An Analysis of the Islamic Banking Profit Rate and Conventional Banking Interest Rate in Malaysia

Devagi d/o Erusan Universiti Tunku Abdul Rahman (UTAR), Malaysia devagie@utar.edu.my Haslindar Ibrahim Universiti Sains Malaysia (USM), Malaysia haslindar@usm.my

Abstract
The paper examines the performance of profit rate of Islamic Bank against fixed deposit rate of conventional banks and foreign conventional banks for the period of 2002 until 2006. About 12,600 observations were categorized into 1-month, 3-months, 6-months, 9-months, 12-months and 15-months of rates. This study examines whether there is any differences of profit rate and fixed deposited return between Islamic bank, local conventional banks, foreign conventional banks and finance companies. Analyses of interest rate reveal that, finance companies generally provide the highest interest rate compared to Islamic bank profit rate, local conventional banks and foreign conventional banks interest rate. The findings also suggest that there is a significant difference in mean return between the Islamic bank, local conventional banks, foreign conventional banks and finance companies. Keywords: Islamic banking, Profit rate, interest rate

1. Introduction
At present, the analysts and customers instinctively want to compare the performance and the pricing between the Islamic and conventional banking systems. Malaysia has practiced a dual banking system where Islamic banking system operates side-by-side with a conventional one. According to Bank Negara, the number of branches of Islamic banks increased from 766 at end 2005 to 1,167 at end 2006 in Malaysia. However, Islamic banks only had 329 (Auto Teller Machines) ATMs compared with 4,869 for the conventional commercial banks. Indeed, in the same period the number of official Islamic banks increased from 6 to 10 in the same period, including the wholly-owned foreign Islamic banks such as Asian Finance Bank (a consortium bank owned by Saudi, Qatari, Bahraini and Kuwaiti institutions), Saudi-owned Al-Rajhi Bank (Malaysia), and Kuwait Finance House (Malaysia) (Parker, 2007).

The earliest of Islamic banking activity could be traced back to September 1963 when Perbadanan Wang Simpanan Bakal-Bakal Haji (PWSBH) was set up. PWSBH was set up as an institution for Muslims to save for their Haj expenses. In 1969, PWSBH merged with Pejabat Urusan Haji to form Lembaga Urusan dan Tabung Haji (now recognized as Lembaga Tabung Haji). The first Islamic bank was established in 1983. In 1993, commercial banks, merchant banks and finance companies were allowed to offer Islamic banking products and services under the Islamic Banking Scheme (IBS). These institutions however, are required to separate the funds and activities of Islamic banking transactions from that of the conventional banking business to ensure there would not be any combination of funds. The depositors are the lenders to the bank and the bank is the borrower. The aim of this paper is to examine the dissimilarity in Islamic banking profit rate and conventional banking interest from year 2002 to 2006 between Islamic Bank, local conventional banks, foreign conventional banks and finance companies. The findings show that there is a significant difference in mean return between Islamic banks and local conventional banks and Islamic banks and foreign conventional banks and Islamic banks and finance companies. This finding suggests that the interest rate is one of the important considerations in explaining the customers or individuals behaviour in choosing the bank to deposit their money. In 2006, there are more than 200 interest-free institutions operating in 40 nations worldwide and providing services that are compatible to those services offered by conventional banks. Western conventional based financial institutions such as Citibank, JP Morgan, Deutsche bank, ABN Amro and American Express have started introducing interest-free products to customers. Like conventional banks, Islamic banks also depend on depositors money as a major source of funds. Bank Islam Malaysia Berhad (one of the Islamic banks in Malaysia) for example, had total deposits amounting to 83% of total liabilities and shareholders equity as at the end of December 1998. According to Haron (2000), since depositors money is a major source of funds, it is important for the management of Islamic banks to know the factors that influence customers decision making in depositing their money with the banks. Since, depositors are motivated by returns, it is important for Islamic banks management to understand the extent that rates of return on deposits influence their customers decision to deposit.

2. Literature review 2.1 Introduction of Islamic Bank

The primary objectives for the formation of the first Islamic bank, Bank Islam Malaysia Berhad was to strive in its operation as a commercial bank based on Shariah laws in facilitating and banking services to both the Muslim and non-Muslim societies in this country by achieving strength and capacity to develop from time to time. Therefore, the bank has to operate its business without Riba or usury as an alternative to the conventional banking operating based on usury or interest. In order to operate a 2

banking business and other financial dealings, the bank has to operate based on profit and loss sharing mechanism. This is to ensure better social justice in the distribution of the added created wealth of the bank to the depositors, customers benefiting from financings and the equity holders of the bank. In this regard, the bank has to ensure it may become strong financially and expanding in all aspects of its operation as this will then become the measure on the ability of Shariah laws and rules as well as capabilities of the Muslims in offering an alternative way of life when dealing with banking business (Mohd Nasir and Amirul Hafiz, 2006). The key characteristic of Islamic finance is the prohibition of Riba, Islamic Financial ethics and law. The literal meaning of Arabic word, Riba is increase, addition of growth. However, it is usually translated as usury. Riba or usury is defined as extra or excess in lending and borrowing or additional in terms of weight or measurement in an exchange or buying and selling transaction. All transactions and contracts must be free from elements of Riba. The prohibition of Riba in Islamic finance is form based traditions (habith) and relates to prohibition of Riba in loan, sale or exchange contracts or exchange sale contract. Those who earn from usury stand only like one who is struck by the devils touch. This is because they claim that usury is a form of trade. Therefore the act of giving and taking as well as managing usury or interest is forbidden in Islam. Usury is any fixed percentage of earnings in return for funds deposited (Mohd Nasir and Amirul Hafiz, 2006) Islamic banking is an activity based on Islamic Syariah principles, which do not allow the paying and receiving of interest and promotes profit sharing in the conduct of banking. The most important difference between Islamic and conventional banking is the prohibition of interest in Islamic banking. Islamic banking activity is based on the trading principles of buying and selling of assets. Following that, in conventional financing, customers outstanding loan consists of principal plus the interest charged then onwards. The interest is actually the financial institutions cost in obtaining the funds and its profit. Islamic financing work on the concept of buying and selling where the financial institution purchases the property and subsequently sells it to customers above the purchase price (Mohd Nasir and Amirul Hafiz, 2006). The Islamic banking system has gained momentum worldwide. Citibank opened one new branch in Bahrain and Sudan adhering to Islamic Shariah principles. When a customer borrows money from a bank, it may lead to the interest rate. Thus, Islamic bank will use Shariah principles and specially offer the product and services like conventional banks. Customer pleasure has been a critical perception in contemporary marketing related to buyer behaviour. If customers are satisfied with a particular product or services offering after its use, then they are likely to engage in a repeat purchase. Then, the customer satisfaction is often described as being related to factors such as service quality and future services like convenience, competitiveness, location of service providers and a form of attitude that results from the comparison of expectation with performance. The Islamic banking system is expected to face strong competition not only from the Islamic banks but also from well-established conventional banks offering Islamic products and services (Naser and Pendlebury, 1997). 3

3. Providing interest rate will maximize the profit.

Determination of profit rates of return to depositors and investors is generally, in principle the institution need not have to pay any profit to the depositors of current accounts but this is not the case for depositors in saving accounts and depositors in general investment accounts. In determining the rates of returns to depositors, the classes of accounts are categorized by types of accounts. Further, the general investment accounts are categorized by the pre-set periodical tenors of investment or in simpler term by the durations of periodical investment, which are in practice range from the period of one month to a period of sixty months or five years. The pre-set periods of tenors are 1 months, 3 months, 6 months, 9 months, 12 months, 15 months, 18 months, 24 months, 36 months, 48 months, and 60 months. In practice, the rates of returns are usually computed automatically by the assistance of management accounting system of the bank. The gross pool of profits created by utilizing the depositors funds shall then be determined on a daily basis. The total profits are then distributed amongst the various categories of deposits and investment by types of accounts and further by tenors of investment. The distribution of profit shall be computed by taking the daily weighted proportion of balances for each category of deposits or investment accounts as numerator and the total of all the daily or monthly weighted proportion of balances for all categories of deposits or investment accounts as denominator and be multiplied by the duly recognized daily profits created utilizing the funds of depositors and investors. Since, all categories of accounts by types and further by tenors of deposits and investment have already been apportioned with profits, each categorys profits shall now be shared according to the pre-agreed ratio, such as 30:70 between the institution and the depositors. Finally, the rates of returns are determined by taking the daily depositors profits for each types or tenors of deposits or investment as numerator and the actual average daily balance for each category of deposit or investment by types of accounts and further by types of tenors as denominators and be multiplied 100 and subsequently be annualized in obtaining the rates of returns for each class of deposit accounts which are used when making payment of profits to the individual depositors (Mohd Nasir and Amirul Hafiz, 2006) The higher the rate of interest, the more money will be saved, since at higher interest rates people will be more willing to present consumption. Each of the different types of deposits available at the conventional and Islamic banks carries a different rate of interest or yield to the depositor. In general, the longer the maturity of a deposit, the greater the yield to the depositor, in part because of time value of money and the frequent upward slope of the yield curve. Similarly, saving or deposits are designed to attract funds from customers who wish to set aside money in anticipation of future expenditures or financial emergencies. These deposits generally pay significantly higher interest rates to customers than transaction deposits do particularly for those deposits the customer aggress to hold with the bank for several months or years. Conventional bankers have learned that deposit pricing can be used to shape the kind of customers base each bank can best serve. Changing deposit prices affect not only spread 4

between bank loan rates and deposit interest rates but also customers balances and deposit mix decision, which in turn, influence both bank growth and profit margin (Kamel, 2002). Haron (2001) finds that the interest rate has long been recognized not only by classical and neo-classical economists but also by contemporary economist as one of the factors that determine the level of savings in the economy then found that interest rate has a positive relationship with savings. In other words, customers are guided by the profit maximization theory. Since there is no pre-determined rate of return involved in Islamic banking system, it is unknown whether Islamic bank customers are subjected to the normal conventional theory of economic behaviour. He concludes that both interest rate of deposit accounts of conventional banks and rate of profit declared by Islamic banks have strong relationship with the amount of deposits of Islamic banks. The management of Islamic banks is bound to follow the market rate when declaring the rate of profit to their customers and vice versa. Haron (2001) also finds that conventional interest rates and rates of profit on funds deposited with Islamic banking system in Malaysia had raised a few important elements. One of it was the acknowledgment by conventional banks that those who are willing to part with their money must be rewarded. Other than the acknowledgement, the recognition that different types of deposits carry different amount of returns or rewards had been identifies. Due to this, he believes that if the management of Islamic banks believes that the attitude of depositors of Islamic banks is indifferent to those of conventional banks, the same rates of return will be rewarded with rates of conventional banks. There are several serious repercussions if the management of Islamic banks believes that depositors at Islamic banks posses similar attitudes to those at the conventional banks. The interest rate will continue to have an influence on the operations of Islamic banks as long as this thought remains in the mind of their management. Therefore, the testable null hypotheses of the study have been developed as follows: H01: H02: H03: H04: There is no difference in the mean return of interest rate performance between ISLAMIC BANK and LOCAL CONVENTIONAL BANKS There is no difference in the mean return of interest rate performance between ISLAMIC BANK and FOREIGN CONVENTIONAL BANKS There is no difference in the mean return of interest rate performance between ISLAMIC BANK and FINANCE COMPANIES There is no difference in the mean return of interest rate performance between ISLAMIC BANK, LOCAL CONVENTIONAL BANKS, FOREIGN CONVENTIONAL BANKS and FINANCE COMPANIES

4. Methodology
Sources of secondary data are manually collected from Personal Money magazine and individual banks websites. The data are consists of 1 Islamic bank (Bank Islam), 10 local conventional banks (Affin bank, Hong Leong bank , Alliance bank Malaysia, Malayan bank, Am Bank, Public bank, Bumiputra-commerce bank Malaysia, RHB bank, EON bank and Southern bank) ,13 foreign conventional banks (ABN Amro bank, HSBC bank Malaysia, Bangkok bank, J.P. Morgan Chase bank, Bank of America Malaysia, OCBC bank, Bank of China, Standard Charted bank, Bank of TokyoMitsubishi, The bank of NOVA Scotia, Citibank, United Overseas bank and Deutsche bank) and 11 finance companies (Alliance Finance, Am finance, Affin-ACF finance, Bumiputra-commerce finance, EON finance, Hong Leong finance, Kewangan bersatu , Mayban finance, MBF finance, Public finance, Southern finance ). Each banks data consists of five years period from year 2002 until 2006. A number of 12,600 observations were used in each category ranging from 1-month, 3- months, 6-months, 9-months, 12-months and 15-months of rates performance to analyze how much of return will earn for profit rate of Islamic bank against fixed deposit rate of local conventional banks, foreign conventional banks and finance companies. The data were analyzed by using SPSS software. SPSS is a sophisticated software used by social scientists and related professionals for statistical analysis. Using ANOVA (one-way between groups with post-hoc comparison) and Independent T-Test as a tools to analyze performance of fixed deposited rate (return on deposit) in Bank Islam compared to conventional banks and foreign conventional banks.

5. Results and discussions 5.1 Descriptive Statistics

The objective of this study is to measure and compare the performance of profit rate of Islamic bank against fixed deposit rate of local conventional banks, foreign conventional banks and finance companies. Thus, Table 1 displays the descriptive statistics for Islamic banks, local conventional banks, foreign conventional banks and finance companies. Generally, the findings show that the highest total average of mean return of 3.350 is offered by the finance companies compared to Islamic, local and foreign conventional banks which are offered total average of mean return of 2.473, 3.301 and 3.305 respectively. By looking at the individual month of the year period between 2002 and 2006, the highest average of mean return of 2.835 for Islamic banks is offered in November. Meanwhile, the highest average of mean returns of 3.392, 3.333 and 3.357 are offered in January for finance companies, local and foreign conventional banks respectively.

Table 1: Descriptive Statistics for Islamic Bank, Local Conventional Banks and Foreign Conventional Banks for Year 2002 to 2006
Islamic Bank (N=1) Mean January February March April May June July August September October November December Total 2.766 2.698 2.706 2.649 2.679 2.610 2.664 2.684 2.708 2.667 2.835 2.688 2.473 Std Dev 0.531 0.576 0.489 0.506 0.474 0.555 0.483 0.429 0.395 0.393 0.397 0.411 Local Conventional Banks (N=10) Mean Std Dev 3.333 0.349 3.274 0.343 3.273 0.344 3.273 0.344 3.332 0.363 3.301 0.348 3.305 0.349 3.303 0.349 3.305 0.349 3.304 0.349 3.304 0.349 3.299 0.343 3.301 Foreign Conventional Banks (N=13) Mean Std Dev 3.357 3.302 3.302 3.302 3.333 3.288 3.296 3.289 3.298 3.299 3.299 3.297 3.305 0.377 0.369 0.369 0.369 0.368 0.366 0.360 0.370 0.363 0.365 0.364 0.365 Finance Company (N=11) Mean Std Dev 3.392 0.348 3.369 0.348 3.367 0.348 3.367 0.348 3.377 0.336 3.332 0.333 3.333 0.332 3.333 0.332 3.330 0.329 3.333 0.330 3.332 0.330 3.334 0.333 3.350

Variables

5.2 Test of Differences between Banks

As depicted in Table 2, the mean of return performance for Islamic bank in January is 2.766 compared to the mean return performance of local conventional banks of 3.333. Independent sample T-test has been used to analyze whether the mean is significantly different from zero between Islamic bank and local conventional banks. The findings show that, the two-tailed test for the variable Islamic bank and local conventional banks indicates that p-value not exceed 1 percent level of significance. So, there is a significant difference between Islamic bank and local conventional bank in each month thus rejecting the null hypothesis of there is no difference in the mean return of interest rate performance between Islamic bank and local conventional banks (H01). It concludes that local conventional bank have been providing higher return of interest rate in each month compared to Islamic bank for year period between 2002 and 2006.

Table 2: Test of Differences between Islamic Bank and Local Conventional Banks for Year 2002 to 2006
Variables January February March April May June July August September October November December Islamic Bank (N=1) Mean 2.766 2.698 2.706 2.649 2.679 2.610 2.664 2.684 2.708 2.667 2.835 2.688 Local Conventional Banks (N=10) Mean 3.333 3.274 3.273 3.273 3.332 3.301 3.305 3.303 3.305 3.304 3.304 3.299

t-statistics -5.728* -5.38 0* -6.196* -6.600* -7.327* -6.679* -7.084* -7.649* -7.966* -8.541* -6.236* -7.870*

*significant at 0.01 level Table 3 shows the results of the independent t-test between both groups of Islamic bank and foreign conventional banks for each month starting from year 2002 until 2006. It shows that all conventional banking interest rate is higher than Islamic bank profit rate for all months. The results also show that mean return between Islamic bank and foreign conventional bank is statistically significant difference for each month thus rejecting null hypothesis H02. Table 3: Test of Differences between Islamic Bank and Foreign Conventional Banks for Year 2002 to 2006
Variables January February March April May June July August September October November December Islamic Bank (N=1) Mean 2.766 2.698 2.706 2.649 2.679 2.610 2.664 2.684 2.708 2.667 2.835 2.688 Foreign Conventional Banks (N=13) Mean 3.357 3.302 3.302 3.302 3.333 3.288 3.296 3.289 3.298 3.299 3.299 3.297 t-statistics -5.978* -5.658* -6.533* -6.929* -7.384* -6.571* -7.017* -7.514* -7.927* -8.526* -6.206* -7.877*

*significant at 0.01 level 8

Table 4 presents the findings of the independent t-test between both groups of Islamic bank and finance companies. The results show that all interest rate of finance companies are higher than Islamic bank profit rate for all months and it is statistically significant difference in mean return for each month. So, the study rejects the null hypothesis H03. Table 4: Test of Differences between Islamic Bank and Finance Companies for Year 2002 to 2006
Variables January February March April May June July August September October November December Islamic Bank (N=1) Mean 2.766 2.698 2.706 2.649 2.679 2.610 2.664 2.684 2.708 2.667 2.835 2.688 Finance Company (N=11) Mean 3.392 3.369 3.367 3.367 3.377 3.332 3.333 3.333 3.330 3.333 3.332 3.334 t-statistics -6.332* -6.279* -7.234* -7.601* -7.884* -6.999* -7.429* -8.068* -8.365* -8.986* -6.660* -8.354*

*significant at 0.01 level

5.3 One Way Analysis of Variance

One way analysis of variance (ANOVA) is used to measure the difference of mean returns for each month from 2002 until 2006 for all samples of banks. Table 4 demonstrates the comparison of mean return performance between Islamic bank, local conventional banks, foreign conventional banks and finance companies between January to December. The comparison shows that finance companies returns performance is the highest as compared to Islamic bank, local conventional banks and foreign companies while Islamic bank returns performance is lowest compared to other banks. In Table 5, the estimated F-statistic is 27.134 and significant at 1 percent level (as p-value<0.01) in January. The decision is to reject the null hypothesis (H04) of equal means at 1 percent significant level. The mean return performance for each month differs among the period of time. Finance companies have the highest mean return performance of 3.392 in January. Therefore, Islamic Bank has the lowest mean return performance of 2.610 in June.

Table 5: Descriptive Statistics and One-Way ANOVA for Islamic Bank, Local Conventional Banks, Foreign Conventional Banks and Finance Company for Year 2002 to 2006
Islamic Bank (N=1) Mean 2.766 2.698 2.706 2.649 2.679 2.610 2.664 2.684 2.708 2.667 2.835 2.688 Local Foreign Finance Conventional Conventional Company F-statistic Banks Banks (N=11) (N=10) (N=13) Mean Mean Mean 3.333 3.357 3.392 27.134* 3.274 3.302 3.369 32.001* 3.273 3.302 3.367 31.655* 3.273 3.302 3.367 36.881* 3.332 3.333 3.377 34.479* 3.301 3.288 3.332 37.652* 3.305 3.296 3.333 33.376* 3.303 3.289 3.333 31.010* 3.305 3.298 3.330 29.275* 3.304 3.299 3.333 33.410* 3.304 3.299 3.332 18.600* 3.299 3.297 3.334 31.328*

Variables

January February March April May June July August September October November December

*significant at 0.01 level

6. Conclusion
This study measures the mean returns of interest rate between Islamic banks, local and foreign conventional banks and finance companies in Malaysia from year 2002 until 2006. In addition, the study also examines the difference in mean return of interest rate between Islamic bank and local conventional banks, Islamic bank and foreign conventional banks and Islamic bank and finance companies. When the data has been analyzed, some interesting result emerged. The evidence of this result is shown in the data analysis of independent t-test and one way ANOVA. Using independent t-test, the results reject all null hypotheses of the study. The local conventional banks, foreign banks and finance companies provided higher return than Islamic bank to their investors. The findings conclude that there is a difference in means of returns between Conventional and Islamic banks. By using one-way ANOVA, the result suggests that the Finance companies are the highest mean return performance of 3.392 in January compared to other banks. Then, Islamic Bank has the lowest mean return performance of 2.6102 in June compared to other conventional banks. The most important difference between Islamic and conventional banking is the prohibition of interest in Islamic banking. Islamic banking activity is based on the trading principles of buying and selling of assets. Following that, in conventional financing, customers outstanding loan consists of principal plus the interest charged onwards.

10

REFERENCES Ariff, M. (1988). Islamic Banking, Asian Pacific Economic Literature, 2-2, pp46-64 Haron, S. (2003). Performance of Islamic and mainstream banks in Malaysia. International Journal of Social Economic, 20, 1249-1265. Haron, S. (2001). Islamic banking and finance, Leading issues in Islamic Banking and Finance, 20 (1), pp 17-32. Kamel, J. (2002). Islamic Banks Profitability in an Interest Rate Cycle. International Journal of Islamic Financial Services, 4 (2) Manandhar, R. and Tang, J. C. S. (2002). The evaluation of bank branch performance using data envelopment analysis. Journal of High Technology Management Research, 13, pp.1-17. Mohd Nasir, M.Y. and Amirul Hafiz, M.N. (2006) . Islamic Banking and Finance. 1 st Edition. Kuala Lumpur, Malaysia. McGraw-Hill Mohd Nasir, M.Y. (2000). The principles and practices of non-interest unit trust funds. Journal of Accountants. Ewcastle, UK. Jan Naser, M. and Pendlebury, M. (1997). The influence of Islamic bank financial reporting, International Journal of Commerce and Management. Naser, M . (2000). Determinants of Islamic Banking Profitability. Journal from University of New Orleans. Parker, M. (2007). Malaysias Islamic Banking Gathers Steam, Arab News, 23 April 2007 Turen, S. (1995). Performance and risk analysis of Islamic banks: The case of Bahrain Islamic Bank, Journal of Abdulaziz University , Vol 1568-1599

11