Impacts of Monetary Policy Shocks on the Domestic and Foreign Banks in Malaysia

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IMPACTS OF MONETARY POLICY SHOCKS ON THE DOMESTIC AND FOREIGN BANKS IN MALAYSIA

Salina Hj Kassim
Turkhan Ali Abdul Manap

Department of Economics
Kulliyyah of Economics and Management Sciences
International Islamic University Malaysia
Jalan Gombak
53100 Kuala Lumpur

ABSTRACT

This study investigates the impact of monetary policy shocks on bank loans extended by local banks and foreign banks in Malaysia over the period from January 1991 to December 2006. It adopts the impulse response functions and the variance decomposition analysis to study the responses of these types of lending to monetary policy shocks. The study finds that foreign banks do not react negatively to monetary policy shock, supporting the view that foreign banks in Malaysia do not abandon the domestic market in times of economic distress. The different responses of the balance sheet items of these banks have several important implications, particularly on monetary policy implementation and risk management practices of the banks.

Keywords: Monetary policy; foreign and domestic banks; VECM; impulse response functions; variance decomposition analysis

1. INTRODUCTION
The presence of foreign banks in a domestic financial landscape has positive as well as negative implications, particularly for a developing economy.
On one side of the argument, foreign banks’ presence contributes positively in the development of a strong and stable domestic banking industry. The comparatively more efficient foreign banks which adopt cutting-edge technology in their banking services create competitive pressure on the domestic banks, resulting in positive spill-over effects on the banking industry in general (Berger, DeYoung, Genay and Udell, 2001). Due to their cost efficiency, foreign banks are able to offer more competitively priced products and services. In terms of product range, foreign banks are argued to be more responsive and creative to the changing consumer preference and increased consumer sophistication. Foreign banks, therefore, are more profitable than the domestic banks due to the wider range of banking services and operations that they provide (Claessens, Demirguc-Kunt and Huizinga, 2001). In view of this, the domestic banks have to provide quality financial products and services which are competitively benchmarked against those being offered by the foreign banks so as to stay ahead of the competition.

The foreign banks also help to fulfil the financing needs of the economy, particularly in times where there are shortages of funds from the domestic sources. Foreign banks help to provide ample liquidity to meet the financing requirements of the domestic economy (Goldberg, Dages and Kinney, 2000; Levin, 1996). In this regard, foreign banks presence results in lower cost of capital to borrowers and higher economic activity in the host economy (Agenor, 2001; Bekaert, Harvey and Lundblad, 2005).

The positive role of the foreign banks is also extended to stabilizing the financial system and economic well-being of the domestic economy. Better quality and wider range of product and services as well as increased efficiency of the banking industry result in a more effective intermediation process in the economy. This improves the access to financing by all the economic agents. A well-functioning financial intermediation process ensures a strong and stable financial market which is better-abled to weather systemic shocks in times of financial market turbulence. Furthermore, since the competitive pressure compels banks to adopt the best banking practices, greater foreign bank participation is found to reduce the probability of a banking crisis (Goldberg, Dages and Kinney, 1999; Kono and Schuknecht, 1999). Overall, foreign banks presence plays a positive role of increasing the strength of the domestic financial system, thus contributing towards a stable and more efficient domestic banking industry.

On the other hand, the...
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