CONCLUSIONES Y RECOMENDACIONES

Commercial and industrial loans, Consumer price index, Unemployment rate, Duration of

unemployment, Labour cost per unit, Prime rate and others

LEADING INDICATORS Money supply, Interest rate, Stock prices, Consumer expectation, New consumer goods order,

New orders for plant and equipment and others BUSINESS CYCLE COINCIDENT INDICATORS Industrial production, Economy expects employment, Personal income, Sales rise and others.

During an economic upswing and rising incomes, it indicates improving conditions for firms and reduces the likelihood of loan defaults. The interest-based banks are expected to reflect this feature of their decisions on lowering the contingency reserve and provision for bad and doubtful financing during an economic boom for the reasons of profit driven enthusiasm. Whilst during recession with a downturn of economic activities and decreasing incomes the opposite behaviour of loan defaults will begin to exist. The interest-based banks tend to increase them during a downturn for over pessimism.

For the Islamic bank, on the other hand, it is important to them to adhere to the Quran’s instruction (12:46-49), that is, by increasing them during an economic boom for institutional safety. During economic downturns, the provision for contingency reserve and provision for bad and doubtful financing will be reduced for the reasons of societal benefits (maslahah ummah) by increasing the amount of financing to improve the economic condition.

The Islamic banks should provide sufficient contingency reserve and provision for bad and doubtful financing when the economy is growing as shown by a high growth rate of real gross domestic product and high financing growth rate. Failing to do so, when the economic conditions reverse, the loan losses will begin to emerge, profitability decreases and credit supply tend to decrease. This will force the Islamic banks to increase their contingency reserve and provision for bad and doubtful financing thus amplifying the effects of the recession.

Alternatively, the Islamic banks should spend the contingency reserve and provision for bad and doubtful financing during an economic downturn. During the economic

downturn, refuse to spend will worsen the economic environment and at the end will affect the Islamic banks’ performance in the long term.

During an economic upswing, abiding by the Quran’s instruction (Chapter Yusuf, 12:46-49), an increase in the provision for contingency reserve and provision for bad and doubtful financing will directly decrease banks’ earning assets. Decreases in bank’s earning assets will directly reduce the banks’ excess funds that can be offered to the financial market. This will directly weaken the growth rate of bank financing operations and subsequently making it to behave counter-cyclically.

In the event of economic downswing, the reversal behaviour will take place to mellow down the business cycle swing. The excess of contingency reserve and provision for bad and doubtful financing during prosperous economic condition will be utilised in this period by delivering more credit opportunity into the financing market. By reducing the volume of contingency reserve and provision for bad and doubtful financing during an economic downswing, the banks’ earning assets will directly increase. Increases in bank’s earning assets will directly increase the banks’ excess funds that can be offered to the financial market. This will directly strengthen the growth rate of bank investment and financing operations and subsequently making it to behave counter-cyclically.

Another unique characteristic in the Islamic bank financing operation is the existence of the zakat instruments. With the role of zakat as the automatic investment motivator mechanism, the holding of liquid assets will be at a minimum safety level. In order to avoid the depletion of the liquid assets value of the economic downswing because of the zakat obligation this will force the Islamic bank to look for new investment opportunities for returns at the least equals to the zakat rate.

The Islamic bank financing quality effect on its operations mentioned above could be observed and examine through the movement in the Islamic bank balance sheet. The bank’s balance sheet records the flows of funds of people who have an excess of funds to the borrowers that are short of funds. The Islamic bank management on its contingency reserve and provision for loan losses is visualised and can be analysed from the movement in the banks’ balance sheet as shown in Figure 4.5 below.

Figure 4.5: Islamic Bank Financing Framework

4.2.3 Islamic Bank Assets Management and Bank’s Counter-cyclical Behaviour

Regardless of types of banking systems practiced by the economy, it is irrefutable the bank’s financing or lending volume is increasing during the period of strong economic growth and decreasing during the periods of weak economic growth. Clearly, the investment spending by the private sectors will increase from high growing of household consumption spending during strong economic growth.

1. Interest-free financing 2. Obedient to Allah

instruction on contingency reserve and provision for loan losses policy.

3. Non-speculative trading, unambiguous financial

transaction and avoiding financial risk transaction 4. Ethical investments and consumption financing 5. Asset backed financial transaction

Equity-Based Financing

Deposits Banks Financing

Balance Sheet

Household

Trade-Based Financing Firms

During weak economic growth the opposite reaction will occur, a drop in private investment activities will follow a decrease in households consumption spending. If the Islamic bank adheres to Allah’s (swt) instruction related to the buffer management during the upswing and downswing of economic activities as stated in the Quran (Chapter Yusuf (12):46-49) it will be able to behave counter-cyclically to the economic cycle.

Diagrammatically Figure 4.6 below shows the process of counter-cyclical behaviour of the Islamic bank operation.

Figure 4.6: Conceptual Framework of The Islamic Bank Financing Counter-cyclical Behaviour

4.2.4 Conceptual Framework of Bank Cyclical Behaviour

Conceptually, the business cycle phenomena will affect the behaviour of economic agents from both sides namely the depositors and borrowers. The changes in the behaviour are detectable by the changes in the banks’ balance sheet. Figure 4.7 below

Increase in Contingency Reserve and Provision for loan losses growth Diminishing growth of Commercial and Industrial Financing Earning Assets Decrease Increasing growth of Commercial and Industrial Financing Decrease in Contingency Reserve, and Provision for loan losses growth Earning Assets Increase Increasing Consumption Spending Counter- cyclical Financing Behaviour Increasing Investment Spending Decreasing Consumption Spending Decreasing Investment Spending Expanding Economic Contracting Economic

shows how the changing behaviour of the main economic agents is caused by the fluctuations in the macroeconomic activities. Changes in the banks’ balance sheet reflect the changes of all the economic agents’ behaviour. Those changes of behaviour will be visualised through the changes of both the banks’ assets and liabilities statement.

Figure 4.7: Business Cycle Influence on The Economic Units

4.3 Research Design

The following section of the chapter explained the research framework and analytical model. The model developed here will examine the cyclicality behaviour of the Islamic bank financing and factors that contribute to that cyclicality behaviour. To determine the cyclicality behaviour of the Islamic bank financing at the bank level the study begins with defining the variables at the basis supply function of financing. Then the study resolves the problem of endogenous variables and lastly the study identifies the Islamic bank financing cyclicality behaviour at the bank level.

Firms Households Deposit Banks Balance Sheet Financing Households Firms BUSINESS CYCLE IMPACT

MAJOR INDICATORS OF BANK’S CYCLICALITY BEHAVIOUR