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Archives of Business Research – Vol. 10, No. 2

Publication Date: February 25, 2022

DOI:10.14738/abr.102.11791. Khalidin, B. (2022). Monetar Policy, Macroeconomic Variables and the Performance of Islamic Banks Financing. Archives of Business

Research, 10(02). 90-102.

Services for Science and Education – United Kingdom

Monetar Policy, Macroeconomic Variables and the Performance

of Islamic Banks Financing

Bismi Khalidin

State Islamic University of Ar-Raniry, Banda Aceh, INDONESIA

ABSTRACT

Islamic banks are banks that operate based on sharia, where one of the principles

is free from usury or interest rates. Instead of the rates, the banks uses a profit

sharing system. In Indonesia, the Islamic banks grow significantly, even though the

prevailing monetary policy is still based on the interest system. This phenomenon

is interesting to study, because on the one hand there is a close relationship

between banking and monetary policy, but on the other hand monetary policy is

based on interest rates while the Islamic banks are based on profit sharing rates.

This study aims to examine the relationship and influence of monetary policy and

macroeconomic variables on the performance of the Islamic bank financing. This

research was conducted from 2010 to 2019, by using statistical approaches of

Vector Auto Regression (VAR) and Pearson Correlation. The results show that the

performance of Islamic bank financing, both profit-sharing-based and murabahah

financings, is influenced by monetary policy and several selected macroeconomic

variables. In addition, the profit sharing rates of financing is influenced by

conventional bank interest rates and the rates of some monetary instruments. One

important thing in this finding is that the financing and the profit sharing rate

applied by Islamic banks resemble those of conventional banks, so that the

influence of interest rates is very dominant in the operations of Islamic banks, both

from monetary policy instruments and other interest rates.

Keywords: Monetary Policy, Macroeconomic Variables, Islamic Banks & Financing

INTRODUCTION

The term "Islamic bank" is a new term in the realm of Islamic Economic and Finance. Such the

term first appeared when the Islamic Development Bank (IDB) was founded in 1975 in Jeddah,

Saudi Arabia (Egresi & Belge, 2015). After that, several large Islamic banks emerged, such as

Dubai Islamic Bank (1975), Faisal Islamic Bank of Egypt (1977). However, even though Islamic

banks were formally established in the 1970s, the essence of Islamic banking practices have

existed before. It means that before the 1970s some financial institutions have operated

without applying an interest-based system and implemented a profit sharing-based system

instead, but they were not named formally by “Islamic bank”.

Islamic banks are defined as financial institutions adopting Islamic regulations in their

activities (Al-Harbi, 2015), and do not implement interest rates (Samad, 2019). After the

financial crisis of 2007-2009, the banks were at a significant growth either in developed or

developing countries (Berger et. al, 2019). Islamic banks play an essential role towards the

financial and economic sectors (Samhan & Al-Khatib, 2015). However, assimilation of the

Islamic priciples into the financial system requires absolute integration in conceptual

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Khalidin, B. (2022). Monetar Policy, Macroeconomic Variables and the Performance of Islamic Banks Financing. Archives of Business Research, 10(02).

90-102.

URL: http://dx.doi.org/10.14738/abr.102.11791

foundations and applications (Omar, 2011). Indonesia is an Islamic country that establishes the

rights for the existence of Islamic banks, where they have been operating since 1991 indicating

with the establishment of Bank Muamalah Indonesia (Adnan & Muhammad, 2007). Hence, two

banking systems are operating simultaneously in Indonesia and have the rights equality under

the Indonesian constitution, Islamic banks and Commercial banks, also known Conventional

banks.

Currently, the implementation of the Islamic banking and finance system has started a new

episode in Indonesia, where one of the provinces in the country, namely Aceh, only allows the

Islamic banking and finance system to operate. This is due to the granting of privileges or

specificity to the region applying the Islamic law. However, it should be underlined that this

momentum is very important, if this is successful in the sense that the Islamic banking and

finance system implemented results in an increase in the economy, it will be imitated and

followed by other regions or province in Indonesia.

Neither interest rates nor usury is accepted in Islamic banks, they are prohibited in the banking

system (Omer, 2019), which differentiates specifically from commercial banks (Rasheed &

Chauhan; 2015). They use profit sharing rates (PSR) instead. Moreover, the PSR are regarded

as the most important instrument instead of interest rates. Such the reality prevails in the

Indonesian Islamic banks in which the banks do not utilize interest rates, they adopt PSR system

instead. The development of an Islamic financial system generates a challenge to discover a

monetary policy, which conforms with Islamic economics principles. (Ahmad & Ismail, 2018)

However, monetary policy which supervises, and has strong relationship with the Indonesian

banks including the Islamic banks, is still an interest-based. Moreover, regulations related to

monetary policies, such as monetary instruments, still contain interest rates, while the Islamic

banks must be free from the rates. This, of course, will sway the stability of Islamic banks, their

financing in particular, whereas the financing is one of the most essential activities in the

Islamic banks. In addition, by theory, Islamic banks are influenced by economic conditions in a

country.

This research is to explore financing stability of the Islamic banks under interest-based

monetary instruments. The research is very essential because it will uncover the crucial

problems happening in the financial market world, where one side that financing of Islamic

banks must be free from interest rate, but the other side they must follow to monetary policy

with interest rates. This seems to contradict one to another, which affect on the stabililty of

financial market. Besides, the research will reveal the existence of some core economic

variables towards the Islamic banks.

LITERATURE REVIEWS

Islamic Bank

There are several definitions given to Islamic banks by experts. In general, an Islamic bank, also

known “Sharia bank”, means a bank based on the main sources of Islamic law, which is the Holy

Quran and the Hadith of the Prophet Peace be Upon Him (pbuh). In addition, the Islamic bank

can be interpreted as a financial institution that applies the Islamic economic principles. The

more simple definition of Islamic bank that is commonly understood by the general public is a

bank that does not contain or utilize interest rates, or the bank implements a profit sharing

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Services for Science and Education – United Kingdom

system instead of the rates. Some defines the Islamic banking is a banking system which is

based upon equity type of financing (Tabash, 2019)

The main principle of Islamic banks’ operation as regulated by either the Holy Quran or the

Hadith is that there should be no element of usury or ribawy in their activities. Eliminating riba

is considered a crucial part of Islamic business principles (Ahmad & Hassan, 2015). Because the

interest rate system is similar to ribawi (riba qardh), the interest rates is prohibited by the

majority of Islamic scholars (ulama). Therefore, interest rates are not allowed under the Islamic

banking system. Moreover, the prohibition on interest rates is not only limited to banking

matters, but for all forms and types of economic and financial activities.

The crucial principle for Islamic banks in their activities is sharing of the output, either profit

or loss, which is usually known as the Profit-Loss Sharing (PLS) principle. The relation between

investment accounts holders and shareholders, in Islamic banks, is based upon the PLS

principle to which considered as the foundation of Islamic banking intermediation (Hamza,

2015). However, due to as a business institution, Islamic banks also employ a number of

financing in order to achieve the profit as much as possible, such as mark up-based financing

and etc.

Based upon experiences throughout the world either in Muslim countries or not, Islamic banks

face a strong competetion with their counterpart, conventional or commercial banks, usually in

terms of generating of a profit and serving customers. Therefore, the competition faced by

Islamic banks has forced them to concentrates dominantly the fixed return instruments like

Murabahah, Ijara, and Diminishing Musharakah. (Rashid & Jabeen, 2016). In this case, Fakhri

and Darmawan (2021) argue that, one of the solutions, is Islamic banks must make a number

of improvement so that more resilient to external problems and conditions, such as

strengthening liquidity management and managing the financing quality.

Financing of Islamic Banks

Islamic banks use the term “financing” instead of the term “credit” of conventional or interest- based banks. Basically, the purpose of financing of Islamic banks and credit of conventional

banks is the same, namely to gain profit or to carry out their function as intermediary

institutions. Theoretically, there are many forms of financing in Islamic banking, however, only

three kinds of them dominantly operated by Islamic banks throughout the world, including in

Indonesia. They are mudharabah, musyarakah and murabahah financing.

The most important thing that differentiating between financing of Islamic banks and credit of

conventional banks is with respect to the existence of interest rates. Islamic banks, according

to the theory, do not use the interest rates as the yardstick of financing, like their counterpart

of conventional banks. They use the variable of profit-sharing rates in a variety of financing

products instead. Therefore, financing of Islamic banks can be formulated as the following:

Fin = f (PSR) (1)

PSR is Profit Sharing Rates, calculated under an ratio-based between the banks and the

costumers, not a percentage-based. Besides, the Islamic banks’ financing is also influenced by

the economic growth which indicates the interrelationship between two sectors, banking and

economy.

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Khalidin, B. (2022). Monetar Policy, Macroeconomic Variables and the Performance of Islamic Banks Financing. Archives of Business Research, 10(02).

90-102.

URL: http://dx.doi.org/10.14738/abr.102.11791

Fin = f(PSR, GDP) (2)

However, PSR as mentioned above is for mudharabah and musyarakah financings. Such the

financings are also known PLS-based Financing. The Islamic bank financing correlates

significantly and positively with economic growth and capital accumulation (Furqany &

Mulyany, 2009). Concerning PSR, the rates in principle must be in the form of ratio, not a

percentage-based. Nevertheless, Islamic banks dominantly apply it in the form of percentage

and refers to interest rates. Therefore, the PSR is influenced by interest rates. Then,

PSR = f( r) (3)

Experiences show that nearly all forms of financing correlate with interest rates, both the rates

of conventional banks and monetary instruments. Another financing is murabahah defined as

a re-sale-based financing with a mark-up on purchase price, and also known as a cost-plus

financing (Siddiqi, 2004). Murabahahh is a very beneficial financing that is asset based

financing for Halal (lawful) purposes (Hanif, 2011). Basically, murabahahh is a type of sale

where the total profit is determined as percentage of the cost or as an absolute amount (Shah

& Niazi, 2019).

Monetary Policy, Profit Sharing Rates and Interest Rates

Monetary policy is a policy consisting of monetary instruments in regulating the circulation of

money with the aim of achieving economic growth and stability. The most important target of

monetary policy is to realize macroeconomic and price stability (Juhro & lyke, 2019). In Islam,

monetary policies and theories have appeared when the religion was established and the

Prophet Muhammad pbuh Himself as the monetary authority at that time (Khalidin, 2021). This

policy is based on a perception that the circulation of money plays an important role in

achieving a desired economic target. Monetary policy is divided into two categories, viz.

quantitative and qualitative (Bidabad, et al., 2011), while the difference of the both lies in the

form of instruments used in it.

Monetary policy has strong relationship between interst rates and profit sharing rates of

Islamic banking. Monetary policy affects the real economic condition of a country through

various channels or events, including bank lending (Majid & Hasin, 2014). Two core variables

in the forms of bank lending channels are interest rates in conventional banks and profit

sharing rates in Islamic banks. The both rates influence money supply in the economy through

saving, credits and financing.

Monetary policy is carried out by the central bank in order to regulate the volume of money

liquidity aimed at macroeconomic stability through demand management (Tahir, 2013).

Monetary policy is a significant tool for a government to achieve goals and targets in the

economy (Sari, 2012). Basically, monetery policy in Islam is the same as the existing monetary

policy in terms of economic-targets of stability and growth. However, Islamic monetary policy

are not interest rates based and must be far from the prohibited instruments in Islam such as

gharar, tadlis etc. The core idea of monetary management in Islam is to reach the stability in

money demand (Ascarya, 2014).

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Archives of Business Research (ABR) Vol. 10, Issue 2, February-2022

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ECONOMETRIC MODELS AND DATA

Econometric Models

Similiar to commercial banks, Islamic banks have also several kinds of financing, namely

mudharabah, musyarakah, murabahah and others (Khalidin & Masbar, 2017). However, the

financing of the banks in Indonesia is dominated by two main catagories, PLS and Murabahah

financings. Therefore, this research will explore the both types of financing in terms of the

existence of monetary policy and some selected macroeconomic variables. The followings are

econometric models used:

Finpls = f(PSRpls, NBRwc, NBRi, BIrate, JIBOR, CPI, ER, ICI) (4)

Finmura = f(PSRmura, NBRc, NBRi, BIrate, JIBOR, CPI, ER, ICI)(5)

Finpls and Finmura are PLS-based Financing, consisting musyarakah and mudharabah , and

murabahah financing respectively. PSRpls and PSRmura denote rates of profit sharing of the both

financing, while NBRwc, NBRi , and NBRc are interest rates of commercial banks for working

capital, investment and consumption respectively. Monetary policy is represented by BI Rate

(BIrate) and Jakarta Interbank Offered Rate (JIBOR), issued by the Central Bank of Indonesia (BI),

and three selected economic variables included in the model, they are Consumer Price Index

(CPI), Exchange Rate (ER) and Indonesian Composite Index (ICI).

Data

The data used are monthly time series with a period of ten years, from 2010 to 2019. There are

two reasons for determining this period, firstly looking at the development of Islamic banks

after the enactment of the Islamic banking law (UU Nomor 21/2008), the second is that after

2020, Islamic banks have been merged into one Islamic bank called BSI (Bank Syariah

Indonesia).

The data was analyzed by a VAR method (Vector Auto Regression), and the following is a

general form of VAR (Johnston & Dinardo, 1997).

yt = m + A1yt-1 + A2yt-2 + ... + Apyt-p + ε (6)

EMPERICAL RESULTS

The Indonesian Islamic Banks

The Islamic banking industry has been operating in Indonesia for four decades, namely since

the 1990s. As a Muslim-majority country, Indonesia can be considered late in implementing the

Islamic banking system when compared to other Muslim countries such as Pakistan, Egypt and

Malaysia. Nevertheless, the growth of Islamic banking in Indonesia is quite significant, both in

terms of savings, financing, number of customers and others. Even now there is province in

Indonesia that require only Islamic banks to operate, while conventional banks or interest- based banks are not allowed to operate. The province is Aceh.

Not only do commercial banks but also Islamic banks play an important role as a financial

intermediary towards economic growth and stability in Indonesia (Fikri, 2018). The Islamic

banks were at a significant growth particularly after the 1997/1998 Indonesian monetary

crisis. Currently, they are employing various types of financing generally devided into three

main categories, viz. PLS-based financing, murabahah financing and non-commercial financing.