Are Islamic banks really interest-free?

The operations of Islamic banks, unlike conventional banks, are supposedly based on the premise of justice and fairness and not just maximising profits. The advocates of Islamic banking are convinced of its advantages and the contributions it makes to society compared to conventional banking (Sugema, Bakhtiar and Effendi, 2010; Khairul, Shamsher and Eskandar (2014)). 

However, there remains much skepticism about the practicality of Islamic banking given that the infrastructure in financial markets is largely conventional. The perception that there is no real difference between the Islamic and conventional banking in terms of their intermediary functions to real economic activities remains an intriguing empirical issue.

The skeptics claim that Islamic banks are no different from conventional banks, as most of the products and services mimic those of conventional banks and operate with interest in a disguised form (Ariff and Rosly, 2011). However, the divergence from Islamic or sharia-based principles creates reputational risk and will adversely affect the Islamic banking sector in the long run.

The main issue is whether deposit and investment accounts in Islamic banks in Malaysia are interest-free. If the evidence suggests a close relationship between interest rates on similar investments in conventional banks and profit rates achieved by Islamic banks, then there is a high probability that these accounts in Islamic banks are not really interest-free. 

The second issue of concern is to ascertain whether the profit rates of Islamic banks are influenced by interest rates. There is also a possibility that Islamic banks might benchmark their profit rates to interest rates on similar investments just to stay competitive, as most of their investors are non-Muslims.

One way to ascertain the validity of the profit rates offered by Islamic banks and finance companies is to ascertain whether these rates are highly correlated with the interest rates offered on similar accounts in the conventional banks. Furthermore, if there is any significant correlation between the profit and interest rates, is there a possibility that the profit rates are influenced by the interest rates in conventional banks?

Since Malaysia operates a dual banking system on a parallel basis, it provides a good opportunity to conduct  these tests. For this purpose, the monthly fixed rate of return of conventional banks and the investment deposit rates of 17 Islamic banks were collected for the period from January 1994 to December 2012. The data for finance companies was only available until December 2005.

The tests were conducted using a bivariate model for each maturity-matched pair – that is, Islamic banks’ investment deposit rate for one month and conventional bank fixed deposit rate for one month, Islamic finance companies’ investment deposit rate for one month and conventional fixed deposit rate for one month, and so on. The Vector Autoregressive method was applied to identify the causal relations and dynamic interactions between variables. 

We conducted the comparative analysis of Islamic investment deposit rates and conventional interest rates on investments with various maturities (1, 3, 6, 9 and 12 months) and saving deposits. 

Findings
A casual observation of the two different rates in table 1 (below left) 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 is 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. This raises 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 seems 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 summarised in table 2 (below right) 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. This indicates that conventional banks are the driver and Islamic bank profit rates response 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 follow the changes in the conventional deposit rates for both banks and finance companies.

These findings infer that there is a gap between Islamic banking principles in theory and practice. Competitiveness could be a rationale for the behaviour of the deposit rates in the two banking systems, consistent with the documented evidence (Ergec and Arslan (2013)). 

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 – especially Muslims – with low creditworthiness 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 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 (2 lags) show one-way causality – that is, profit rates are affected by interest rates – and consistent with the findings of previous studies (Chong and Liu, 2009; Cevik and Charap, 2011).

Conclusion
Overall, the findings indicate 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 raise some 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-maximisation mentality of customers. A very large percentage (more than 70%) of customers of Islamic banks and finance companies 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 imply 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.