Obiyathulla Ismath Bacha, Management Center, Kulliyyah of Economics & Management Sciences, International Islamic University Malaysia, examines 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.

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