Monetary policy transmission to Islamic bank financing in Indonesia: evidence from a Structural VAR Approach

This study investigates the dynamic effects of monetary policy shocks on Islamic bank financing in Indonesia using a Structural Vector Autoregression (SVAR) approach. Within the context of a dual banking system, the analysis focuses exclusively on the Islamic segment, employing quarterly data from 2010 to 2023 to capture both normal and volatile macroeconomic conditions. The results reveal that Islamic bank financing is significantly responsive to changes in the policy rate, despite its interest-free foundation, largely due to benchmarking practices such as the use of the BI 7-Day Reverse Repo Rate. Additionally, expansionary monetary shocks via money supply positively influence financing, highlighting the role of liquidity in supporting Shariah-compliant credit growth. Inflation shocks exert a negative and persistent impact, indicating the importance of price stability in maintaining Islamic credit momentum. Exchange rate fluctuations, while statistically significant, demonstrate a relatively minor and transitory effect due to the limited foreign currency exposure of Islamic banks in Indonesia. Forecast Error Variance Decomposition (FEVD) confirms that interest rate and money supply shocks are the most dominant sources of variance in Islamic bank financing, followed by inflation and exchange rate shocks. The findings suggest that, although Islamic banks operate under distinct principles, they remain intricately linked to the conventional macro-financial system. The study underscores the need for Shariah-aligned policy instruments and robust macroeconomic management to enhance monetary transmission effectiveness within Islamic financial institutions.