Islamic banking and real performances in a dual banking system

Abstract

There is a rich debate on the nature of Islamic banking (IB)–growth nexus and the direction of causality governing this nexus. This study aims to focus on this issue in the case of Saudi Arabia, the largest country-holder of Islamic Banks (IBs)’ assets worldwide. It assesses empirically the nature of dynamic interactions between IBs’ financing and the real performances in the non-oil private sector (investment and GDP) in the context of a dual banking system where IBs operate alongside their conventional counterparts.,This study employs the Bounds test in the context of reparametrized autoregression distribution lags (ARDL) models to analyse both long-run and short-run dynamics governing Islamic and conventional banks’ (CBs) financings on one hand and real investment and GDP in the private sector on the other hand over the 2007q1-2016q4 period. It also uses the Toda and Yamamoto (1995) augmented Granger-causality test to assess the direction of causality governing these dynamics.,The more important results are: there is a stable and significant long-run relationship between IBs’ financing and real performances in the private sector. This nexus is governed by the “feed-back hypothesis”, implying the validity of both the “supply-leading” and the “demand-following” hypotheses. In a dual banking system context, IBs exert two effects on the financing of their conventional counterparts: a negative “crowding-out” effect and a positive and “stimulating” effect which transmits through the “competition” channel. Finally, in the long-run, steady-state, real GDP is dissociated from CBs’ financing.,This paper highlights an issue that has not received the needed attention in the case of Saudi Arabia. It has also found novel results with important policy implications.