Dependency of Islamic bank rates on conventional rates in a dual banking system: A trade-off between religious and economic fundamentals

Abstract The dependence of Islamic bank rates on the conventional bank rate violates the religiosity principle and the fundamentals of an efficient market due to the possibility of arbitrage profit from the rate differences. This study tests such dependency in a dual banking system by considering monthly data from January 2009 to April 2018 on Malaysia banks using several ARDL tests, supplemented by robustness tests using a 12-month correlation of the rolling standard deviation and causality models based on the Toda-Yamamoto approach to investigate the short- and long-run dependency of rates. The study finds that Malaysia's Islamic bank deposit and financing rates are influenced by both the conventional and Bank Negara Malaysia's policy rates. Results imply that Islamic banks do serve profit-driven customers. We suggest that Islamic banks are forced to benchmark their rates to conventional rates because of the trade-off between religious and economic fundamentals by profit-driven customers. The study demonstrates that the question of Islamic legitimacy of Islamic banks needs to be addressed considering the correct profiling of the customer-base and the regulatory environment in which Islamic banks operate in. We discuss implications for Islamic rate-setting behavior in the presence of monetary shocks in a dual banking system.