Assessing the Islamic banking contribution to financial stability in Indonesia: A non-linear approach

Abstract

Islamic banks have become alternative intermediary institutions in the banking industry and are expected to play a significant role in the financial system. Therefore, this study aims to examine Islamic banks’ contribution to financial stability, also focusing on the underlying contracts implemented in financing activities from the perspective of a non-linear relationship. The study employs time-series data from 2006m1 to 2021m11 and adopts non-linear autoregressive distributed lag (NARDL). The findings reveal that the presence of Islamic banks has a non-linear influence on financial stability. Overall financing has a symmetric effect on financial stability, but an asymmetric effect is evident when total financing is categorized based on underlying contracts. Moreover, in the short run, musharakah financing strengthens financial stability, while during a long-run relationship mudarabah financing plays the most pivotal role in increasing the level of stability in the banking system. The study proposes that the financial authorities should be concerned with the non-linear symmetric and asymmetric relationships with Islamic banks, particularly in the underlying contracts that the banks employ. This is considered to be important to avoid financial instability in the banking system. AcknowledgmentThe authors gratefully acknowledge the support from Direktorat Penelitian dan Pengabdian Masyarakat (DPPM) Universitas Islam Indonesia No.: 023/ Dir/ DPPM/ 70/ Pen.Unggulan/ XII/ 2022 and for providing a research grant for the study.