Islamic Banking System. Case of Malaysia - Essay Example

?Causality between Banking Instruments of Islamic and Conventional Banking System: A Case of Malaysia In Muslim countries, Islamic banking industry has significantly contributed in the process of economic development. The profit and loss sharing concept as an alternative source of banking has added largely to importance of Islamic banking. Similar to conventional banking, Islamic banks also collect the additional savings of people and then those savings are extended to those needy sectors of economy. In past, few researches have been developed to find out the relationship between the interest rate increase and funds flow from Islamic banking. This paper analyses the relationship between deposit returns of Islamic and conventional banks with an alternative econometric technique involving Units Root Test to estimate the presence of stationarity and Granger Causality test to estimate the linkage between the deposit returns of the two banking systems. The basic objective of this study is to find out the impact of the change in return deposits of one banking system on to the other. Thus, this study assists the policy makers in determining the role of Islamic banking in the overall economic, fiscal and monetary environment of the country. Introduction The purpose to conduct this study is to examine the level of substitutability in the depository returns under Islamic and conventional banking system. This study comprises on the comparison of the data relating depository returns between the Islamic banking system and the conventional banking system which includes commercial, merchant banks and other financial institutions. Malaysia is considered as a case study in which both Islamic and conventional systems are aimed to be operated on parallel basis by the monetary authorities. In 1983, the first ever Islamic bank that was established in Malaysia was Bank Islam Malaysia Berhad (BIMB). The Islamic banks truly started competition with their conventional counterparts in 1993 when Islamic banking scheme (IMS) was introduced by the Government of Malaysia. This scheme permits the conventional banks to introduce and participate in the products and services initially designed by Islamic banks. By the end of 2002, Total Islamic banking deposits were 10.20% of the country’s total deposits. Since Malaysian financial system is under the sole control of Central Bank of Malaysia, therefore the evidence that there are relationships between TDRs of Islamic and conventional banks and the monetary policy is argued under this study. In case if the there is no substitutability between the rates of depositing and financing in both Islamic and conventional banking systems, then relatively lesser restrictive effects of monetary policy can be observed in this regard. For instance, interest rates are used as a tool by the Central banks to adjust the money supply flowing in the economy. Interest rates are increased or decreased to tighten or loosen the flow of money circulating in the economy respectively. The same phenomenon cannot be established in the Islamic banking system as the depositors are not offered a fixed rate of deposit returns. There is a likelihood that if the required rate of deposit returns on Islamic banking products is not ensured to at least the amount of that conventional banking products, the depositors of Islamic banks would switch to other financial instruments of the conventional banks because of fact that the Islamic banking products would be of little use for the monetary purposes. Literature Review The individual saving behaviours are mainly explained by the interest rates offered in the economy as one of the key considerations. The interest rate offerings are considered as a key element because different banks offer different rates of depository returns on varying schemes of deposits. Interest rates are determined mainly because of the concept of time value of money. The longer the time that deposits takes in maturity, the higher will be the yield required by the depositors. For examples, the current account deposits have the property of being withdrawn whenever asked be the depositors. Therefore, those deposits do not carry any interest rate to the depositors. On the contrary, the saving accounts and time deposits pay interest to the depositors because amounts under time deposits are deposited for a substantial amount of time ranging from months to years. In order to determine the costs and returns associated with the amount of deposits in the beginning for both bankers and the depositors, interest rates are generally fixed in advance. Islamic banks offer various kinds of depository schemes just like the conventional banks. These Islamic banks enjoy the rights pertaining to the capital providers regarding the investment opportunities involving different factors which include risk appetite, time horizon and the rate of interest offered. Ariff (1995) examined Islamic banking system and concluded that there are mainly three kinds of depository accounts namely as current, savings and investment based. Nominal values of the deposits under current and savings account are guaranteed, but the amount of return on those deposits is not guaranteed. On the other hand the investment accounts are operated on the assumption of sharing profit and loss such that neither of the principal amount of deposits nor the return on those deposits is guaranteed by the Islamic banks. Few variation are found by Ariff (1995) relating to investment accounts. For example in Bangladesh, three different types of PLS accounts are offered which are PLS Deposit, PLS Special Deposit and PLS Term respectively. Whereas, in Malaysia the investment accounts are bifurcated into two broad categories, one for general public and the other one is designed to cater the institutional investors. Gafoor (2001) formulated the argument that risk should be included in the financial transactions. The rationale given in this regard is that banks face various kinds of risks in order to generate the amount of income, therefore, in this ways there are likelihoods that losses can also occur in conducting trade and business. In case, if risks are excluded from the financial transactions, then that would become a kind of usury not the trade or business activity. Another argument put forward by Gafoor (2001) is that due to the performance of the bank and not due to the interest rate change, the profits are accrued from one year to another year. On the whole, the depositors of Islamic banks are not offered profit percentages at the time of deposits. The only way to obtain the knowledge of returns is the past returns given by the Islamic banks or the comparison of interest rates offered by their conventional counterparts. Khan (1983) presented a different point of view regarding the Islamic banks running their operations in the Middle Eastern countries. The researcher found conclusive evidence depicting the presence of difficulty faced by Islamic banks in conformance with the rules of Shariah, operating under the dual banking system under the Middle East zone. The study also found that the amount of profit of Islamic banks in percentage term was around nine percent to twenty percent and on the other way, the rate of return offered to depositors was around eight percent to fifteen percent very similar to that of the conventional banking system. Man (1988) found some other evidences in the case relating to Bank Islam Malaysia Berhad (BIMB) comparing the average rate of return of the bank with that of offered by the conventional banks. The researcher concluded that the bank had spread the number of branched to fourteen only in its three years of operations by the end of 1986. Nevertheless, around ninety percent of the total deposits of the bank were to be matured in two or less than two years. The percentage of non-Muslim depositors was very less, only amounting to two percent. In the study of Metawa and Almossawi (1997), the three core reasons which evolved the Islamic banking system in Bahrain were the religious beliefs and then the required rate of returns and thirdly on an interesting note, the location of the banks. Haron and Noraffifiah (2000) observed another interesting behaviour in 1984, when profits were not distributed at all by the Kuwait Finance House, but no deposits were withdrawn despite of having no return distribution to the depositors. The other studies affirmed the actual reason of increasing deposits in Islamic banks. The reason was the higher rate of return offered to the depositors of Islamic banks. This factor is found to be opposing to that of Metawa and Almossawi (1997) in which religious beliefs were the prime reason behind investments in Islamic banks. According to the study conducted by Erol and El-Bdour (1989), the prime reason for increasing the amount of deposits in Islamic banks were the estimated higher rate of return but not the religious beliefs of the depositors or customers. As the services offered by the Islamic banks are not differentiated significantly with that of commercial banks by the depositors in Islamic countries, therefore, the Islamic banks should no longer highlight religion as the core area in order to persuade the Islamic banking customers rather they should see as how their products and services are viewed by the customers. Islamic banks are supposed to offer the quality services which there conventional counterparts provides to their customers. Radiah (1993) found that in Malaysia, there are two broad categories of Muslims, one are those who follow the religion strictly and wants the religious way of banking in Islamic banking. The other type is kind of moderate Muslims who prefer time value of money and the services offered by the Islamic banks. In a similar point of view given by Haron and Planisek (1994), the two major motivating factors that cause the depositors to deposit in Islamic banks in Malaysia are the profits and the religion. Their observation stated that Islamic banking is preferred by the forty percent of Muslims. The remaining Muslims as well as other non-Muslims still believe on the importance of time value of money. They also anticipate faster banking transactions. The researchers also found the evidences that Muslims and non-Muslim customers want to establish the relationships with those Islamic banks whose complete understanding of operations are provided to the depositors. The researchers also presented their remarks by suggesting to the top management of the Islamic banks not to only focus on their Muslim depositors and also understand the importance of time value of money. In this regard, they should also cater to the non-Muslim depositors to bring them in their monetary base. In Singapore, similar types of observations are reported by Gerrad and Cunningham (1997). The researchers concluded that the actual reason behind the maintaining of the relationship between the depositors and the Islamic banks are profits and religious beliefs. On a concluding note, the respondents of the survey which was conducted by the researchers found that majority of the Muslim depositors will not withdraw their deposits in case if Islamic banks do not manage to generate any income. On the other hand, in the survey, non-Muslims were more interested in high return generating products and services. Haron and Shanmugam (1995) have also studied the same concept and have done empirical research in order to link the interest rates of the total deposits in Islamic banks of Malaysia. The autoregressive lag distributed model had been made and Pearson correlation had been employed in order to get the results. They concluded that strong negative correlation exist between the total Islamic deposits and interest rates. Change in interest rates caused Islamic banking deposits to respond significantly. In another study, conducted by same authors, Haron and Shanmugam (2000) investigated the relationship between the rates of returns with that of Islamic banking deposits. The study undertook the conventional and Islamic banking schemes of Malaysia. Monthly data of fifteen years had been taken from the period of January 1984 - December 1999. The model that was employed in order to conduct this study was “Adaptive Expectation Model”. Again, their findings show negative relationships between the total interest free deposits and interest rates. They concluded that investment account holders and Islamic savings impact highly to the profit motive. Hypothesis After having a comprehensive analysis of the above discussion, it is assumed that different market forces such as religious beliefs of people, service quality and information about the substitutes are the key factors that shape the behaviour of the depositors of Islamic Banking. The basis of Islamic Banking is that it works on the concept of sharing of profit and loss unlike the conventional banking system which offers fixed return to its depositors. Depositors of Islamic Banking system do not know the exact amount that they will be receiving on their investments. For that reason, if the assumption is made that Islamic banking depositors have the approach of maximizing their profits, then it will be immensely influenced by the interest rate of conventional banking as well as the historical rate of return of Islamic banking systems. The prohibition of interest rate must not escort the management of Islamic banking to take their depositors for granted. Islamic banking deposits continue to be influenced and caused by the conventional banking systems if the proportion of total assets and deposits of Islamic banks is not significantly aligned with that of conventional banking systems. A certain level of proportion needs to be maintained between Islamic and Conventional banking systems in order to provide Islamic banking depositors a fair amount of rate of return. Research Methodology Granger causality test is used to investigate whether one variable causes the other variable or causes any change in the other variable. It has been employed in this paper to investigate whether there is any relationship or association between the conventional banking system and Islamic banking systems. Term deposit returns (TDRs) for six different categories ranging from 1 month to 12 month and savings account has been selected. Granger causality is useful in forecasting and predicting the values of a specific variable by integrating the present and past values of another variable. In this paper, the granger causality has been employed in order to find out the direct or inverse relationship between conventional TDRs and Islamic TDRs. The output provides F-statistics for the hypothesis. If null hypothesis is rejected, it is considered as true. Following are equations for Granger Causality Test, Conventional t = a + ?bI (Islamic) t-i + ?? (1) Islamic t = a + ?bI (Conventional) t-i + ?? (2) Where, “Conventional” and “Islamic” are the changes in the Islamic and Conventional returns on deposits during the “t” period of time. The data for this article has been taken from the period of January 1994-December 2002. It incorporates the returns of TDRs under finance companies, merchant banks and commercial banks. The secondary data in order to conduct the research has been taken from the publications of Central Bank of Malaysia. Results & Discussion In table 1, initial results for the time series data are presented. Table 1 covers all the TDRs that are offered by merchant banks, financial institutions and commercial banks. The Augmented Dickey-Fuller test has been used in order to calculate the outcome. As per the outcome of the tables, the order of integration is at I (0). These results validates that the null hypothesis cannot be rejected for Unit Root in all the cases. Table 1 Dickey Fuller Tests for Presence of Unit Root in Islamic & Conventional TDRS For dependent variable, two lags have been taken at the first different in order to compute the test statistics based on regression. Causal Relationship between Islamic Banking Systems and Conventional Banking Systems Causal relationship refers to investigate what type of relationship exists between the variable. Since, the granger causality test incorporates only two variables therefore; the causal relationship can be uni-directional or bi-directional. The basic difference between the both is that in unidirectional, only one variable causes another, whereas in bi-directional both the variables cause each other. In further tables, we find if any of the banking system has some direct or indirect causality for another and if yes, than what banking systems cause change in the other. Table 2 Granger Causality Test Results for Islamic and Conventional TDRS offered under Commercial Banks The above table covers the data from January 1984 to December 2002. It represents the granger causality test between the Islamic banking TDRs and conventional banking TDRs in order to find which causes what. The results indicate that the conventional banking TDRs have substantial impact in all the above mentioned cases (from 1 month to 12 months and savings account). At 1% level, F-statistics show a significant value which supports the hypothesis that the TDRs of conventional banking systems have stronger influence on the TDRs of Islamic banking systems. There are no results found in table 2 regarding whether there is any inverse relationship which validates that Islamic banking TDRs cause the conventional banking TDRs. Table 3 Results of Granger Causality Test for Islamic and Conventional TDRS offered under Finance Companies Note: ** indicates the level of significant at 1% and * indicates level of significant at 5%. Where, VEC represents Vector Error Correction model. In Table 3, the causal relationship between conventional and Islamic banking systems has been highlighted for financial institutions. It can be noticed that the conventional TDRs in all the cases fall in the critical region at level 1%. Furthermore, the results reveal that Islamic banking sector’s 1-month TDRs significantly granger cause conventional banking TDRs at level 5%. It can be said that there is a higher degree of competition that exist between the conventional banking TDRs and Islamic banking TDRs. Table 4 Results of Granger Causality Test for Islamic and Conventional TDRS offered under Merchant Banks Note: ** indicates the level of significant at 1% and * indicates level of significant at 5%. Where, VEC represents Vector Error Correction model. In Table 4, the Granger causality relationship offered by merchant bank has been demonstrated for Islamic banking TDRs and conventional banking TDRs. It can be observed that in all cases, TDRs series fall at a critical region of level 1%. Furthermore, the results show that 12 months and 9 months series are in contrast with the null hypothesis and reveal that there is no substantial impact of Islamic TDRs on conventional TDRs at a significant level of 1%. By observing these figures, the conclusion can be derived that for long-term deposits, high level of competitions exist between series of Islamic banking TDRs and series of conventional banking TDRs. Conclusion The purpose of this research papers is to define if there is any causal relationship between the Islamic banking system and conventional pattern of banking systems. Results support the argument that in all cases and all tenure of time period, conventional banking TDRs granger cause Islamic banking TDRs. Furthermore, the results also reveal that in case of merchant banks and financial institutions, significant level of competition exists between the Conventional TDRs and Islamic TDRs. Overall conclusion of the results state that Islamic banking system does consider the rates of interest before setting and adjusting its return on deposits. References Ariff, M, 1988. Islamic Banking. Asian Pacific Economic Literature, 2 (2), p. 48-64. Bank Negara Malaysia, 1994-2001. The Bank Negara Malaysia Quarterly Bulletin, Kuala Lumpur, Malaysia. Dickey, D, A and W, A, Fuller, 1979. Distribution of the Estimators for Autoregressive Time Series with a Unit Root. Journal of American Statistical Association, 74, p. 427-437 Erol, C and El-Bdour, R., 1989. Attitudes, Behaviour and Patronage Factors of Bank Customers towards Islamic Banks. International Journal of Banking Marketing, 7 (6), p. 31-39. Gafoor, A.L.M, 1996. Interest Free Commercial Banking, A S Noordeen, Kuala Lumpur. Gerrad, P and Cunningham, J B, 1997. Islamic Banking: A Study in Singapore. International Journal of Banking Marketing, 15 (6), p. 204-216. Granger, C, W, J, 1969. Investigating Causal Relation by Econometric Models and Cross Spectral Methods. Econometrica, 37, p. 424-438. Haron and Planisek, L.,1994. Bank Patronage Factors of Muslim and Non-Muslim Customers. International Journal of Bank Marketing, 12 (1), p. 32. Khan, M F, 1983. Profit and Loss Sharing: An Economic Analysis of an Islamic Financial System. Ph.D. University of Michigan. Man, Z, 1988. Islamic Banking: The Malaysian Experiences. Islamic Banking in South East Asia. Institute of South East Asian Studies, Singapore. Metawa, S A and Almossawi, M, 1997. Banking Behavior of Islamic Bank Customers: Perspectives and Implications. International Journal of Bank Marketing, 16 (1) p. 32. Noraffifah, A, 2000. The Effects of Conventional Interest Rates and Rate of Profit on Funds Deposited With Islamic Banking System in Malaysia. International Journal of Islamic Financial Services, 1 (3). Radiah, A K, 1993. Performance and Market Implication of Islamic Banking (A Case Study of Bank Islam Malaysia Berhad. PhD. Shanmugam, B., 1995. The Effects of Rates of Profit on Islamic Bank’s Deposits: A Note. Journal of Islamic Banking and Finance, 12 (2), p. 18-28. Read More