Islamic Banks and Monetary Transmission Mechanism in Malaysia

(ProQuest: . denotes formulae omitted.)1. IntroductionThe monetary policy conducted by central banks targets to influence the overall performance of the economy in order to achieve its objectives. The common objectives of monetary policy are: sustainable economic growth, stable price, full employment, and exchange rate stability. To achieve such objectives, central banks set an intermediate target, i.e. monetary aggregate or interest rate that are strongly linked to economic activities. For example, during boom period, a central bank conducts tight monetary policy by raising interest rate or using other monetary policy tools, i.e. increase of statutory reserve requirement (SRR) or selling bonds, to reduce inflation. An increase in the interest rate causes the price of loans to increase as well and this in tum will induce investors to reduce their borrowings. As a result, investment spending declines, thereby causing aggregate demand to decrease. Hence, output falls.The channel of monetary transmission in affecting economic activities is also important and much relevant to the effectiveness of monetary policy. The above description has illustrated on the mechanism of monetary transmission through the interest rate channel. The interest rate is used to influence the decision of investors in making borrowing and investment. Investment spending is part of GDP; lower investment spending will reduce aggregate demand, thereby causing the economic activities to decline. However, the interest rate channel is not the only channel that monetary policy can be transmitted. There are also other channels which can be conduits for monetary transmission such as bank lending, exchange rate, asset price and balance-sheet channels.Bank lending is one of conduits through which monetary policy can be transmitted. In boom period with high inflation, a central bank might implement tight monetary policy by increasing the statutory reserve requirement (SRR) in order to reduce inflation. Upon this regulation, bank reserve decreases, causing fewer bank loans to be made available. Consequently, the investment spending will declines due to fewer number of investors applying for getting loans. Consequently, aggregate demand decreases, affecting output to decline. In this channel, banks play an important role as financial intermediary that have specialized knowledge in making credit which cost them less than other sources. In market imperfection, there are some borrowers who depend on loans of banks. In other words, loans are perceived as imperfect substitution for other types of credit, i.e., raising money in capital market. Hence, the reduction of loans leads to the decline in investment spending, and consequently, output decreases.Bank lending channel has captured the attention of many economists and researchers. There is substantial literature in this area for developed countries, such as those by Bemanke and Blinder (1992), Gertler and Gilchrist (1993), Kashyap and Stein (1997), and Brissmis et al. (2001). There have been many studies documented evidences supporting the existence of the bank lending channel in both advanced and emerging economies. Altunbas et al. (2002), for example, have found the bank lending channel in Europe. Also, many aspects of the bank lending channel have been analyzed, among them are: the issue of sensitiveness of bank lending with different size, capital strength and liquidity on monetary policy (Brissmis et al., 2001; Gambacorta, 2005; Worm, 2001), and also the issue of sectoral effects of monetary policy (Dale and Haldane, 1995; Dedola and Lippi, 2001; Arnold and Vrugt, 2002). Furthermore, many studies on monetary transmission for developing countries were also conducted by those such as Arena et al. (2006), Agung (1998) and Ramlogan (2004). Various channels of monetary transmission are investigated in those countries. The results vary from one country to another, yet all of these studies seem to suggest the existence of credit channel (Ramlogan, 2004; Huang and Pfau, 2008; Ahmad, 2008). …