Business cycle and bank lending procyclicality in a dual banking system

The paper studies bank lending behaviour over the business cycle in a dual banking system, Malaysia, with the objective of ascertaining whether Islamic banks have a role in stabilizing credit. The study makes use of unbalanced panel data of 21 conventional banks and 16 Islamic banks covering mostly the period 2001-2013. Applying dynamic GMM estimators, we find the aggregate loans by banks to be pro-cyclical in conformity with existing studies. However, when we segregate the lending/financing behaviour of conventional and Islamic banks, the cyclicality of bank lending seems to be true only for conventional banks. As for the Islamic banks, the business cycle does not seem to affect their financing decisions. Indeed, there is indication that the Islamic banks in general and the full-fledged Islamic banks in particular can even be counter-cyclical in their financing decisions. This conclusion is fairly robust to a different loan measure, alternative model specifications, and to an alternative business cycle measure. Hence, our results provide further support to the “stability” view of the Islamic banks in that they have the ability to stabilize credit.