domestic Islamic bank credit more significantly than domestic conventional bank credit. These findings are in contrast with parts of the literature, which insinuates that Islamic banking is relatively immune to the weaknesses of the conventional banking system (see Hasan and Dridi, 2011;Rahim and Zakaria, 2013;Sorwar et al., 2016;Mohammed and Muhammed, 2017 for examples).

Another reason why Islamic bank credit is more highly affected by the international bank lending channel and the exchange rate compared to domestic conventional bank credit is that Islamic bank credit has the tendency to finance small and medium enterprises (SMEs). It found that SMEs are more responsive to monetary and macroeconomic shocks (Aysan et al., 2018b). Thus, in order to reduce of the effect of the international bank lending channel and the exchange rate on Islamic bank credit, they should expand their business to cater larger firms.

## 6. CONCLUSION AND POLICY IMPLICATIONS

Employing the non-linear Autoregressive Distributed Lag (NARDL) framework and using data for Indonesia as a case study reveal that, though the principles of Islamic banking prohibit interest rates (riba), there is a long-run negative equilibrium relation between foreign interest rates with Islamic bank credit due to changes of monetary policy stance in developed foreign economies. This result is more significant in the case of foreign interest rate hikes. Moreover, this result found that domestic Islamic bank credit is significantly more affected by the international bank lending channel than domestic conventional bank credit. Furthermore, not only is domestic Islamic bank credit more prone to the international bank lending channel, but it is also more significantly influenced by exchange rate dynamics compared to domestic conventional bank credit. These results highlight several findings; firstly, that both domestic Islamic and conventional bank credit are influenced by the international bank lending channel and the dynamics of the exchange rate. Secondly, the direction of the long-run relationship of foreign interest rate and bank credit differ between Islamic and conventional bank credit. Thirdly, domestic Islamic bank credit is more prone to the dynamics of the exchange rate, and changes in monetary policy stance of developed countries than domestic conventional bank credit. This result is in contrast with parts of the literature which insinuates that Islamic finance is relatively immune to the weaknesses of the conventional financial system—particularly in relation to external economic factors. The study also found that domestic interest rates have a negative long-run relationship but only with conventional bank credit, which is consistent with findings in previous literature. In terms of policy recommendation, authorities in charge of financial stability in an open economy with a dual banking system should pay close attention to the dynamics of foreign interest rates and the exchange rate in formulating policies. In particular, they should design policies that consider the different directions and magnitudes of relationship that foreign interest rates, as well as exchange rates, have on Islamic bank credit and conventional bank credit. In addition, policymakers should realize that external factors affect domestic Islamic bank financing more than conventional bank credit. Furthermore, Islamic banks should expand their business to cater larger firms’ credit needs. All these factors must be taken into account in order to enhance the effectiveness of policies aimed at achieving and maintaining financial stability in the domestic economy. This study’s contribution compared to previous studies is providing a comparative analysis results of the effect the international bank lending channel, measured by foreign interest rate changes, and exchange rate dynamics on domestic Islamic bank credit and conventional bank credit. However, due to data limitation, this analysis is conducted prior to the current global crises. When data becomes available, further research should be extended to consider the current global crises.

## Figures

The share of Islamic bank credit to total bank credit in Indonesia.

Islamic Bank Credit (Federal Funds rate).

Islamic Bank Credit (Libor).

Conventional Bank Credit.

## Tables

Share of bank credit to total credit

Stationarity test

Long run estimate

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