Islamic Banking in Indonesia: New Perspectives on Monetary and Financial Issues

"As the most populous Muslim country, there is tremendous potential for Islamic banking in Indonesia. In this pioneering study, Dr. Rifki Ismal assesses the progress to date of Islamic banking in Indonesia and the challenges facing the industry. The profile of existing depositors is examined as well as those seeking Shari'ah-compliant finance. Risk management and regulatory issues are discussed in detail, notably how constraints on liquidity can be overcome. Overall, the book makes an important contribution to the empirical literature on Islamic finance which will be of interest to academic researchers, as well as bankers and other professionals."

—Rodney Wilson, Emeritus Professor, Durham University, UK; Professor, INCEIF, Malaysia

"Islamic banking in particular has developed common standards and practices,and has attracted the interest of players and investors outside the Muslim community. Yet, its economics and implications for financial stability are generally not well understood. Islamic Banking in Indonesia makes a significant contribution to our understanding by linking its foundations not only to the fundamentals of Islamic banking, but also to classical Western banking thought. It provides a convincing analysis of the structural weaknesses of conventional finance, and the role of monetary policy in causing misallocation of resources and boom-and-bust cycles."

—Prof. Dr. Mohammad Rusydi, Director, Australian Centre for Islamic Financial Studies, Brisbane, Australia

"This comprehensive volume is a collection of essays covering a wide range of topics on Islamic banking in Indonesia. While the focus of several chapters is on liquidity risk and its management, the book presents several theoretical and empirical studies on a variety of issues related to the demand-side and supply-side of Islamic banking. Given the potential and growth of the sector in the country, it is a valuable source of information for anyone who would like to study Islamic banking in Indonesia."

—Professor Habib Ahmed, PhD, Sharjah Chair in Islamic Law and Finance School of Government and International Affairs, Durham University

"This book highlights a trusted relationship between bank and entrepreneur as well as the current practices and principles of Islamic banking industries in Indonesia. I would urge those who are interested in studying about Islamic banking to refer to this book."

—M.S. Sujimon, Chair, Australian Shari'ah Board for Islamic Finance Studies (ASBIF)

In Islamic Banking in Indonesia, renowned economist Dr. Rifki Ismal explores current issues in Islamic banking and financial products with a particular focus on the danger of liquidity risk in Indonesia. It approaches liquidity risk from the conventional perspective of international banking standards, as well as from the Islamic banking perspective. Dr. Ismal also covers the issues of asset-liability balancing, liquidity risk index, organizational structures for managing liquidity, industrial analysis, withdrawal risk, bankruptcy risk, moral hazard risk, and market risk.

Compiling all the latest academic research on liquidity risk and other risks in Islamic banking, the book provides a theoretical foundation for managing risk that will is highly useful for researchers on Islamic banking and practitioners and academics.

• Written by a renowned expert on Islamic banking who works on monetary policy at the central bank of Indonesia
• Covers the latest developments in Islamic banking, particularly liquidity risk, for a rapidly expanding market
• Ideal for European and American readers, in addition to Asian readers, who need a fuller understanding of Islamic banking institutions, markets, and products

With the latest academic research and the expertise of a leading practitioner in Islamic banking, this book offers in-depth coverage of the most pressing issues in the field.

Until recently, information about Indonesian Islamic finance and economics has been hard to find. That's why author Rifki Ismal, a leading authority on the emerging Indonesian Islamic finance markets, has written Islamic Banking in Indonesia. Engaging and accessible, this reliable resource skillfully covers the most essential issues in this field—from risk management and industrial operations to depositors' characteristics and Islamic monetary operations.

Containing comprehensive and high-quality research, Islamic Banking in Indonesia provides you with valuable insights on:

• Programs to help develop the Indonesian Islamic banking industry
• Liquidity risk issues based on conventional and Islamic perspectives, as well as the experiences of the Indonesian Islamic banking industry
• The performance of the Indonesian Islamic banking industry, including the highs and lows of its growth
• Assessing the risk-capturing liquidity index; strengthening and improving liquidity management in Islamic banks; and assessing the supply and demand of liquidity in Islamic banks
• Research related to withdrawal risk and bankruptcy risk in Islamic banks, including a survey of withdrawal risk and econometric modelling
• Issues related to the efficient portfolio frontier, such as the volatility of a bank's return and the moral hazard problem found in Murabahah financing

Written to fulfill the demands and expectations of anyone interested in this field—from Islamic bankers, analysts, and investors to academics, students, and institutions—this book will put you in a better position to understand and excel in the world of Islamic banking in Indonesia.

Preface xix

Acknowledgments xxi

CHAPTER 1 Classic Arab Financial Contracts in Modern Financial Institutions 1

Introduction 1

Economic Conditions in the Prophet Muhammad’s (pbuh) Era 1

Development of Classic Economic Contracts 6

Conclusion 12

Notes 13

References 13

CHAPTER 2 Program to Develop Indonesian Islamic Banking 15

Introduction 15

The Indonesian Islamic Banking Industry 15

A Program to Improve the Performance of the Islamic Banking Industry 26

Conclusion 27

References 27

CHAPTER 3 Understanding Characteristics of Depositors 29

Introduction 29

Studies on the Output of Empirical Surveys 30

Segmentations of Banking Depositors 33

Investment Behavior of Banking Depositors 35

An Integrated Program to Develop the Industry 41

Conclusion 43

References 44

CHAPTER 4 Liquidity Risk Management in Banks: The Conventional Perspective 45

Introduction 45

Liquidity Risk in Banking Institutions 45

Process of Liquidity Risk Management 49

Asset-Liability Imbalance and Maturity Mismatch Risks 52

Techniques to Mitigate Liquidity Risk 55

Financial Instruments as Sources of Banks Liquidity 58

Conclusion 60

Note 61

References 61

CHAPTER 5 Liquidity Risk Management in Banks: The Sharia Perspective 63

Introduction 63

Liquidity Risk Issues in Islamic Banking 63

Characteristics of Islamic Banks Facing Liquidity Risk 64

Sharia Issues in Liquidity Risk Management 67

Approaches to Manage Liquidity Risk Based on Sharia 71

Techniques to Mitigate Liquidity Risk Based on Sharia 75

Conclusion 80

Notes 81

References 81

CHAPTER 6 Islamic Banking Characteristics, Economic Conditions, and Liquidity Risk Problem 83

Introduction 83

Supporting Factors of Development 83

Characteristics of the Industry in Relation to Liquidity Problems 85

Investment Behavior of Depositors and Economic Conditions 88

Ideas for Improvements 94

Conclusion 95

References 95

CHAPTER 7 Performance of the Islamic Banking Industry 97

Introduction 97

Background of the Indonesian Islamic Banking Industry 98

Organizational Approach to Managing Liquidity 99

Liquidity Risk Management Related to the Liability Side 102

Instruments to Manage the Demand for Liquidity 120

Conclusion 124

Notes 125

References 125

CHAPTER 8 Growth of the Islamic Banking Industry 127

Introduction 127

Islamic Banking Industry and Its Development Programs 128

Literature Reviews 129

Construction and Output of the Models 133

ARIMA Models 134

Conclusion 143

References 144

CHAPTER 9 The Optimal and Decreasing Growth Rate of the Islamic Banking Industry 145

Introduction 145

Conditions Leading to the Optimal and Decreasing Growth Rate 146

Papers Analyzing Growth and Development of the Islamic Banking Industry 146

Construction of the ARIMA Models and Estimations 147

Findings and Strategic Policy Recommendations 154

Conclusion 155

References 155

CHAPTER 10 Liquidity Management Index 157

Introduction 157

Liquidity Risk Problem in Sharia Perspective 157

Construction of Liquidity Risk Management Index 158

Assessing the Indonesian Islamic Banking Industry 160

Overall Assessments of the Islamic Banking Industry 163

Conclusion 164

Appendix 10A: Liquidity Risk Management (Survey Manuals) 165

Appendix 10B: Bank X Survey Results 171

Appendix 10C: Bank Y Survey Results 177

Appendix 10D: Bank Z Survey Results 183

Note 189

References 189

CHAPTER 11 An Empirical Survey on Liquidity Risk Management 191

Introduction 191

Depositors Understanding of Islamic Banking 192

Investment Behavior of Depositors 193

Liquidity Behavior of Depositors 198

Risk Management Committee in Islamic Banks 205

Sources of Liquidity Risk Problem and Liquid Instruments 212

Conclusion 214

Notes 214

References 215

CHAPTER 12 Islamic Banking Behavior Model of Indonesia (ISLAMI) 217

Introduction 217

Framework of ISLAMI 217

Model Review and Justification 219

Asset Liability Balance Models: Theoretical Background 221

Liquidity Reserves Model: Theoretical Background 227

Model of Islamic Monetary Operation: Theoretical Background 231

Econometric Analysis 236

Interpretation of the Models 250

Long-Run Causality and Dynamic Responses of Variables 253

Findings and Recommendations 261

Conclusion 262

Notes 263

References 263

Appendix 12A: Proofing Formula 265

Appendix 12B: Proofing Formula 266

Appendix 12C: Proofing Formula 266

Appendix 12D: Proofing Formula 266

CHAPTER 13 Strengthening and Improving Liquidity Management 267

Introduction 267

Organizational Structures 268

Integrated Output of the Previous Chapters 269

Discussion of the Depositors’ Side 270

Discussion of the Islamic Banking Side 273

Liquidity Problems and Islamic Liquid Instruments 274

A Proposed Program to Manage Liquidity Risk 275

Conclusion 280

References 281

CHAPTER 14 Demand and Supply of Liquidity in Islamic Banks 283

Introduction 283

Short-Term Demand for Liquidity 284

Short-Term Suppliers of Liquidity 285

Historical Performance of Short-Term Liquidity Management 287

Future Performance of Short-Term Liquidity Management 289

Findings and Suggestions 299

Conclusion 301

References 301

CHAPTER 15 An Empirical Survey on Depositors’ Withdrawal Behavior 303

Introduction 303

Potential Problems of Withdrawals Risk in Islamic Banks 304

Depositors’ Behavior in Withdrawing Funds 304

Empirical Survey on Deposit Withdrawal Behavior 308

Policy Recommendation 315

Conclusion 316

Notes 316

References 316

CHAPTER 16 An Econometric Model of Depositors’ Withdrawal Behavior 319

Introduction 319

Flow of Funds in Islamic Banking 320

Model of the Liability Side in the Competitive Banking Sector 321

Econometric Analysis 323

Findings from Models and Suggestions 329

Limitation of the Models 331

Conclusion 331

References 331

CHAPTER 17 Formulating Withdrawal Risk and Bankruptcy Risk 333

Introduction 333

Characteristics of Islamic Banking Industry 334

Assumptions and Risk Formulas 335

Withdrawal Risk Scenarios 336

Bankruptcy Scenarios 338

Soundness and Failure of Islamic Banks 339

Revenue-Sharing Equilibrium Ratio 340

Conclusion 342

Notes 342

References 343

Appendix 17A: Proofing Formula of the Invulnerable and Vulnerable Condition 343

Appendix 17B: Proofing Formula of Solvency and Bankruptcy Condition 344

Appendix 17C: Proofing Formula of Combination of Scenarios 345

CHAPTER 18 An Optimal Risk-Return Portfolio of Islamic Banks 347

Introduction 347

The Dominant Islamic Financing Instruments 348

Risk-Return Portfolio Theory 348

Efficient Portfolio Theory 350

Risk-Return Analysis of Islamic Financing Instrument 351

An Efficient Portfolio Financing Frontier 360

Conclusion 362

References 362

Appendix 18: Derivation of Variances of 1–4 Financing Instruments 363

CHAPTER 19 Volatility of the Returns and Expected Losses of Islamic Bank Financing 365

Introduction 365

Islamic Financing Instruments 366

Value at Risk Approach 367

Value at Risk (VAR) Analysis for the Indonesian Islamic Banks 369

Value at Risk Result 372

Recommendations 376

Conclusion 377

References 377

CHAPTER 20 The Moral Hazard Problem in Murabahah Financing 379

Introduction 379

Murabahah Financing 380

Moral Hazard in Murabahah Financing 382

Minimizing Moral Hazard in Murabahah Financing 386

Conclusion 388

Note 389

References 389

CHAPTER 21 Central Bank Islamic Monetary Instruments: A Theoretical Approach 391

Introduction 391

General Assumptions 392

Islamic Monetary Instruments 393

Utility of Islamic Monetary Instruments 402

Conclusion 403

Notes 405

References 405

Appendix 21A: Derivation of Central Bank Wakalah wa Ijarah Certificate 406

Appendix 21B: Derivation of Central Bank Wakalah wa Ijarah Muntahia Bitamlik Certificate 407

Appendix 21C: Derivation of Central Bank Islamic Securitization Wa Ijarah Certificate—Ijarah Rental Rate 407

Appendix 21D: Derivation of Central Bank Islamic Securitization wa Ijarah Certificate—Investors Investment Decision 408

CHAPTER 22 Assessing Economic Growth and Fiscal Policy in Indonesia 409

Introduction 409

Wagner’s Law and Keynes’s Law on Economic Development 410

Assumptions and Economic Modeling 411

Defining Variables and Model Specification 412

Autoregressive Distributed Lag (ARDL) Model 415

Long-Run Dynamic Model 417

Findings and Historical Conditions 418

Conclusion 421

Notes 421

References 421

CHAPTER 23 Bank Lending Channel and Islamic Banks 423

Introduction 423

Underlying Conditions and Assumptions 424

Econometrics Analysis 425

Findings from Econometrics Analysis 430

Conclusion 431

Note 432

References 432

CHAPTER 24 Islamic Gracious Monetary Instruments: A Theoretical Approach 433

Introduction 433

General Assumptions 434

The Islamic Gracious Monetary Instruments 436

Utility of the Islamic Gracious Monetary Instruments 448

Conclusion 450

References 451

CHAPTER 25 Assessing Gold Murabahah in Islamic Banking 453

Introduction 453

Underlying Finance Theory 454

Analysis of Gold Murabahah Financing in Islamic Banking 457

Regulating Gold Murabahah 465

Conclusion 466

References 466

CHAPTER 26 Simulation-Based Stress Testing 467

Introduction 467

Stress-Testing Guidance 467

Stress-Testing Simulations and Findings 471

Conclusion 480

References 482

CHAPTER 27 Does the Return on Islamic Deposits Mimic the Interest Rate? 483

Introduction 483

Performance of Islamic Deposit Return 484

Literature Review 486

Research Framework 490

Results of Applying Ayuda Neurointelligence 490

Interpretations of the Results 497

Conclusion 497

References 498

About the Author 501

Index 503