Diversification and banks' willingness to lend to small businesses: evidence from Islamic and conventional banks in Indonesia

This is the first study to provide a comprehensive analysis of banks’ willingness to lend to small businesses (SBs) by differentiating between conventional and Islamic banks’ behaviour in Indonesia. In our initial analysis we examine the determinants of banks’ willingness to lend to SBs and in the second part we investigate the Granger-causes of diversification towards SB lending and banks’ efficiency and ex-post risk. Our results reveal that large banks are less interested in SB lending compared to small banks. Profitability is an important determinant for Indonesian banks to lend to SBs. Islamic banks, however, benefit more from lending to SBs given the substantial improvement in their net interest margin and lower capital compared to conventional banks. Our findings signal overpricing behaviour by Islamic banks, represented by a relatively high unadjusted rate of return given the risk exposure of their products. It is also evident that Islamic banks’ managers seem to hold less capital, counting on the benefits of portfolio diversification towards SBs lending. As expected the moral hazard hypothesis is only evident for Islamic banks in terms of loan and income portfolio diversification.