Academic journal article Journal of Economics, Finance and Administrative Science

The Impact of Monetary Policy on Islamic Bank Financing: Bank-Level Evidence from Malaysia

Academic journal article Journal of Economics, Finance and Administrative Science

The Impact of Monetary Policy on Islamic Bank Financing: Bank-Level Evidence from Malaysia

Article excerpt

1. Introduction

Islamic bank is a deposit-taking institution with all functions similar to currently known modern banking activities but with Islamic-bearing products only offered by the bank. Islamic bank mobilizes funds based on Mudarabah (profit-sharing) or wakalah (as an agent charging a fixed fee for managing funds) as part of its liabilities, while financing of a

profit-and loss-sharing (PLS) basis or through the purchase of goods (on cash) and sale (on credit) or other trading, leasing and manufacturing activities as part of the assets. Except a part of demand deposits, which are treated as interest-free loans from the clients to the bank and are guaranteed to be repaid in full, it plays the role of an investment manager for the owners of deposits akin to universal bank. Underpinning the Islamic banking system is the principle, which is derived from a set of rules stemming for the Shari'ah rules[1].

Unlike the conventional banking principles, the basic principles of Islamic banking can be characterised by the following features (Iqbal, 1997): risk-sharing, in which providers of financial capital and the entrepreneurs should share business and financial risks in return for shares in the profits; money as "potential", that is, it becomes the actual capital only when it joins hands with other resources to undertake a productive activity; prohibition of speculative behaviour that discourages hoarding and prohibits transactions featuring extreme uncertainties, gambling and risks; and Shari'ah-approved activities that only those business activities that do not violate the rules of Shari'ah qualify for investment.

On the other hand, many scholars argue that Islamic banking mimics conventional banking schemes, in particular the operational aspects of the bank. This includes the claim that most of Islamic financing has a debt-like character and is not based on the true principles of Shari'ah (Aggarwal and Yousef, 1999; El-Gamal, 2006; Hamoudi, 2007), i.e. there is no substantial difference between mark-up and interest. The main difference between the two is the legal form. El-Gamal (2005) has concluded that Islamic finance is primarily a form of rent-seeking legal arbitrage and seeks to replicate the operations of conventional financial instruments. Nevertheless, as an alternative finance, some researchers have argued that Islamic financial institutions have a huge potential to absorb macro-financial shocks and promote economic growth (Dridi and Hasan, 2010; Mills and Presley, 1999).

In terms of deposit, Islamic banks mainly use the risk-sharing PLS instruments, while in financing, most Islamic banks rely on debt-like instruments such as mark-up financing and a guaranteed profit margin, that are based on deferred obligation contracts. Moreover, conventional interest rate, i.e. the London Interbank Offered Rate (LIBOR) or a domestic equivalent, will always be a benchmark for Islamic banks' mark-up or profit margin. As a result, in the case of such debt-like instruments, the pricing of Islamic financing is not a function of real economic activity but is based on a pre-determined interest rate plus a credit risk premium.

The objective of the paper is to investigate the impact of monetary policy on Islamic financing behaviour while taking into consideration bank-specific characteristics. The study aims to provide understanding of how efficiently Islamic banks perform their roles as suppliers of capital for businesses and entrepreneurs. Since the rate of return on retail PLS accounts closely follow interest rates offered by conventional banks in the case of Malaysia (Chong and Liu, 2009; Cervik and Charap, 2011), little is known about Islamic financing behaviour, which is operated alongside with the conventional banks.

This paper is set out as follows: Section 2 overviews of Malaysian Islamic finance industry. Section 3 provides the theoretical view of Islamic financing and profit rate. …

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