The Importance of the Islamic Banks in the Monetary Transmission Mechanism in Malaysia

Monetary policy influences the real economy through various channels, including bank lending. Currently, Malaysia is operating under dual banking systems: conventional and Islamic banking. The latter has the distinctive feature of interest-free. Hence, this study aims to empirically explore the relevance of Islamic banks’ financing in channeling the monetary policy effects to the real economy. To achieve this objective, the study relies on an autoregressive distributed lag (ARDL) bound testing approach and innovation accounting approach and uses quarterly data spanning from 1991:Q1 to 2010:Q4. The study documents that Islamic financing channel for monetary transmission exists in Malaysia. Islamic financing is unequally distributed to economic sectors in response to monetary policy shock. Furthermore, the findings also reflect that Islamic banking, as operating a dual banking system, is not spared from the interest rate and monetary conditions of the country. This clearly shows the behavior of Islamic banking, which cannot shun the interest rate while its operation delinks from the interest rates. In designing monetary policy, the central bank should consider Islamic financing as an alternative or complement channel for monetary transmission, since this channel is just as active as conventional lending channel.