Are Pakistani Islamic Banks Really Interest-free?

Transcription

1. Are Pakistani Islamic Banks Really Interest-free ? *Zubair Ahmad **Moeed Ahmad Sundhu ***Nadeem Ahmed Sheikh Abstract The performance of Islamic banks is considered as a realistic evolution from the study of history. Islamic banking is actually the system of banking that is purely based on Islamic jurisprudence. It has become an undeniable reality, and it is evident from the increasing number of Islamic banks. The discriminatory features of Islamic banking are the prohibition of riba (interest) and Profit and Loss Sharing (PLS) according to Shariah principles. The current study investigates the impact of conventional banks‟ deposit rates on investment rates of Islamic banks in Pakistan. Also, the study attempts to resolve the puzzle that Islamic banking is interest-free or interest-based by using the data from Islamic and conventional banks in Pakistan from 2010 to 2016. From the analysis, it is found that the concept of Islamic banking is not much different from that of conventional banking in Pakistan. Besides, investment rates of Islamic banks are caused by deposit rates of conventional banks, but not vice versa. Furthermore, the results showed that the Islamic rates do not have any impact on conventional banks‟ deposit rates. But in case of non-Islamic banks, deposit rates have a significant impact on Islamic rates which shows that different economic policies and religious factors also affect the fluctuation in investment rates. Keywords: Deposit rates, Conventional banks, Investment rates, Islamic banks, Islamic finance, Pakistan. JEL classification: E44, G21, P51, Z12. 1. Introduction: Islamic banking is based upon the principles of Shariah and practical application with the development of Islamic finance/economics. The Islamic banking concept goes back to the 7th century but commercially it was implemented in the previous century, and now Islamic finance is growing in Western as well as in Islamic countries. Islamic banks are developed under religious viewpoint, and its success depends not only on the achievement of financial goals but also on following the Islamic faiths.1 Islamic banking has an annual global growth rate of 10-15%, and Islamic financial institutions are present in more than 51 countries.2 *(Corresponding Author), Assistant Professor, Institute of Management Sciences, Bahauddin Zakariya University, Multan. **Assistant Professor, Institute of Management Sciences, Bahauddin Zakariya University, Multan. **Assistant Professor of Finance, Institute of Management Sciences, Bahauddin Zakariya University, Multan. 1 Syed Farhan Shah, Muhammad Wajid Raza and Malik Rizwan Khurshid, “Islamic Banking Controversies and Challenges,” Interdisciplinary Journal of Contemporary Research in Business 3, no. 10 (2012): 1018-1026. 2 Juan Solé, “Introducing Islamic Banks into Conventional Banking Systems,” IMF Working Papers, (July 2007): 1-26. Accessed April 28, 2018. doi: http://dx.doi.org/10.5089/9781451867398.001. 105
2. Pakistan Journal of Islamic Research Vol : 19, Issue: 2 Moreover, Islamic banks contain a larger share of their assets to finance their activities than conventional banks. On the other hand, Islamic banks are less competitive and less profitable than the conventional banks.3 Background of the Study: In 1980 government of Pakistan planned to eliminate interest from the financial sector. After a great struggle, they started Islamic banking practices in Pakistan in 2002 within existing conventional system.4 The growth of Islamic banks in Pakistan is on a fast track because the State Bank of Pakistan (SBP) is well committed with this sector. Conventional banking also exists in Pakistan, and it creates competition between Islamic and conventional banks in Pakistan. In the last six years, Islamic banking in Pakistan has grown at an annual rate of 76%. 5 The growth of Islamic banks is very fast in Pakistan as compared to other countries. The SBP has established a separate Islamic Banking Department to facilitate and catalyze the development of Islamic banking industry in the country. Accordingly, in June 2010 Islamic banking had total assets of 411 billion dollars. Islamic banking is based on the Shariah principles and prohibition of riba (interest) is its most important feature. The Islamic banking model encourages labors and emphasizes on risk sharing between both parties instead of only one party is responsible.6 As the Islamic banking system is grounded on Islamic principles and all undertakings of banks follow Islamic morals; so it can be said that financial transactions within Islamic banking are the culturally-distinct form of ethical investing. Two basic principles behind Islamic banking are PLS and prohibition of usury (collection and payment of interest, also commonly called riba in Islamic discourse). Although collecting and paying interest is not permitted under Islamic law, revenue-sharing arrangements are generally permitted.7 According to some, usury or excessive and exploitative charging of interest; while according to others, interest per se – is forbidden in Islam. But the Holy Quran says: “And that which you give in gift (loan) (to others), in order that it may increase (your wealth by expecting to get a better one in return) from other people‟s property, has no increase with Allâh; but that which you give in Zakât (sadaqa - charity etc.) seeking Allâh‟s Countenance, then those, they shall have manifold increase”.8 But in Malaysia, Islamic banking is not different from conventional banking because a majority of Islamic banks‟ financing is still based on the non-PLS mode that 3 Rima Turk Ariss, “Competitive conditions in Islamic and conventional banking: A global perspective,” Review of Financial Economics 19, no. 3 (2010), pp.101-108. Accessed April 28, 2018. doi: https://doi.org/10.1016/j.rfe.2010.03.002. 4 M. Mansoor Khan, “Main features of the interest-free banking movement in Pakistan (19802006),” Managerial Finance 34, no. 9 (2008), pp.660-674. Accessed April 28, 2018. doi: https://doi.org/10.1108/03074350810890994. 5 Muhammad Hanif, “Differences and Similarities in Islamic and Conventional Banking,” International Journal of Business and Social Sciences 2, no. 2 (2011), pp.166-175 6 Faisal Fasih, “Inclusive growth in India through Islamic banking,” Procedia-Social and Behavioral Sciences 37, (2012), pp.97-110. Accessed April 28, 2018. doi: https://doi.org/10.1016/j.sbspro.2012.03.278. 7 Hina Ali and Samreena Zubair, “Interest Free Banking and Economic Stability,” Pakistan Journal of Islamic Research 17, no. 2 (2016), pp.175-185 8 Al-Quran, Sura Ar-Rum (30: 39). 106
3. Are Pakistani Islamic Banks Really Interest-free ? ignores the spirit of usury prohibition and Islamic deposits are also interest-based.9,10 The main cause behind the lack of PLS sharing is the imbalance in management and control.11 It is theoretically expected that Islamic banking should not be effected by interest rates as it is an interest-free banking system but deposits and loans in Islamic banks in Turkey are highly dependent on changes in the interest rate.12 There is just a negligible part of Islamic finance which is based on PLS, and these Islamic deposits are not interest-free.13 Profit distribution of many Islamic banks is directly linked to religiosity, financial growth, asset composition and existence of discretionary reserves, whereas it is inversely linked to market familiarity with Islamic banking, market concentration, depositor funding reliance and bank age.14 Most of the Islamic banks perform commercial and investment banking services but do not set a firewall to separate these services legally and managerially. Supervisory authorities in the countries have taken various steps to regulate Islamic banks. This includes introducing Islamic banking act and regulating Islamic banks by-laws that govern all the banks.15 Islamic banking industry is making significant improvements to become an alternative to conventional banking, and it has attained a significant ground in the Middle East, South East, and South East Asia.16 The existing system of Islamic banking in Pakistan is based on illegal subterfuges, and there is only a little support to this system from Islamic law, but the real Shariah objectives in practicing Islamic banking is tramping.17 Few problems existing in Islamic banking especially in the area of financing can be eliminated with minor changes, and resultantly Islamic banks can offer interest-free banking. These problems can be eliminated by using two types of financing: loans along with service charges and participatory financing in mudarabah. Moreover, there exists a significant difference between male and female customers‟ awareness regarding Islamic banking in Pakistan, but in conventional 9 Shaista Wasiuzzaman and Umadevi Nair Gunasegavan, “Comparative study of performance of Islamic and conventional banks: The case of Malaysia,” Humanomics 29, no. 1 (2013), pp.43-60. Accessed April 28, 2018. doi: https://doi.org/10.1108/08288661311299312 10 Manshor Amat Taap, Siong Choy Chong, Mukesh Kumar and Tat Kee Fong, “Measuring service quality of conventional and Islamic banks: a comparative analysis,” International Journal of Quality & Reliability Management 28, no. 8 (2011), pp.822-840. Accessed April 28, 2018. doi: https://doi.org/10.1108/02656711111162505. 11 Humayon A. Dar and John R. Presley, “Lack of Profit Loss Sharing in Islamic Banking: Management and Control Imbalances,” International Journal of Islamic Financial Services 2, no. 2 (2000), pp.3-18 12 E. H. Ergeç and B. G. Arslan, “Impact of interest rates on Islamic and conventional banks: the case of Turkey,” Applied Economics 45, no. 17 (2013), pp.2381-2388. Accessed April 29, 2018. doi: https://doi.org/10.1080/00036846.2012.665598. 13 Feisal Khan, “How „Islamic‟ is Islamic Banking?,” Journal of Economic Behavior & Organization 76, no. 3 (2010), pp.805-820. Accessed April 29, 2018. doi: https://doi.org/10.1016/j.jebo.2010.09.015. 14 Sayd Farook, M. Kabir Hassan and Gregory Clinch, “Profit distribution management by Islamic banks: An empirical investigation,” The Quarterly Review of Economics and Finance 52, no. 3 (2012), pp.333-347. Accessed April 29, 2018. doi: https://doi.org/10.1016/j.qref.2012.04.007. 15 Rifaat Ahmed Abdel Karim, “International accounting harmonization, banking regulation, and Islamic banks,” The International Journal of Accounting 36, no. 2 (2001), pp.169-193. Accessed April 29, 2018. doi: https://doi.org/10.1016/S0020-7063(01)00093-0. 16 M. Mansoor Khan and M. Ishaq Bhatti, “Islamic banking and finance: on its way to globalization” Managerial Finance 34, no. 10 (2008), pp.708-725. Accessed April 29, 2018. doi: https://doi.org/10.1108/03074350810891029. 17 Ali and Zubair, Interest Free Banking, 2. 107
4. Pakistan Journal of Islamic Research Vol : 19, Issue: 2 banking, no such difference exists. Furthermore, Islamic banks in Pakistan are more concerned in increasing their branch network and are neglecting customer orientation strategy.18 Both Islamic and conventional banks have different types of instruments for liquidity management, and these instruments are based on the basic idea of these banks. Compared to the conventional system, Islamic financial system has more equity-based instruments. The Islamic financial system is criticized by Shariah scholars because most of the Islamic financial institutions are not practicing according to Shariah rules. Islamic banks in Pakistan are engaged in a hybrid representation of Islamic and traditional financing and are moving slowly in adopting the PLS contracts in Pakistan as compared to other countries.19 Islamic financial system gives the concept to invest money in halal business opportunities and utilizing funds on PLS basis. Islamic modes of financing can be classified into two types: fixed-return (murabahah, ijarah, salam, and istisna) and variable-return (which are mainly mudarabah and musharaka).20 The purpose of this research is to make a clear difference between Islamic and conventional banking by analyzing whether Islamic banking is actually a PLS or it‟s just an alternative name for interest-based finance. Our study typically pays attention to examine the impact of conventional banks‟ deposit rates on investment rates of Islamic banks in Pakistan. Islamic Banking in Pakistan: Islamic banking in Pakistan was started in 2001 when the Pakistani government decided to promote Islamic banking in the country. In this regard, Meezan bank was granted a license on 31st January 2002, and the bank started their operations in March 2002 as the first Islamic bank in Pakistan. From that time till now Islamic banking in Pakistan is continuously growing. Figure 1 captures the exponential growth (in terms of total assets) of Islamic banking in the country. In 2006 total assets of Islamic banks in Pakistan were 119 billion (2.4%) and it increased to 206 billion (become 4.2%) in 2007. Over the years Islamic banking assets were continuously growing and they reached 1089 billion in 2014 (10.4%). Remarkably, in 2015 total assets became 1610 billion (which is 11.4%) and in 2016 it increased to 1853 billion which is 11.7% of the share of the overall banking industry. $ in billion 2000 1610 1500 1000 500 119 206 277 366 477 641 837 903 1853 1089 0 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Years 18 Khan, How ‘Islamic’, 3. Anjum Siddiqui, “Financial contracts, risk and performance of Islamic banking,” Managerial Finance 34, no. 10 (2008), pp.680-694. Accessed April 29, 2018. doi: https://doi.org/10.1108/03074350810891001. 20 Dar and Presley, Lack of Profit Loss Sharing in Islamic Banking, 3. 19 108
5. Are Pakistani Islamic Banks Really Interest-free ? Figure 1: Total Assets’ growth of Islamic Banks in Pakistan: Furthermore, Table 1 provides information about the percentage of Islamic banking assets in 2016 as compared to other financial institutions. The Table shows that Islamic banking assets are only 7.9% as compared to other financial institutions in Pakistan. Commercial banks take up 46.01% of total assets, whereas Development Financial Institutions (DFIs) have just 0.06% of the assets. Table 1: Islamic Banking Assets by Type of Institutions No. of Total assets (in % of total institutions billion) assets Islamic banksa 5 1853 7.90 Commercial banksb 23 10752 46.01 Domestic banksc 12 10302.53 44.08 Foreign banksd 7 279.66 1.20 Specialized bankse 3 170.06 0.73 DFIsf 6 13.67 0.06 All Banks and DFIs 56 23370.92 a Full-fledged Islamic banks in Pakistan. b Commercial banks including foreign, domestic and Islamic banks. c Domestic banks including both conventional and Islamic. d Foreign banks including both conventional and Islamic. e Industrial Development Bank of Pakistan, SME Bank, Zarai Taraqiati Bank, The Punjab Provincial Cooperative Bank. f All DFIs in Pakistan. Figure 2 indicates the market share of Islamic banks by various financial institutions in 2016. The Figure shows that Islamic banks have a small percentage of the assets. In particular, it takes up 1% of all banking industry which is the second smallest market share. Contrariwise, commercial banks have the largest market share which is 50% of all banks, while DFIs have the lowest market share of the industry. The Figure also tells that foreign commercial banks have the second lowest share, whereas domestic commercial banks have the second highest share in the banking industry. Figure 2: Market Share of Banking Industry 109
6. Pakistan Journal of Islamic Research Vol : 19, Issue: 2 Mode-wise financing of Islamic banking industry remained concentrated. Both murabahah and Diminishing musharaka modes collectively contributed about 65% of the overall financing as shown in Table 2. Murabahah decreased to 15.8 in December 2016 which was 24.5 percent in December 2015, but musharaka increased to 15.6% in December 2016 which was 14% in December 2015. Thus, musharaka is the highest mode of financing during the last two quarters among other modes of financing. Table 2: Financing mix of Islamic Banking (% share) Dec-15 Sep-16 Dec-16 Murabahah 24.5 16.9 15.8 Ijarah 6.6 7.8 6.8 Musharaka 14.0 12.0 15.6 Diminishing Musharaka 31.7 38.5 34.7 Salam 5.3 3.3 4.4 Istisna 8.6 7.0 8.4 Others 9.3 14.5 14.3 Total 100.0 100.0 100.0 Source: Islamic Banking Bulletin December 2016 by SBP. The remainder of this paper is structured as follows: section two presents a review of the literature. Data and research methodology is described in section three. Section four is devoted to empirical results and discussion. Finally, section five summarizes the results of this research and draws a conclusion. 2. Literature Review: The major cause of lack of PLS in the practice of Islamic finance is an imbalance between management and control rights. The agency problem gets accentuated too. However, there is no theoretical reason to believe that PLS is inherently inefficient. 21 The controversies are faced by Islamic banking. It was judged that among the most crucial challenges for an Islamic bank is to create confidence in its depositors as well as all other operators in the market about the harmony of its operations with that of Sharia.22 The functions and tools of central banking in an Islamic framework showed that the current monetary policy tools of interest-based economies could be modified and used in an interest-free Islamic banking system. It was concluded that the existence of high-speed computer technology and new accounting practices have increased the feasibility of a true interest-free Islamic banking.23 There is almost no difference between Islamic and conventional banking, as Islamic deposits are not interest-free but are closely similar to that of conventional deposits. Various types of Islamic banking contracts were taken into consideration during examining Islamic law and finance and reported that the spirit of PLS mechanism is found in contracts of Islamic banking.24 Returns on mudarabah deposits were compared with equity in Islamic banks and results showed that return on equity is two times higher 21 Dar and Presley, Lack of Profit Loss Sharing in Islamic Banking, 3. Sorina Aioanei, “European Challenges for Islamic Banks,” The Romanian Economic Journal 10, no. 25 (2007), pp.7-20 23 Hamid Zangeneh and Ahmad Salam, “Central Banking in an Interest-Free Banking System,” Journal of King Abdulaziz University: Islamic Economics 5, no.1 (1993), pp.25-36 24 Abdul Ghafar b. Ismail and Achmad Tohirin, “Islamic law and finance,” Humanomics 26, no. 3 (2010), pp.178-199. Accessed April 29, 2018. doi: https://doi.org/10.1108/08288661011074954. 22 110
7. Are Pakistani Islamic Banks Really Interest-free ? than the returns on mudarabah deposits.25 Islamic banking runs its operations on the basis of Islamic jurisprudence and is according to the Holy Quran and Sunnah. Furthermore, analysis told that the distinctive characteristic of Islamic banking is a prohibition of riba (interest). The potential effect of the Islamic practices on Western economic relationships was illustrated on the prohibition of interest (riba) in Islamic finance/economics. Studies showed that the alternative method of financier remuneration (i.e., mudarabah PLS) would, under certain conditions, enhance capital investment on account of its ability to act as an efficient revelation device. The products offered by Islamic banking and their specifications and benefits are not familiar to most of the customers like ijarah and murabahah financing. The study concluded that many unaware customers believe that Islamic banks do not provide satisfactory products and services as compared to conventional banks.26 The authors conduct research on products/services and performance of Islamic banks in Pakistan. They document that there is a clear difference between operations of Islamic and conventional banking, as the former is totally Sharia-based and later is interest-based.27 The researchers study the impact of conventional banks‟ interest rates and profit rates on deposited funds in Islamic banks of Malaysia. Furthermore, Adaptive Expectation Model was used to examine the influence of interest rates of deposit account facilities of conventional banks and past dividend rates on funds deposited by customers on Islamic deposit facilities of Malaysian banks. They find that there is a strong relationship between interest rates of deposit accounts of conventional banks and profit rates declared by Islamic banks. Subsequently, they suggest that management of Islamic banks should manage and adjust according to the market rate to satisfy its customers.28 It was theoretically expected that Islamic banks, relying on interest-free banking, shall not be affected by interest rates; however, in concurrence with previous studies, they find that interest rates evidently influence Islamic banks in Turkey. 29 Key determinants of Islamic banking in banking customers living in Peshawar (Khyber Pakhtunkhwa, Pakistan) were examined using primary data which was collected through questionnaires and tested through regression technique. The results showed that positive aspects of Islamic banking and flaws of interest-based banking had a positive relationship with acceptance of Islamic banking in Muslim customers across Peshawar.30 25 Abdou Diaw and Abdoulaye Mbow, “A comparative study of the returns on Mudhārabah deposit and on equity in Islamic banks,” Humanomics 27 no. 4 (2011), pp.229-242. Accessed April 29, 2018. doi: https://doi.org/10.1108/08288661111181288. 26 Naveed Azeem Khattak and Kashif-Ur-Rehman, “Customer satisfaction and awareness of Islamic banking system in Pakistan,” African Journal of Business Management 4, no. 5 (2010), pp.662-671 27 Ashfaq Ahmad, Rehmat Ullah Awan and Muhammad Imran Malik, “An overview of the operations/products offered by Islamic banks in Pakistan,” African Journal of Business Management 5, no. 11 (2011), pp.4185-4190. Accessed April 29, 2018. doi: https://doi.org/10.5897/AJBM10.724. 28 Sudin Haron and Norafifah Ahmad, “The Effects of Conventional Interest Rates and Rate of Profit on Funds Deposited with Islamic Banking System in Malaysia,” International Journal of Islamic Financial Services 4, no. 1 (2000). 29 Ergeç and Arslan, Impact of interest rates on Islamic and conventional banks, 3. 30 Muhammad Asif and Muhammad Asif Anjum, “Acceptance of Islamic banking in Muslim Customers: A Comparative Study on Flaws of Interest Based Banking vs Positive Aspects of 111
8. Pakistan Journal of Islamic Research Vol : 19, Issue: 2 The authors test the impact of various internal characteristics of Islamic banks such as non-interest earnings, liquidity, capital ratio, bank size and administrative costs on profitability, and conclude that bank size and capital ratio are positively related to return on equity and earnings per share. While administrative costs are negatively related to all measures of profitability.31,32 There is a vital link between investment rates of Islamic banks and deposit rates of conventional banks. Furthermore, they find that fluctuations in conventional deposit rates cause Islamic investment rates to change, but not the other way round.33 To the authors‟ best knowledge, no study has yet explored these dimensions with respect to Islamic commercial banks in Pakistan. Thus, the findings of this research have filled the contextual gap in the literature. Additionally, the results of the study provide support to bank managers and regulatory authorities in their decision-making processes. 3. Data and Research Methodology: The current research for practical implementation has selected five Islamic banks (i.e., Al Baraka Islamic Bank, Dubai Islamic Bank, Meezan Islamic Bank, BankIslami Pakistan and Burj Islamic Bank) and five conventional banks (i.e., KASB Bank, MCB Bank, National Bank of Pakistan, Habib Metropolitan Bank and Summit Bank). Owing to the special nature of this research the authors take data from annual reports published by the Islamic and conventional banks over the period of 2010 to 2016. It is important to note that data of these banks was fully available; whereas, data of other banks which were excluded in the present study was found incomplete due to the reason that (excluded) banks started their operations at different points in time during the study years. Investment rates of Islamic banks and deposit rates of conventional banks are variables of the study. Following are abbreviations of the variables: ALWA_IB_00: Al-wadia Islamic banks‟ saving deposit rates. MUD_IB_01: Mudarabah deposit rates of Islamic bank 1-month term deposit. MUD_IB_03: Mudarabah deposit rates of Islamic bank 3-month term deposit. MUD_IB_06: Mudarabah deposit rates of Islamic bank 6-month term deposit. MUD_IB_12: Mudarabah deposit rates of Islamic bank 12-month term deposit. SD_CB_00: Saving deposit rates of conventional banks. FD_CB_01: Conventional bank rates on 1-month fixed deposit. FD_CB_03: Conventional bank rates on 3-month fixed deposit. FD_CB_06: Conventional bank rates on 6-month fixed deposit. FD_CB_12: Conventional bank rates on 12-month fixed deposit. Islamic Banking,” International Review of Management and Business Research 1, no. 1 (2012), pp.9-17 31 Nadeem Ahmed Sheikh and Sitara Karim, “Determinants of Profitability of Islamic Commercial Banks: Evidence from Pakistan,” Pakistan Journal of Islamic Research 17, no. 1 (2016), pp.71-78 32 Muhammad Sadiq Shahid, Muhammad Hassan and Muhammad Rizwan, “Determinants of Islamic Banks‟ Profitability: Some Evidence from Pakistan,” Pakistan Journal of Islamic Research 16, (2015), pp.149-167 33 Beng Soon Chong and Ming-Hua Liu, “Islamic banking: Interest-free or interest-based?,” Pacific-Basin Finance Journal 17, no. 1 (2009), pp.125-144. Accessed April 30, 2018. doi: https://doi.org/10.1016/j.pacfin.2007.12.003. 112
9. Are Pakistani Islamic Banks Really Interest-free ? We first applied Pairwise Granger Causality Test to decide dependent and independent variables. We further used this technique to test the following null hypotheses: H01: Islamic banks‟ investment rates does not Granger cause conventional banks‟ deposit rates. H02: Conventional banks‟ deposit rates does not Granger cause Islamic banks‟ investment rates. Additionally, to confirm that the relationship between Islamic and conventional banks‟ rates is not forged, we applied the regression test. The relationship between two variables is modeled as follows: Yt= β0 + β1Xt + εt ……………………………………………………………………………………………… (1) Where Yt denotes dependent variable(s), Xt represents independent variable(s), and εt is the error term. The model is a modified form of the original equation by Chong and Liu (2009).34 4. Results and Discussion: Descriptive statistics for the sample data are shown in Table 3. The results indicate that mean values of the investment rates of Islamic banks are lower than the deposit rates of conventional banks; and mean differences between the Islamic and conventional rates having zero, three and six months maturities are statistically significant. Moreover, the table illustrates that standard deviation values of Islamic banks‟ investment rates are lower as opposed to the rates of conventional banks, and the differences between two types of bank rates with three, six and twelve months maturities are statistically significant. Furthermore, minimum values of the investment rates are higher than the deposit rates, except for Al-wadia Islamic bank saving deposit rates; however, maximum values are lower for the investment rates than their corresponding rates, except the investment rates having one-month maturity. These findings are contradictory to theory because according to the PLS theory, higher risks are associated with Islamic deposits compared with conventional deposits. Table 3: Descriptive Statistics and Correlation Coefficients Varia blea Min Ma x Mea n Std. dev. Islamic Banks‟ Investment Rates ALW A_IB_ 00 MUD_ IB_01 MUD_ IB_03 MUD_ IB_06 MUD_ IB_12 6.00 5.00 8.82 6.34 5.99 8.50 * 6.65 6.14 8.25 6.93* 9.50 Min Me an Std. dev. Correl ation coeff icien tb Conventional Banks‟ Deposit Rates *** 3.20 5.80 Variable Ma x 4.39 7.87 0.78 SD_CB_00 5.00 8.00 5.92 0.79 0.48 0.92 FD_CB_01 5.00 8.00 6.46 0.93 0.21 FD_CB_03 5.03 9.00 7.10 1.20 0.08 FD_CB_06 5.05 10.00 7.43 1.40 0.35 FD_CB_12 5.12 11.50 8.40 1.69 0.45 0.62** * 0.60** * 0.88** * Note: ***, **, * indicates the significant differences between Islamic banks‟ investment rates and conventional banks‟ deposit rates at 1%, 5%, and 10% level, respectively. 34 Chong and Liu, Islamic banking, 8. 113
10. Pakistan Journal of Islamic Research Vol : 19, Issue: 2 All variables are represented in the aaaa_bbbbbb_cc format; where aaaa is indicating the deposit type, bbbbbb is the bank type, and cc is representing the maturity in months. For instance, MUD_IB_01= Mudarabah deposit rates of Islamic bank 1-month term deposits; FD_CB_01= Deposit rates on commercial banks‟ 1-month fixed deposits. b Indicates the correlation coefficient between Islamic and conventional banks‟ rates having similar maturity. The last column of Table 3 tells the association between banks‟ investment and deposit rates with similar maturities. The results of Correlation Technique reveal that the investment rates are positively related to conventional banks‟ deposit rates. The values of correlation coefficient range from 0.08 to 0.48. The results are perfectly in line with prior research.35 The authors further applied Pairwise Granger Causality Test to decide whether conventional banks‟ deposit rates Granger cause Islamic banks‟ investment rates, or vice versa. The Results of the test are presented in Table 4. Table 4: Pairwise Granger Causality Test Null Hypothesisa SD_CB_00 does not Granger cause ALWA_IB_00 ALWA_IB_00 does not Granger cause SD_CB_00 FD_CB_01 does not Granger cause MUD_IB_01 MUD_IB_01 does not Granger cause FD_CB_01 FD_CB_03 does not Granger cause MUD_IB_03 MUD_IB_03 does not Granger cause FD_CB_03 FD_CB_06 does not Granger cause MUD_IB_06 MUD_IB_06 does not Granger cause FD_CB_06 FD_CB_12 does not Granger cause MUD_IB_12 MUD_IB_12 does not Granger cause FD_CB_12 F-Statistic 14.92 1.12 4.97 0.10 12.84 0.52 13.21 0.77 5.65 0.57 P-value 0.001 0.360 0.050 0.905 0.003 0.618 0.002 0.492 0.026 0.586 The Table describes the results of Pairwise Granger Causality Test. We tested the two null hypotheses: H01 (Islamic banks‟ investment rates does not Granger cause conventional banks‟ deposit rates) and H02 (Conventional banks‟ deposit rates does not Granger cause Islamic banks‟ investment rates). In all the hypotheses, we failed to reject the first null hypothesis (H01), but we rejected the second null hypothesis (H02). a All variables are represented in the aaaa_bbbbbb_cc format; where aaaa is indicating the deposit type, bbbbbb is the bank type, and cc is representing the maturity in months. For instance, MUD_IB_01= Mudarabah deposit rates of Islamic bank 1-month term deposits; FD_CB_01= Deposit rates on commercial banks‟ 1-month fixed deposits. The results demonstrate that for each of the five deposit rates (with similar maturities), we can reject the null hypothesis (H02) that “conventional banks‟ deposit rates does not Granger cause Islamic banks‟ investment rates”. In contrast, we cannot reject the null hypothesis (H01) that “Islamic banks‟ investment rates does not Granger cause conventional banks‟ deposit rates”. To conclude, the deposit rates affect investment rates, but not the other way round. These results are consistent with previous studies.36 After defining dependent and independent variables through the Granger Causality Test, the researchers then applied Ordinary Least Square (OLS) regression test to analyze the relationship between endogenous (Islamic banks‟ investment rates) and exogenous (conventional banks‟ deposit rates) variables. 35 36 Chong and Liu, Islamic banking, 8. Chong and Liu, Islamic banking, 8. 114
11. Are Pakistani Islamic Banks Really Interest-free ? Table 5: OLS Regression Dependent variable ALWA_IB_00 MUD_IB_01 MUD_IB_03 MUD_IB_06 MUD_IB_12 a Independent variablea SD_CB_00 FD_CB_01 FD_CB_03 FD_CB_06 FD_CB_12 Intercept (β0) Slope (β1) 7.72 (0.04) 9.00 (0.00) 0.21 (0.14) -5.61 (0.00) 11.44 (0.00) 1.04 (0.08) 0.38 (0.03) 1.19 (0.00) 0.18 (0.09) 0.43 (0.02) Adjusted R2 0.37 0.59 0.50 0.32 0.48 We tested the following regression equation to analyze the relationship between Islamic and conventional banks‟ rates having the similar maturity: Yt= β0 + β1Xt + εt Where Yt denotes the dependent variable(s), Xt represents the dependent variable(s), and εt is the error term. a All variables are represented in the aaaa_bbbbbb_cc format; where aaaa is indicating the deposit type, bbbbbb is the bank type, and cc is representing the maturity in months. For instance, MUD_IB_01= Mudarabah deposit rates of Islamic bank 1-month term deposits; FD_CB_01= Deposit rates on commercial banks‟ 1-month fixed deposits. The results of regression estimation are presented in Table 5. The values of Adjusted R-squares are high. Table 5 indicates that Adjusted R2 values range from 32% to 59%, which means that 32-59% of the variations in endogenous variables (i.e., Islamic rates) are explained by exogenous variables (i.e., conventional rates). The Table also shows that Islamic banks‟ investment rates have a positive and significant relationship with maturity-matched conventional banks‟ deposit rates. These findings are fully in line with past research.37 5. Conclusion, Limitations and Policy Implications: The current research is based on the concept of Islamic banking in Pakistan. In this study, the authors try to test whether Islamic banking in Pakistan is interest-free or interest-based. To achieve the research objectives, the researchers applied the Descriptive Statistics, Correlation Analysis, Pairwise Granger Causality Test and OLS Regression. Opposite to our expectations, the results of Descriptive Statistics show that the mean values of Islamic banks‟ investment rates are lower than conventional banks‟ deposit rates. Moreover, contrary to the PLS theory, standard deviation values of the Islamic rates are lower than deposit rates of conventional banks. The findings from Correlation technique indicate that the Islamic and conventional rates are positively correlated with each other. By applying the Granger Causality Test, we find that the conventional rates cause variations in Islamic banks‟ investment rates in Pakistan, but not vice versa. The results from OLS Regression indicate a positive and significant relationship between Islamic investment rates and conventional deposit rates having similar maturities. Thus, our overall findings provide a new evidence that reveals the Islamic deposits in Pakistan are not really interest-free but are quite identical to conventional deposits. According to the study, it is observed that there are no major differences among the operations of Islamic and conventional banking, except PLS in Islamic banks. Hence, Sharia is being followed up to a certain extent, but not completely. However, still returns on Islamic accounts are far more attractive than on conventional accounts. Although there may be some agency problems in PLS in Islamic banking system, it is preferable too. 37 Ibid., 11. 115
12. Pakistan Journal of Islamic Research Vol : 19, Issue: 2 The present research has a number of limitations, most notably that only small number of banks are used as a sample. In addition, the market must be efficient to observe an impact of changes in the deposit rates of conventional banks on investment rates of Islamic banks in Pakistan. However, it cannot be guaranteed that the banks used as a sample in this study met the efficient market assumption; so, the results may be biased. The empirical findings of the study have some practical implications for customers, investors, policymakers, and shareholders. Our results show that Islamic banking is very similar to conventional banking in practice. Hence, one implication of our study is that Islamic banks should be regulated and supervised in a similar manner as conventional banks. For example, results suggest that there should not be any capital relief for assets that are funded by mudarabah deposits. Some important and relevant recommendations for future research to expand the area of research might be: using the large sample size to analyze the effects of changes in deposit rates of conventional banks on Islamic banks‟ investment rates in order to provide more comprehensive evidence; and employing different econometric techniques (such as Johansen Co-integration Test, Error Correction Model, etc.) to observe any significant changes in the study. 116