International Journal of Islamic and Middle Eastern Finance and

Management
The roles of domestic and foreign Islamic banks in Malaysian monetary transmission
Fidlizan Muhammad Asmak Ab Rahman Ahmad Azam Sulaiman
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Fidlizan Muhammad Asmak Ab Rahman Ahmad Azam Sulaiman , (2014)," The roles of domestic and
foreign Islamic banks in Malaysian monetary transmission ", International Journal of Islamic and Middle
Eastern Finance and Management, Vol. 7 Iss 2 pp. 161 - 169
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The roles of domestic and foreign Domestic and

foreign Islamic
Islamic banks in Malaysian banks
monetary transmission
Fidlizan Muhammad 161
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Department of Economics, Sultan Idris Education University, Tanjong

Malim, Malaysia, and
Asmak Ab Rahman and Ahmad Azam Sulaiman
Department of Syariah & Economics, Academy of Islamic Studies,
University of Malaya, Kuala Lumpur, Malaysia

Abstract
Purpose – The aim of this paper is to empirically test the presence of the bank lending channel for the
Islamic banking system in Malaysia.
Design/methodology/approach – Distributional effects from monetary policy changes were
analyzed by three bank characteristics such as size, liquidity and capital. Using the econometric model
by Kashyap and Stein (1995), the implementation of a policy contraction leads to reduction in loan
supply because some banks may not able to offset a reduction in deposits. The paper explores the
response shown between domestic and foreign Islamic banks in Malaysia using bank-level data from
2005 to 2010.
Findings – The empirical result indicates presence of the bank lending channel in the Islamic banking
system in Malaysia, size and liquidity as sources of difference response of financing supply in domestic
bank and capital for foreign Islamic bank and Islamic interbank rate as an efficient tool in conducting
monetary policy especially in the Islamic banking system.
Originality/value – The paper manages to explore the effectiveness of Islamic the monetary policy
tools in the Islamic Banking system in Malaysia. Using Islamic interbank rate as a policy tool, it
provides valuable view to policy makers, who are analyzing for efficiency of transmission channel.
Keywords Islamic banking, Bank loan supply, Monetary transmission mechanism
Paper type Research paper

1. Introduction
In general, the main source of capital for economic sectors’ activity in developing
countries is still dominated by banking credit channeling. In Malaysia, the dependency
of these economic sectors is also undeniable. Between 2002 and 2010, the credit from
banking sectors contributed an average of 90 per cent to economic activity compared to
the capital from debt market as well as equity.
Due to the existence of significant dependency between economic sectors and
banking credit monetary policy makers should play important role in ensuring stability
International Journal of Islamic and
in the financial system. This matter was acknowledged by the Governor of Bank Negara Middle Eastern Finance and
Malaysia (BNM) who admitted to the failure of banking system supervision that has Management
Vol. 7 No. 2, 2014
caused all sorts of economic crisis today. pp. 161-169
The experience of battling the economic crisis in 1997 has taught important lessons © Emerald Group Publishing Limited
1753-8394
to most of Asian countries for the improvement of financial policy and also the banking DOI 10.1108/IMEFM-11-2011-0084
 IMEFM system. In Malaysia, problematic banks underwent the process of merges and
acquisition (M&A). This was conducted to ensure competitiveness of banking system
7,2 and continue to play its important role in economic growth toward achieving the aims of
economic growth.
Development of banking system in Malaysia is very unique. The effect of crisis has
motivated the policy makers to encourage the establishment of more transparent
162 banking system. The Islamic banking system is fairer and more transparent because it
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operates based on tangible asset. This is different with the conventional banking system
that is based solely on interest rate.
After a decade the crisis has passed by, a stimulating growth takes place in the
Islamic banking system. The number of Islamic banking institutions is increasing from
time to time. This scenario drives to the competition in credit channeling activity
involving both Islamic and conventional banking institutions. In this situation, it gives
challenge to the policy makers to carry out monetary policy target tool that is based on
an interest-free system.
In this research, the response of credit offering to economic sectors which is known as
financing by the Islamic banking institution, in dealing with changes in monetary policy
will be studied. This study will compare the responses shown between domestic and
foreign Islamic bank.

2. Overview of Islamic banking

The Islamic banking industry has shown a dramatic growth in almost three decades in
Malaysia. Since its first establishment in 1983, which was known as Bank Islam
Malaysia Berhad, the number of players in this industry has increased. The
implementation of an interest-free Islamic banking system (Islamic banking-window
scheme) in 1993 expanded the capability of this sector to compete. This can be proven
based on the total of assets and financing that experienced a rapid increase. During
1993-2010, the Islamic banking asset increased from MYR2.5 billion to MYR267 billion,
while the total financial sector boomed to MYR162 billion compared to MYR1.1 billion in
1993. The same achievement was seen in the increase of total deposit of nearly MYR218
billion in 2010 compared to MYR1.6 billion in 1993.
Great accomplishment by Islamic banking sectors was caused by encouragement
and motivation given by policy makers for domestic or foreign industry players to
establish the Islamic banking institution in Malaysia. Until 2010, there were 17
operating Islamic banking institutions with 9 domestic institutions, and another 8
institutions were foreign Islamic bank entities. As a consequence to the increasing
number of institutions, it made easy for customer to access the Islamic banking sector
which currently owns 2,087 branches compared to only 136 branches in 2004.
The common enquiry among the economists and also policy makers who are
involved in the financial policy implementation is whether the transmission differential
of monetary policy for both entities the same or contrastive. BNM as the responsible
party in implementing the financial policy must understand the reaction in ensuring a
conducive policy and be able to attain the specified macroeconomic target.
In an effort of realizing a strong and Syariah-compliant financial system, BNM
created a policy target tool known as Islamic inter-bank rate for Islamic banking sectors.
This rate is for allowing the Islamic banking institution to channel surplus fund to
deficit institutions that is suitable with the principles of Islamic transaction. For BNM,
 this rate is the rate used as transmission tool in implementing the financial policy Domestic and
toward Islamic banking institutions.
Because of the dual banking system practiced by Malaysia it is moving hand in hand
foreign Islamic
and is supported by bank entities and different target tools, thus the stability of the banks
Islamic financial system is essential to be researched in detail. The research finding will
provide information regarding the level of response by Islamic banking institutions on
financial policy via the proxy of this Islamic bank rate. 163
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3. Literature review
Hypothesis related to the bank lending channel was based on the research by Bernanke
and Blinder (1988) and Kashyap and Stein (1995). A lot of empirical studies were
conducted and evidence produced on the efficiency of this channel. Early research was
focused on the USA, according to Bernanke and Blinder (1992), Kashyap et al. (1993),
Peek and Rosengren (1995), Kishan and Opiela (2000) and also Kashyap and Stein (2000).
Following the efficiency of this channel, extended research was carried out in a few
countries such as Issing (1997) in Germany, de Bondt (1999) in Germany, Belgium and
The Netherlands, de Haan (2003) in The Netherlands, Rich (1996) in Switzerland,
Gambacorta (2005) in Italy and Ehrmann et al. (2003) in France, Germany, Italy and
Spain. The testing of this channel subsequently grew to Asian countries such as Agung
(1998) in Indonesia, Choi (2000) in Korea, Ogawa (2000) and Hosono (2006) in Japan and
Gunji and Yuan (2010) in China.
These studies exploited cross-sectional data involving variables of specific bank
characteristic such as size, capital and liquidity to evidence the response in bank credit
supply toward shock in the monetary policy. These specific variables are important and
need to be considered in the research, as the level of response is different among banks.
The tested hypothesis in this channel assumed that small size of the bank, less liquidity
and lack of capital indicated a high level of change whenever a shrunken and tight policy
was implemented (Kashyap and Stein, 1995, 2000; Kishan and Opiela, 2000).
The same research was done in Malaysia. Nevertheless, these studies only used
aggregated data from the work of Azlan and Aisyah (2005), Goh and Yong (2007), Zaini
et al. (2006), Salina and Turkhan (2008), Salina and Shabri (2009a, 2009b). This scenario
invoked complication to comprehensively summarize the type of response from this
banking institution toward the change in policy (Hosono, 2006). Therefore, research
adapting micro-bank data is still limited. Research adopting this data included work by
Fathin and Ghafar (2007, 2008) and Zulkefly et al. (2010). However, the finding was
general in sense because the banking institution was not categorized into Islamic
banking and conventional banking.
This difference should be prioritized, as the principles basing the two systems are
different. Steps by BNM to create a monetary policy target tool as policy transmission
tool for Islamic banking institutions reflect the need to understand its efficiency toward
the stability of the financial system. The implementation of transmission tool based on
free interest was studied by Darrat (1988) in Tunisia, Kia and Darrat (2003) in Iran and
in Malaysia by Samad (1999), Rosly (1999), Kaleem (2000) and Samad and Hassan (2000).
Furthermore, this study will analyze in detail the effectiveness of the monetary policy
target tool as monetary policy transmission for BNM. In this study also, three specific
characteristics of bank will be analyzed. Apart from that, to analyze the differences of
bank financing supply response, Islamic banking institutions are divided into domestic
 IMEFM and foreign Islamic banking. This entity factor was significantly proven in a few
studies, namely, Ashcraft (2006), Gambacorta (2005), Berger et al. (2008) and Salina and
7,2 Turkhan (2008) in Malaysia.

4. Econometric model and data

Empirical research model involving Islamic banking in Malaysia is based on the
164 approach introduced by Bernanke and Blinder (1988) and Kashyap and Stein (1995,
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2000). This empirical approach is frequently adopted in analyzing the existence of credit
channel especially bank lending channel and testing the bank response toward the
change in loaning cost. The model specification is formulated as in the equation (1):
l l l

⌬(log TFi,t ) ⫽ ␣i ⫹ ␤1⌬ 兺

j⫽0
(log Yt ) ⫹ ␤3⌬IIRt ⫹ ␤4 兺
j⫽0
Xi,t⫺1 ⫹ ␤5 兺 ⌬IIR *X
j⫽0
t i,t⫺1 ⫹ ␧it

(1)

where i ⫽ 1…N and t ⫽ 1…T and N denote the number of banks and l the number of
lags. In equation (1), ⌬(log TF) is regressed on the nominal gross domestic product
(GDP) growth rate, ⌬(log Y) , to control for loan demand shifts.
According to Kashyap and Stein (1995), better economic situations increase the
economic sectors profitable in terms of expected net present value, thereby increasing
the demand of credit. The introduction of this variable captures cyclical macroeconomic
movements and serves to isolate the monetary policy changes (⌬IIR) .
The econometric specification also includes interactions between changes in the
policy rate, controlled by BNM, and bank-specific characteristics. The three bank
specifics are standard in the literature: SIZE, log of total assets; (Kashyap and Stein,
1995) LIQ; cash, securities and other liquid assets over total assets (Stein, 1998); and
CAP, the capital-to-asset ratio (Kishan and Opiela, 2000; Van den Heuvel, 2002). This
character can be regarded as an ex post accounting measure of credit risk. All
bank-specific characteristics refer to t ⫺ 1 to avoid endogeneity bias.
The bank characteristics are furthermore interacted with the monetary policy
indicator to find out if monetary shocks have distributional effects on financing in
Malaysian Islamic banking institutions. The assumptions is that small size, less
liquidity and poorly capitalized banks will react more strongly to monetary policy
indicators changes. According to equation (1), negative coefficient in ␤5 indicates that
credit channel hypothesis occurs.
Panel data approach is used in this study. Wooldridge (2000) defines panel data as the
data that have both cross-sectional and time-series dimensions. In this study, the
cross-sectional units are the Islamic banking institutions in Malaysia. Annual data
spanning is used from 2005 to 2010 for 17 Islamic commercial banking. These banks are
categorized into two panels which are panel A for domestic bank institution involving
nine banks, while panel B includes eight foreign Islamic banks. The entrance of many
foreign banks which are granted operational license by BNM is the factor for the year
selection of this research.
Besides that, during this period also there are occurrences of a few crises that also
give effect to the Malaysian economy such as the increase of petrol price and global food
and financial crisis in the USA and also in Europe. The bank-specific characteristics
data for all banks are obtained from banks’ annual report for the period of study. The
 macroeconomic variable is obtained from BNM and Malaysia Treasury annual report, Domestic and
while monetary policy indicator from Islamic Interbank Money Market (IIMM) and
BNM Web sites.
foreign Islamic
Next, fixed effects and random effects models are both estimated. The fixed effect banks
model assumes that the idiosyncratic error, ␮it, is independent of the exogenous
variables across all time periods (Wooldridge, 2000). In this context, the fixed effects
estimators permit for arbitrary correlation between the unobserved effects and the 165
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independent variables in any time periods.

On the other hand, the random effects model is used with the assumption that the
unobserved effect is uncorrelated with the explanatory variables (Wooldridge, 2000).
The random effects estimators are inconsistent if the error term and the regressors are
correlated. Therefore, the Hausman (1978) test is used to determine if there is any
correlation between the explanatory variables and the error term. If such a relationship
exists, then the fixed effect model is said to be appropriate.

5. Findings
To determine whether the fixed effect is more appropriate or random effect, the
Hausman test is used. The result for Hausman test (Table I) indicates that the null
hypothesis, in which individual effects are uncorrelated with the explanatory variables,
can be rejected for model of panel B. Hence, the fixed effect model is said to be
appropriate for report in foreign Islamic bank case, while results of the random effect is
suitable for domestic Islamic bank.
The result in Table II shows the response of domestic and foreign Islamic bank
toward shock on monetary policy conducted via Islamic interbank rate.
Based on Table II, it is found that the GDP growth indicates a negative correlation
with the total financing by domestic Islamic banking. Although the result is surprising,
the analysis time period requires careful interpretation (Cappielo et al., 2010). An
illustrative example for comprehending the situation can be associated with the
inability to achieve the expected target of economic growth that influences the financing
supply. This matter also can be reflected by basing on detailed observation of Islamic
banking financing growth that is slower and in fluctuation mode compared to the prior
period.
For the relationship between monetary policy rate and total financing, it is found
significant and positive for domestic Islamic banks. However, scarcity of evidence fails
to prove the same pattern for foreign Islamic banks. Regarding the relationship of policy
rate and this total financing, it can be justified to the stability of the financing rate and
no element of uncertainty. This is because change in policy rate will cause direct change
to bank financing rate. The stating of cap financing rate in Malaysian Islamic banking
has given confidence to economic sectors to choose and place Islamic banking
institutions as alternative capital source.

Panel Hausman test p-value

Panel A – domestic Islamic banks 0.60 0.997

Panel B – foreign Islamic banks 16.00 0.042**
Table I.
Note: ** implies significance at 5 per cent Hausman test
 IMEFM Explanatory variables Domestic Foreign
7,2
Constant 3.005** –
(1.4960)
⌬GDP ⫺0.0828*** 0.0098
(0.0273) (0.0185)
⌬IIR 11.2321*** ⫺3.4857
166 (4.3110) (2.3590)
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SIZEt⫺1 ⫺0.0873 ⫺0.8307***

(0.0937) (0.1755)
LIQt⫺1 ⫺1.0247*** ⫺4.7172***
(0.3381) (0.8247)
CAPt⫺1 2.0939** 0.9979***
(0.9601) (0.1565)
⌬IIR* SIZEt⫺1 ⫺0.2169** 0.0810
(0.0978) (0.0508)
⌬IIR* LIQt⫺1 ⫺1.1159*** 0.9094*
(0.3693) (0.5336)
⌬IIR* CAPt⫺1 1.5462* ⫺2.9124***
(0.8488) (0.4260)
Observations 54 48
R2 0.58 0.88
Ajd. R2 0.40 0.81
F-statistic 3.22*** 13.38***
Table II.
Regression results Note: * , ** , *** implies significance at 10 per cent, 5 per cent and 1 per cent

From the aspect of bank specific criteria, it is discovered that liquidity and bank size are
essential factors in determining the distribution of monetary policy in domestic Islamic
banks, whereas for foreign Islamic banks, all three aforementioned criteria are found
significant. This shows that the criteria of small or large size, less or well capitalized and
less or more liquidity influence banks in expanding their credit total. Negative
relationship between size and total financing indicates that small Islamic banks are less
affected by the adverse implications of informational frictions. This is in line with
justification found in Ehrmann and Worms’s (2004) research that associates the deposit
guarantee, strong supervision system and close relationship between industry players.
In terms of interaction terms between bank characteristic and Islamic monetary
policy rate, it obviously demonstrates different responses among these two entities.
Hypothesis in credit channel implies that small-size domestic Islamic banks will
decrease the total of financing due to the shock in financial policy. Whereas, for foreign
Islamic banks, there are no support of significant evidence obtained.
In addition, for interaction between liquidity and capital with policy rate, response
shown is different. Domestic Islamic banks are found less liquid compared to foreign
Islamic banks. This entails that the change response exhibited by domestic Islamic
banks are stronger compared to foreign Islamic banks. Meanwhile, interaction between
capital and policy rate finds that domestic Islamic banks are well capitalized compared
to foreign Islamic banks. This situation describes that reduction in financing is stronger
for foreign Islamic banks than domestic banks. Conforming the bank lending channel
literature, well-capitalized banks are able to buffer their financing activity against
 shocks affecting the availability of external finance (Kashyap and Stein, 1995, 2000; Domestic and
Kishan and Opiela, 2000). The well-capitalized banks are also able to expand their
financing because they have many branches that enable accumulation of great total
foreign Islamic
deposit. Besides, domestic Islamic banks have intimate relationship with economic banks
sectors especially involving small economic sectors (Altunbas et al., 2011; Ehrmann
et al., 2003).
167
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6. Conclusion
This paper discusses the role of domestic and foreign Islamic banks in the transmission
of monetary policy in Malaysia. Generally, the research finding shows that this credit
channel is effective in influencing both entities. By using microdata on banks, it is found
that liquidity and size are important to characterize a domestic Islamic bank’s reaction
to monetary policy change. Bank with less liquidity, for example, react more strongly
than more liquid banks do. Contrary result is found for foreign Islamic banks, with
capital as dominant character for policy change.

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Corresponding author
Fidlizan Muhammad can be contacted at: fidlizan@fpe.upsi.edu.my

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