Islamic Banking System: A Credit Channel of Monetary Policy – Evidence from an Emerging Economy

Abstract

Since its inception, Islamic banking in Pakistan has shown remarkable growth and development. Most recent statistics unveil that industry has captured around 13% of the total banking market in Pakistan. This outstanding augmentation of the industry highlights the crucial role of Islamic banks for monetary policy considerations. The study aimed to evaluate the role of Islamic banks in monetary transmission process in Pakistan. The study examined the role of two most crucial balance sheet items of Islamic banks in monetary transmission process; (1) Islamic deposits and (2) Islamic financing. The paper employed time serious techniques like JJ-cointegration test, vector auto regression (VAR), Variance Decomposition Analysis (VDC) and Impulse Response Function (IRF) to investigate the role of Islamic banks in monetary transmission process. The study sample covered the time period of 2007-17. The results unveiled the significant role of Islamic banks in transmitting monetary decisions to the real economy. Moreover, the evidence demonstrated active bank lending channel of Islamic banking in Pakistan. The findings also corroborated the functional role of Islamic banks along with their conventional counterparts for effective formulation of monetary policy in Pakistan.

Keywords: Islamic banks, Islamic deposits, Large Scale Manufacturing Index (LSMI), Monetary policy, IRF, VDC

JEL Classification: E52, G21, P40, Z12