The findings have implied that Islamic banks are not different from conventional banks, except for different branding to cater for a different category of clients.
By Nazarul Islam
Islamic Banks hold nearly $900 billion in assets and are reportedly growing at over 15% p.a. Islamic Banking and Finance (IBF) in its concept involves wider ethical and moral issues than simply ‘interest-free’ transactions. Its advocates argue that these make it more economically efficient than conventional banking and promote greater economic equity and justice.
To what extent, then, do actual Islamic Banking practices live up to the ideals, and how different are they from conventional banking? A preliminary investigation shows that, three decades after its introduction, there remain substantial divergences between IBF’s ideals and its practices, and much of IBF still remains functionally indistinguishable from conventional banking.
This runs into direct conflicts with the claims being made by IBF advocates that it would rapidly differentiate itself from conventional banking. However, unable to demonstrate an alternative to conventional banking and finance, IBF simply strengthens a distinctly Islamic identity by providing the appropriate Islamic terminology for de facto conventional financial transactions. And, this is highly misleading when comparing the high ideals of purpose, ideals and principles of the Islamic concept developed, for financial institutions.
A casual observation of the two different rates in indicates that, on average, Islamic investment deposit rates and savings deposit rates are lower than the conventional deposit rates for both banks and finance companies, although Islamic finance companies’ deposit rates are quite close to the rates of their conventional counterparts.
For both the banks and finance companies, the volatility and minimum/maximum range of Islamic investment deposit rates are also significantly lower than those of conventional deposit rates.
There appears to be a high correlation between the interest and profit rates of Islamic and conventional banks and finance companies (with a correlation coefficient of 0.90) – it is particularly high between conventional and Islamic banks. Obviously, this has raised doubts that the profit rate in Islamic banks and finance companies is based on the profit-and-loss sharing paradigm.
The findings suggest that profit rates of Islamic banks are significantly linked with interest rates of conventional banks both in the short and long run. The results were also fairly consistent with those for finance companies, as the profit rates of Islamic finance companies seem to be closely related to interest rate of conventional finance companies.
However, the impact of interest rate is less severe for Islamic finance companies.
The information infers that for each maturity-pair the conventional deposit rates are the exogenous variables, implying that conventional bank deposit rates do not depend on the changes in the profit rates of the Islamic banking system.
And this is indicative of the fact that conventional banks are the driver and Islamic bank profit rates are able to ‘conveniently’ respond to the changes in the interest rates on matching investments in conventional banks.
Also, the competition for long-term deposits between Islamic and conventional finance companies is intense. The findings imply that the Islamic deposit rates of matching investments simply follow and respond to the changes in the conventional deposit rates for both banks and finance companies.
Therefore, such findings infer that there is a gap between Islamic banking principles in both, theory and practice. Competitiveness could be a rationale for the behavior of the deposit rates in the two banking systems, consistent with the documented evidence
These findings also imply a close competition for deposits between Islamic and conventional finance companies. Several factors could explain the findings for finance companies. In general, they are more dependent than banks on deposits as their source of funding and are also less regulated hence they can service those unable to get loans from banks.
Therefore, many customers – particularly Muslims – with low credit worthiness will source funds from Islamic finance companies.
The ability of conventional deposit rates to explain the changes in the Islamic deposit rates varies at different maturity periods and between different types of deposit. However, in general the Islamic deposit rates are influenced by the conventional deposit rates.
For finance companies, there is close competition for deposits between Islamic and conventional finance companies, and the profit rates of Islamic finance companies seem to be influenced by deposit rates of conventional finance companies. The results are similar to the results for banks, but profit rates of Islamic finance are less affected by deposit rates of conventional finance companies as compared to Islamic banks.
The pair-wise Granger causality tests show one-way causality – that is, profit rates are affected by interest rates – and consistent with the findings of previous studies. Again, this is a paradox that needs to be carefully examined, whether the institutional banking practices are truly and genuinely ’Islamic’.
Overall, the findings have indicated that the profit rates of Islamic banks and finance companies are driven by the movements of interest rates of conventional banks and finance companies, respectively. These findings have raised doubts as to whether Islamic banks deposit rates are based on the profit-and-loss sharing (PLS) paradigm in practice, where returns are obtained through mudarabah or musharakah contracts.
In fact, it seems this is not the case, probably due to competitive pressure on the part of Islamic banks to meet investor expectations and the profit-maximization mentality of customers. A very large percentage (more than 70%) of customers of Islamic banks and finance companies, in secular Muslim countries like Malaysia are non-Muslims—who want to earn the highest rates on their deposits or lowest rates for financing, irrespective of the type of banking system.
Furthermore, lengthy due diligence for PLS instruments and the lack of an Islamic secondary market makes it more challenging for Islamic banks and finance companies to operate fully using the PLS paradigm.
The findings have also implied that Islamic banks are not different from conventional banks, except for different branding to cater for a different category of clients.
The disparity in the expectation and practice of Islamic banks has reputational risk implications and is not healthy for the long-term future of the industry. The main challenge for policy-makers and regulators is to provide a proper platform and time line for gradual but effective compliance in the near future.
In addition, creating better public awareness of this niche banking sector is also important for its long-term survival.