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Analysis On Islamic Bank On Rate of Return Risk
Analysis On Islamic Bank On Rate of Return Risk
The objective of this study is to analyze the dynamic effects of interest rate
changes on the rate of return of Islamic banks and the amount of deposits
in the conventional and Islamic banks. In analyzing the potential rate of
return risk in the Islamic banks and interest rate risk in the conventional
banks, for the Islamic banks, the 3-month Islamic deposit rate of return and
total Islamic deposit are considered, while for the conventional banks, the
3-month fixed deposit interest rate and total conventional deposits are
considered. Using data covering the period from January 1997 to October
2008, the study applies the cointegration analysis, bi-variate Granger
causality test, Impulse Response Function (IRF) and Variance
Decomposition (VDC) analysis based on the Vector Auto-regression
(VAR) framework. The results of the study have important implications on
the risk management practices of the Islamic banks in Malaysia. Several
suggestions are put forward to mitigate the rate of return risk so as to
ensure healthy growth of the Islamic banking institutions.
1. Introduction
1
Corresponding author: PhD candidate, Institute of Islamic Banking and Finance,
International Islamic University Malaysia. E-mail : [email protected].
2
Assistant Professor, Kulliyyah of Economics and Management Sciences,
International Islamic University Malaysia, P. O. Box 10, 50728 Kuala Lumpur,
Malaysia. Email : [email protected].
60 An Analysis of Islamic Banks Exposure to Rate of Return Risk
Similar to the conventional banks, the Islamic banks also face the
financial risks but with variations due to specific requirements to
comply with the shariah. With regard to the interest rate risk, the
Islamic banks could also be exposed to the same risk, known as the rate
of return risk as suggested by the Islamic Financial Services Board
(IFSB) (2005). In the context of their overall balance sheet exposures,
the Islamic banks are exposed to a squeeze resulting from holding
fixed-return assets such as murabahah that are financed by investment
accounts, the holders of which expect a rate of return in line with the
benchmark rates. An increase in the benchmark rates may result in
investors or fund providers having expectations of a higher rate of
return.
However, rate of return risk differs from interest rate risk in that Islamic
banks are concerned with the result of their investment activities at the
end of the investment-holding period. According to Iqbal and Greuning
(2008), the rate of return risk is different from the interest rate risk in
two ways. First, since Islamic banks have a mix of mark up-based and
equity-based investments, there is higher uncertainty in the rate of return
earned on investments compared to conventional banks which operate
on interest-based whereby there are fixed-income securities on the assets
side. Second, the return on deposits in conventional banks is pre-
determined, while the return on deposits in Islamic banks is anticipated
but not agreed beforehand.
Islamic banks may be under market pressure to pay a return that exceeds
the rate that has been earned on assets financed by investors or fund
providers when the return on assets is under-performing as compared
with competitors rates. Islamic banks may decide to waive their rights
to part or entire mudharib share of profits in order to satisfy and retain
their fund providers and dissuade them from withdrawing their funds. In
short, DCR derives from competitive pressures on Islamic banks to
attract and retain investors or fund providers. An example for the
practice of this approach is the International Islamic Bank for
Investment and Development in Egypt which distributed all of its profit
to the investment account holders and nothing to its shareholders from
the middle to late 1980s.
In view of the important issue of the rate of return risk, this study aims
to provide empirical evidence on the exposure of the Islamic banks to
the rate of return risk and suggest effective ways to mitigate the risk.
Focusing on the Malaysian case, this study aims to analyze the effect of
interest rate changes to the rate of return in Islamic banks and the effect
of the deposit rate changes on the deposits of the conventional banks and
the Islamic banks.
The rest of the study is organized as follows: the next section presents
the overview of interest rate risk in the banking industry and rate of
return risk in the Islamic banks. Section 2 reviews the literature to
understand the inevitable role of bank in the risk business and highlights
the typical risk factors and characteristics inherent in the banking
operation in general. Subsequently, the discussion focuses on the rate of
return risk and exposure of the Islamic banks to rate of return risk.
Section 3 discusses the research methodology which includes the
methods adopted, nature of the data and model specification. Section 4
presents the empirical findings and discusses the results. Finally, Section
5 concludes.
2. Literature Review
Interest rate risk is a major issue that needs serious attention by banks.
The Basel Committee on Banking Supervision (2004) describes that
changes in the interest rates can have adverse effects on both banks
earnings and its economic value. Bacha (2004) states that a constant rise
in the interest rate may lead to several problems to the bank such as
increasing in cost of fund since the bank would have to pay higher rate
Journal of Economic Cooperation and Development 63
in order to attract new deposits and maintain the existing ones. Variation
in market interest rates could also affect the economic value of a banks
assets, liabilities and off-balance-sheet positions due to a mismatch in
rate-sensitive assets and rate-sensitive liabilities. For this reasons, banks
should be aware of the reduced earnings or outright losses that could
threaten the financial stability of an institution by undermining its
capital adequacy and reducing market confidence.
For the Islamic banks, a study conducted by Khan and Ahmed (2001)
finds that the rate of return risk is the most critical risk faced by the
Islamic banks compared to other risks such as the operational risk and
liquidity risk. According to How et. al (2005), interest rate risk
management or rate of return risk management should be a concern to
the Islamic banks, particularly in a dual banking context such as in
Malaysia. This is due to the misconception that the Islamic banks, which
are not using interest rate in their dealings, are not exposed to interest
rate risk or rate of return risk. The study documents that banks that offer
Islamic financing are exposed to a higher rate of return risk than banks
that do not offer the Islamic financing. This is due to the differences in
the interest rate sensitivity of assets and liabilities in the Islamic banks.
Unlike conventional bank that have more flexibility on the asset side,
the Islamic bank have the fixed rate assets that not sensitive to the
changes in market interest rate while the liabilities are sensitive to
interest rate changes. Therefore the Islamic banks cannot react swiftly to
changing interest rate and this lead to a higher exposure to rate of return
risk.
The rate of return risk stems from uncertainty in the returns earned by
Islamic banks on their assets. This uncertainty can cause a divergence
from the expectations that investment account holders have on the
liabilities side. The larger the divergence, the bigger is the rate of return
risk. In this matter, Rosly (1999) argues that the Islamic banks in
Malaysia have less flexibility on the asset side than conventional banks
since most of the Islamic financing in Malaysia takes the form of
murabahah and bay bithaman ajil (BBA) which is insensitive to the
market interest rates. Since all the Islamic liabilities are interest-
sensitive, he argues that the fund gaps of the Islamic banks will always
be negative. Consequently, the Islamic banks are at disadvantage in the
face of changing interest rates. This is supported by his findings that
64 An Analysis of Islamic Banks Exposure to Rate of Return Risk
3. Methodology
The validity of the VAR analysis depends on the stationarity of the time
series. This implies that the time series should have no trends or fixed
seasonal patterns and economic time series have to be transformed
before these properties hold. This study utilizes two unit root tests on the
individual stochastic structure, that are the Augmented Dickey-Fuller
(ADF) test and Phillip-Perron (PP) test which have been frequently used
for time series data.
In Malaysia, where the Islamic banks operate hand in hand with the
conventional banks, the two systems may interact given that they
operate in a common macroeconomic environment (Bacha, 2004). If the
rate of return in the Islamic banks and interest rate in the conventional
banks are related, an increase in interest rate may induce the Islamic
banks to increase their deposit return in order to avoid the problem of
depositors switching their deposits to the conventional banks or
withdrawing their funds. In addition, no restriction is imposed on the
depositors in the dual banking system in Malaysia who wishes to move
their funds from one system to another could also expose the bank to the
problem of DCR.
In term of the deposit rate, Chong and Liu (2008) suggest that the rate of
return on the Islamic investment is closely pegged to the conventional
banks interest rate. Additionally, Kaleem and Md Isa (2003) and Bacha
(2004) find the evidence of a significant relationship between Islamic
banks rate of return and conventional banks interest rate and prove that
the changes in conventional banks interest rate Granger cause changes
in Islamic banks rate of return.
In term of the total deposits, Bacha (2004) finds that there is a strong
correlation between the total deposits of the Islamic banks and
conventional banks. The Granger causality test shows a uni-directional
causality from the conventional banks total deposits to the Islamic
banks total deposits. Islamic banks total deposits were also found to
have a relationship with Islamic banks rate of return and conventional
banks interest rate. Haron and Shanmugam (1995) for instance, find a
strong negative relationship between interest rate and Islamic banks
total deposits. In another study, Haron and Ahmad (2000) and Kasri and
Kassim (2009) show a negative relationship between the interest rate
and Islamic banks total deposits. These findings lead to a conclusion
that the DCR is observed among the depositors of Islamic banks.
Moreover, these studies find that Islamic banks total deposits and
Journal of Economic Cooperation and Development 67
Islamic banks rate of return are positively related which indicates a rate
of return risk in the Islamic banks whereby the depositors are attracted
to a high rate of return and may switch or withdraw their deposits when
the rate of return decreases.
In order to analyze the potential rate of return risk for the Islamic banks,
this study analyzes the relationship between the rate of return of the
Islamic banks and interest rate of the conventional banks. Thus, the two
key variables of the Islamic banks being examined in this study are the
rate of return and total deposits since the interest rate changes would
possibly give a direct impact on them. If interest rate risk resulting from
the change of interest rate exists in the conventional banks, it follows
that if the costs of funds for the Islamic banks are equally changing, then
they must face rate of return risk.
The data for this study are taken from the various issues of Bank Negara
Malaysias Monthly Statistical Bulletin. The study uses monthly data
covering the period from January 1997 to October 2008. The total
deposits data are aggregated across all accounts including demand
deposits, investment deposits and savings deposits.
68 An Analysis of Islamic Banks Exposure to Rate of Return Risk
Table 2 presents the results of the stationarity test at level and first
difference. From the results, it is found that the null hypotheses of non-
stationary for all the time series failed to be rejected at level. However,
the null hypotheses are rejected for all the time series at first difference.
The results clearly indicate that all variables are stationary at I(1).
For all models, Schwarz Criterion test confirmed that a one-period lag is
suggested as the optimal lag length. Based on the results from the
maximum eigenvalue and trace statistics as reported in Table 3, the null
hypothesis of no cointegration vector hypothesis (r = 0) is rejected at 5
percent significance level. In other words, at least one cointegration
vector exists for series of variables in the system. The existence of the
cointegrating vector suggests that the variables in the system have a
long-run equilibrium.
70 An Analysis of Islamic Banks Exposure to Rate of Return Risk
The results of the Granger causality test show two significant causal
relationships. First, there is a bi-directional causal relationship between
Islamic banks rate of return and conventional banks interest rate. This
result is supportive of our earlier findings based on the Pearson
correlation. Second, there is a significant uni-directional relationship
between Islamic banks rate of return and Islamic banks total deposits
suggesting that the level of Islamic banks total deposits significantly
affected by their rate of return. This result leads to a conclusion that the
depositors behavior is driven by profit motive.
Journal of Economic Cooperation and Development 71
More importantly, the IRF results show that Islamic banks total
deposits respond significantly to the conventional banks interest rate,
but not the Islamic rate of return suggesting the important influence that
the conventional banks interest rate has on the Islamic banks total
deposits. This finding suggests two important implications; first, since
the changes in Islamic banks total deposits depend on the level of
conventional banks interest rate, this could mean that there is a deposit-
72 An Analysis of Islamic Banks Exposure to Rate of Return Risk
flight from the Islamic banks to the conventional banks when the
conventional banks interest rate increases. This is an evidence of DCR.
Second, the important relationship between conventional banks interest
rate and Islamic banks total deposits suggests that the customers of
Islamic banks are sensitive to the reward received on their deposits and
their saving behavior is driven by profit motive (Haron and Ahmad,
2000 and Haron and Wan Azmi, 2008). This also implies a rate of return
risk whereby a higher rate of return would increase the level of Islamic
deposits, and vice versa (Kasri and Kassim, 2009).
.2 .2 .2
.0 .0 .0
.4 .4 .4
.2 .2 .2
.0 .0 .0
The ordering of the variables for VDC in this study is based on the
Cholesky decomposition method which suggests the following order of
the variables: IBROR, CBINT, LNIBTD, and LNCBTD. Results of the
VDC method are presented in Table 5. Similar to IRF, the results are
reported for a 24-month horizon.
Variance Innovations in
Period
Decomposition of IBROR CBINT LNIBTD LNCBTD
IBROR 1 100 0 0 0
4 51.748 47.708 0.319 0.224
8 32.214 64.930 0.240 2.616
12 23.785 66.325 0.141 9.749
24 15.122 56.705 1.300 26.877
5. Conclusions
a dual banking system may expose them to the problem of rate of return
risk. Thus, the aim of this study is to analyze the potential of interest rate
risk for Islamic banks as they may be affected by the interest rate
movements in the conventional system.
At the same time, this study indicates the profit motive among the
Islamic bank depositors as reflected by the significant impact of the
Islamic banks rate of return on Islamic banks total deposits. The
implication of this finding is that the Islamic banks might be exposed to
the rate of return risk. Ironically, the depositors will increase their
deposits only when the rate of return is increase. Otherwise, when the
rate of return decreases, they will definitely decrease their total deposits
in Islamic banks and they could switch their funds to the conventional
banks. This also implies the problem DCR in the Islamic banking
system.
forgoing part or all of the shareholders profits may adversely affect the
banks own capital which can lead the banks to insolvency risk in
extreme cases.
References
Bacha, O. I. (2004). Dual banking systems and interest rate risk for
Islamic banks [Electronic Version]. Retrieved 15 August 2008 from
www.fivepillarsassc.com/documentation/Dual-Banking-Systems.pdf .
Greuning, H. V., and Iqbal, Z. (2008). Risk Analysis For Islamic Banks.
Washington D.C.: The World Bank.
APPENDIX
Bacha (2004) To analyze the extent of potential The study uses Malaysias monthly data The results show that the changes
interest rate risk for Islamic banks from January 1994 to July 2003. In this in conventional banks interest
in Malaysia by investigating the study, the methods employed are rates and total deposits Granger
linkages between 3 month interest Pearson correlation, Ordinary Least cause changes in Islamic banks
rate and 3 month rate of return and Square (OLS) regression analysis and rate of return and total deposits
also the linkages between the total Granger Causality Test. respectively. The results imply
deposits of the two banking that the Islamic banks operating
systems within a dual banking system may
also be subject to interest rate risk.
When the interest rate rise, Islamic
bank have to raise the deposit rate
to avoid liquidity problem.
Journal of Economic Cooperation and Development 82
How, Abdul To examine the exposure of Using the sample of 23 banks in The results show that the
Karim and Malaysian banks that offer Islamic Malaysia from year 1988 to 1996, the commercial banks in Malaysia that
Verhoeven financing to credit risk, interest rate study employs the parametric t-test, non- offer Islamic financing facilities
(2005) risk and liquidity risk. parametric Mann-Whitney test and OLS have significantly lower credit and
regression. liquidity risks but significantly
higher interest rate risk than banks
that do not offer such facilities.
Therefore, the Malaysian Islamic
banks should give attention to the
interest rate risk (rate of return
risk) management.
Rosly (1999) To provide an empirical proof on Using the sample of six banks in The study finds that the profit
the declining performance of Malaysia (namely BIMB, Maybank, margins of BIMB decline during
Islamic banking during a period of Bank Bumiputra, Public Bank, Oriental the period of rising interest rate,
rising interest rate Bank and Pacific Bank) from year 1996 while the interest margins of
to 1997, the study compares the profit conventional banks show a rising
margin in the Islamic banks and interest trend. Thus this study suggests that
margin in the conventional banks. the Islamic banks should diversify
into equity financing such as
mudharabah and musyarakah to
avoid the decline in income due to
the interest rate volatility.
Journal of Economic Cooperation and Development 83
Ismail and To examine the provisioning This paper analyzes on a sample of 15 The results show that the
Shahimi behavior of Profit Equalization commercial banks that offer Islamic provisioning decisions should be
(2006) Reserve (PER) and to identify the banking products and services from 2002 based on the entire future profile
underlying determinants of PER to 2004. The methods employed are the of expected losses and the PER
in Malaysian Islamic banks panel least squares for OLS and GLS decisions should be dependent on
(Generalized Least Square). the way in which financings are
priced.
Chong and Liu To examine the relationship The data used are the monthly series of The results show that the changes
(2008) between the investment rates Islamic and conventional rates based on in conventional deposit rates cause
offered by the Islamic banks and the average rates across all financial changes in Islamic investment
the deposit rates offered by the institutions from April 1995 to April rates, not vice versa. The overall
conventional banks 2004. The methods used are the bi-variate results show that the return on the
Granger Causality test, Unit Root test Islamic banks deposit accounts are
(ADF and PP), Cointegration test effectively pegged to the return on
(Johansen procedure) and Engle-Granger conventional banks deposit
ECM. accounts.