Qualitative Research in Financial Markets

An assessment of liquidity policies with respect to Islamic and conventional banks: A

case study of Indonesia
Raditya Sukmana Muhammad Kholid
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Raditya Sukmana Muhammad Kholid, (2013),"An assessment of liquidity policies with respect to Islamic
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QRFM
5,2 An assessment of liquidity
policies with respect to Islamic
and conventional banks
126
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A case study of Indonesia

Received 14 September 2011
Revised 4 February 2012
10 April 2012
Accepted 23 April 2012
Raditya Sukmana
Department of Islamic Economics, Faculty of Economics, Airlangga University,
Surabaya, Indonesia, and
Muhammad Kholid
Islamic Economic Forum for Indonesian Development (ISEFID),
Jakarta, Indonesia

Abstract
Purpose – This paper aims to describe, compare and analyze liquidity policies from the central bank
of Indonesia, particularly reserve requirements, with respect to Islamic as well as conventional banks.
Design/methodology/approach – This paper provides some critical assessments on the policy
applied by the central bank of Indonesia to both Islamic and conventional banks with regards to the
reserve requirements applied in the Indonesian banking system. The analysis is based on whether
both policies (Islamic and conventional) provide fairness to the banks as well as whether those policies
support the real sector. In addition, the current global practice is also briefly described as a
justification of the important and relevance of the current study.
Findings – The authors find that the policy imposed on the Islamic banks is designed to boost the real
sector, compared to that of conventional banks. For the policy with respect to Islamic banks, it recognizes
the banks which have been doing well in their main role as financial intermediaries and “punishes” them
when they fail to do so. This policy could not be found in the context of conventional banks.
Practical implications – The authors argue that the current approach used for Islamic banks can
also be adopted and imposed on conventional banks. This leads to a more stable financial system,
since it supports the real sector.
Originality/value – This paper is the first to analyze central bank policies with respect to banks
(Islamic as well as conventional banks) in relation to their role as financial intermediaries.
Keywords Reserve requirement, Islamic bank, Financing to deposit ratio, Loan to deposit ratio,
Real sector economy, Reserves, Islam, Banks, Indonesia
Paper type Case study

1. Introduction
The Central Bank of Indonesia (BI) imposes two different liquidity policies on Islamic
banks and conventional banks. The liquidity policy in question from the central bank is
the Giro Wajib Minimum (GWM) or minimum reserve requirement (MRR), which is
Qualitative Research in Financial central to this paper. The central bank takes a different approach to determining
Markets MRR for each banking system, due to the different characteristics of Islamic and
Vol. 5 No. 2, 2013
pp. 126-138
q Emerald Group Publishing Limited
1755-4179
JEL classification – E52, E58
DOI 10.1108/QRFM-09-2011-0023 The authors thank Dr Brian Bloch for his accurate and articulate translation of the manuscript.
 conventional banking. BI determines MRR for Islamic banks, based on the financing to Assessment of
deposit ratio (FDR), a loan to deposit ratio (LDR) equivalent for conventional banks. liquidity policies
The central bank imposes a lower MRR for Islamic banks that have a high FDR, than for
those with a low FDR. On the other hand, BI determines MRR for conventional banks
based on the amount of deposits. The MRR rate apply is progressive, with higher
deposits requiring a higher rate of deposit funds being placed as MRR with the
central bank. 127
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This paper argues that MRR based on FDR is fair to Islamic banks, as it encourages
them to channel funds from saving surplus units (SSU) to saving deficit units (SDU).
Hence, it also helps Islamic banks to achieve one of their main objectives, which is to
promote growth of the real economy. It is also argued that this approach could help set the
banking system restore its original function as a financial intermediary, thus reducing
systemic vulnerability. This approach is relevant in the global context since the banking
industry worldwide theoretically sees MRR as a “tax” that limits its loanable funds and
thus limits its capital efficiency. Hence, the monetary policy that constructively aligns
MRR levels and LDRs is expected to be effective since it will benefit the bank to channel its
loanable funds to the real sector in order to achieve lower levels of MRR. The discussion
reveals that the MRR determination approach for Islamic banks is equally fair and
appropriate for conventional banks. The discussion begins with an introduction, to
provide background for the paper. Section 2 contains a theoretical framework dealing
mainly with reserve requirements and the financing/lending to deposit ratio. Section 3
considers the reserve requirement policy imposed by the Central Bank of Indonesia (BI) on
both Islamic and conventional banks. Section 4 is the heart of the discussion, in which we
evaluate the reserve requirements presented above. Moreover, this paper argues that the
adopting the appropriate policy in this context could restore the banking system to its
original function as a financial intermediary. This will not only promote the real economy,
but also protect the financial system from imprudent and irresponsible practices that
destabilize financial sector and have caused the current financial crisis. Section 5 then
discusses in brief how the policy is relevant to the global context. This paper ends with
some conclusions, including setting out the limitations of this paper.

2. Theoretical frameworks
2.1 Reserve requirement ratio changes and perceived bank safety
Traditional discussions of reserve requirements frequently characterize these regulations
as providing liquidity for financial institutions, as they deal with depositors who wish to
withdraw funds from their accounts. This characterization can be misleading. Bank
reserves have traditionally been considered a source of liquidity for banks that allows
them to meet the withdrawal needs of their customers and reduce their overall default risk.
This perception may be true in the case of excess reserves, but is false where required
reserves are concerned. Required reserves do not provide any substantive liquidity,
because banks are required to replenish them prior to the end of a two-week maintenance
period, if they are depleted below the required level (Hein and Steward, 2002, p. 46).
Furthermore, if banks fail to maintain the reserve requirement, the central bank may
impose a penalty (O’Brian, 2007, p. 13). A study conducted by Yueh-Yun and C. O’Brian on
reserve requirements in OECD countries, shows that in order to discipline the market, all
OECD countries with a reserve requirement scheme impose penalties on failure to comply.
The majority assess penalties on the shortfalls of required reserves at a rate well above
 QRFM the country’s money market or lending rates. Some countries require depository
5,2 institutions with deficient reserves to hold interest-free deposits.
From the above explanation, we can see that required reserves are more
appropriately thought of as a liability to the institutions holding them, rather than an
asset. However, contrary to the conventional wisdom, increasing reserve requirements
may ultimately increase the risk of financial institution failure. As Alan Greenspan has
128 stated, increased reserve requirements are likely to reduce the profitability of banks by
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raising the proportion of nonearning assets they must hold. Moreover, increased reserve
requirements reduce financial institutions’ true liquidity and correspondingly increase
the total cost of short-term funds, again leading to a reduction in bank profitability. Also,
with a given dividend payout policy for the bank, reduced profitability means that
additions to equity capital will be lower and banks will not be as well capitalized as they
would otherwise have been (Hein and Steward, 2002, p. 46).

2.2 Lending or financing to deposit ratio

Dividing the banks total loans by its total deposits yields a commonly used statistic for
assessing a bank’s liquidity. This number is also known as the LDR or FDR, as the
LDR equivalent for Islamic banks. LTD is expressed as a percentage. If the ratio is too
high, it means that banks might not have enough liquidity to cover unforeseen fund
requirements; if the ratio is too low, banks may not be earning as much as possible.
This seems to contradict the current practice of Islamic banks that treat deposit funds
like conventional banks, where customers have the right to demand their money at any
time, since deposits under conventional systems are seen as a liability or a loan from
customer to bank. With this perspective, it is true that Islamic banking should also
manage its liquidity like its conventional counterpart. Therefore, high a FDR would also
increase Islamic bank liquidity risk. However, theoretically, we should take into account
that Islamic banking deposits are divided into two groups, one is under wadiah contract
(safe keeping) and the other is under mudharabah contract (profit sharing investment).
The former are exactly the same as conventional deposits, where customers can demand
their deposits at any time, but the latter is not the case. Theoretically, mudharabah
customers may demand their deposit, but, because the constitute an investment deposit,
the funds are subject to the conditions applying to such deposits. Mudharabah deposits
are locked in for a certain period of time to fund financing, where the deposit return based
on profit sharing is contingent on the investment result. As it is locked in for a specific
period of time, it would ease Islamic banking if were possible to manage liquidity, thus
enable the banks to maintain their FDR level on one hand and to achieve its objective to
support the real sector on the other hand. Furthermore, mudharabah deposits provide
returns in the form of profit sharing, while wadiah deposits do not provide returns.
Should Islamic banks provide remuneration for wadiah deposits, it is on a
non-contractual basis and solely at the bank’s discretion. Remuneration for wadiah
deposits, if any, are usually far below the remuneration for mudharabah deposits.

3. Reserve requirement policies of the Central Bank of Indonesia for

conventional and Islamic banks
3.1 Reserve requirement for conventional banks
The Bank of Indonesia has introduced a policy specifying a calculation for the GWM
Rupiah or MRR for conventional banks as part of the policies to increase monetary
 stability, which can effectively support economic development in Indonesia. The central Assessment of
bank decision to increase the MRR is to reduce liquidity in the money market, which can liquidity policies
be done effectively through banking channels. With this new policy, the MRR for
conventional banks is based on the deposit levels of the banks. As shown in Table I, the
percentage of MRR is divided into four tiers, in which the larger the deposit, the larger
the amount of MRR. Nevertheless, in order to avoid a potential increase in the lending
rate as a result of an increase in the cost of funds (due to a decrease in loanable funds), the 129
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central bank provides remuneration for every 3 percent incremental increase in MRR.

3.2 Reserve requirements for Islamic banks

As part of the national banking industry, Islamic banking is also required to support
the above mentioned monetary policy of the central bank. However, since Islamic
banking operations and characteristics are different from those of the conventional,
monetary policy should be adjusted so that it can be implemented appropriately to
Islamic banking. Islamic banking portfolios prefer traditional banking, since they do
not engage in derivative products, which do not conform to Islamic principles.
Any policy pertaining to Islamic banking should be based on sharia principles.
There are three sharia perspectives in relation to increases in MRR:
(1) The Central bank of Indonesia plays a central role as the monetary authority
controlling the money supply. This role has precedent in the Islamic history of
Baitul Maal (Wealth Agency of Islamic Khalifah/Kingdom). The role complies
with the sharia principle of “Tasharruful Imam manuuthun bil maslahah”, that
monetary authority is needed to safeguard the public welfare.
(2) Decisions made by the Bank of Indonesia to increase MRR levels comply with
sharia principles, since the objective is to safeguard monetary stability and the
money supply.
(3) Nevertheless, there is an issue, if the central bank provides remuneration to an
incremental MRR as in conventional banking. Under Islamic principles, any
rewards should have an equivalent counter value (iwad), otherwise it would be
categorized as interest (riba) which is prohibited. Hence, MRR for Islamic banking
bears no return, in order to avoid the prohibited earning and paying of interest.
Unless central bank sets a program to achieve certain monetary objective through
involving Islamic banks, the central banks may use sharia contract of Juala, an
agreement that one party promise to give other party a renumeration if the specific
task is done/objective is achieved by the latter for the former, to use Islamic banks
as its vehicle to achieve the monetary objective. Under Juala contract, central bank
may give renumeration to Islamic banks if the central bank achieve its objective.

Deposit amount New % MRR Previous MRR (%) Remuneration rate

$Rp 50 trillion 8 3 3% of the incremental MRR

Rp 10-50 trillion 7 2 3% of the incremental MRR
Rp 1-10 trillion 6 1 3% of the incremental MRR
, Rp 1 trillion 5 1 No remuneration
Sources: Islamic Banking Development Report Year 2004; Islamic Banking Directorate; Central Bank Table I.
of Indonesia, 2004 MRR conventional bank
 QRFM Based on these considerations, the Central Bank of Indonesia uses FDR to determine
5,2 the MRR for Islamic banks as shown in Table II.

4. Critical evaluation of the reserve requirement policy of Central Bank of

Indonesia
4.1 Islamic banking real sector role and its reserve requirement policy
130
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First, we consider a fundamental concept. The underlying concept and role of money is
crucial to any financial system. Hence, it is also important to discuss this here, in view
of the Islamic banking role in the real sector and in the context of suitable policy
concerning reserve requirements for Islamic banking. Under Islamic finance principles,
money is primarily, even exclusively a measure of value, a means of exchange and
standard for deferred payment. As distinct from the ethos of Western economics and
conventional banking, however, money is not regarded as a commodity in itself, to be
bought, sold and used to beget more money (Ahmad, 2000, p. 65). As a logical
consequence, in an Islamic framework and thus Islamic banking, money has to operate
through some real economic activities or services. From this perspective, it is evident
that Islamic banking always deals with the real sector economy, which is one of the
salient characteristics of Islamic banking.
It is clear that Islamic banking is to engage only in real economic activity that
fosters real sector development. In this regard, Islamic banking’s main role is to
channel funds from SSUs to SDUs in the economy, so that financing for the real sector
is available and economic development can take place. This seems like classic banking,
as conventional banking also does the same things. However, the fundament is
different, in which Islamic banking specifies this role as one of its objectives, while
conventional banking is not. Islamic banking prohibits interest, speculation and debt
trading, focusing only on supporting the real sector, while conventional banking
permits the other activities, so long it provides a short-term benefit, even though not a
sustainable one, and even if the benefits do not accrue to society as a whole. In other
words, it is not necessary for conventional banks to finance the real sector, if other
investment opportunities (e.g. investment in securities or derivatives) offer seemingly
better opportunities. Interestingly, precisely these non-real transactions, coupled with
irresponsible banking practice and the detachment of baking from its main functions
as a financial intermediary constituted the source of the recent financial crisis.
Islamic finance and thus Islamic banking proved resilient during subprime mortgage
crisis, because of its inextricable link with the real sector. This contrasts with its
conventional counterpart that has periodically experienced crises. Islamic finance is

FDR Islamic
bank (%) MRR Remark

$ 80 5% MRR rate of 5% apply to any amount of deposit collected by

bank
, 80 MRR for conventional MRR rate is tied up with the amount of deposit collected by
banking bank. MRR of Islamic banking does not pay interest
Table II. Sources: Islamic Banking Development Report Year 2004; Islamic Banking Directorate; Central Bank
MRR of Islamic banks of Indonesia, 2004
 considered as a stable financial system capable of promoting sustained growth of income Assessment of
and employment. Islamic finance establishes a one-to-one mapping of the financial and liquidity policies
real sectors of the economy and prohibits interest, speculation and debt trading. That is, it
is based exclusively on real trade and productive activities. The financial sector cannot
expand beyond the real economy, and is immune to unbacked credit expansion and
speculation that are characteristics of conventional finance, that have destabilized even
the most sophisticated and complex financial systems (Mirakhor, 2009). 131
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The above discussion clearly demonstrates that Islamic banking is a catalyst for real
sector development. The intermediary role of channeling deposit funds to finance real
sector activities is fundamental. It can be seen in the graph below, which compares the
LDR of conventional banking and FDR of Islamic banking in Indonesia from 2003 to
2009. We can see that the average FDR of Islamic banking is around 90 percent, while the
LDR of conventional banking for the same period is only around 60 percent. This implies
that deposits in Islamic banking are indeed mostly channeled into financing, with little
latitude for non-real-sector investment. On the other hand, deposits in conventional
banking reveal only around 60 percent being used for advancing loans and a substantial
amount of deposits is used for purely capital market activities including derivative
transactions, which is of course not prohibited in conventional banking. Since most of
the deposits of Islamic banks are channeled into productive financing, therefore, the
critical measure of Islamic banking performance in terms of its intermediary role and
liquidity is the FDR. In this regard, the FDR level shows the achievements of Islamic
banks in fulfilling their objective as a financial intermediary (Figure 1).
In view of the above discussion, the Central Bank of Indonesia has developed a
special approach to determining the MRR for Islamic banking. The central bank
determines the MRR of Islamic banks, based on their FDR. This approach is suitable
for Islamic banks, since the focus of Islamic banking is more on real sector financing
and less on non-real-sector investment. Furthermore, because of Islamic banking
characteristics, less non-real-sector investment activity is also due to the limited
availability of sharia-compliant investment. Hence, the FDR of Islamic banks is more

Figure 1.
LDR & FDR of Banks
Source: Conventional and Islamic Banking Statistics Report,
in Indonesia
Central Bank of Indonesia
 QRFM relevant to describing bank liquidity conditions than holdings of securities or other
5,2 liquid assets. By contrast, conventional banks use a significant portion of their deposits
to invest in securities or other liquid assets, so that using LDR as an approach to
describing conventional bank liquidity would be potentially misleading.
A high FDR level and likewise a high LDR level are associated with high liquidity risk.
High FDR means that only a small portion deposits are cash and other liquid assets
132 available to meet customer withdrawal. On the other hand, Islamic banking has the
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objective of fostering real sector and limited sharia-compliant capital market investment
instruments, which ultimately leads to relatively high FDR in Islamic banks, compared to
LDR in conventional banks. Hence, applying the reserve requirements of conventional
banks, that is, based on reservable deposit levels, is not fair or appropriate for Islamic
banks. This is because Islamic banks face two constraints in maintaining liquidity. First,
increases in deposits will be followed by increases in financing, so as to maintain high
levels of FDR. Therefore, charging reserve requirements based on Islamic bank deposits
will burden the bank. Second, there are limited funds in liquid instruments; therefore to tie
up the deposit fund in MRR, based on the amount of bank deposits, would burden Islamic
banks. Furthermore, if the bank deposits are channeled into real sector financing, and on
the other hand, the central bank imposes reserve requirements based on the level of bank
deposits, this will simply slow down real sector growth, which is not good for economy. By
contrast, conventional banks use a significant portion of their deposited funds for non-real
sector activities, such as investment in securities or derivatives. Given this scenario, the
central bank needs to impose reserve requirements based on amount of bank deposits to
control the expansion of non-real-sector activities, which can be toxic for economy if too
excessive.

4.2 Critical evaluation of the reserve requirement policy for conventional banking
As mentioned above, the Central Bank of Indonesia has applied a differential policy for
the reserve requirements of conventional and Islamic banks. For the conventional
banks, the MRR is based solely on the amount of deposited funds. This ratio is
progressive, meaning that banks with more deposited funds will be charged a higher
ratio than those which have lower levels of deposited funds. For a bank which has a
collected deposit of Rp 1 trillion, the reserve ratio is 5 percent. However, for a bank with
more than Rp 50 trillion, its reserve ratio increases to 8 percent.
For the policy with respect to Islamic banks, the central bank has taken into account
the philosophical concept of Islamic banking, which is to develop the economy through
the real sector through its reserve requirement policy. Unlike the policy for
conventional banks, which is based on the amount of deposited funds, the reserve ratio
for Islamic banks uses the financing deposit ratio (FDR) as the basis for determining
the reserve requirement. As indicated, for Islamic banks, the higher ratio of FDR is
more preferable as it fulfils the core objective of Islamic banks to grow the real sector.
Hence, the policy imposed by the Central Bank of Indonesia on Islamic banks which
perform with a high FDR (i.e. FDR $ 80 percent) are required to hold lower reserves.
Conversely, Islamic banks which have a moderate or low FDR (i.e. FDR , 80 percent)
are required to obtain more reserves.
This policy is formulated on the basis of fairness and appreciation of the banking role
as a financial intermediary institution to generate real sector economic activity. Hence,
the banks which have a high FDR should be most highly regarded, since they have been
 able to fulfil their designated role of supporting the real sector. The appreciation of the Assessment of
central bank takes the form of a lower reserve requirement. We believe that this policy is liquidity policies
fair and appropriate not only for Islamic banks, but also for conventional ones, as the real
rationale for existence of the two is their role as financial intermediaries.
The reserve ratio policy for conventional banks, we believe, is less supporting to the
development of real economy than that of Islamic banks. For conventional banks, the
reserve requirement is determined solely from the amount of deposited funds. This 133
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means that banks which are able to mobilize large deposits have to lodge a large portion
of the deposit with the central bank as a reserve fund. This discourages conventional
banks, as increases non-income-earning funds, or, if the central bank provides
remuneration in the form of interest the earnings from the reserve fund will be lower than
that obtained from loans or investments in securities. On the other hand, the reserve
requirement for Islamic banks is based on the bank’s FDR. Hence, Islamic banks are
motivated to mobilize more deposits, as this entails lower reserve requirements, if they
able to achieve a certain level of FDR, or a higher reserve requirement as a “punishment”
by the central bank, if they fail to achieve a certain level of FDR (low FDR).
Another positive aspect of the policy for Islamic banks is that, setting the FDR as
the parameter for determining the reserve requirement, encourages Islamic banks to
channel deposits into the real sector. In other words, this policy has encouraged banks
to play their basic and intended role as financial intermediary. As for the policy for
conventional banks, which is not based on the LDR to determine the reserve
requirement, there is therefore no equivalent motivation to banks. Indeed, conventional
banks may use excess reserves to buy securities and other non-real sector activities. If
this is the case, conventional banks fail to function as financial intermediary that
ultimately generate real economic activity.

4.3 Adoption of reserve requirement based on LDR to promote a stable banking system
There are fears that the subprime mortgage crisis may have exposed the world economy
to a long period of economic slowdown. There are, therefore, calls for a new architecture
that would minimize the frequency and severity of such crises in the future. The
generally recognized main cause of almost all crises has been excessive and imprudent
lending by banks over an extended period, coupled with excessively leveraged, non-real
sector activity, such as derivatives that tend to constitute mere speculation than
investment. Some of those points are clearly acknowledged by the Bank for International
Settlements (BIS), which states as much in its annual report (released on 30 June 2008).
This raises the question of what enables banks to resort to such unhealthy practices,
which not only destabilize the financial system, but is also not in their own long-term
interest. There are three key factors. The first is inadequate market discipline in the
financial system, resulting from the absence of profit-and-loss sharing (PLS). The second
is the truly mind-boggling expansion of derivatives, particularly credit default swaps
(CDSs), and the third is the “too big to fail” concept, which tends to provide an assurance to
large banks that the central bank will definitely come to their rescue and not allow them to
fail (Chapra, 2008, p. 8).
With regard to the three above factors, we focus on the second – the explosive
expansion in derivatives and speculative investment. These are all non-real-sector
activities that have nothing to do with the financial intermediary role of banks.
Banking practice has moved beyond its original role and objective as a financial
 QRFM intermediary to engage in and promote real sector activity. In response to such
5,2 practice, the introduction of LDR as the basis for reserve requirements of conventional
banks surely represents one of the viable measures to encourage the banking system to
return to its original function as a financial intermediary. Banks will pursue high LDR
since they can get incentive on the MRR side and thus increase loanable funds which in
turn generate more revenues.
134 The existing reserve requirement policy, as applied by all monetary authorities around
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the world, does not seem to connect the liquidity measure with safeguarding the function
of the banking system, so as to ensure that it concentrates on its intermediary role. Our
proposal is to apply the reserve requirement policy of Islamic banking – as practiced by
the central bank of Indonesia – which bases the reserve requirement on the financing/LDR
in the conventional banking system. We argue that the policy would bring about a more
stable banking system, by motivating a return to its original function and objective. The
scenario will surely work, because the basic concept of the policy is to provide rewards in
the form of lower reserve requirements for banks that perform well in channeling funds to
debtors. In other words, banks which perform effectively as financial intermediaries, as
indicated by their LDR level, receive incentives in the form of lower reserve requirement,
thus leaving banks with more income-earning deposits. This policy ensures that banks
remain focussed on their financial intermediary role, which not only optimizes economic
growth, but also shields the financial system from imprudent and irresponsible practices
that damage the economy and destabilize the financial system.

5. Relevance to the global context

Theoretically, the reserve requirement is a monetary instrument applied by the central
bank to control money supply. It is used to manage the bank’s liquidity as well as to
manage the economic objectives of the financial intermediaries, i.e. economic growth.
However, from the banks’ perspectives, this instrument acts as a tax which is
burdensome due to the limit imposed on (profit-generating) loanable funds. In other
words, increases in the required reserve will reduce each individual bank’s efficiency
and thus reduce the competitiveness of the banking industry as a whole. From an
economic perspective, increases in reserve requirements lead to increases in the lending
rate and lead the business to resort to cheaper sources of funds such as the capital
market. Conversely, decreases in the required reserve allow the banks to have more
loanable funds which brings a cheaper rate of lending. From this theoretical
perspective, it is clear that when central banks decide upon lower levels of required
reserves, they are effectively aiming to generate more lending and eventually increase
economic growth.
This theory empirically exists at the practical level. Increases in reserve
requirements have led to the deterioration of economic growth. In 1930s, the reserve
requirement was increased in the USA in August 1936, January 1937, and May 1937
(Mishkin, 2006), which resulted in slow money growth. In 1937-1938 recessions
occurred. We argue that if the reserve requirement had increased it might have eased
the situation at that time.
This shows that the reserve requirement is a vital instrument for the central bank in
managing the economy. However, currently this instrument is less effective in managing
monetary policy due to a lack of alignment between the monetary objective of central
banks and the economic objective of the banking industry on the one hand, and the
 sophistication of the money market in the current system on the other. As a result, cuts in Assessment of
reserve requirements aimed at increasing bank’s loanable funds and, in turn, economic liquidity policies
growth is not assured to work. Banks might put the funds in money market instruments
instead of channeling them to the real economy. Therefore, monetary policy operated
through reserve requirements might not be effective if there is a lack of alignment
between the monetary objective of the central bank and the economic objective of the
banking industry. 135
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Considering the condition above, the issue therefore relates to how monetary policy
through reserve requirement management can constructively align the competing
objectives. In this context, the objective of the central bank is to achieve the monetary
conditions that can drive the economy in a certain, preferable, direction. For instance,
an increase in reserve requirements aims to reduce money supply and thus slow down
economic growth. Alternatively, a decrease in reserve requirements aims to increase
money supply and thus expand economic growth. The economic objective of the
banking industry is to maximize its capacity to render loan, hence, the higher the
reserve requirement the lower the efficiency in the banking industry.
Central banks can set monetary policy that constructively align the above two
objectives. To do so, monetary policy should connect the parameter in the reserve
requirement with that in the bank’s LDR. The policy incentives banks with high
LDRs with lower reserve requirements, and conversely, it penalizes bank with low
LDRs with higher reserve requirements. A central bank could therefore set low reserve
requirements to increase money supply and economic growth and vice-versa. On the
other hand, banks will always pursue lower reserve requirements to meet economic
objectives. Since the policy connects reserve requirements with LDRs, banks will be
incentivised to use low level reserve requirement only if they can achieve certain levels
of LDRs. Hence, a monetary policy objective of increased economic growth can be
achieved since banks will increase loan to the real sector in order to pursue a low
reserve requirement level.
In conclusion, the global relevance of the present study is that in the current
dynamic world with heightened use of sophisticated financial techniques and products,
central bank instrument use will need to assimilate the global financial advancement.
One of the things that the central bank can do is to redefine the reserve requirement
instrument, initially based on funds from third parties, onto the basis of LDR ratios at
its respective banks.

6. Conclusion
This paper describes and critically evaluates the policy currently imposed by the Central
Bank of Indonesia (BI). The particular policy assessed in this study are the liquidity
requirements for both conventional and Islamic banking in Indonesia. For the former,
the BI has regulated that the MRR is imposed progressively, based on the amount of
deposits. Conventional banks which have large levels of deposits have a higher
percentage of MRR, compared to banks with low levels of deposit. Meanwhile, for the
Islamic banks, the central bank policy is to impose a MRR which is based on the FDR.
Islamic banks which have a high FDR have a lower percentage of MRR imposed on
them, compared to the Islamic banks which have a low FDR.
The fundamental elements firmly retained by the BI in developing a policy for Islamic
banks are justice and promoting the real sector. These have been the main values in
 QRFM developing all the policies and instruments of Islamic finance. Adopting this concept
5,2 in relation to the liquidity policies being implemented, is that the BI rewards the
Islamic banks which perform well in terms of their role as financial intermediaries, as
represented by the FDR. The reward given to the high-FDR Islamic banks is that of a
low percentage of MRR. Conversely, BI punished a higher percentage MRR for Islamic
banks which have a low FDR. This implies that justice has truly been done in creating
136 this policy. Moreover, the BI has used the FDR, as opposed to the amount of deposits in
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the banks, as the basis for the MRR of Islamic banks. This policy encourages Islamic
banks to concentrate on the intermediary role that supports the real sector of the
economy.
The introduction of the LDR as the basis for determining the reserve requirements
of conventional banks could arguably become one of measures for restoring the
banking system to its original function as a financial intermediary. The scenario
should work effectively, because the basic concept of the policy is to provide rewards in
the form of a lower reserve requirement for banks that perform well in channeling
funds to debtors. In other words, banks which perform well as financial intermediaries,
as indicated by their LDR level, have the incentive of lower reserve requirements, thus
leaving them with more income-earning deposits. This policy creates a more stable
banking system and supports the real economy.
Over the years, the FDR of Islamic banks has been much higher than the LDR of
conventional banks. One might question whether the high FDR of Islamic banks is due
to the underdeveloped Islamic capital and money market, or simply because the demand
for Islamic financing is high. Both might be true, but, either way, it is important to note
that imposing the liquidity policy of the BI for Islamic banking continues to encourage
Islamic banks to channel deposit funds into financing activities. Hence, even with more
developed Islamic capital and money markets, the FDR of Islamic banking would
remain high. This could also true for conventional banks if BI imposed MRR policy for
Islamic banks to conventional banks.
The limitation of this paper is that this paper only sees effect of the MRR
towards banks ability to loan deposit, however it does not incorporate effect of other
means of monetary instruments such as open market operations and standing facility[1].
Implementing monetary policy through altering MRR is less favorable in some
developed banking system like in the USA and big European countries as there is lag
between the altering MRR and the targeted monetary result. Those countries prefer to
use open market instrument to manage monetary system. However, China, India,
Russia and Brazil, frequently alters MRR to implement monetary policy[2].
Bank Indonesia actually already implements MRR based on LDR requirement for
conventional banks through its new policy issued in late 2010. However, the
requirement is only implemented partially where overall MRR for conventional bank is
basically still based on the amount of third party deposit not LDR[3].

Notes
1. www.ecb.europa.eu/mopo/implement/intro/html/index.en.html
2. http://en.wikipedia.org/wiki/Reserve_requirement and http://online.wsj.com/article/
SB10001424052970204012004577069804232647954.html
3. www.bi.go.id/NR/rdonlyres/D275DE41-9213-44E7-8C8A-73FE9900F837/20980/Key
ExplanationsRupiahStatutoryReserveRequirement.pdf
 References Assessment of
Ahmad, K. (2000), “Islamic finance and banking: the challenge and prospects”, Review of Islamic liquidity policies
Economics, No. 9, pp. 57-82.
Chapra, U. (2008), “The global financial crisis: can Islamic finance help?”, paper of Ibn
Khaldun Lecture Series, held by Institute of Islamic Banking and Insurance, London, 10
November.
137
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Hein, E.S. and Steward, D.J. (2002), “Reserve requirements: a modern perspective”, Economic
Review, Federal Reserve Bank of Atlanta, Fourth Quarter.
Mirakhor, A. (2009), “Resilience and stability of Islamic finance”, New Horizon, available at: www.
newhorizonIslamicbanking.com/index.cfm?section¼academicarticles&action¼view&
id¼10775 (accessed 29 May 2010).
Mishkin, F.S. (2006), The Economics of Money, Banking, and Financial Markets, 7th ed.,
Pearson Addison Wesley, Singapore.
O’Brian, Y.-Y.C. (2007), Reserve Requirement System in OECD Countries, Finance and Economics
Discussion Series Division of Research and Statistics and Monetary Affairs Federal
Reserve Board, Washington, DC.

Further reading
Bank Indonesia (2006), Laporan Perkembangan Perbankan Syariah Tahun 2006 (Shariah Banking
Development Report 2006), Bank Indonesia, Jakarta, Author, available at: www.bi.go.id/
web/id/Publikasi/PerbankanþdanþStabilitasþKeuangan/LaporanþPerbankanþSyariah
Bank Indonesia (2010), Rupiah Statutory Reserve Requirement, available at: www.
bi.go.id/NR/rdonlyres/D275DE41-9213-44E7-8C8A-73FE9900F837/20980/KeyExplanations
RupiahStatutoryReserveRequirement.pdf (accessed 23 January 2012).
Bank Indonesia (n.d.), Statistik Perbankan Syariah Bank Indonesia (Shariah Banking Statistic),
Bank Indonesia, Jakarta, Author, Various issues, available at: www.bi.go.id/web/id/
Statistik/StatistikþPerbankan/StatistikþPerbankanþSyariah/
Bennet, P. and Peristiani, S. (n.d.), “Are US reserve requirements still binding?”,
FRBNY Economic Policy Review, available at: www.fednewyork.org/research/
epr/02v08n1/0205benn.pdf (accessed 23 January 2012).
Feinman, J. (1993), “Reserve requirement: history. Current practice, and potential reform”, Federal
Reserve Bulletin, June, available at: www.federalreserve.gov/monetarypolicy/0693lead.pdf
(accessed 23 January 2012).
Hassan, K. (2003), Text Book on Islamic Banking, Islamic Economics Research Bureau, Dhaka.
Siegel, J.J. (1992), Reserve Requirement and the Indicator Properties of Monetary Aggregates,
available at: http://finance.wharton.upenn.edu/, rlwctr/papers/9205.PDF (accessed
23 January 2012).
Sofyan, S.H. and Yuswar, Z.B. (2003), “History and development of Islamic bank in Indonesia”,
paper presented at International Islamic Banking Conference 2003, Kuala Lumpur.

Appendix
Murabaha is a “cost-plus sale”, in which parties bargain on the margin of profit over the known
cost price. The seller has to reveal the cost-incurred by him for acquisition of the goods and
provide all cost-related information to the buyer.
Mudarabah is a special kind of partnership in which an investor or a group of investors
provides capital to an agent or manager who has to trade with it; the profit is shared according to
the pre-agreed proportion, while the loss has to be borne exclusively by the investor.
 QRFM Profit loss sharing ¼ it defines as the ratio at which the profit will be shared between the
party and the bank.
5,2 Wadiah is a safekeeping account.
Riba means loan where borrower has to return to the lender more that the amount borrowed.
Bayt al-mal was the department that dealt with the revenues and all other economical matters
of the state.
Shariah ¼ Islamic law.
138
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Iwad ¼ countervalue.
Juala ¼ fee based income.

Corresponding author
Raditya Sukmana can be contacted at: momyadit@gmail.com

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