Macroprudential Regulation and Policy for the Islamic...

Muhamed Zulkhibri Abdul Ghafar IsmailSutan Emir Hidayat Editors

Macroprudential Regulation and Policy for the Islamic Financial IndustryTheory and Applications

Macroprudential Regulation and Policy for the Islamic Financial Industry

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Muhamed Zulkhibri • Abdul Ghafar Ismail Sutan Emir Hidayat Editors

Macroprudential Regulation and Policy for the Islamic Financial Industry Theory and Applications

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ISBN 978-3-319-30443-4 ISBN 978-3-319-30445-8 (eBook) DOI 10.1007/978-3-319-30445-8

Library of Congress Control Number: 2016938180

© Springer International Publishing Switzerland 2016 This work is subject to copyright. All rights are reserved by the Publisher, whether the whole or part of the material is concerned, specifi cally the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfi lms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed. The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a specifi c statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. The publisher, the authors and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or the editors give a warranty, express or implied, with respect to the material contained herein or for any errors or omissions that may have been made.

Printed on acid-free paper

This Springer imprint is published by Springer Nature The registered company is Springer International Publishing AG Switzerland

Editors Muhamed Zulkhibri Islamic Research and Training Institute Islamic Development Bank Jeddah , Saudi Arabia

Sutan Emir Hidayat Business Administration Department University College of Bahrain Manama , Bahrain

Abdul Ghafar Ismail Islamic Research and Training Institute Islamic Development Bank Jeddah , Saudi Arabia

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Foreword

Despite the interlinkage between macroprudential policy and fi nancial stability being widely acknowledged in the literature, there are only a few in-depth studies in this area of research focusing on this relationship for Islamic fi nancial industry. Moreover, issues pertaining to macroprudential policy infl uences on bank risk-tak-ing have been given even greater attention since the fi nancial crisis in 2008/2009. Macroprudential approaches are widely adopted by many central banks and regula-tors for supervision and regulation in order to maintain fi nancial stability and, ulti-mately, improve social welfare by aligning private incentives with social objectives. As the Islamic banking sector assets grow rapidly, increasing its market share, it will pose higher systemic risks to the overall fi nancial system. Understanding the impact of macroprudential policy and regulation for the Islamic fi nancial sector is crucial as it infl uences the variety of structural forms of Islamic fi nancial institutions.

The Islamic Research and Training Institute (IRTI) as a leading research institu-tion has been actively engaged in promoting and disseminating knowledge in Islamic economics and fi nance through research, publication, seminar, conferences, workshop, etc. This book is the result of the Workshop on Macroprudential Regulation and Policy for Islamic Financial Industry in 2015, which was held in Manama Bahrain, organized by IRTI, in collaboration with University College of Bahrain (UCB), Bahrain. This book is intended to fi ll the gap in the academic and policy literature by providing new insights on macroprudential policy and regula-tion as well as policy and tools that could be employed by central banks and super-visory authority in a dual banking system to mitigate systemic risks.

I believe that the topic of macroprudential policy and regulation for Islamic fi nan-cial industry is a subject of great importance for policy-makers, academics, and prac-titioners. I hope this book will contribute in sharing knowledge and provide new insights for the various stakeholders. Finally, I would like to take this opportunity to congratulate the editors for publishing this important book. I would also like to extend my thanks to the Springer team for the smooth cooperation in fi nalizing this book.

March 2016 Professor Dato’ Dr. Mohamed Azmi Omar

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Preface

In general, policymakers use simultaneously the set of monetary, fi scal, and prudential policies that would ensure macroeconomic and fi nancial stability. They believe that this arrangement would set the foundations of steady growth. These policies that are later combined together as macroprudential policy are recognized to adequately address the fi nancial system risk. However, it has become clear that developments in the shariah-based fi nancial system can be important for macroeconomic stability, even when infl ation is low (i.e., as the objective of monetary policy) and stable and fi scal policy seems to be sound, because this system may be also exposed to the consequences of episodes of fi nancial instability.

Several countries, as reported in Kashyap et al. ( 2011 ), have already been using a well-developed macroprudential framework to address systemic concerns before the episodes of fi nancial instability. The discussion on this framework has reached a wide range of topics such as instruments, indicators, objectives, and systemic risk. These topics are the main components of transmission channel on the working of macroprudential policy. The practical model of macroprudential has also been applied in several countries such as New Zealand, Japan, and India. They have started to develop macroprudential toolkits for addressing fi nancial systemic risk or have reconsidered and recalibrated existing tools in the light of their potential appli-cation at the systemic level.

Islamic fi nancial system, which is relatively new Ibrahim and Ismail ( 2015 ), is given a mandate to be part of the fi nancial system, and the regulatory bodies such as Islamic Financial Services Board and fi nancial authority such as central bank and fi nancial services authority are assigned to regulate and supervise the system. At the jurisdiction level, as mentioned in Ismail and Che Pa ( 2015 ), fi nancial authorities have started to incorporate macroprudential considerations into standard practices for Islamic fi nancial institutions.

Does each jurisdiction that practice the Islamic banking need to have a separate macroprudential policy? Before we could answer this question, we ask on what we know about macroprudential policy.

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What Do We Know About Macroprudential Policy?

For any public policy, it should have its objectives, tools and indicators, and more importantly its mandate. All these elements will be discussed as follows.

Policy Mandates

What mandate does the fi nancial authority have for implementing macroprudential policy? In some jurisdictions, such as Malaysia, Pakistan, and Indonesia, the fi nan-cial authority is explicitly given the responsibility for fi nancial stability or for con-tributing to fi nancial stability—a responsibility that is usually implicitly or explicitly part of the fi nancial authority’s mandate. For example, the Central Bank of Malaysia under the Article 27 of the Central Bank Act 2009 defi nes that “the fi nancial system in Malaysia shall consist of the conventional fi nancial system and the Islamic fi nan-cial system.” It has signifi cant effect on the development Islamic monetary policy instruments. In addition, under the Islamic Financial Services Act of 2013, the “ulti-mate objective” of supervision (i.e., microprudential policy) is to promote the “safety and soundness of banks and the banking system” and Shari’ah compliant banking.

Objectives

The normal ultimate objective of macroprudential policy is to avoid output and wealth losses in the long run by limiting the buildup of system-wide fi nancial risk. One of the key purposes of macroprudential policy is to address negative externali-ties by acting as a countervailing force to the natural decline in measured risks in a boom and the subsequent rise in measured risks in the downturn. It also aims to mitigate risks linked to fi nancial sector concentration and interconnectedness. It shows that macroprudential policy has both a time dimension and a cross-sectional (or structural) dimension.

However, in some cases, where the objective of banking supervision includes on an equal basis both the soundness of individual institutions and the safety of the banking system, confusion may arise as to who is ultimately responsible for address-ing emerging systemic risk and what actions are needed to preserve fi nancial stabil-ity. Therefore, the supervisor need to address the following two issues: fi rst is the risk parameter —the microprudential supervisor, while taking decisions concerning individual banks, will need to take into account risks arising from the internal envi-ronment in which the bank has to operate, for instance, in the context of Islamic banks. Such Shari’ah risk assessments are a key element of the macroprudential policy objectives.

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Second issue is the institutional perimeter —the more diversifi ed a fi nancial system is, the less the system itself is affected by the actions or the stability of an individual institution. In a highly diversifi ed system (i.e., Islamic fi nance not only cover the Islamic banking institutions but also non-banking institutions such as zakat and waqf institutions, Islamic mutual funds, and Islamic microfi nance institutions), supervisory action aimed at an individual institution or a few institution could have less systemic consequences. Hence, policy actions to address systemic risks would have less signifi -cant consequences for the few individual fi rms that make up the fi nancial system.

It shows that the microprudential authority is concerned with risk concentration within individual institutions, while the macroprudential authority is concerned with similar portfolio holdings among institutions in the system, the holding of portfolios that would not erode the output and wealth in the long run. However, the objectives of macroprudential policy also need to consider the preservation of the Maqasid al-Shari’ah (Ngalim and Ismail 2014 ; Ngalim et al. 2015 ).

Tools

Basically, macroprudential tools vary among the jurisdictions. For example, in New Zealand (a good example of regulatory in place), countercyclical capital buffer (CCB), adjustments to the minimum core funding ratio (CFR), sectoral capital requirements (SCR), and restrictions on high loan-to-value ratio (LVR) residential mortgage lending are among the instruments of macroprudential policy. But in other countries, like India (an example of the presence of interconnected and diversifi ed fi nancial landscape), countercyclical measures such as investment fl uctuation reserve and time-varying risk weights and provisioning norms to sectors such as housing, commercial real estate, retail, and equity; policies to address the cross- sectional dimensions of systemic risks such as dealing with interconnectedness and common exposures and monitoring fi nancial conglomerates; and framework for the management of the capital account are used as macroprudential tools.

It implies that the varieties of tool instruments are used in response to differences in the structure of the fi nancial system and the presence of a sound regulatory frame-work. Basically, the set of policy tools currently being considered is mostly based on existing microprudential and regulatory tools (i.e., caps on loan to value ratios, limits on credit growth, additional capital adequacy requirements, reserve require-ments, and other balance sheets restrictions).

Moving Forward

Even though both the objectives and expected effectiveness of macroprudential policy are known, usage has often proceeded on an ad-hoc or experimental bases. Evaluations of usage to date, mostly aimed at affecting developments in fi nancing

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and housing markets and bank capital, suggest that some tools can help reduce fi nancial pro-cyclicality and lower crisis risks. Therefore, caps on fi nancing to value and debt service to income ratios seem; and asking for higher capital are important to help in reducing booms, and thereby busts, in real estate markets, and bank’s insolvency that become the major sources of instability. Reserve requirements and targeted levies on foreign exchange exposures also help in reducing system-wide vulnerabilities. Macroprudential policies are also needed to reduce the systemic risks created by large fi nancial institutions and social fi nance institutions. Questions arise on the best institutional (in line with the view given by Ismail and Ahmad ( 2006 )) design for usage, e.g., who is made in charge of macroprudential policies. The major issue, closely related to institutional design, is how the political economy of macroprudential policies will play out. In addition, the way forward also has to look into the implication on the reporting requirement, which may suggest a next generation of balance sheets.

Jeddah, Saudi Arabia Abdul Ghafar Ismail

References

Ibrahim WHW, Ismail AG (2015) Conventional bank and Islamic banking as institutions: as many similarities as differences. Humanomics 31(3):272–298

Ismail AG, Ahmad I (2006) Does the Islamic fi nancial system design matter? Humanomics 22(1):5–16

Ismail AG, Che Pa AS (2015) Financial soundness indicators and the objectives of Shari’ah in assessing the stability of Islamic banks. IRTI working papers 1436- 11. Islamic Research and Training Institute, Jeddah

Kashyap AK, Berner R, Goodhart CAE (2011) The macroprudential toolkit. IMF Econ Rev 59(2):145–161

Lim C, Columba F, Costa A, Kongsamut P, Otani A, Saiyid M, Wezel T, Wu X (2011) Macroprudential policy: what instruments and how to use them? Lessons from country experi-ences. IMF working paper no. WP/11/238. International Monetary Fund, Washington

Ngalim SM, Ismail AG (2014) An Islamic vision development based indicators in analysing the Islamic banks performance: evidence from Malaysia, Indonesia and selected GCC countries. IRTI working papers WP-1436-02. Islamic Research and Training Institute, Jeddah

Ngalim SM, Ismail AG, Yaa’kub NI (2015) A comparative analysis of the Maqasid Shari’ah of Islamic banks in Malaysia, Indonesia and the Gulf Cooperation Council Countries. In: Asutay M, Turkistani AQ (eds) Islamic fi nance, political economy, performance and risk, vol 1. Gerlach Press, Berlin

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The Islamic Research and Training Institute, a research arm of the Islamic Development Bank, Saudi Arabia, co-organized and sponsored the workshop, while the University College of Bahrain (UCB), Bahrain, hosted the workshop on Macroprudential Regulation and Policy for Islamic Finance Industry (MPRIF) 2015, Bahrain. The objective of the workshop was to bring together global experts to advance the current knowledge frontier on Islamic fi nance.

The editors are grateful to Professor Dato’ Dr. Azmi Omar, Director General of Islamic Research and Training Institute of Islamic Development Bank, for his sup-port and encouragement. The editors would also like to extend their gratitude to committee members of the workshop on macroprudential policy and regulation (MPRIF 2015), Bahrain, scientifi c reviewers for this volume, and all contributing authors.

Jeddah, Saudi Arabia Muhamed Zulkhibri Jeddah, Saudi Arabia Abdul Ghafar Ismail Manama, Bahrain Sutan Emir Hidayat

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Acknowledgement

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Part I Institutional Framework for Macroprudential in Islamic Banking System

1 Macroprudential Policy and Regulation in a Dual Banking System: An Exploratory Perspective ..................................... 3 Muhamed Zulkhibri and Ismaeel Naiya

2 Doctrinal Challenge for Islamic Banking on Macroprudential Regulations: A Religion- Regulation Mismatch 2.0 .............................. 25 Etsuaki Yoshida

3 Conceptual Proposal for Future Macroprudential Framework Under a Dual Financial System in Indonesia .................. 35 Ascarya , Adiwarman A. Karim , Siti Rahmawati , Masyhudi Muqorrobin , and Dimas Bagus Wiranatakusuma

Part II Macroprudential Policy, Systemic Risks and Financial Stability in Islamic Financial Industry

4 Risk Management Methodologies: An Empirical Macro-prudential Approach for a Resilient Regulatory Framework for the Islamic Finance Industry ...................................... 57 Samir Alamad

5 Competitive Condition and Market Power of Islamic and Commercial Conventional Banks in Indonesia ............................. 79 Cupian and Muhamad Abduh

6 Early Warning Indicators and Macroprudential Policy Tools ........... 101 Hazik Mohamed

7 A Proposed Formula for Reserve Requirement–Financing to Deposit Ratio: The Case of Islamic Banking in Indonesia.............. 121 Rifki Ismal and Sutan Emir Hidayat

Contents

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8 Testing of the Procyclicality of Islamic and Conventional Banks in Indonesia .................................................................................. 133 Ascarya, Siti Rahmawati , and Adiwarman A. Karim

9 Short-Term Liquidity Management Mechanisms in the Absence of Islamic Interbank Loan Markets ............................ 153 Magomet Yandiev

Part III Experiences in Implementing Macroprudential Policy in a Dual Banking System

10 Macroprudential Analysis of Financial Crisis Impacts on Banks’ Soundness: Evidence from Pakistan ................................... 163 Azam Ali and Noraini Ariffi n

11 Regulatory Framework for Islamic Finance: Malaysia’s Initiative ................................................................................ 177 Siti Muawanah Lajis , Obiyathulla Ismath Bacha , and Abbas Mirakhor

12 Islamic Finance and Macroprudential Policy: The Case of Iranian Banking System .................................................... 193 Mehdi Hadian

Part IV Interplay Between Macroprudential Policy with Other Markets

13 Indonesia Shari’ah Compliance Stock Index Responses Toward Macroprudential and Monetary Policy of Indonesian Central Bank ................................................................... 213 Helma Malini

14 Socioeconomic Development and Its Effect on Performance of Islamic Banks: Dynamic Panel Approaches ..................................... 229 Mohammad Ashraful Ferdous Chowdhury, Md. Mahmudul Haque, Syed Othman Alhabshi, and Abul Mansur Mohammed Masih

15 Macroprudential Tools and Its Relationship with Monetary Policy Tools .................................................................... 245 Abdul Ghafar Ismail and Zuriyati Ahmad

Contents

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Contributors

Muhamad Abduh School of Business and Economics, Universiti Brunei Darussalam, Bandar Seri Begawan , Brunei , Darussalam

Zuriyati Ahmad Universiti Teknologi MARA , Selangor , Malaysia

Samir Alamad Aston Business School, Aston University , Birmingham , UK

Syed Othman Alhabshi International Centre for Education in Islamic Finance (INCEIF) , Kuala Lumpur , Malaysia

Azam Ali State Bank of Pakistan , Karachi , Pakistan

Noraini Ariffi n Kulliyyah of Economics and Management , International Islamic University , Gombak , Malaysia

Ascarya Center for Central Banking Research and Education, Bank Indonesia , Jakarta , Indonesia

Obiyathulla Ismath Bacha International Centre for Education in Islamic Finance (INCEIF) , Kuala Lumpur , Malaysia

Mohammad Ashraful Ferdous Chowdhury Shahjalal University of Science and Technology , Sylhet , Bangladesh

Cupian Faculty of Economic and Business , Universitas Padjadjaran , Bandung , Indonesia

Mehdi Hadian Faculty of Economic and Political Sciences , Shahid Beheshti University , Tehran , Iran

Md. Mahmudul Haque International Centre for Education in Islamic Finance (INCEIF) , Kuala Lumpur , Malaysia

Sutan Emir Hidayat University College Bahrain , Manama , Bahrain

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Abdul Ghafar Ismail Islamic Research and Training Institute, Islamic Development Bank , Jeddah , Saudi Arabia

School of Economics, Institut Islam Hadhari, Universiti Kebangsaan Malaysia , Selangor , Malaysia

Perdana Leadership Foundation , Putrajaya , Malaysia

Rifki Ismal Bank Indonesia , Jakarta , Indonesia

Adiwarman A. Karim KARIM Consulting Indonesia , Jakarta , Indonesia

Siti Muawanah Lajis Bank Negara Malaysia , Kuala Lumpur , Malaysia

Helma Malini Faculty of Economics and Business , Tanjungpura University , Pontianak , Indonesia

Abul Mansur Mohammed Masih International Centre for Education in Islamic Finance (INCEIF) , Kuala Lumpur , Malaysia

Abbas Mirakhor International Centre for Education in Islamic Finance (INCEIF) , Kuala Lumpur , Malaysia

Hazik Mohamed Stellar Consulting Group , Singapore , Singapore

Masyhudi Muqorrobin Department of Economics , Universitas Muhammadiyah Yogyakarta , Yogyakarta , Indonesia

Ismaeel Naiya Islamic Development Bank , Jeddah , Saudi Arabia

Siti Rahmawati Center for Central Banking Research and Education, Bank Indonesia , Jakarta , Indonesia

Dimas Bagus Wiranatakusuma Department of Economics , Universitas Muhammadiyah Yogyakarta , Yogyakarta , Indonesia

Magomet Yandiev Faculty of Economics , Lomonosov Moscow State University , Moscow , Russia

Etsuaki Yoshida Waseda University , Tokyo , Japan

Muhamed Zulkhibri Islamic Research and Training Institute, Islamic Development Bank , Jeddah , Saudi Arabia

Contributors

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Part I Institutional Framework

for Macroprudential in Islamic Banking System

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35© Springer International Publishing Switzerland 2016 M. Zulkhibri et al. (eds.), Macroprudential Regulation and Policy for the Islamic Financial Industry, DOI 10.1007/978-3-319-30445-8_3

Chapter 3 Conceptual Proposal for Future Macroprudential Framework Under a Dual Financial System in Indonesia

Ascarya , Adiwarman A. Karim , Siti Rahmawati , Masyhudi Muqorrobin , and Dimas Bagus Wiranatakusuma

Ascarya (*) • S. Rahmawati Central Banking Research Department, Bank Indonesia , Jakarta , Indonesia e-mail: [email protected]; [email protected]

A. A. Karim KARIM Consulting Indonesia , Jakarta , Indonesia e-mail: [email protected]

M. Muqorrobin • D. B. Wiranatakusuma Department of Economics, Universitas Muhammadiyah Yogyakarta , Yogyakarta , Indonesia e-mail: [email protected]; [email protected]

Abstract The chapter focuses on analyzing the risks exposed in Islamic banks and proposes criteria to design and implement macroprudential policy under dual fi nan-cial system in Indonesia. Under this fi nancial system, Islamic bank’s risks are among the primary concern due to the common and unique risks exposed. The study uses gap analysis to analyze the macroprudential design. The study suggests redefi ning on two main aspects: (a) objective and role of central bank and (b) objective, scope, instrument, and authority of macroprudential policy. Therefore, some preconditions need to be in place toward achieving effective macroprudential framework under dual systems such as institutional, instruments, and related arrangements in order to preserve fi nancial system stability.

Keywords Macroprudential policy • Islamic fi nance • Financial system stability

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3.1 Introduction

Severe repeated fi nancial crises and the presence of instability in money markets emerge over centuries. Its instability can trigger some shocks in the fi nancial system and transmit them to the Islamic fi nancial institutions. Moreover, under dual fi nan-cial systems where Islamic fi nancial system is side by side with conventional coun-terpart, the probability of instability occurred is relatively high due to an increased interconnectedness. The macroprudential policy is one out of six main pillars of preserving fi nancial system stability. However, fundamental different features between Islamic and conventional fi nancial systems challenge the setup of the cur-rent macroprudential framework enabling to preserve dual system, particularly in Indonesia.

Since August 1971, the price of gold had risen and continued to rise until reach-ing US$183.9 per troy ounce in December 1974. The price of gold has multiplied 5.25 times, in less than three and a half years. In September 1980, the price of gold reached US$666.8 per troy ounce, an increase of 6.4 times in fi ve years from US$104 in August 1976. Thereafter, the price of gold experienced a downward trend for two decades until it reached US$255.7 per troy ounce in August 1999. After the gold price again increased rapidly up to a record of $1,825.6 per troy ounce in August 2011, it decreased again to US$1,201.6 per troy ounce in December 2013. In June 2014, the price of gold rose to US$1,327.3 per troy ounce (Figure 3.1 ). The increase in the price of gold actually showed a decrease in the value of the US$, which is losing its purchasing power against the real assets, so that the US$ fi at cur-rency has not been able to function well as a store of value.

In the fi nancial system with increased systemic risks (due to larger-sized, more complicated business and increased interdependence among institutions and/or fi nan-cial markets), increased imbalances, and lower quality of intermediation, while the fi nancial system is also becoming increasingly globalized, uncertain, competitive, and innovative, the future role of the central bank under dual fi nancial system would focus on two main objectives, namely, (1) to maintain the purchasing power of currencies or

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IDR/US$ (L) US$/XAU (R)

Fig. 3.1 Movement of US$ and Rupiah in post-Bretton Woods system

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maintain price stability and (2) to maintain fi nancial stability by contributing to the preservation of and the enhanced resilience of systemic fi nancial stability, in an envi-ronment which is independent and free from the intervention of other parties.

Macroprudential policy under dual fi nancial system conducted by the central bank in the future should include both conventional fi nance and Islamic fi nance in a comprehensive and integrated form, in order to eliminate and prevent systemic risk and the fi nancial crisis. Moreover, in the midst of increasing fi nancial system vola-tility, the enhanced resilience in Islamic fi nancial system is a must. In Indonesia, the economy is characterized as bank-based economy. It implies the risks are highly stemmed from banking exposures toward risks. Therefore, the chapter is focused to answer several questions, including (1) what are the risks exposed in Islamic banks in Indonesia, (2) how to develop some criteria to design macroprudential policy under fi nancial system in Indonesia, and (3) how would macroprudential policy be implemented in countries adopting dual fi nancial system.

The rest of the chapter is as follows: Section 3.2 elaborates the literature review. Section 3.3 discusses the discussion conceptual proposal of macroprudential frame-work. Section 3.4 provides the proposal for future macroprudential framework and conclusion and recommendation in Section 3.5 .

3.2 Literature Review

3.2.1 Overview of Macroprudential Policy

The G30 Working Group ( 2010 ) defi nes macroprudential policy comprehensively with four components:

1. Macroprudential policy seeks to develop, oversee, and deliver appropriate policy response to the fi nancial system as a whole rather than focusing on individual institutions or certain economic measures in isolation.

2. Macroprudential policy aims to enhance the resilience of the fi nancial system and to dampen systemic risks that spread through the financial system via the interconnectedness of institutions, their common exposure to shocks, and the tendency of fi nancial institutions to act in procyclical ways that magnify the volatility of the fi nancial cycle.

3. Macroprudential policy should use variable and fi xed tools and apply them with the goal of reducing systemic risk and increasing the resilience of the fi nancial system to absorb such risk.

4. The institutions charged with implementing macroprudential policy must inform and be informed by monetary, fi scal, and other government policies and give due regard to the primary responsibilities of other agencies.

Based on lessons learned from the global fi nancial crisis, some economists look back to macroprudential policies that have emerged and evolved since the 1970s, which is believed to be a forgotten element in the framework of the existing fi nancial

3 Conceptual Proposal for Future Macroprudential Framework…

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system stability. Finally, the additional new sixth element or pillar of fi nancial system stability (FSS) was introduced, named “Sound Framework of Macroprudential Supervision.” It was a macroprudential approach to fi nancial regulation and super-vision, which focused on the systemic risk of the fi nancial system, the cross- sectional risks that arise and the time dimension risks (Borio 2009 ). Furthermore, within macroeconomic-microeconomic policy framework, macroprudential policy is intended to achieve fi nancial stability by preventing its systemic risks, whereas microprudential policy is intended to achieve fi nancial stability by maintaining fi nancial soundness of individual fi nancial institution, where fi nancial stability is a precondition for effective monetary policy. The interconnections of macroeconomic policy framework to achieve macroeconomic objectives are illustrated by Kremers and Schoenmaker ( 2010 ) as exhibited in Figure 3.2 .

3.2.2 Sources and Consequences of Systemic Risk

The causes of systemic risks are rooted from fundamental defi ciencies or fl aws of conventional fi nancial system (CFS) in the structure of banks, interconnectivity of fi nancial institutions as well as information, and control intensity of fi nancial con-tracts, which makes it inherently unstable, and it has not been touched by regulators. Other causes of systemic risks come from specifi c defi ciencies, including fi nancial frictions and systemic risk buildup, which lead to systemic fragility. Financial fric-tions could be due to incentive problems, information frictions, and coordination problems, which are exacerbated by regulatory defi ciencies. Subsequently, CFS fl aws and fi nancial frictions lead to the buildup of systemic risks of cross-sectional dimension and time dimension. Specifi c defi ciencies of CFS have usually been addressed by macroprudential policy and tools during normal condition, while sys-temic crisis has usually been addressed by crisis management protocol. However, fundamental defi ciencies as the real root causes of systemic crisis have yet to be addressed by regulators.

FINANCIAL STABILITY

StableMacroeconomicEnvironment (1)

Sound Frameworkof Macroprudent ial

Supervision (6)

Well-ManagedFinancial

Inst itut ions (2)

Sound Frameworkof Prudent ial

Supervision (4)

Safe and RobustPayment System (5)

Efficient FinancialMarket (3)

Financial Resilience

Avoidance ofImbalance/Excess

Time Dimension Risks

Cross Section Risks

Fig. 3.2 Main pillars or elements of fi nancial system stability. Source : Bank Indonesia

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3.3 Conceptual Proposal of Macroprudential Framework

3.3.1 Macroprudential Framework in Indonesia

The emergence of macroprudential policy in Indonesia cannot be separated from changes in the institutional framework in Indonesia. Regulation of the Financial Services Authority (FSA) in 2011 had pushed the prudential regulatory authority into macropru-dential oversight and microprudential supervision to achieve ultimate objective of fi nancial system stability. Bank Indonesia is clearly mandated to regulate macroprudential aspect. In other words, since the FSA Act, supervisory structure for fi nancial system stability follows the separate regulator (SR) models. Referring to this model, the achieve-ment of stability of the fi nancial system relies on interagency coordination mechanisms (e.g., in Indonesia, it is called Financial System Stability Coordination Forum/FKSSK), and Bank Indonesia is part of the maintenance of fi nancial stability, especially in the aspects of macroprudential policy. Macroprudential policy in Indonesia can be explained through macroprudential policy framework (Figure 3.3 ).

Figure 3.4 shows the fl ows of macroprudential framework in Indonesia. Generally, the framework aims at identifying risk embodied in the fi nancial system which poten-tially leads to create systemic system, realizing how to deal with risks spread, through which channels the risks are spread out, and the precise momentum to release the particular instrument of macroprudential policy so that the potential risks can be pre-vented and spread across fi nancial system, macroeconomic, and real sector. Monitoring the fi nancial system until risk signaling are the fi rst four steps in conducting macro-prudential surveillance process. The planning process is to implement macropruden-tial policy which takes place when risk signaling appears in the critical points, for example, crossing below or above the tolerated thresholds. In other words, the process of macroprudential process is extended to release instruments of macroprudential policy so that the crisis management protocols (CMP) can be activated.

The steps of macroprudential surveillance process (steps 1 to 4) are not neces-sarily implemented in order and could be executed simultaneously. The steps of

Macro-prudential

Monetary Policy

Micro-prudential

Business Conduct

Fiscal Policy

Price Stability

Financial Stability

Soundness of Financial Institutions

Orderly Markets & Fair Treatment of Customer

Increasing Growth & Employment

Stable Ec. Growth (Economic System)

Consumer Protection (Indiv. Institution)

IncreasingWelfare

POLICY OBJECTIVE ULTIMATE GOAL

CB

MoF

FSA

Fig. 3.3 Macroeconomic-microeconomic policy framework. Source : Author adapted from Kremers and Schoenmaker ( 2010 )


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macroprudential policy in Figure 3.1 are set up in order to ease the thinking frame-work and macroprudential concept implementation. Obviously, the effectiveness and reliability of macroprudential policy implementation is determined by adequate data, rigorous information, and extensive research.

Regarding macroprudential instruments, until end of 2013, Bank Indonesia had released four macroprudential policy instruments:

1. Loan to value (LTV) for home loan ownership and down payment for vehicle loan ownership.

2. Loan to deposit ratio (GWM-LDR) for strengthening banking intermediation. 3. Net open position (NOP) for dampening systemic risk related to currency mis-

match in bank due to the rising volatility of exchange rates and foreign capital infl ows- outfl ows in Indonesia.

4. Credit base rate transparency (CBRT) aims to mitigate credit risk exposed in banking by promoting sound and competitive environment in the midst of high credit growth and increase good governance in banking industry.

In the near future, Bank Indonesia is studying to release other two macropru-dential instruments, countercyclical capital buffer (CCB) and capital surcharges (CS) (Table 3.1 ).

3.3.2 Analyzing the Risk Exposed by Contemporary Islamic Banking

Islamic Financial Services Board (IFSB) recognizes six risk categories of Islamic bank, namely, credit risk, equity investment risk, market risk, liquidity risk, rate of return risk, and operational risk. Islamic banking risk profi le can be categorized into

1 2 3 4

Design and Policy Implementation

Design and Policy Implementation

Instrument of Macroprudential Policy

Element 2

Financial System Surveillance

Risk Identification Risk Assessment Risk Signalling

Macroprudential Indicators

EWSPrompt IndicatorComposite IndicatorOutlook

Stress Test Regulator, Public, and

Market

Element 1

Data, Information, and Research

CMP

Crisis Resolution

Under or Closer to Threshold

Crossing Threshold

Normal Condition

Macroprudential Surveillance Process

Planning Process & Implementation of Macroprudential Policy

Fig. 3.4 Conventional macroprudential framework in Bank Indonesia. Source : Author adapted from Harun and Rachmanira ( 2014 )

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Tabl

e 3.

1 M

acro

prud

entia

l pol

icy

inst

rum

ents

Inst

rum

ent

LTV

G

WM

-LD

R

CB

RT

N

OP

CC

B

Cap

ital

surc

harg

es

Obj

ecti

ve

Cre

dit r

elat

ed

Cre

dit r

elat

ed,

liqui

dity

rel

ated

Cre

dit r

elat

ed,

gove

rnan

ce

rela

ted

Liq

uidi

ty

rela

ted

Cap

ital r

elat

ed

Cap

ital r

elat

ed

Rul

es

Sing

le/m

ultip

le

Sing

le

Mul

tiple

Si

ngle

Si

ngle

Si

ngle

Si

ngle

B

road

bas

ed/ta

rget

ed

Targ

eted

Ta

rget

ed

Bro

ad b

ased

Ta

rget

ed

Bro

ad b

ased

Ta

rget

ed

Fixe

d/tim

e va

ryin

g Fi

xed

Tim

e va

ryin

g Fi

xed

Fixe

d T

ime

vary

ing

Fixe

d R

ule/

disc

retio

n R

ule

Rul

e R

ule

Rul

e R

ule/

disc

retio

n R

ule

Cat

egor

y of

inst

rum

ent

Nee

d re

peat

ed

calib

ratio

n D

evel

oped

to

miti

gate

sy

stem

ic r

isk

Dev

elop

ed to

m

itiga

te

syst

emic

ris

k

Nee

d re

peat

ed

calib

ratio

n D

evel

oped

to m

itiga

te

syst

emic

ris

k D

evel

oped

to

miti

gate

sy

stem

ic r

isk

Sour

ce : B

ank

Indo

nesi

a ( 2

014 )


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two, generic risk and specifi c (unique) risk profi les. Generic risks, generally, are the risk exposures of Islamic banking activities which are similar to credit risk, market risk, liquidity risk, and operational risk exposures in conventional banking. However, the generic risks are not straightforward in Islamic banking from the perspectives of risk management process and practices, specifi cally for fi nancing which involves fi nancing assets. Meanwhile, the specifi c (unique) risk is defi ned as the unique risk exposures of Islamic banking activities which include Shari’ah non-compliance risk, rate of return risk, displaced commercial risk, and equity investment and inventory risk. The summary of risks exposed to Islamic bank can be illustrated in Figure 3.5 .

Based on several studies of risks on contemporary conventional bank, contem-porary Islamic bank, and ideal Islamic bank, as well as other related studies on bank’s operations and risks, summary of risks exposed to Islamic and conventional banks can be seen in Table 3.2 .

Table 3.2 shows the risk profi le exposed by Islamic bank and conventional bank. Moreover, naturally, the Islamic banks are basically divided into two types of bank-ing activities, namely, a 100 % reserve system for safekeeping and an investment banking system. Based on two above banking activities, Islamic bank naturally can be grouped into ideal and contemporary form which has several distinctive risk exposures. In practice, there are several risks in the risk profi le exposed in Islamic bank, namely, solvency risk, credit risk, liquidity risk, market risk, operational risk, and reputational risk. Moreover, Greuning and Iqbal ( 2008 ) state that the Islamic banking system is exposed to risks and that it is not supposed to be due to the pres-ence of deviations between the theory and practice. These deviations emerge due to three factors, (a) trend toward less risky short-term assets, (b) low participation in profi t- and loss-sharing arrangements, and (c) lack of clarity between shareholders and investors-depositors. These deviations have created heightened risk either at the institutional or depositor level as explained below.

In terms of solvency risk, contemporary Islamic bank is perceived to expose to this risk. The bank which faces solvency risk cannot meet the fi nancial obligation due to its debt or liability that exceeds its equity and its expense coverage that is larger than its cash fl ow. However, in case of solvency risk, its depositors may approach the

Credit Risk

Market Risk Liquidity Risk

OperationalRisk

Gen

eric

Rate of ReturnRisk

Shariah Non-compliance

Risk

DisplacedCommercial

Risk EquityInvestment

Risk

Islamic Bank

Uni

que

Fig. 3.5 Contemporary Islamic banking risk profi le

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depositor insurance company to get claim of their deposited funds. Therefore, the solvency risk can lead to Islamic bank failure but the depositors’ fund remains insured. In terms of credit risk, either ideal or contemporary Islamic bank is exposed to credit risk due since payments may be delayed or not made at all by counterparty, which can cause cash fl ow problems and affect a bank’s liquidity. Especially in the case of default by the counterparty, Islamic banks are prohibited from charging any accrued interest or imposing any penalty, except in the case of deliberate procrastina-tion. Clients or borrowers take advantage by delaying payment, knowing that the bank will not charge a penalty or require extra payments. During the delay, the bank’s capital is stuck in a nonproductive activity, and the bank’s investors-depositors are not earning any income. Therefore, once credit risk happens, it would deteriorate the balance sheet of an Islamic bank and get impacted to depositors.

In terms of liquidity risk, only contemporary Islamic bank is exposed to this kind of risk. Liquidity risk which applies to Islamic banks is due to lack of liquidity in the market and lack of access to funding. In the case of which the institution is unable to borrow or raise at a reasonable cost, the risk associated with a future of profi t shared with the depositor also gets impacted. The impact of liquidity risk

Table 3.2 Some risks exposed in Islamic and conventional banks

Risk Ideal Islamic bank Contemporary Islamic bank Conventional bank

• Solvency risk – IB CB • Credit risk IB, DEP IB, DEP CB • Liquidity risk – IB, DEP CB • Market risk IB, DEP IB, DEP CB Markup risk – V V Price risk – V V Leased asset value risk – V V Currency risk – V V Security price risk – V V Rate of return risk V V – Equity investment risk V V V Hedging risk – V V Interest rate risk – – V Benchmark risk – V V Business risk V V V • Operational risk IB, DEP IB, DEP CB Displaced commercial risk – V V Withdrawal risk – V V Governance risk V V V Fiduciary risk – V V Transparency risk V V V Shariah risk V V – • Reputational risk IB, DEP IB, DEP CB

Source : various sources


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toward depositors is based on the contractual agreement between the bank and the investors-depositors. A “pass through” mechanism technically leads to infl uence all profi ts and losses to the depositors-investors due to liquidity risk exposure. However, Islamic bank practices a mechanism where actual risk borne by depositors in their investment account can be dampened by holding a profi t equalization reserve (PER). A certain amount of PER is maintained to reduce or eliminate the variability of return on investment deposits and offer returns that are aligned to market rates of return on conventional deposits or other benchmarks. Therefore, the liquidity risk exposed by Islamic bank is shared to depositors as well.

Meanwhile, in terms of market and operational risks, either ideal or contemporary Islamic banks are exposed to these risks. Islamic banks operate within a regulatory framework that is likely to impose on them capital requirements with a view to promot-ing stability and limiting contagion risk due to the existence of risk stemming from market and its operational factors. Surely, this risk exposure would raise the uncertainty risks on risk-sharing deposits. Unlike depositors of conventional banks, the contractual agreement between Islamic banks and investment account holders is based on the con-cept of sharing profi t and loss. This makes investment account holders a unique class of quasi-liability holders in which they are neither depositors nor equity holders. Although they are not part of the bank’s capital, they are expected to absorb all losses on the investments made through their funds either stemming from market or operational bank (unless the market and operational risks are emerged due to negligence or misconduct on the part of the bank). Therefore, depositors remain exposed to these risks.

Finally, in terms of reputational risk, either ideal or contemporary Islamic bank is exposed to these risks. Practically, the reputational risk emerges due to Islamic bank that is unable to act in the best interest of investors-depositors and shareholders. If and when the goals of investors and shareholders diverge from the action of the bank, the reputational risk emerges by previously Islamic bank exposing fi duciary risk. A dire fi duciary risk, for example, inadequate screening and monitoring of projects in the case of partnership-based investment, misman-agement of the funds of current account holders, and mismanagement in govern-ing the business, can cause reputational risk in the form of creating panic among depositors, who may rush to withdraw their funds. Therefore, reputational risk is channel to depositors through damaging the trust of the bank’s activities.

3.4 Proposed Macroprudential Policy Under a Dual Financial System

The design of Islamic macroprudential policy undertaken by the central bank would certainly be different from the design of conventional macroprudential policy, espe-cially in a country adopting dual fi nancial system, such as Pakistan, Malaysia, and Indonesia. The differences are not only related to macroprudential policy itself but also related to objectives and the role of the central bank.

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3.4.1 Objective of Central Bank

Contemporary central bank generally has single objective, which is to maintain the purchasing power of the currency or to maintain price stability. The purchasing power of the currency or domestic price stability is refl ected by infl ation, while the purchasing power of the currency or the foreign price stability is refl ected by the exchange rate. In addition to the primary objective, the central bank is sometimes also burdened with the responsibility to encourage economic growth and expanding employment opportunities, so that the objective of the central bank is also the objec-tive of the macroeconomy of a country.

In countries adopting dual fi nancial system, where Islamic fi nancial institutions coexist with conventional fi nancial institutions, the objectives of the central bank should be a merger between conventional and Islamic macroeconomic objectives. Chapra ( 1985 ) suggested several intermediate objectives of Islamic economic, among others: (1) economic well-being with full employment and optimum rate of economic growth, (2) socioeconomic justice and equitable distribution of income and wealth, and (3) stability in the value of money to enable the medium of exchange to be a reliable unit of account, a just standard of deferred payments, and a stable store of value. In the end, the ultimate goal of Islamic economic is aimed to achieve happiness in the world and the hereafter ( falah ) (Figure 3.6 ).

Lamfalussy ( 2011 ) states that the central bank has, or should have, a more or less well-defi ned macroprudential mandate both in preventing the emergence of a systemic crisis and in participating in the management of such a crisis in case its preventive endeavors fail. Therefore, in the future, single objective of the central bank in the conventional fi nancial system, namely, (a) to maintain price stability, is no longer suffi cient and must be combined with the macroprudential objective, namely, (b) to maintain fi nancial stability by contributing to the preservation of and the enhanced resilience of systemic fi nancial stability. Meanwhile, the central bank

PriceStability

FALAH

Ec Wellbeingwith Full

Employment& Growth

Soc-Ec Justice &Equitable Dist.of Income &

Wealth

Stability inthe Value of

MoneyEconomicGrowthEmployment

Fig. 3.6 Objectives of conventional and Islamic macroeconomic policy. Source : Author based on Mishkin ( 2012 ) and Chapra ( 1985 )


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under dual fi nancial system in the future should also add other Islamic macroeco-nomic objectives, namely, (c) promoting economic well-being with full employment and optimum rate of economic growth and (d) promoting socioeconomic justice and equitable distribution of income and wealth (Table 3.3 ).

3.4.2 Role of Central Bank

The role of contemporary central bank is primarily as monetary authority with the primary objective of maintaining price stability. Central bank also plays an increasing role in maintaining systemic fi nancial stability by assuming macropru-dential responsibility. Moreover, some central banks are also given the mandate as payment system authority to maintain effi cient, safe, swift, and reliable payment system. These roles are also applied for central bank under dual fi nancial system.

In the future model, the above roles of central bank should be strengthened. The most crucial challenge is whether central bank should also be in charge of microprudential policy. Lamfalussy ( 2011 ) gives two powerful arguments which reinforce each other. Firstly, the central bank is always in the front line whenever there are signs of an emerging crisis. Secondly, central bank, as an oversight responsibility for clearing, settlement, and payment systems, has access to direct market information. Therefore, central bank should also be given stronger role in macroprudential policy as the highest authority, so that an integrated model, where macroprudential and microprudential authorities are vested in one institu-tion, is preferable. Moreover, under dual fi nancial system, central bank should be given a role as real sector enabler to encourage and stimulate real sector produc-tive activities (Table 3.4 ).

Table 3.3 Central bank’s objective: current, future, and gap

Current 1. Maintaining the purchasing power of money or price stability Future 1. Maintaining the purchasing power of money or price stability

2. Maintaining fi nancial stability (by contributing to the preservation of and the enhanced resilience of systemic fi nancial stability)

3. Promoting economic well-being with full employment and optimum rate of economic growth

4. Promoting socioeconomic justice and equitable distribution of income and wealth

Gap (a) CB has not been able to reach its ideal in maintaining purchasing power of money

(b) CB has a new role in preserving and enhancing the resilience of systemic fi nancial stability

(c) CB has a new role in encouraging the real sector to achieve well-being, socioeconomic justice, and equity

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Therefore, as a monetary authority under dual fi nancial system, future central bank should have comprehensive framework of monetary policy under dual fi nan-cial system, so that it can benefi t from both worlds. Future central bank should be given a clear mandate to assume a well-defi ned responsibility in the preservation of systemic fi nancial stability, as well as reassume microprudential authority. Future central bank should also meet the challenge of effi cient, safe, swift, and reliable future payment system. Moreover, future central bank under dual fi nancial system should have access to the real sector, since Islamic fi nance cannot be detached from the activity in the real sector.

3.4.3 Macroprudential Policy Objective and Scope

The term macroprudential is part of fi nancial stability assessment process, particularly dealing with systemic risks. Systemic risks are cumulated risks across institutions, markets, and even countries to levels that could disturb the real economy. Global inter-connectedness and procyclical behavior are two primary sources of triggering systemic risks within fi nancial system. Broadly then, systemic risks can be distinguished into two types, namely, (1) “resiliency risk” which denotes for a concentration of risk that can arise at a point in time due to the interconnectedness and similar exposure among fi nancial institutions and markets and (2) “procyclical risks” which refl ect the ten-dency of the fi nancial system to procyclical behavior that might exacerbate economic booms and bursts. Therefore, macroprudential policies are designed to strengthen the ability of the fi nancial system to withstand stresses and strains and continue to provide fi nancial services.

Obviously, looking at the current macroprudential policy objective, it cannot be put away toward contributing to the overall stability of the system. Hence, macro-prudential policy should be able to eliminate all fl uctuations in the fi nancial system

Table 3.4 Central bank’s role: current, future, and gap

Current 1. Monetary authority 2. Macroprudential responsibility 3. Payment system authority

Future 1. Monetary authority 2. Macroprudential authority 3. Microprudential authority 4. Payment system authority 5. Real sector enabler

Gap (a) CB should have comprehensive framework of monetary policy under dual fi nancial system

(b) CB should be given a clear mandate to assume a well-defi ned responsibility in the preservation of system fi nancial stability

(c) CB should reassume its microprudential authority (d) CB should meet the challenge of effi cient, safe, swift, and reliable future

payment system (e) CB should have access to the real sector


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by (1) preventing and reducing systemic risk, (2) encouraging balanced and sustain-able intermediation, and (3) improving the effi ciency of the fi nancial system and fi nancial access. Meanwhile, in the future, macroprudential policy objectives should comprise of several objectives, namely, (1) eliminating and preventing both sys-temic risks and fi nancial crises, (2) encouraging balanced and sustainable intermediation, and (3) improving the effi ciency of the fi nancial system and fi nan-cial access (Table 3.5 ).

However, by comparing future and current objectives, there remain some out-standing gaps, namely, (1) there exist structural gaps which need to be reformed, while central bank should be more aggressive in utilizing current macroprudential (MaP) instruments; (2) there exist imbalances in terms of sectoral and spatial as well as in terms of asset-liability; and in Islamic fi nance, (3) there exists imbalance due to the domination of debt-based fi nancing, the absence of interrelated channels among fi nancial sectors (particularly to microfi nance sector), and the presence of interest rate anomaly.

According to IMF ( 2011 ), BIS ( 2011 ), Bank of England ( 2009 ), and Working Group G-30 ( 2010 ), macroprudential policy is basically a policy which aims at maintaining fi nancial stability as a whole by limiting systemic risks and cost of systemic risks in the fi nancial system because of interconnectedness and procyclical behavior among fi nancial institutions. Hence, the primary scope of macroprudential policy should address risks arising in the fi nancial system and risks amplifi ed by the fi nancial system, leaving other identifi ed sources of systemic risks to be dealt with by other public policies. In addition, since macroprudential policy is a part element to preserve fi nancial stability, recently, Bank Indonesia released central banking regulation No. 16 2014, which offi cially states a commitment to encourage a bal-anced and sustainable intermediation function and enhance the effi ciency of fi nancial system and expose to fi nancial access. In other words, macroprudential policy deals with not only creating sound fi nancial system but also providing con-ducive environment for real sector development.

Based on the above description, the scope of macroprudential policy in Bank Indonesia is being focused on (1) promoting effective and solid fi nancial system

Table 3.5 Macroprudential objective: current, future, and gap

Current 1. Prevent and reduce systemic risks 2. Encourage balanced and sustainable intermediation 3. Improve the effi ciency of the fi nancial system and fi nancial access

Future 1. Eliminate and prevent both systemic risks and fi nancial crises 2. Encourage balanced and sustainable intermediation 3. Improve the effi ciency of the fi nancial system and fi nancial access

Gap (a) There exists structural gap, which needs to be reformed, while CB should be more aggressive in using current MaP instruments

(b) There exist imbalances in terms of sectoral and spatial as well as in terms of asset-liability. In Islamic fi nance, there exists imbalance due to the domination of debt-based fi nancing

(c) The absence of interrelated channels among fi nancial sectors (particularly to microfi nance sector) and the existence of interest rate anomaly

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surveillance and (2) conducting precise examination of bank and relevant institu-tions as needed. In practice, Bank Indonesia has set up MaP policy framework and developed systemic risk index consisting of size factor, interconnectedness among fi nancial sectors, and complexity (represented by net performing loan, domestic government bond price, and capital adequacy ratio). Moreover, fi nancial system stability index also is developed by incorporating exchange rate volatility, IHSG, and yield of obligation, in order to conduct surveillance mechanism in the fi nancial system.

Meanwhile, in the future model, the scope of macroprudential policy must be also concerned with (1) fi nancial system surveillance and (2) promoting examina-tion of bank and relevant institution as needed. However, in the future, the scope of macroprudential policy is not merely concerned with the fi nancial system and the institution per se but also should be extended to the source of fi nancial distress in the fi nancial system, such as excessive credit growth, price bubble in property sector, and increasing foreign debt (Table 3.6 ).

Obviously, there are gaps between current and future objectives of central bank in terms of macroprudential scope. Bank Indonesia needs to develop credible lead-ing indicators and the fi nancial stability index (FSI) as better predictor for detecting fi nancial turmoil. In addition, the need to have strong and comprehensive legal foundation for macroprudential policy implementation so that macroprudential authority could conduct its examination tasks effectively.

3.4.4 Instrument of Macroprudential Policy

Instruments of macroprudential policy are sequential steps of surveillance process in macroprudential policy framework. Instruments of macroprudential policy have several unique characteristics, namely, (1) the primary purpose is to mitigate sys-temic risks; (2) its scope covers the fi nancial system as a whole; (3) macroprudential policy is implemented through prudential or monetary tools; (4) it has connection with other policies; and (5) it encompasses cross-sectional and time series dimensions. In addition, Lim et al. ( 2011 ) classify instruments of macroprudential policy into credit, liquidity, and capital related. Recently, Bank Indonesia adds up

Table 3.6 Macroprudential scope: current, future, and gap

Current 1. Financial system surveillance 2. Examination of bank and relevant institutions as needed

Future 1. Financial system surveillance 2. Examination of bank and relevant institutions as needed

Gap (a) Credible leading indicators and fi nancial stability index (FSI) are needed, including better predictor. The predictor can be divided into internal sources (stress indicators) and external sources of risks (imbalances indicators)

(b) A strong and comprehensive legal foundation is needed, so that macroprudential authority could perform its examination tasks effectively


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the instrument with governance related. Therefore, in short, instruments of macro-prudential policy can be used to specifi cally and effectively target systemic risks.

Given the instrument of macroprudential policy is very important to achieve ultimate target, the instruments must ensure that they can affect not only the mone-tary side but also the real side. Recall on Irving Fisher equation which tries to balance between left-hand side, comprising money and velocity, and right-hand side, comprising price and output. According to this theory, it comes up with fi ve hypotheses, namely, (1) the money growth is source of infl ation; (2) the money sup-ply is exogenous in nature; (3) the money demand is a stable function of nominal income and interest rate; (4) injecting money into economy is not able to affect the output in the long run; and (5) the real of interest rate is merely infl uenced by non-monetary factor, such as productivity of capital and time preference. Therefore, according to the above hypothesis, the left-hand side is dominantly affecting the process toward equilibrium state. In other words, relating to macroprudential policy, it should be able to generate such mechanism for activating either left- or right-hand side altogether.

The current instruments of macroprudential policy try to focus on several goals, namely, (1) strengthening the resilience of capital and preventing excessive lever-age; (2) managing intermediation and controlling credit risk, liquidity risk, foreign exchange risk, and interest rate risk, as well as other risks which could potentially become systemic; (3) limiting exposure concentration; (4) strengthening the resil-ience of the fi nancial infrastructure; and (5) improving the effi ciency of the fi nancial system and fi nancial access. Meanwhile, in the future, instruments of macropruden-tial policy should be directed toward: (1) instruments which affect MV (instruments on the fi nancial sector, like current instruments), (2) instruments which affect PT (instruments on the real sector), and (3) instruments which include conventional and Islamic macroprudentials (Table 3.7 ).

Table 3.7 Macroprudential instrument: current, future, and gap

Current 1. Strengthening the resilience of capital and preventing excessive leverage 2. Managing intermediation and controlling credit risk, liquidity risk,

foreign exchange risk, and interest rate risk, as well as other risks which could potentially become systemic

3. Limiting exposure concentration 4. Strengthening the resilience of the fi nancial infrastructure 5. Improving the effi ciency of the fi nancial system and fi nancial access

Future 1. Instruments which affect MC (instruments on the fi nancial sector, like current instruments)

2. Instruments which affect PT (instruments on the real sector) 3. Instruments, which include conventional and Islamic macroprudential

Gap (a) The central bank currently has conventional and Islamic macroprudential instruments affecting the fi nancial sector, which still need to be improved

(b) The central bank should have conventional and Islamic macroprudential instruments affecting the real sector

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In conclusion, the gap which should be taken care of is that the central bank should develop both conventional and Islamic macroprudential instruments which could affect either the fi nancial or real sector.

3.4.5 Authority of Macroprudential Policy

The agency responsible for macroprudential policy should be given the authority to implement it. The authority given the mandate of macroprudential policy should be highly credible. This seems very important due to the nature of macroprudential policy implementation. It has the long-term nature of macroprudential risks and goals and the short-term effect of some of the tools available to respond to macro-prudential policy’s goals. Therefore, only a credible authority is likely to be able to persuade the public that the long-term advantages justify the short-term costs. In addition, an effective macroprudential policy tool needs communication and moral suasion, and they will be effectively implemented only in the hand of an agency that is credible.

Looking back to macroprudential policy, Canada states itself as one of the best countries which has coped in response to fi nancial distress so that it has been held up as a model of good performance. However, in the case of Canada, it is still lacking in terms of which agencies will carry out that responsibility in order to preserve fi nancial system stability. In the case of Indonesia, the current fi nancial system stability preservation includes a committee, called Financial System Stability Coordination Forum, made up of the Bank Indonesia, Financial Services Authority, Indonesia Deposit Insurance Corporation, and Ministry of Finance. This established forum is set up to ensure that all the expert informa-tion and advice is brought to bear on macroprudential issues (Jenkins and Thiessen 2012 ). This forum is chaired by the minister of fi nance, similar with what United States does. This means that the minister of fi nance is given respon-sibility. According to Jenkins and Thiessen ( 2012 ), this model gives an advan-tage, particularly in the normal political process that would provide for full accountability for macroprudential policy to parliament and the public. These political processes, however, provide shortcomings, namely, disincentives to act promptly when systemic risks may be building up. Meanwhile, for macropru-dential responsibility, currently, Bank Indonesia, on its own, is given responsi-bility for macroprudential policy.

In the future, like in the United Kingdom and European Central Bank (ECB), the governor of the bank of England and the president of the ECB chair the Financial Policy Committee. Thus, in the case of Indonesia, the governor of Bank Indonesia would be the most appropriate chair for Financial System Stability Coordination Forum. According to Jenkins and Thiessen ( 2012 ), that is primarily because of the broad perspective provided by the governor’s existing responsibili-ties for dealing with system-wide issues of monetary policy and the monitoring of fi nancial stability. Meanwhile, in terms of macroprudential responsibility, Bank


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Indonesia is given responsibility but with joint responsibility along with other related agencies. This joint responsibility led by central bank would be the most suitable mechanism since this alternative would provide the strongest incentive to make full use of all the knowledge and expertise of committee members, given their direct involvement in all decisions and their collective responsibility for them (Table 3.8 ).

Therefore, the gaps remain in respect to macroprudential authority, namely, (1) regulation related to the establishment of Financial System Stability Coordination Forum (FKSSK) should be amended and (2) regulation related to the separation of macroprudential and microprudential authority should be amended.

3.5 Conclusion

The repeated crises and fi nancial instability have forced some authorities to activate the macroprudential policy. The presence of systemic risk and highly interconnect-edness among fi nancial institutions creates common understanding on the crux of prudent and solid fi nancial ecosystems. Moreover, the presence of dual fi nancial systems, conventional and Islamic, which principally have their own characteristics, becomes an outstanding challenge under macroprudential framework. Indonesia is running its economy under dual fi nancial systems, and a challenge remains on how it would be designed without practically disturbing one another.

The contemporary Islamic banks which record the dominant share in the fi nan-cial system, in fact, expose some common risks (credit, market, liquidity, and opera-tional risks) and unique risks (rate of return and Shari’ah non-compliance risks). Therefore, the current practice of macroprudential needs to adopt such challenges which accommodates the dual systems. The chapter fi nally proposes the framework toward future macroprudential policy under dual fi nancial system, including the (1) objective of central bank, (2) role of central bank, (3) objective of macropruden-tial policy, (4) scope of macroprudential policy, (5) instrument of macroprudential policy, and (6) authority of macroprudential policy.

Table 3.8 Macroprudential authority: current, future, and gap

Current 1. Financial System Stability Coordination Forum (FKSSK) chaired by the minister of fi nance

2. Central bank as macroprudential authority Future 1. Financial System Stability Coordination Forum (FKSSK) chaired by

the governor of central bank 2. Central bank as macroprudential authority, as well as microprudential

authority, should be amended Gap (a) Regulation on the establishment of FKSSK should be amended

(b) Regulations related to the separation of macroprudential authority and microprudential authority should be amended

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Kremers J, Schoenmaker D (2010) Twin Peaks: Experiences in the Netherlands. Special Paper, (196), pp. 1–11

Lamfalussy A (2011) Keynote speech. In Monetary and Economic Department BIS (2011) The future of central banking under post-crisis mandate. BIS Papers No. 55. Bank for International Settlements, Basel, Switzerland

Lim C, Columba F, Costa A et al (2011) Macroprudntial policy: what instruments and how to use them? IMF Working Paper, WP/11/238, October. International Monetary Fund, Washington, DC

Mishkin FS (2012) Macroeconomics policy and practice. Addison-Wesley, Boston


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Part II Macroprudential Policy, Systemic

Risks and Financial Stability in Islamic Financial Industry

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Chapter 8Testing of the Procyclicality of Islamic and Conventional Banks in Indonesia

Ascarya, Siti Rahmawati, and Adiwarman A. Karim

Ascarya (*) • S. RahmawatiCentral Banking Research Department, Bank Indonesia, Jl. MH Thamrin No. 2, Sjafruddin Prawiranegara Tower, 22nd fl., Jakarta 10350, Indonesiae-mail: [email protected]; [email protected]

A.A. KarimKARIM Consulting Indonesia, Jakarta, Indonesiae-mail: [email protected]

Abstract Procyclicality of banking system is believed to be one of the importantsources of financial system systemic instability which could be addressed bymacroprudential policy. This study aims to test procyclicality of Islamic and con-ventional banks in Indonesia using several quantitative methods in developingIslamic macroprudential policy. The study shows that as growth increases, growthof Islamic financing increases more than the increase of conventional loan. Itimplies that Islamic bank is more procyclical than conventional bank. The studyalso shows that procyclicality of Islamic bank does not create credit bubbles, sothat it can be classified as good procyclicality, which can be beneficial to long-term economic growth. On the contrary, procyclicality of conventional bank doescreate bubbles, so that it can be categorized as bad procyclicality. Taking intoaccount Islamic bank has inherent stability and has closer link to the real sector,therefore measures for Islamic macroprudential should be more flexible thanthose for conventional macroprudential.

Keywords Procyclicality • Islamic macroprudential policy • Islamic bank • Dualfinancial system

8.1 Introduction

Since the collapse of the Bretton Woods Agreement (BWA) in August 1971, thegold standard system collapsed and a modern financial system has started to form,characterized by volatility, exchange rate fluctuations, excessive credit expansion,

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asset price bubbles, financial fragility, imbalances, and ultimately repeated finan-cial crisis, such as the banking crisis in the U.K (1973–1974), deep recession inindustrial countries (1978–1980), debt crisis in developing countries (1980–1982),savings and loan crisis in Latin America (1980), the collapse of the capital marketin the U.S and the UK (1987), the collapse of low-quality debt securities (1989),the financial crisis in Mexico (1994), the financial crises in Asian countries, Russia,Brazil, and Argentina (1997–1999), as well as the global financial crisis (2007–2008) which has not yet been recovered and has spread to European countries suchas Greece, Ireland, Portugal, Italy, Spain, Cyprus, Slovenia, Slovakia, Finland, andBelgium.Following the collapse of BWA in 1971, financial crises have reemerged more

frequently and spread wider all over the world. The probability of systemic crisesappears to have been rising (Bordo et al. 2001). There is no single country that couldescape from financial crisis, even though some countries have generally followedsound fiscal and monetary policies (Chapra 2008). Furthermore, financial criseshave evolved and occurred not because of cyclical or managerial failures, butbecause of structural failures/fundamental deficiencies in various countries undercompletely different regulatory systems as well as at different stages of economicdevelopment (Lietaer et al. 2009). Since the collapse of the BWA, Laeven andValencia (2012) recorded that there have been 431 episodes of financial crises, con-sists of 147 banking crises, 218 currency crises, and 66 foreign debt crises, includ-ing 68 twin-crisis and eight triplet-crisis (see Figure 8.1).Banking crisis was recorded as the second most frequent financial crisis and it

was the major cause of recent global financial crisis. The procyclicality of bankingsystem, which refers to the interactions between the banking system and the realeconomy, are mutually reinforcing and tend to amplify the amplitude of the busi-ness cycle. It has been identified as one of the important sources of systemic insta-bility in the financial system. Meanwhile compared to conventional bank, Islamicbank has a different kind of banking system compared to conventional bankingsystem, where it provides various Islamic financial services in accordance to Islamic

BankingCrises

DebtCrises

CurrencyCrises

100 18

153

28 298

11

Fig. 8.1 Financial Crisespost Bretton Woods.Source: adapted fromLaeven and Valencia(2008)

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thought, especially it should be free from riba (usury or interest), free from maysir (game of chance or speculation), and free from gharar (excessive uncertainty).Conceptually, Islamic bank performing “true” Islamic finance would not be sus-

ceptible to man-made financial crisis, which occurs due to the transgressions ofAllah’s laws in financial dealings, especially in the abandonment of the main pillars ofIslamic finance, namely prohibition of riba (usury or interest), prohibition of maysir (speculative transaction), and prohibition of gharar (excessive uncertainty), in theirmany forms, as well as misconduct of economic actors, poor governance, and unsus-tainable fiscal system (Ascarya 2013a). Meanwhile, natural financial crisis occurs dueto natural phenomena, such as drought, natural disaster, and natural business cycle.In a contemporary world of dual banking system, a “true” Islamic finance/bank-

ing could not be fully applied in Islamic financial institutions, in which Islamic bankcould not operate full-fledge in accordance with Islamic teachings. For example, themain pillars of ideal Islamic banking (see Table 8.1) are still lacking in the realworld application. Consequently, Islamic finance/banking still creates financialbubble through multiplier and leveraging of fractional reserve banking system.Islamic banking is still susceptible to liquidity risks, since it is still dealing withmismatches, including maturity and nominal mismatches.Nevertheless, empirical studies show that, though Islamic banking is still far

from ideal, this type of Islamic finance/banking is more resilience to financial insta-bility/crisis than conventional finance/banking. For the case of Indonesia that hasdual financial system, Ascarya (2009) and Ascarya (2013b) show that Islamicfinance, based on profit-and-loss sharing (PLS), is more resilience to financial insta-bility/crisis than conventional finance that based on interest rate. In a country thatadopts dual banking system, whereas conventional bank co-exists with Islamicbank, the procyclicality of both banking systems should be well understood by reg-ulators, since they are two different kinds that need different treatments.As an early study in developing macroprudential policy under dual financial sys-

tem in Indonesia, this chapter aims to test the procyclicality of Islamic bank financ-ing and conventional bank credit, as well as to provide a better understanding to aproper design of macroprudential policy and/or instruments under a dual financialsystem in Indonesia. This chapter applies several quantitative methods to ensure therobustness of the results, including Ordinary Least Square (OLS), Error CorrectionModel (ECM), and Autoregressive Distributed Lag (ARDL) to test procyclicality ofIslamic and conventional banks in Indonesia.

Table 8.1 Some essential pillars in Islamic economic system

Pillar Islamic ideal Islamic contemporary

Mode oftransaction

Main: PLS; and trade (no Riba,Gharar and Maysir)

Main: Trade; and PLS (no Riba,Gharar and Maysir)

Money system Full bodied (or backed up) money Fiat MoneyBanking system 100% reserve banking Fractional reserve bankingZakat system Obligatory Zakat (Tax in idle

assets); redistributionVoluntary Zakat; no redistribution

8 Testing of the Procyclicality of Islamic and Conventional Banks in Indonesia

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8.2.1 Overview of Procyclicality

Many scholars believe that procyclicality is an inherent feature of contemporaryfinancial sector of an economy, which potentially affects financial stability. Landau(2009) defined procyclicality as the tendency of financial variables to fluctuatearound a trend during the economic cycle, so that the increase of procyclicalitysimply means fluctuations with broader amplitude. Similar to Landau (2009),Abdellah (2009) defined procyclicality as the interactions between the financial sys-tem and the real economy, which are mutually reinforcing, where these interactionstend to amplify the amplitude of the business cycle. However, Landau (2009) asserted that such a simple description seldom fits the behavior of financial systemsin real life, which characterizes as a complex system. Usually, after a shock, the pathof asset prices and evolution of financial aggregates will show various and highlyirregular forms of volatility, with possible non-linearities and discontinuities (liquid-ity freezes is one good example).Furthermore, the procyclicality can also be defined as a mechanism that encom-

passes the interactions of at least three reinforcing cycles moving in tandem. Theyare business cycle, financial cycle, and cycle of risk-taking behavior represented byfluctuation in asset price or the asset price cycle. These three cycles are self-reinforcing (Abdellah 2009). As also stated by Nijathaworn (2009), procyclicalityis not just the outcome of interactions between business cycle and financial cycle,but it is also affected by risk-taking cycle, characteristic by over-optimism duringeconomic boom and over-pessimism in times of economic bust cycle (Table 8.2).According to Athanasoglou and Daniilidis (2011), the causes of procyclicality

can be stemmed from market imperfections and deviations from efficient markethypothesis, while other factors—including Basel II and accounting standards—may have exacerbated it. Furthermore, Geršl and Jakubik (2010) stated that procy-clicality is caused by a full range of interconnected factors (or natural sources),such as information asymmetry, fluctuations in balance-sheet quality, over-opti-mistic (or over-pessimistic) expectations, herd behavior by market participants,and financial innovation. In addition, financial regulation and accounting rules forfinancial assets revaluation in the financial institutions’ balance sheets can alsoplay an important role.Not all procyclicality is bad (Landau 2009). He stated that it all depends on the

causal link. Is the financial system the origin or the amplifier of destabilizing dynam-ics? Or does it simply react to cyclical evolutions in the real economy? Landau (2009) suggested that we should only be concerned by “intrinsic procyclicality,” which is cre-ated inside and by the financial system. He further explained that real and significantdamages could only occur if and when financial imbalances are allowed to occur for along time with two consequences. First, asset prices significantly deviate from theirfundamental trend, which creates distortions in the allocation of resources. Second,those imbalances unwind suddenly and abruptly, triggeringmajor disruptions in growth

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and the economic cycle, which closely resembles the definition of a bubble. Landaumentioned further that cyclical fluctuations cannot develop into a bubble unless someamplification mechanisms are allowed to fully work in an overall permissive financialenvironment. Therefore, the procyclicality of banking system, which causes financialbubble is bad, but, the procyclicality of banking system which does not cause financialbubble is good and it can be beneficial to long-term growth.

8.2.2 Previous Studies

In most countries, financial systems are procyclical. It is due to loan growth to non-financial sector private sector, whereas in the banking system, output is expandingand contracting during the recessions, either Islamic or conventional. There are anumber of empirical studies of the procyclicality nature of banks’ behavior. Wideempirical evidences have shown that lending rapidly increases during economicupturns, suggesting credit cycle would lead to amplify cycles. Several studies inves-tigated Procyclicality behavior brought about by bank lending growth, namelyKupiec et al. (2013), Ghosh (2013), Utari et al. (2011), Bebczuk et al. (2011), Geršland Jakubik (2010), Jeong (2009), Hyung (2009), Akinboade and Makina (2009),and Foos et al. (2010).Kupiec et al. (2013) found that a bank’s loan portfolio performance was an

important determinant of its subsequent loan growth. When troubled loans of a bank

Table 8.2 Interaction between business cycle, risk behavior, and financial cycle

Phase Business cycle Risk-taking cycle Financial cycle

Expansion phase • Macroeconomicstability

• Confidence andoptimism up

• Risk value down,interest rate spreaddown

• Increased economicgrowth

• Risk-taking up • Asset prices up,pushing up collateralvalue

• Credit demandup

• Leverage up• Foreign capital inflowsup

• Credit extension upContractionPhase

• Lifted macrovolatility

• Marketconfidencedown

• Banks do deleveraging

• Decreased economicactivity

• Risk averse • Loan loss provision up• Credit demanddown

• Interest rate spread up• Credit extension down• Capital inflows down

Source: adapted from Nijathaworn (2009). See rethinking procyclicality what is it now and whatcan be done, BIS (2008)


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increase, on average, the bank would reduce its lending growth in the subsequentquarter. Also, consistent with the literature, he found evidence that a bank’s overallprofitability was an important determinant of its subsequent loan growth. Their esti-mates suggested that a bank’s capital and liquidity ratios were positively related toits subsequent loan growth. The data clearly showed that when banks sufferedlosses, would affect their lending behavior. When faced with losses, banks appearedto curtail their lending growth since they have poor investment performance.Ghosh (2013) examined whether the funding structure of a bank amplified

procyclicality. Using disaggregated data on GCC banks for 1996–2009, thestudy employed panel data techniques to explore the lending behavior of GCCbanks which incorporated period of the recent economic crisis. More specifi-cally, the study suggested that bank with greater dependence on wholesalefunds appeared to have cut back its lending by a significant amount. The pro-cyclicality of the financial system and the crisis appeared to exacerbate theeffect, though the impact was a slightly moderate for Islamic banks. The reasonprocyclicality exacerbated the conventional banks is because in terms of realloan growth, commercial banks expanded their loan book at a much faster ratethan those of Islamic banks .Utari et al. (2011) investigated banking procyclicality and assessed on risk-

taking channel in Indonesia. Linear regression and panel data were employed byusing monthly time series data ranging from 2000 to 2012. The findings suggestedthat: (1) by using correlation and panel data approaches, supply of bank loan, eitheraggregate or disaggregate, showed a procyclicality. In aggregate, the loan growthtended to increase during the expansion (boom) period and slowed down duringcontraction (burst) period. The procyclicality effect was empirically stronger duringexpansion period rather than contraction period; (2) The GDP growth did not sig-nificantly lead to consumption credit growth due to the absence of collateral assetswhich was influenced by economic cycle; (3) Procyclicality behavior in bankingwas caused by economic growth, collateral assessment in credit evaluation, bankrisk, capital, bank size, and bank ownership (foreign or domestic); (4) the rise ofrisk perception rose in the banking sector played an important role on monetarypolicy transmission mechanism through credit channel.Bebczuk et al. (2011) provided an up-to-date worldwide evidence on whether

changes in credits precede (and eventually cause) changes in economic activity inthe short run. They found that according to the evidence, credit procyclicality, in thesense that the simple correlation coefficient was positive and significant at 10% orless, prevailed at only just 45% of the countries when annual data were used, and23% with quarterly data. A study done by Gersl and Jakubik (2010) found thatunder certain assumptions the feedback effect on the real economy could be around1–2% points of year-on-year GDP growth over a period of at least one year. Againstthis background, procyclicality of the financial system should thus be taken intoaccount in economic and macro-prudential policy-making.Jeong (2009) studied banks’ behavior which could be more procyclicality as

their dependence on wholesale funding increased. He found that: (1) after the1997–1998 financial crisis, the sensitivity of the real growth rate of corporate

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lending to the real GDP growth rate changed into a figure greater than one, sug-gesting that the banking industry might unnecessarily amplify swings in the realeconomy, (2) the coefficient of the interaction between the real GDP growth rateand the wholesale funding ratio was positive and statistically significant, indicat-ing that when banks depend more on wholesale funding, lending tend to be moresensitive to the business cycle. Korean banks’ heavy reliance on wholesale fund-ing might have been partly responsible for the substantial increase in procyclical-ity, (3) following the 1997–1998 financial crisis, the procyclicality of banks’behavior in corporate lending augmented substantially, and (4) after LTV ratioregulation was introduced in 2002:3, the procyclicality of banks’ behavior inhousehold loans decreased dramatically.Akinboade (2009) studied empirical analysis on the linkage between the

behavior of bank lending and business cycles in South Africa. Overall evidencesuggests that procyclicality of bank lending was covered both at macro and microlevels. At macro level, bank lending and lending rates have moved in line withbusiness cycles. At micro level, bank lending to households and firms was gener-ally procyclical.Foos et al. (2010) investigated how loan growth affects the riskiness of indi-

vidual banks in 16 major countries. This study found that: (1) past abnormal loangrowth has a positive and highly significant influence on subsequent loan losseswith a lag of two to four years, (2) abnormal loan growth leads to a decline in therelative interest income of banks. This finding holds for most countries and sup-ports the view that new loans are granted at rates that do not compensate for theassociated default risk, and (3) abnormal loan growth is significantly negativelyrelated to bank solvency. Despite intertemporal two-way linkages are foundbetween abnormal loan growth and losses, the positive relation between pastabnormal loan growth and contemporaneous losses remains robust and turns out tobe economically more important than the inverse relation. In additional tests ofrobustness, they have considered gross loan growth instead of abnormal loangrowth and obtain highly similar results.

8.3 Data and Methodology

8.3.1 Data

Data used in these empirical studies are three sets of monthly time series data. Thefirst set of data is used for testing procyclicality of Islamic and conventional bank-ing, started from January 2004 to August 2014, including:

– Islamic model: Islamic real financing (RFN), gross domestic product which isproxied by industrial production index (GDP), non-performing financing ratio(NPF), Islamic overnight Interbank Money Market margin (IMM), and Islamiccapital to asset ratio (ICTA).


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– Conventional model: conventional real credit (RCR), gross domestic productwhich is proxied by industrial production index (GDP), non-performing loanratio (NPL), conventional overnight Interbank Money Market margin (MM), andconventional capital to asset ratio (CCTA) (Figure 8.2).

8.3.2 Model to Test the Procyclicality of Bank Financing Growth

Procyclicality is a term to describe the mutually reinforcing mechanism throughwhich the financial system can amplify business cycle fluctuations and possiblycause or exacerbate financial stability (BIS 2008). Meanwhile, Geršl and Jakubik(2010) define procyclicality as the magnification of swings in the economic cycle byfinancial sector activities most notably bank lending. Since Keynes’ seminal workon the general theory of employment, interest, and money (1936), researcher havegrappled with a question as to whether banks change their lending standards sys-tematically over the business cycle, and that if they do whether there is a discernibleand economically important effect on aggregate fluctuations. Some of empiricalresearches suggest that one major contributor to the boom and bust nature of thebusiness cycle is the way that banks alter their lending standards over economicpeaks and troughs (Farmer 1985; Gorton and Kahn 1993; Greenwald and Stiglitz1993; Smith 1995; and Zarnowitz 1985). Asea and Blomberg (1998) further reportedsystematic patterns in lending standards, with banks tightening credit in recessionsand easing it during expansions, arguing that lending cycles exacerbate businesscycle. In any case, bank lending in general tends to be procyclical, i.e., it contractsduring an economic slowdown and rises during an expansion (Akinboade et al.2009; Craig et al. 2006).In general, economic literature considers banking system as inherently procycli-

cal (Gersl and Jakubik 2009; Craig et al. 2006). Jeong (2009) argued that financialaccelerator, over-optimism, reduced supervisory toughness, low capital require-ments, worsening screening technology quality, are the sources of procyclicality. In

80

90

100

110

120

130

0

40

80

120

160

200

Jan-04 Jul-05 Jan-07 Jul-08 Jan-10 Jul-11 Jan-13 Jul-14

Financing GDP (R)

80

90

100

110

120

130

0

800

1600

2400

3200

4000

Jan-04 Jul-05 Jan-07 Jul-08 Jan-10 Jul-11 Jan-13 Jul-14

Credit GDP (R)

Fig. 8.2 Islamic financing (left) and conventional credit (right) in Rupiah (trillion). Source: BankIndonesia

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addition, Craig et al. (2006) view that the sources of procyclicality in the bankingsystem originating in the structure of financial systems comprise excessive relianceon collateral to mitigate credit risk, delayed recognition of and provision on NPLsand regulatory forbearance, underpricing credit risk such that lending margins aretoo narrow to cover risk, deterioration in the quality of credit assessment duringcyclical upswings, directed and connected lending by state-owned bank, bank reli-ance on volatile foreign sources of funding, and financial liberalization.To estimate procyclicality, the chapter sets up model specification using fixed-

effect model, based on Berger and Udell (2004) and Jimenez and Saurina (2005), asfollows:

cloang GDPg conc controli t i t

i

n

i i t i t, , ,= + + + + +-=

-åb g b b b0 1 2 13

1t

(8.1)

where cloang denotes the real growth rate of corporate loans of bank i in period t; GDPg is the real GDP growth rate; conc is the 4-firm market concentration ratio; g represents an individual fixed effects; and control denotes control variables ofwhich prior studies have found to affect loan growth.In this study,wemodify the above employedvariables byusing Industrial Production

Index (IPI) as a proxy for GDP. IPI is used in the equation to proxy the business cycle.If banks behave procyclicality, loan growth (demand side) is procyclical due to positivesign on GDP growth (supply side) (Craig, et al. 2006). This model 1 is applicable foranalyzing either the procyclicality in Islamic or conventional banks.

dLRCR dGDP dNPL dCMM dCCTAt t t t= + + + + +a a a a a1 2 3 4 5 t t (8.2)

dLRCRt=first difference of ln [(CRt/CPIt)] “monthly amount of real credit,” whereln denotes the natural logarithm, CR is aggregate credit, CPI is the consumerprice index, and t denotes time of monthly period.

dGDPt=first difference of Industrial Production Index.dNPLt=first difference of Non-Performing Loan.dCMMt=first difference of Conventional Interbank Money Market.dCCTAt=first difference of Conventional Capital to Asset.∈t=error term.

dLRFN dGDP dNPF dIMM dICTAt t t t t t= + + + + +a a a a a1 2 3 4 5 (8.3)

dLRFNt=first difference of ln [(FNt/CPIt)] “monthly amount of real financing,”where ln denotes the natural logarithm, FN is aggregate financing, CPI is theconsumer price index, and t denotes time of monthly period.

dGDPt=first difference of Industrial Production Index.dNPFt=first difference of Non-performing Financing.dIMMt=first difference of Islamic Interbank Money Market.dICTAt=first difference of Islamic Capital to Asset∈t=error term.


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Empirically, the procyclicality between GDP growth and real credit growth can beseen by looking at their positive correlation, and vice versa (Craig et al. 2006). Whenthe coefficient of GDP growth is close to 1 (one), it suggests that the pattern of creditis in line with the cycle on average rather than having a much greater amplitude.During an economic expansion, for example, the opposite occurs, as more businessesbecome eligible for loans under the banks’ terms and condition of lending. AsBernanke and Gertler (1989) and Berger and Udell (1992) argue, this scenario sug-gests not only that bank lending is procyclical, but also that the availability of bankloans to fund the economic activities of businesses may exacerbate the magnitude ofbusiness cycles itself. The positive sign on interbank money market rate (MM) sug-gests that the authorities increase interest rates as credit growth accelerates, whichsuggest monetary policy is not adding to procyclicality. The estimated coefficient ofNPL is expected to be positive as this would weaken the banks, which then latercould exacerbate procyclicality by leading them to cut lending further (Craig, 2006).The capital to asset ratio (CTA) is expected to positively promote procyclicality, sug-gesting stronger banks increase their lending much faster (Craig 2006).

8.3.3 Methodology

To obtain more robust results, three quantitative methods will be applied simultane-ously in this study, namely, Ordinary Least Square (OLS), Error Correction Model(ECM), and Autoregressive Distributed Lag (ARDL). An error correction model(ECM) is a time-series econometric dynamic system with characteristics that devia-tion or error of the level state from its long-run relationship will be fed into its short-run dynamics. ECM requires that the underlying variables are stationer at firstdifference or I(1) but there exists cointegration(s) between/among variables. Thegeneral equation of ECM is illustrated as follows:

D a a D g b b ey x y xt i iti

p

t i iti

p

t= + + - - += - -=å å0 1 1 0 11

( ) .

(8.4)

where y is dependent variable, which is either economic growth or inflation; xp is p selected independent variables, specific for each model; and εt is disturbance orerror term with zero means and constant variance-covariance. Moreover, αi are short-run coefficients, βi are long-run coefficients, and g is a speed of adjustmentcoefficient, known as error correction terms (ECT), where - < <1 0g .An autoregressive distributed lag (ARDL) is a time-series econometric model

for analyzing long-run relations when the underlying variables are stationary atfirst difference or I(1), but there exists cointegration(s) between/among vari-ables. Based on Engle and Granger (1987), a linear combination of two or morevariables might be stationary I(0), even though the variables individually are notstationary I(1). If the combination is stationary, the linear relationship can bereferred to as cointegration, and if it is in the form of equation, then this is the

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cointegration equation and its parameters are cointegration parameters, whichreflect the long-term relationship.After optimum different number of lag(s) of each variable is added to the equa-

tion, the general equation of ARDL can be illustrated as follows:

y c y x x xt i t ii

p

j t ji

q

k t kk

r

z nt ll

z= + + ++ +-= -= -= -=å å å å0 1 10 20 0

d d d d ++e t

(8.5)

8.4 Empirical Results

Several data testing should be conducted as a standard procedure using ECM andARDL methods. Tests for ECM include unit root test, cointegration test (Engle-Granger), error correction term (ECT) check, and diagnostic test (if OLS is used),prior estimating the ECMmodel. Tests for ARDL include cointegration test (BoundTest) and model selection with appropriate tests, before estimating the ARDLmodel. In addition, Granger causality test is conducted to determine causal relation-ships between variables. A thorough result of all ECM and ARDL procedures canbe obtained from the authors.

8.4.1 ECM Tests

8.4.1.1 Unit Root Tests

Table 8.3 shows unit root tests of all variables in Islamic model. The tests show thatmost Islamic variables are not stationary in level, but they are all stationary at firstdifference. Meanwhile, Table 8.4 presents unit root tests of all variables in conven-tional model. The tests show that not all conventional variables are stationary inlevel, however, they are all stationary at first difference.

Table 8.3 Unit root test of Islamic variables

Variable

Augmented Dickey-Fuller value Phillips-Perron value

Level First difference Level First difference

LRFN −3.155141 −7.780960a −3.037496 −8.648505a

LGDP −6.703127a −4.387177a −7.025073a −27.22720a

ICTA −2.980469 −13.25947a −3.062872 −13.12512a

IMM −3.874877a −16.38328a −5.761143a −25.29517a

NPF −2.247861 −14.52164a −2.543680 −15.17053a

aIndicates that the data is stationary at 5% McKinnon critical value


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8.4.1.2 Cointegration Test

Tests of cointegration (Engle-Granger) are applied to residuals of the long-termestimates of both Islamic and conventional models. After the residuals are obtained,the next step is to test the stationarity of the residuals. If the residual data is station-ary, it can therefore be concluded that there is cointegration, so that the model canbe estimated using ECM. Table 8.5 shows the results of stationarity tests of long-term estimation residuals. The results of the test show that both residuals are station-ary, since the ADF probability values are less than 5% significance level.

8.4.1.3 Error Correction Term

The error correction term (ECT) of Islamic model is −0.0221 with probability of0.1358, hence even though the negative sign is correct, it is however not significant(see column 7 on Table 8.8). Thus, the results of Islamic ECM model are not valid,and the first difference OLS (ordinary least square) Islamic model could be used asan alternative. Meanwhile, ECT of conventional model is −0.0292 with probabilityof 0.0272, thus the negative sign is correct and it is significant (see column 3 onTable 8.8). Therefore, the results of conventional ECM model are valid.

8.4.1.4 Diagnostic Tests

When ECM model is estimated using OLS, a diagnostic testing of residuals shouldbe conducted. Islamic model result of Breusch-Godfrey Serial Correlation testshows that the probability value (0.0000) is less than 5% significance level, thus

Table 8.4 Unit root test of conventional variables

Variable

Augmented Dickey-Fuller Value Phillips-Perron Value

Level First difference Level First difference

LRCR −3.804909a −10.62743a −2.151449 −10.64863a

LGDP −6.703127a −4.387177a −7.025073a −27.22720a

CCTA −3.043484 −12.33544a −2.822423 −12.33544a

CMM −9.166797a −15.24231a −9.371282a −55.58519a

NPL −4.085413a −6.370945a −3.134822 −11.59630a

aIndicates that the data is stationary at 5% McKinnon critical value

Table 8.5 Engle-Granger cointegration test

Model

Engle-Granger

Probability DescriptionADF t-statistic Critical value

LRFN −7.877317 −3.445590 0.0000 CointegratedLRCR −5.859209 −1.943364 0.0000 Cointegrated

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there is a problem of autocorrelation in the Islamic ECM model (see column 7 onTable 8.8). This problem can be addressed by applyingHeteroscedasticity ConsistentCoefficient Covariance method, namely Newey-West method. The results of WhiteHeteroscedasticity test shows that the probability value of Obs×R2 (0.0853) is morethan 5% significance level, hence no heteroscedasticity problem in Islamic ECMmodel is occurred (see column 7 on Table 8.8).Furthermore, in the conventional model, the Breusch-Godfrey Serial Correlation

test indicates that the probability value (0.9287) is more than 5% significance level,therefore there is no problem of autocorrelation in the conventional ECM model(see column 3 on Table 8.8). The results of White Heteroscedasticity test indicatesthat the probability value Obs×R2 (0.8167) is also more than 5% significance level,so that there is no heteroscedasticity problem in conventional ECM model (see col-umn 3 on Table 8.8).

8.4.2 ARDL Tests

8.4.2.1 Cointegration Test (Bound Test)

Cointegration test using Bound Test (Pesaran and Shin 1997) is conducted by add-ing long-term variables in the model, and later perform a joint test to determinewhether additional long-term variables is significant. If the value of the F-statistic isgreater than the upper value in the Pesaran’s table, this means that the addition ofthe long-term variables is significant and that there is cointegration. The results ofcointegration tests in Table 8.6 show that, up to lag three, there is no cointegrationboth in Islamic and conventional models.

8.4.2.2 Model Selection and Tests

For Islamic model, the results of first difference ARDL in lag-1 and lag-2 still haveautocorrelation problems, indicated by the probability values of serial correlation(0.002 in lag-1 and 0.027 in lag-2) are less than 5% significance level. The results

Table 8.6 Cointegration test

Model

Bound test (ARDL)

Probability DescriptionF test Pesaran

Islamic LRFN(−1) 2.8642 3.805 0.018 No cointegrationLRFN(−2) 1.4194 3.805 0.223 No cointegrationLRFN(−3) 2.0181 3.805 0.082 No cointegration

Conventional LRCR(−1) 2.2960 3.805 0.050 No cointegrationLRCR(−2) 1.7595 3.805 0.127 No cointegrationLRCR(−3) 1.0011 3.805 0.421 No cointegration


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of first difference ARDL in lag-3 indicate that this model has been free from auto-correlation problem (with serial correlation probability value of 0.075, which ismore than 5% significance level) and heteroscedasticity problem (with heterosce-dasticity probability of 0.519, which is more than 5% significance level). However,the highest Schwarz Bayesian Criterion (SBC) is at Lag-2 (309.7375). Moreover,for conventional model, the results of first difference ARDL in lag-1 show that thismodel is free from problem of autocorrelation, where the probability value of serialcorrelation (0.145) is more than 5% significance level. Moreover, this model is freefrom the problem of heteroscedasticity, where the probability value of heteroscedas-ticity (0.582) is more than 5% significance level.

8.4.3 Results of Granger Causality

Granger causality of Islamic model shows one way causality that both IMM(Islamic money market) and NPF (non-performing financing) cause LRFN(Islamic real financing), while LRFN causes LGDP (output). Meanwhile, conven-tional model shows more complex loop of causality. Both CCTA (conventionalcapital to asset ratio) and NPL (non-performing loan) cause LRCR (conventionalreal credit), and LRCR causes CCTA and NPL. CCTA also causes LGDP, and viceversa, and CCTA later causes CMM (conventional money market rate).Furthermore, LGDP causes CMM, and CMM later causes NPL. In addition,CMM does not cause LRCR.

8.4.4 Results of Procyclicality

Tables 8.7 and 8.8 present the results of Islamic and conventional models, which ismainly intended to see the impact of real GDP growth D(LGDP) on real Islamicfinancing growth D(LRFN) as well as on real conventional loan growth D(LRCR),

Table 8.7 Long-term ECM results of Islamic (LRFN) and conventional (LRCR) models

Variable

Conventional

Variable

Islamic

Coefficient Probability Coefficient Probability

LGDP 2.083** 0.000 LGDP 6.477** 0.000CCTA 0.053** 0.000 ICTA 0.028 0.291CMM 0.005 0.167 IMM 0.054** 0.001NPL −0.085** 0.000 NPF −0.024 0.384R2 0.9261 R2 0.8828Adjusted R2 0.9237 Adjusted R2 0.8789

*Significant at the 0.05 level**Significant at the 0.01 level

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and also to see the procyclicality of Islamic financing and conventional credit.Table 8.7 shows that Islamic real financing (LRFN) will increase more than threetimes the increase of conventional real loan (LRCR) when real GDP (LGDP)increases. LRFN will also increase when Islamic interbank money market margin(IMM) increases. Moreover, LRCR will also increase when capital to asset ratio(CCTA) increases, and it will decrease when non-performing loan (NPL) increases.Table 8.8 presents the main results of Islamic and conventional models (note

that Islamic ECM model is not valid, since the ECT is not significant). It showsthat Islamic real financing growth (D(LRFN)) will increase more than the increaseof conventional real loan growth (D(LRCR)) when real GDP growth (D(LGDP)increases. This means that Islamic banking and conventional banking show sig-nificant sign of procyclicality and Islamic banking is more procyclical than con-ventional banking.Moreover, the increase of ICTAgrowthwill decreaseD(LRFN),while the increase of NPF growth in lag-1 (D(NPF)(-1)) will, surprisingly,increase D(LRFN). In addition, the increase of NPL growth (D(NPL)), its lag-1(D(NPL)(-1)) and CCTA growth (D(CCTA)) will decrease D(LRCR) signifi-cantly, while the increase of CMM growth (D(CMM)) in lag-1 will significantlyincrease D(LRCR).

Table 8.8 Short-term results of Islamic and conventional models

Variable

Conventional

Variable

Islamic

OLS ECM ARDL OLS ECM ARDL

D(LRCR)(−1)

D(LRFN)(−1)

0.3081**

D(LRCR)(−2)

D(LRFN)(−2)

0.2540**

D(LGDP) 0.0751* 0.1074** 0.0823** D(LGDP) 0.1612** 0.2337** 0.1050**

D(CCTA) −0.0174** −0.0163** −0.0163** D(ICTA) −0.0072 −0.0073 −0.0071*

D(CMM) −0.0005 −0.0004 0.0005 D(IMM) 0.0021 0.0026 0.0019D(CMM)(−1)

0.0013** D(IMM)(−1)

D(NPL) −0.0072* −0.0076* −0.0086 D(NPF) −0.0052 −0.0057 −0.0043D(NPL)(−1)

0.0073* D(NPF)(−1)

0.0075*

ECT – −0.0292* – ECT − −0.0221 –R2 0.2303 0.2608 0.3120 R2 0.1442 0.1886 0.3976AdjustedR2

0.2050 0.2303 – AdjustedR2

0.1162 0.1551 –

Prob.Serial Corr. Test 0.9287 0.1450 Prob. Serial Corr. Test 0.0000 0.0740Prob. Hetero Test 0.8167 0.5820 Prob. Hetero Test 0.0853 0.5190

Autocorrelation in Islamic ECM is treated using Newey-West option*Significant at the 0.05 level**Significant at the 0.01 level


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8.4.5 Empirical Analysis

8.4.5.1 Procyclicality of Islamic and Conventional Banks

Some interesting findings are found when combining Granger causality and long-term ECM results of Islamic model. This implies that there is a coupling betweenfinancial sector (IMM) and real sector (LRFN), even though the financial sector stillleads the real sector (IMM causes LRFN). Moreover, it is Islamic financing (LRFN)that causes economic growth (LGDP), not vice versa; hence the real sector produc-tive activity that actually induces economic growth. Additional results on Table 8.8 show that the increase of NPF growth (D(NPF)) will not significantly decreaseD(LRFN), while Granger causality results show that NPF does not cause LRFN andLRFN does not cause NPF. These imply that NPF does not hinder the LRFN and itsgrowth, and the increase of LRFN and its growth do not induce NPF and its growth,since real sector activities are always financed by Islamic finance.To this end, there is no indication that procyclicality of Islamic bank creates

credit bubbles. Therefore, it can be concluded that, as mentioned by Landau (2009),the procyclicality of Islamic bank is not categorized as bad procyclicality, whichamplifies and increases the amplitude of business cycle, creates bubbles, and causesfinancial instability. Conversely, procyclicality of Islamic bank is a good procycli-cality, which can be beneficial to long-term economic growth. Meanwhile, combi-nation of Granger causality and long-term ECM results of conventional model alsoshows interesting findings. First, there is a decoupling between the financial sector(CMM) and the real sector (LRCR), where there is no causality between CMM andLRCR, and CMM causes NPL. Second, NPL causes LRCR, and vice versa, in anegative way. This means that the increase of LRCR will increase NPL, suggestingthat there is an indication of excessive risk taking by agents, insufficient risk moni-toring by principals, moral hazard, and adverse selection (to name some), whichwould create credit bubbles.Additional results on Table 8.8 show that using OLS, ECM, and ARDL methods

reveal that the increase of NPL growth (D(NPL)) will decrease D(LRCR), whileGranger causality results show that NPL causes LRCR and vice versa, LRCR causesNPL. In addition, CCTA growth (D(CCTA)) will significantly decrease D(LRCR).These findings support the previous argument that conventional credit creates creditbubbles. Thus, there are indications that procyclicality of conventional bank createscredit bubbles. It can be concluded that the procyclicality of conventional bankseems to be closer to the category of bad procyclicality, which amplifies the ampli-tude of business cycle, creates bubbles, and causes financial instability.

8.4.5.2 Inherent Stability of Islamic Finance and Banking

The findings on the good procyclicality of Islamic bank are consistent with thecharacteristics of Islamic finance and Islamic banking in particular, whereIslamic finance is inherently stable. The intrinsic strength of Islamic finance is

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derived from the Shari’ah principles, where essential features of Islamic financeinclude (Aziz 2010) (1) ethical (avoidance of unethical activities, avoidance ofexcessive leveraging, and economic empowerment for the less fortunate); (2)real activities (must be accompanied by underlying productive economic activi-ties and close link between financial transactions and productive flows); (3)Partnership (equity based and risk sharing transactions and due diligence); and(4) governance (greater transparency and disclosure, effective risk management,and good governance practices).Islamic finance advocated some transactions based on profits and risks sharing.

This encourages participatory financing or active participation in business throughMudarabah contract (partnership and capital participation) andMusharakah (joint-venture). These approaches encourage extensive participation in risk-reward andprofit-loss sharing of these efforts. This risk sharing requires IFS to conduct anappropriate due diligence process on the feasibility of the business proposal. Thesupervision and assessment by related parties such as the board of Shari’ah orShari’ah-compliance review process provide additional protection against practicesthat are not in line with Shari’ah. In contrast, conventional financial instrumentsgenerally separate the risk from the underlying assets.Financial intermediation through IIFS involves mobilizing funds from savers or

investors with excess liquidity, using a combination of non-return-paying current ordemand accounts and profit sharing investment accounts (PSIA), and providingthese funds to firms or individuals for financing assets or business activities. Thebanker–customer relationship is not the conventional debtor–creditor relationshiprather it is based on different contracts that are entered into by the IIFS and thecustomer. However, it should be noted that contemporary Islamic finance has notyet been able to apply the ideal Islamic finance, so that the Islamic finance is stillcreating financial bubbles through multiplier and leverage of fractional reservebanking system (FRBS). Islamic finance is still vulnerable to liquidity risk, as it isstill experienced mismatch (including maturity and nominal mismatches), as well asother common risks in finance, such as business risk, financial risk, operational risk,fiduciary risk, event risk, and displaced commercial risk.

8.5 Conclusion

Based on earlier thorough discussions and analyses on the procyclicality of Islamicand conventional banks, including the empirical tests, several conclusions can bedrawn from the study. Empirical tests using Ordinary Least Square (OLS), ErrorCorrection Model (ECM), and Autoregressive Distributed Lag (ARDL) show thatIslamic bank is more procyclical than conventional bank, where real GDP growthcoefficients in Islamic model are always higher than those in conventional model.This suggests that both Islamic bank and conventional bank are procyclical to theeconomic or business cycle. The procyclicality of Islamic bank, based on additionalresults from Granger causality and Islamic model, does not create credit bubbles, so


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that it can be concluded that, as mentioned by Landau (2009), the procyclicality ofIslamic bank is not categorized as bad procyclicality, which amplifies and increasesthe amplitude of business cycle, creates bubbles, and causes financial instability.Conversely, procyclicality of Islamic bank is a good procyclicality, which can bebeneficial to long-term economic growth.The procyclicality of conventional bank, based on additional results from Granger

causality and Islamic model, does create credit bubbles, so that it can be concludedthat the procyclicality of conventional bank seems to be closer to the category of badprocyclicality, which amplifies the amplitude of business cycle, creates bubbles,builds up systemic risk, and causes financial instability. Good procyclicality ofIslamic bank is consistent with the characteristics of Islamic finance and Islamicbanking in particular, where Islamic finance is inherently stable and does not createbubbles. It is due to the basic principles of Islamic finance and banking, which con-tribute towards the stability of Islamic financial system, including riba-maysir-gharar prohibitions, money as potential capital, profit-loss-and-risk sharing, sanctityof contract, Shari’ah approved activities, and social justice. These results suggestthat Islamic bank has closer link to the real sector, so that measures for Islamic mac-roprudential should be less than those for conventional macroprudential.Developing Islamic macroprudential policy for countries adopting Islamic

financial system or dual financial system is unavoidable, since contemporaryIslamic financial system is still far from ideal and still creates financial bubbles,brought about by the adoption of fractional reserve banking system, fiat money,imperfect Islamic contracts, etc. Therefore, Islamic finance and banking are stillprone to imbalances, instability, and systemic risk. Procyclicality as one of themain causes of systemic risk should be well understood. However, Islamic bankprocyclicality and conventional bank procyclicality should be clearly differenti-ated, such that macroprudential instruments developed for Islamic and conven-tional financial systems would be unique and it became an effective tool to preventsystemic risk and financial crisis. Further studies on all aspects of Islamic macro-prudential policy are deemed needed to develop a solid framework and effectiveinstruments of Islamic macroprudential policy or macroprudential policy underdual financial system.

References

Abdellah B (2009) Pro-cyclicality of the Islamic financial system: theoretical essay and compara-tive study. Komar University of Science and Technology, Kurdistan

Akinboade OA, Makina D (2009) Bank lending and business cycles: South African evidence.Afr Dev Rev 21(3):476–498

Ascarya (2009) Lessons Learned from Repeated Financial Crises: An Islamic EconomicPerspective. Paper presented at the 3rd Annual Workshop Bulletin of Monetary Economics andBanking, Jakarta, 12 August 2009

Ascarya (2013a) Analysis of financial crisis and how to prevent it in Islamic perspective usingvector error correction model. Paper presented at the 9th international conference on Islamiceconomics and finance, Istanbul, 9–10 September 2013

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Ascarya (2013b) The root causes of financial crisis in Islamic economic perspective usingstructural equation modeling. Paper presented at the 10th international conference on Tawhidiand world-system: god conscious organization and conscious social order, Kuala Lumpur,27–28 December 2013

Asea PK, Blomberg SB (1998) Lending cycles. Journal of Econometrics 83(1–2):89–128Athanasoglou PP, Daniilidis I (2011) Procyclicality in the banking industry: causes, consequencesand response. Bank of Greece Eurosystem working paper 139

Aziz ZA (2010) Enhancing the resilience and stability of the Islamic financial system. RegulatorsForum Global Islamic Finance Forum 2010

Bank for International Settlements (BIS) (2008) Addressing financial system procyclicality: a pos-sible framework. Note for FSF working group on market and institutional resilience, pp 1–17

Bebczuk R, Burdisso T, Carrera J, Sangiacomo M (2011) A new look into credit procyclicality:international panel evidence. Banco Central de la Republica Argentina working paper 55

Berger AN, Udell GF (1992) Some evidence on the empirical significance of credit rationing.J Polit Econ 100(5):1047–1077

Berger AN, Udell GF (2004) The institutional memory hypothesis and the procyclicality of banklending behavior. J Financ Intermed 13(4):458–495

Bernanke B, Gertler M (1989) Agency costs, net worth, and business fluctuations. Am Econ Rev79(1):14–31

BordoM, Eichengreen B, Klingebiel D, Martinez-Peria MS, Rose AK (2001) Is the Crisis ProblemGrowing More Severe? Economic Policy 16(32):53–82

Chapra MU (2008) The Global Financial Crisis: Can Islamic Finance Help Minimize the Severityand Frequency of Such a Crisis in the Future? Paper Presented at the Forum on the GlobalFinancial Crisis to be held at the Islamic Development Bank

Craig RS, Davis EP, Pascual AG (2006) Sources of Procyclicality in East Asian Financial System.International Monetary Fund and Hong Kong Institute for Monetary Research pp 55–123

Engle RF, Granger WJ (1987) Co-integration and error correction: representation, estimation, andtesting. Econometrica 55(2):251–276

Farmer REA (1985) Implicit contracts with asymmetric information and bankruptcy: the effect ofinterest rates on layoffs. Rev Econ Stud 52(3):427–442

Foos D, Norden L, Weber M (2010) Loan Growth and Riskiness of Banks. Journal of Banking &Finance 34:2929–2940

Geršl A, Jakubik P (2010) Procyclicality of the financial system and simulation of the feedbackeffect. Czech National Bank Financial Stability Report 2009/2010

Ghosh S (2013) Funding structure, procyclicality and lending: evidence from GCC banks. MPRApaper 51225

Gorton G, Kahn J (1993) The design of bank loan contracts, collateral, and renegotiation. NationalBureau of Economic Research working paper series 4273

Greenwald BC, Stiglitz JE (1993) Financial market imperfections and business cycles. Q J Econ108(1):77–114

Jeong HK (2009) The Procyclicality of bank lending and its funding structure: The case of Korea.Paper prepared for 2009 BOK International conference on the credit crisis: theoretical perspec-tive and policy implication

Jimenez G, Saurina J (2005) Credit cycles, credit risk and prudential regulation. Banco de Espanaworking paper series 0531

Kupiec PH, Lee Y, Rosenfeld C (2013) Macroprudential policies and the growth of bank credit.American Enterprise Institute Economic Policy working paper 2013–08

Landau JP (2009) Procyclicality—What it means and what could be done. BIS Review 94/2009Laeven L, Valencia F (2008) Systemic Banking Crises: A New Database. IMF Working PaperWP/08/224

Laeven L, Valencia F (2012) Systemic Banking Crises Database: An Update. IMF Working PaperWP/12/163

Lietaer B, Ulanowicz R, Goerner S (2009) Options on Managing a Systemic Banking Crisis.S.A.P.I.EN.S Journal 2(1):1–15


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Nijathaworn B (2009) Rethinking procyclicality—what is it now and what can be done? BISReview 160/2009

Smith BD (1995) Sectoral employment and cyclical fluctuations in an adverse selection model. IntEcon Rev 36(2):261–281

Utari DGA, Arimurti T, Kurniati IN (2011) Prosiklikalitas Sektor Perbankan dan assessment risktaking channel. Bank Indonesia working paper WP/09/2011

Zarnowitz V (1985) Recent work on business cycles in historical perspective: a review of theoriesand evidence. J Econ Lit 23(2):523–580

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Chapter 9 Short-Term Liquidity Management Mechanisms in the Absence of Islamic Interbank Loan Markets

Magomet Yandiev

Abstract The Islamic fi nance model is suffi ciently well specifi ed at the “bank-to- client” level, but does not regulate the “central bank-to-bank” and “bank-to-bank” relationships. This chapter proposes a concrete Shari’ah -compatible mechanism for setting up an Islamic interbank loan (In the Islamic fi nance industry, the word “loan” is usually avoided because of associations with interest-based funding. However we use it in this chapter, as the term “interbank loan market” is well established and the substitution of the word “loan” with the word “funding” may lead to misunderstand-ings) market and managing Islamic bank liquidity, which allows a segregation of Islamic and non-Islamic fi nance. Islamic banks should as a minimum, delink from LIBOR and other traditional reference rates and come up with their own fi nancial benchmarks.

Keywords Islamic banks • Central bank • Liquidity • Interbank lending market • Money market

9.1 Introduction

The aim of this chapter is to propose solutions to one of the thorniest problems of the present-day Islamic banking industry, namely, the lack of Shari’ah -compatible tools enabling central banks to manage Islamic bank liquidity and the resultant lack of a full-blown Islamic interbank loan market. A good deal of real-life examples show that Islamic banks must continuously hold excess liquidity, as they are unable to raise or place money in the interbank market without transgressing the Shari’ah principles. Other numerous examples show that central banks apply conventional tools and approaches to Islamic banks, including the interest-based lending and deposit taking, citing the lack of alternatives and the darurah (utmost necessity) principle.

M. Yandiev (*) Faculty of Economics , Lomonosov Moscow State University , Moscow , Russia e-mail: [email protected]

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That said, a central bank’s involvement in trading or partnership-based commercial operations with banks seems unnatural, to say the least.

The key issue behind the above challenges is the rate of profi t to be expected in the Islamic banking industry. In the conventional fi nancial sector, the London Interbank Offered Rate (LIBOR) is one of the generally accepted benchmarks. The Islamic bank-ing industry does not have its own reference rate and is therefore compelled to conduct business looking at the movements of LIBOR, the fl agship of an interest-based econ-omy. This adds up to a discrepancy, while Islamic banks’ external (bank-to-client) relationships are fairly well consistent with Shari’ah , their relationships with each other or with the central bank are generally at variance with Shari’ah rules. Before this discrepancy is corrected, Islamic banking will be unable to stand apart as a fully fl edged independent and self-reliant sector, but will remain an extravagant adjunct to the conventional fi nancial system.


The review of the literature for this study focuses on publications posted on the Social Science Research Network website (ssrn.com). A keyword search for articles containing the terms “Islamic interbank market” and “Islamic money market” produced six and 39 results, respectively. By way of comparison, a search for arti-cles containing the words “Islamic,” “interbank,” and “market” produced 1,084, 218, and 22,800 results, respectively.

Of the fi rst six results mentioned above only one paper by Sundararajan et al. ( 1998 ) addresses the Islamic interbank loan (IBL) market. The study notes that for the liquidity management purposes central banks have to partner and share profi ts with Islamic banks, i.e., take commercial (operating, trading, currency, etc.) risks. The study emphasizes that in the virtual absence of any Islamic IBL market, Islamic banks are exposed to additional costs.

The chapter also outlines an interbank lending mechanism adopted in Malaysia as far back as in 1994. It is interesting as a way to calculate the Islamic banks’ expected profi t rate. The formula for calculating the profi t element to be paid to the provider of funds is as follows:

X

P R T K=

´ ´ ´´365 100

,

( 9.1 )

where X is amount of profi t to be paid to the lending bank; P is principal investment; R is ratio of the investment recipient’s gross profi t to revenue (rate of gross profi t, in percent before distribution for investments for 1 year of the receiving bank); T is number of investment days; and K is profi t-sharing ratio.

A weak point of this model is ratio R , as its projected value depends on the borrower’s actual characteristics, which represents the risk that the borrower will distort its fi nancials to understate the amounts payable on a loan. Besides, from the

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formula’s logic follows that the profi t rate is simply the borrower’s profi tability. One cannot agree with this. Indeed, in a conventional economy, LIBOR refl ects the weighted interest rate at which banks lend money. Each bank’s lending rate, in turn, is a result of the bank’s interaction with a great number of potential borrowers. In other words, this rate is market-based. But the discussed ratio R is not the result of a market competition. It is something that the borrower takes from its own fi nancial statements. This is similar to saying that a conventional bank’s profi t rate depends on clients’ reported fi nancial results, rather than supply and demand for loanable funds.

Of the 39 articles found using the key words “Islamic money market,” four were relevant to the subject. Boumediene ( 2015 ) points out that the Islamic banks’ liquidity management systems are actually based on interest-bearing fi nancial instruments and are not consistent with Shari’ah . This idea is reiterated in Al Ajlouni ( 2013 ), where it is also suggested that an IBL market could be set up based on Qard al- Hasan (an interest-free loan). This instrument does not involve any revenue for the lender and any charge for the borrower and has no chance, in our view, to become suitable for practical use due to the commercial nature of the bank-to-bank relationship. In other paper, Baklanova et al ( 2010 ) argues that available liquidity management instru-ments ( Murabahah, Wakalah , and Sukuk ) carry a higher risk at a similar rate of return or an equal risk at a lower rate of return, than conventional instruments. This statement prejudices the possibility of using these instruments as Islamic liquidity management vehicles.

An additional search is made in eLIBRARY.RU, the Russian-language scientifi c online library, using Russian equivalents for the key words “IBL market” (29 results), “Islamic IBL” (0), “Islamic money market” (0), “Islamic banking” (47), “Islamic cen-tral bank” (10). Most of the publications analyzed had a descriptive nature, which was predictable, since the majority of Russia’s population and even fi nance specialists are unaware of the Islamic fi nance issue. Neither of those publications addressed the questions of banking liquidity management and the Islamic IBL market functioning. The general conclusion that emerges from this review is that the problem of the lack of Islamic banks’ liquidity management tools at central banks’ disposal and the absence of a fully fl edged Islamic IBL market actually exists.

9.3 Practical Review

Islamic countries have repeatedly taken steps to set up an IBL market, but their practical achievements are very limited. In common with Malaysia, Indonesia has developed and introduced interbank deposits operating under the Wadiah (safekeeping) principle and interbank investment certifi cates based on the Mudarabah (profi t-loss sharing) 1 principle. At the same time, the central bank established a minimum interest rate for interbank investment certifi cates, based on the current rate for government investment securities plus a spread. The use of an instrument

1 http://islam-today.ru/ekonomika/islamskie_fi nansovye_rynki_denezhnyj_rynok/

9 Short-Term Liquidity Management Mechanisms in the Absence of Islamic Interbank…

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that allows a bank to reward a depositor at its discretion ( Wadiah) instead of paying compensation for depositing money and charge a fixed rate on investment certificates renders the system unstable and dependent upon human factors.

An interesting “semi-market” practice is being used in Bahrain. The Bahrain- based Arab Banking Corporation (ABC) has launched a special-purpose subsidiary and supplied it with assets. At ABC, they open an account for any customer who desires to make a deposit. In the evening, they use customer deposits to buy the subsidiary’s shares in order to sell them out next morning and then return the pro-ceeds to the depositors with an annual gain of up to 0.15%. The gain is allegedly the result of the subsidiary’s stock overnight appreciation. ABC claims that it would com-pensate the depositors for any stock revaluation losses. ABC only takes deposits and does not give out any loans, which is probably its way to maintain short-term liquidity. In all probability, the corporation maintains a short-term defi cit consciously as part of its policy.

Thomson Reuters has also contributed to the development of the Islamic fi nance industry by launching the Islamic Interbank Benchmark Rate (IIBR). This indicator is a weighted estimate of the expected profi t rate, deducted based on a survey of Islamic banks and “Islamic banking windows.” A similar indicator, the Emirates Interbank Offered Rate (EIBOR), is used in Dubai. It corresponds to ratio R from the above formula and refl ects a bank’s profi tability rather than risk premium.

Commodity Murabahah , the most widely used “central bank-to-bank” relationship tool (involving the sale of some liquid commodities goods at a price) compels a central bank to take commercial risks, which, of course, is unacceptable. This example (and other similar examples) once again highlights the problems posed by the lack of a fully fl edged IBL market and Shari’ah -compatible Islamic banks’ liquidity management tools.

9.3.1 Criticism of the “Central Bank-to-Islamic Bank” Relationship Models

The main point that this chapter seeks to prove is that the existing forms of the central bank-to-Islamic banks interaction in the liquidity management area are Shari’ah - incompatible. Consequently, all kinds of transactions between Islamic banks and a central bank should be redefi ned.

To prove this, we need to consider two principal forms of interaction between the parties, namely the provision of central bank liquidity to Islamic banks and the depositing of Islamic banks’ funds at a central bank, and show that both are unac-ceptable from the Shari’ah perspective.

(a) A central bank is a priori a risk-free institution. This means that when an Islamic bank is placing money with a central bank, it does not assume any risk.

(b) Consequently, it may not only accept but also expect any compensation for depositing money (no risk, no reward).

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(c) As a risk-free institution, central bank may not take any business risks. Therefore, it may not, among other things be a party to any sale and purchase transactions conducted with the aim of providing funding to Islamic banks.

(d) Besides, a central bank is not authorized to engage in profi t-making activities and may not therefore take business risks when issuing loans or taking deposits. Consequently, it may not make a commercial profi t from such operations. But where there is no profi t, there also is nothing to share with potential partners.

(e) All Islamic fi nancial products that have been developed so far are intended for retail customers, there are no products designed for the interbank market or for operations with central banks.

(f) It can be concluded that (1) a central bank should not transact with Islamic banks directly, there should be an intermediary special-purpose vehicle (SPV), acting as central bank’s agent for management of Islamic banks’ liquidity and (2) a special fi nancial asset should be used by a SPV in transactions with Islamic banks.

9.4 Proposal for Establishing a Central Bank-to-Islamic Bank Relationship

Based on the above conclusions, the following measures are recommended for establishing a Shari’ah -compatible system for managing Islamic liquidity and administering the IBL market:

(a) Central bank should set up a SPV responsible for supplying/taking out liquidity to/from Islamic banks.

(b) Ministry of Finance should issue long-term sukuk with a daily payable coupon, and central bank should set a minimum share of assets an Islamic bank must hold in the form of such sukuk and vest SPVs with the exclusive right to transact such sukuk .

(c) SPV and Islamic banks should jointly purchase the volumes of sukuk using central bank’s funds.

The proposed Islamic liquidity management procedure looks like this. Suppose that a central bank decides for some reason to enhance banking system liquidity. To this end, it orders a SPV to enter into repurchase agreements with Islamic banks. At stage one, the banks sell their sukuk holdings to the SPV. At stage two, the parties use the assets: the SPV receives sukuk’s daily payments and the Islamic banks invest the raised funds. At stage three, the parties do the reverse operation. In both opera-tions, sukuk have the same value (the value of a debt does not change). Following these operations, the Islamic banks are expected to see some gains from additional investments (if, of course, they know how to invest effectively), and the SPV to benefi t from the daily coupon payments.

Table 9.1 provides a simple example by considering a situation where an Islamic bank sells 100 sukuk each worth one ruble to a SPV.


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In another example, a central bank may deem it necessary to decrease banking sector liquidity. To this end, it orders a SPV to enter into repurchase agreements with Islamic banks. At stage one, the SPV sells its sukuk holdings to the banks. At the last stage, the SPV repurchases the bonds. Following these operations, the Islamic banks see their liquidity decreased, but benefi t from sukuk proceeds.

It should be noted, however, that repo agreements are not appropriate from the Islamic fi nance perspective. It is because the repurchase price is different from the original sale price, and because the reverse transaction may not be carried out if the item is not available in a suffi cient quantity. Therefore, we emphasize the following elements of the proposed liquidity management operations:

(a) Ministry of fi nance is not a risk-free institution, and any sukuk -related transac-tion will carry a risk, meaning that the obtained reward (daily coupon) is con-sistent with Shari’ah rules.

(b) Parties to repurchase agreement already have sellable/purchasable bonds in their asset portfolios, meaning that at the start of the reverse repurchase, the seller actually holds sukuk and not just promises to sell them in the future. In this respect, the repurchase agreements are Shari’ah -compatible.

(c) Sukuk repurchase price is the same as the original sale price, which is in line with Shari’ah rules.

One important issue is the selection of a repurchase agreement counterparty in a situation of mismatch between the demand and supply. In a conventional economy, this is governed by the offered/ asked interest rate. The proposed model also involves competition—but for the quantity of sukuk available for repurchase (at stage three) rather than for bond price. Suppose that a SPV is placing available funds with counterparties, which is planning to enhance banking system liquidity. To this end, it buys some volume of sukuk from Islamic banks. Obviously, the amount of money necessary for liquidity enhancement is specifi ed by the central bank and the SPV

Table 9.1 A way to enhance banking system liquidity

Repo operation stage SPV Asset movement Islamic bank

Stage one 1.1. +100 sukuk < == −100 sukuk 1.2. −100 rubles == > +100 rubles Stage two Day 1 + sukuk ’s interest payments 100 rubles invested Day 2 + sukuk ’s interest payments 100 rubles invested ⋯ ⋯ ⋯ Day n + sukuk ’s interest payments 100 rubles invested Stage three 3.1. −100 sukuk == > +100 sukuk 3.2. +100 rubles < == −100 rubles

Note : all numbers are given as an example Source : author’s elaboration

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knows beforehand how many sukuk it needs to buy. However, the amount of repurchased sukuk may be different, which creates a potential for competition. Banks may offer the SPV different quantities of sukuk depending on market conditions, which allows the SPV to choose among sellers who name their best offer for repur-chase (in terms of sukuk quantities).

9.5 Conclusion

As a risk-free institution, central bank may not enter into fi nancial arrangements with Islamic banks directly. It should set up a SPV for the purpose of such interactions. To establish the Islamic liquidity management process, a special fi nancial instru-ment— sukuk with a daily coupon—should be issued by the ministry of fi nance.

SPV should act both as the central bank’s liquidity management tool and as the Islamic IBL market organizer. In the Islamic fi nance industry, profi t rate depends on income generated by sukuk with daily coupon payments, which is a reward for the low-est possible risk in the market. Competition for funding in the Islamic fi nance sector depends on the quantity of sukuk repurchased at stage three of repo operations.

In the future, Islamic countries will be able to set up their national currency sup-porting systems with the help of domestic SPVs. To this end, the latter will enter into repo agreements with each other using national currency and sukuk bonds. In a more distant future, a special agency issuing the Islamic Dinar, a common currency for the Muslim world, could be established based on national SPVs.

References

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Baklanova V, Tanega JA, Arakcheev A (2010) Islamic money management: a western view. Cap Mark Law J 6(2):238–252

Boumediene A (2015) Financing government budget defi cit as a liquidity risk mitigation tool for Islamic banks: a dynamic approach. Int J Islam Middle East Financ Manage 8(3):329–348

Sundararajan V, Marston D, Ghiath S (1998) Monetary operations and government debt manage-ment under Islamic banking. IMF Working Paper No 98/144. International Monetary Fund, Washington, DC


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Part III Experiences in Implementing

Macroprudential Policy in a Dual Banking System

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Part IV Interplay Between Macroprudential

Policy with Other Markets

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credit risks for debt-related financing. Therefore, both the tools of macroprudential and monetary policies are complement to each other.

15.6 Conclusion

The aim of this chapter is to help guide policymakers and researchers in identifying policy-relevant questions that can inform policy decisions on the design and imple-mentation of macroprudential policy tools going forward and on the interaction with monetary policy, and to provide information for policymakers on existing issues, which can inform their current policy debates. From the discussion we can provide the following solutions on the current debate. First, there is the same mon-etary policy target for Islamic financial system. However, the monetary policy tools work differently to affect the target. Second, the difference exists due to the need to scrutinize and select the suitable tools that is compatible with Islamic principles. Third, we identify that macroprudential and monetary policy tools are different. Fourth, the target variables are also different. The effects of macroprudential policy tools are on the financing growth, leverage or capital, and asset prices. While the effects of monetary policy tools are on the reserve position and the benchmark rate in determining the profit margin and profit to be distributed. Fifth, the challenge for policymaker in analyzing the effectiveness of both macroprudential and monetary policies is to avoid financial instability.

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