Impact of Monetary Policy Shocks on the Conventional and Islamic Banks in a Dual Banking System: Evidence from Malaysia

Abstract

This study analyzes the impact of monetary policy shocks on the conventional and Islamic banks in a dual banking system environment. The responses of the conventional banks to monetary policy shocks is expected to be different from that of the Islamic banks due to the nature of the Islamic ones which only involve with interest-free instruments. Focusing on the Malaysian data covering the period from January 1999 to December 2006, the study aims at determining the sensitivity of the Islamic banks by analyzing the impact of interest rate changes on the banks? financing and deposits. To provide meaningful comparison, the same analysis is also conducted on the conventional banks so as to determine the unique risks confronting the Islamic banks. The study employs the impulse response functions and variance decomposition analysis based on the Vector Auto-Regression (VAR) methodology. Contrary to the general expectations, the results show that the Islamic banks? balance sheet items are relatively more sensitive to monetary policy changes, while the conventional banks? balance sheet items, particularly the conventional loans are insensitive to interest rate changes. This implies that the impact of monetary policy is more de- stabilizing on the Islamic banks than the conventional banks. The results of this study have important implications for the risk management * Department of Economics, Kulliyyah of Economics and Management Sciences, International Islamic University Malaysia (IIUM), P.O. BOX 10, 50728 Kuala Lumpur, Malaysia. Telephone: +603-6196 4613 and e-mail: ksalina@iiu.edu.my. The authors would like to thank the IIUM Management Center for providing the financial assistance under the ?Management Center Research Fund? in completing this research project. practices of the Islamic banks, particularly in a dual banking system such as in Malaysia.