The impact of a dual banking system on macroeconomic efficiency

The rapid growth of Islamic banking around the globe has led to questions about its role in the economy. In this paper, we examine whether Islamic banking acts as a substitute or complement to conventional banking in promoting macroeconomic efficiency in countries with a dual-banking system. Using a one-stage Stochastic Frontier (SF) approach, we find evidence that similar to conventional banking, Islamic banking positively contributes to a country's macroeconomic efficiency. However, Islamic banking acts as a substitute not as a complement to conventional banking in contributing to macroeconomic efficiency. The results are robust to using both credit and deposit ratios as proxies of financial development. The findings are consistent with growing evidence that despite the apparent philosophical differences between the two banking systems, Islamic banking is increasingly converging in its operations to conventional banking. [Display omitted] •A sound financial system mobilizes and allocates funds in a more efficient way.•Both conventional and Islamic banks play a key role in promoting macroeconomic efficiency.•Islamic banking substitutes rather than compliments conventional banking in promoting macroeconomic efficiency.•For economic analysis, Islamic banks may be treated like conventional banks.