ISLAMIC BANKING, FINANCIAL INCLUSION, AND REGIONAL ECONOMIC DEVELOPMENT PANEL EVIDENCE FROM INDONESIAN PROVINCES

Abstract

This study investigates the role of Islamic banking in promoting financial inclusion and regional economic development across 34 Indonesian provinces over the period 2017 to 2022. Using a two-step system generalised method of moments (GMM) estimator to address the dynamic nature of financial inclusion and the potential endogeneity of Islamic banking expansion, the analysis examines how the growth of Islamic banking assets, the density of sharia bank branch networks, and the penetration of Islamic rural banks (Bank Pembiayaan Rakyat Syariah, BPRS) affect a multidimensional provincial financial inclusion index and provincial economic growth. The results indicate that Islamic banking asset growth and branch density are both positively and significantly associated with improvements in the provincial financial inclusion index, with standardised effects of 0.214 and 0.287, respectively. The financial inclusion index, in turn, significantly mediates the relationship between Islamic banking development and provincial GDP growth, with the mediated pathway accounting for approximately 38 percent of the total effect. These findings are robust to alternative specifications of both the financial inclusion index and the Islamic banking development proxy. The study contributes original subnational evidence on the finance-growth nexus in an Islamic banking context and carries important implications for regulatory policy on branch licensing, microfinance institution development, and the design of inclusive Islamic financial products in Indonesia