Al‐Bay' Bithaman Ajil financing: Impacts on Islamic banking performance

Abstract

AbstractThe dual‐banking system in Malaysia is expected to put Islamic banks at a disadvantage due to the latter's over‐dependency on fixed rate asset financing such as al‐bay' bithaman ajil and murabahah. When interest rates are rising, rational product choice among non‐Muslim customers (NMC) is expected to produce a shifting effect that may frustrate deposit mobilization and at the same time able deplete an Islamic bank's earnings. The shifting effect occurs when NMC either transfer deposits from Islamic banks to conventional banks, or, in a period of declining interest rates, opt for loans rather than for deferred sale financing. These shifts occur solely due to pecuniary incentives sought by NMC as the suppliers of deposits or demanders of funds. During an economic slowdown normally accompanied by falling interest rates, the shifting effect is expected to increase idle balances as the demand for fixed rate asset financing declines. Thus, in the choice of banking products, it is argued that NMCs will be the main beneficiaries of the dual‐banking system since they are open to more options than the Muslim customers (MC). Consistent with these expectations, we find that profit margins of Bank Islam Malaysia suffered a decline between the 1996–1997 period of rising interest rates while interest margins of conventional banks showed a rising trend. © 1999 John Wiley & Sons, Inc.