What is the development of interest rate under the conditions of Islamic banking?

Question

What is the development of interest rate under the conditions of Islamic banking?

Answer

Interest rate changes play an important role in determining the specific demand for Islamic financing in dual banking systems. In this context, it has become relevant to clarify that the competitiveness of Islamic banks can be expanded through offering flexible financial services that match those provided by conventional banks (Kader and Leong, 2009). It has been further illustrated that Islamic banks are persistently exposed to interest rate risks, which can be explained with the existence of fixed profit rate in these financial institutions. Even though the profit margin of conventional banks cannot be affected, irrespective of changes in interest rate, Islamic banks are unable to increase the rate of returns on its deposits (Imam and Kpodar, 2016). It should be noted that customers of Islamic banks are not guided by profit objectives in carrying out particular financial transactions, thereby certain changes in the basic lending rate may not result in important changes to the level of Islamic bank financing. At times when interest rates are significantly high, Islamic financing would be a preferable option to customers, whereas falling interest rates would indicate customers’ preference for obtaining conventional loans. Even though Islamic banking operates on interest free principles, Islamic bank financing is obviously exposed to interest rate risks (Imam and Kpodar, 2016). A proper recommendation resulting from the development of interest rate under the conditions of Islamic banking is that Islamic banks should detach themselves from the prevailing interest rate movements. This objective can be achieved if Islamic banks reconsider the use of fixed rate instruments (Kontot et al., 2016). In the profit-sharing system under Islamic banking, it is essential to note that returns are derived from real sector performance, indicating that interest rate appears an exogenous factor in profit-sharing mechanisms.

References

Imam, P. Kpodar, K. (2016). Islamic banking: Good for growth? Economic Modelling. 59(1) 387-401. Kader, R. A. Leong, Y. K. (2009). The impact of interest rate changes on Islamic bank financing. International Review of Business Research Papers. 5(3) 189-201 Kontot, K. Hamali, J. Abdullah, F. (2016). Determining factors of customers’ preferences: A case of deposit products in Islamic banking. Procedia-Social and Behavioral Sciences. 224(15) 167-175..