Impact of dual banking system liquidity creation on economic activity

Following the recent global financial crisis, Islamic banks (IBs) have grown rapidly and are found to create more liquidity for the economy relative to their conventional counterparts. Nonetheless, the significance of their impact on real economic output relative to pure conventional banks (PCBs) has not been examined empirically. The aim of this study therefore is to investigate the liquidity creation impact of full-fledged Islamic banks (FIBs) and PCBs on real economic output. We examine 12 Muslim-majority countries over a period of 13 years from 2010 to 2022. We employ both the feasible generalized least square (FGLS) and panel-correlated standard errors models. Our findings show that both FIBs and PCBs liquidity creation per capita have a statistically significant positive impact on real economic output. Notably, FIBs have a marginally higher impact than PCBs. In terms of bank size, our findings show that only large FIBs and PCBs have positive impacts on real output. These findings are robust for both types of banking systems’ on- and off-balance sheets liquidity creation components and subsamples including countries where IBs are systematically important. Finally, our findings also indicate a positive bidirectional causality between the liquidity creation of FIBs and real output but a reverse unidirectional causality between PCBs’ liquidity creation and real output. Our results imply that policymakers should maintain a clear differentiation between the business models of FIBs and PCBs and act to enhance their liquidity creation to spur real economic output.