Berita

Yogyakarta—Doctoral dissertation entitled “The Effect of Fractional Reserve Banking and Financial Variables on Banking Performance and Soundness in Indonesia” has successfully been defended in front of the examiners by Dr. Ayif Fathurrahman, SE., SEI., M.Si. on Monday (8/1). “The major motivation of this dissertation is to examine the existing system, namely fractional reserve banking, which has been and will always be adopted by Islamic banking since it appears to lack what we can call “an Islamic system” to be implemented in Islamic banks”, said Dr. Ayif when interviewed on Wednesday (10/1).

He emphasized that Islamic banking (IB), basically and historically, does not have a purely theoretical foundation in running banking system rested on Islamic principle. In such unfavorable condition, Islamic banking therefore sought to look over the adequate system to be applied and subsequently the fractional reserve banking that has been established system for years and widely adopted by conventional system was chosen. Nonetheless, such a fractional system, along with the interest system, proves vulnerable to the financial crisis as several decades have witnessed the looming economic crisis erupted repeatedly from mainstream banking system.

The Heated Debate on Fractional Reserve Banking (FRB)

 “As a deleterious consequence, the implementation of this (fractional reserve banking) system in Islamic banking system which is still new made an imperfect system which appears utterly unable to absorb the shocks and hence the Islamic banking system will probably be facing instability and in an acutely vulnerable position. The adverse effects of fractional reserve banking has been explicated by many economists encompassing every school of Economics from Austrian economists, Positive money—the movement initiated by the young British who strongly criticized the established concept of banking which brought about the instability in the system, Chicago school which proposed an alternative concept known as Neuro-banking system, Limited purpose banking, to New Economic Foundation”, he explained the development of several economics school proposing fractional free banking system.  

He also added, saying: “Islamic banking which has been widely believed to be an alternative system which can promote the financial stability is in fact adopting the similar system as conventional that may in turn lead to a severe crisis. From this point of view, many might argue that the primary factor of instability is merely riba, yet it seems complete when Riba and financial intermediary (fractional reserve system) are mutually reinforcing.”

Regarding to the implementation of FRB, Dr. Ayif stated that numerous prominent scholars in the field of Islamic economics Nejatullah Siddiqi and Umer Chapra among others have strongly recommended for Islamic banks not to adopt the fractional reserve system. However, in actual fact the vast majority of Islamic banks across the globe, from Gulf Cooperation Council (GCC) countries to Indonesia, are still applying this system to Islamic banks.

“Those aforementioned facts and studies have motivated me to carry out a thorough research in my Doctoral Dissertation on this issue, as there might be a growing literature discussing the detrimental impact of fractional reserve banking, further study on this issue is required to investigate empirically its effect since the previous studies have focused merely on normative and theoretical standpoint, “said Dr. Ayif.

The adverse effect of FRB on Islamic Bank Performance and Soundness

After conducting extensive research, he reveals that, because I constructed two different models namely IB performance model and IB soundness model to be assessed, there are two variables of fractional reserve banking that impact negatively on the both Islamic bank’s performance and soundness, those are reserve ratio which stands for the minimum amount of cash required by Central Bank to be held by all banks including Islamic banks and Fiduciary ratio as proxy of securities that have not been backed up by the liquid money. While another variable, that is short term liability, has positively affected the performance of Islamic banks. It indicates that Islamic banking relied heavily on short term financing yet it has long term financing which spans from 5 years until 10 years in the form mudharabah contract or musyarakah.

This fact can be a reasonable argument that Islamic banks have been and will always be dealing with a serious liquidity problem, namely: mismatch maturity. More importantly, he argued that in the normal time fractional reserve banking is still able to exacerbate the Islamic banks condition. If the crisis looms in the future IB may likely to suffer acute crisis so it can be said that Islamic banks might become the “main locomotive” of financial crisis.

Furthermore, he said: “I examine the soundness of Islamic banks model by using financing-to-deposit ratio and funding gap, as the proxy variable, in two different models. The result reveals again the negative effect of FRB on the soundness of IB as the FDR tended to rise on the one hand and there is decreasing trend in funding gap on the other hand.”

Finally, it can be concluded that since Islamic banking is implementing the fractional reserve banking system, IB will always cope with mismatch maturity and has a high operation cost. Meanwhile its conventional counterpart may operate efficiently when adopting FRB because of interest system applied which is able to shield conventional banks from the asymmetric information and to provide efficient services to its customers, hence the cost can certainly be reduced. At the end, he strongly recommended Financial Service Authority to control tightly the reserve requirement and urged Dewan Syariah Nasional to reexamine critically whether it is maslahah for IB to adopt FRB. [Aw]