Dual Banking Systems and Interest Rate Risk for Islamic Banks

In introducing Islamic banking in Malaysia, the basic strategy was to replicate the products/ services offered by conventional banks. The successful implementation of such a strategy has meant that Malaysia today has a truly dual banking system. Islamic banks in Malaysia not only have product similarity with conventional banks but share the same overall economic environment and a common customer base. The ability of non Muslim customers/depositors to switch between the two banking systems, means that deposit / financing rates have to be similar – else give rise to arbitrage flows. The implication is that, though Islamic banks operate on interest free principles, the economic environment in a dual banking system inevitably exposes them to the problems of conventional banks; in particular interest rate risk. Using monthly data over the 10 year period 1994 – 2003, the paper argues that, paradoxical as it may seem, Islamic banks operating within a dual banking system may also be subject to interest rate risk.