Comparing Credit Procyclicality in Conventional and Islamic Rural Bank: Evidence from Indonesia

Abstract

The procyclicality of loan expansion is one of several factors that have contributed to financial instability. Numerous empirical studies conducted in developed nations have demonstrated that financial crises always follow periods of excessive credit during economic booms. Since small and medium-sized businesses still dominate the economy in Indonesia, Islamic and conventional rural banks play a significant role in the provision of debt. This study compares conventional and Islamic rural banks in Indonesia, both of which are classified as pro-cyclical, in order to investigate the pro-cyclicality of the loan funneled through small and medium-sized enterprises. The procyclicality derived from rural bank indicator variables may have an impact on the real sector, and this study uses the Autoregressive Distributed Lag (ARDL) model and a frequency-based filter to construct the credit/financing cycle created by credit growth from both conventional and Islamic rural banks. The findings of this study suggest that both conventional and Islamic rural credit institutions do not closely track economic growth in the short run. Accordingly, procyclicality in Islam and the wider world does not behave in the short run. In contrast, conventional rural banks tend to be more procyclical than Islamic rural banks over the long term, particularly when the economy has expanded. Islamic rural banks exhibit countercyclical behavior in both the short and long terms compared to conventional banks from a capital perspective. Additionally, whereas Islamic rural banks are favorably impacted by credit risk, conventional rural banks have an adverse reaction to the rise in credit risk due to their bad loans. Finally, the outcomes of the frequency-based filter indicate that, in response to shifting economic situations, the cycles of credit provided by conventional rural banks and finance provided by Islamic rural banks are distinct.