Paper Title: Monetary Policy and Islamic Banks: A Critical Literature Review

Author:        Zakaria Savon and Abdellah Yousfi

Publisher:    Journal of Islamic Accounting and Business Research, 16(2), 444 – 457.

This review paper explores the relationship between monetary policy and Islamic banks. The authors explain that Islamic banks adhere to Islamic economic and financial principles, differing from the conventional banks. They operate in over 70 countries, often alongside conventional banks in a dual banking system. Central banks use monetary policy tools, like interest rates, to influence the economy, and conventional banks transmit these policies through credit channels.

The role of Islamic banks in this process is complex due to their unique banking model. This paper reviews existing research to understand how monetary policy is transmitted through Islamic banks and suggests directions for future studies.

Monetary policy, which central banks use to manage the economy by adjusting the money supply and interest rates, has been crucial since the 1980s and especially during the 2007-2008 crisis and the COVID-19 pandemic. It operates through various channels, including interest rates, credit availability, and asset prices, to achieve economic stability.

The transmission of monetary policy through Islamic banks is complex and raises questions for central banks. The prohibition of interest in Islamic finance suggests that these banks might be unresponsive to interest rate-based monetary policies. However, some argue that they are still affected due to factors like the nature of their assets, the lack of Islamic benchmarks, and the behaviour of their customers.

Empirical studies on this topic are relatively recent and limited, showing mixed results. Some studies indicate that Islamic banks do transmit monetary policy, while others find no significant impact. These differences may be due to variations in research methodologies, geographical focus, and the specific characteristics of the banks being studied.

The authors conclude that more research is needed to fully understand the relationship between monetary policy and Islamic banking. They emphasize the importance of considering factors like the structure of Islamic banks’ balance sheets and the influence of profit-and-loss sharing in deposits and financing.

The authors note that the existing research has a lack of theoretical grounding. Most studies focus on whether monetary policy influences Islamic banks, but they do not investigate why this happens. The authors suggest that the theory of Islamic finance could offer explanations.

The authors also point out that much of the research is geographically limited, with a heavy focus on Malaysia and Indonesia. This creates a fragmented view of how monetary policy is transmitted through Islamic banks.

Additionally, the authors highlight that the empirical studies vary in their methodology, sample, and time horizon. Some studies examine the Islamic banking system as a whole, while others use panel data to analyze individual banks. This variation could explain why the studies have conflicting results.

Finally, the authors mention that several bank-specific factors, like size, liquidity, and capital, can influence how banks respond to monetary policy. However, empirical studies have not consistently included these factors in their analyses.

The literature in this research area needs further impetus. The existing research lacks theoretical grounding. Most studies focus on whether monetary policy influences Islamic banks, but they do not investigate why this happens. Research is geographically limited, with a heavy focus on Malaysia and Indonesia. Empirical studies vary in methodology, sample, and time horizon.

Several bank-specific factors, like size, liquidity, and capital, can influence how banks respond to monetary policy, but empirical studies have not consistently included these factors. Authors recommend that the future research should focus on addressing the identified gaps to provide a more comprehensive understanding of the relationship between monetary policy and Islamic banking.