An analysis of the resilience of Islamic banking in Indonesia

Abstract

Financial crises have adversely affected the Indonesian economy from time to time. The banking sector is considered to be the most affected type of institution due to it being an important channel through which the financial intermediation process takes place. One of the main reasons for the financial crises becoming severe was that the banking sector built up excessive balance sheet leverage, which, in turn, happened to be linked to financial cycles. Fluctuations in the financial cycles gradually eroded the level and quality of the capital base and liquidity buffers. In Indonesia, Islamic bank is the dominant sector in the Islamic financial system. This asserts that Indonesia’s Islamic financial system is a bank-based economy. Thus, any financial stresses on the Islamic banking system will disturb the prospects of the economy and trigger a financial crisis. For this reason, the resilience of Islamic banking is important to ensure its ability to withstand shocks and increase its financial services. This research aimed to analyze the resilience of Islamic banking in Indonesia. More specifically, it had three objectives: measuring and determining the level of resilience of Islamic banking and its components; identifying the leading indicators that signal the emergence of external shocks with adverse implications for the resilience of Islamic banking; and analysing the link between macroeconomic indicators and the resilience of Islamic banking, in order to aid policy-making to strengthen the Islamic banking sector. This study focused on three things in order to achieve the above objectives. Firstly, the building of an Islamic banking resilience index (IBRI) which incorporates the components of resilience. Secondly, the construction of a macroeconomic vulnerability index (MVI) which serves as the signalling indicator. Thirdly, the development of a framework for the resilience of Islamic banking (FRIB) which analyses the linkage between macroeconomic indicators and the resilience of Islamic banking. The signal-extraction approach was used to determine the resilience of Islamic banking in Indonesia; this was achieved by using time-series data from 2010 until 2016 taken on a monthly basis. The findings showed that the level of resilience of Islamic banking in Indonesia has not emerged, which is reflected by its resilience components that tend to behave at levels of resilience that are no longer at their optimal level. In addition, the rate of inflation and the nominal exchange rate were confirmed as leading indicators that will signal the emergence of external shocks with adverse implications for the resilience of Islamic banking in Indonesia. Thus, improving the resilience of Islamic banking can be conducted by making a connection between the MVI’s tolerable limits of shocks and the IBRI’s optimal level of threshold. At the intersection level, the linkages between macroeconomic indicators and the resilience of Islamic banking can be analysed by using the thresholds of risk signalling that are shown in the FRIB. The study finally suggested that the resilience of Islamic banking requires a sustainable level of leverage, which is achieved by ensuring a more balanced asset-financing allocation, sources of funding composition, and costs over income proportion. In addition, the resilience requires a contractionary monetary policy in order to appreciate the Indonesian nominal exchange rate