Bank margin determination: a comparison between Islamic and conventional banks in Indonesia

Abstract

PurposeThe purpose of this paper is to examine the relationship between Islamic bank margin (BM) and its determinants. It also compares the BM behavior of Islamic and conventional banks in the Indonesian dual banking system.Design/methodology/approachThe paper employs a time series approach under the dealership framework of Ho and Saunders. The autoregressive distributed lag model is used to inspect cointegration between BM and its determinants for the period of January 1996 to February 2006 of five sample banks (two Islamic banks and three conventional banks).FindingsThe result confirms that there exists a long‐running relationship between the Islamic BM and its determinants. In particular, as interest rate volatility increases, Islamic BM responds negatively while that of conventional banks responds positively. The findings differ from most of the other studies as they found a positive relationship between BM and interest rate volatility. This paper also shows that the margin behavior changes as the basis of bank operations changes from conventional to Islamic principles.Research limitations/implicationsThe paper uses a relatively small sample of three (out of 150) conventional banks as a comparison to two sample Islamic banks. However, as they come from the same peer with the Islamic banks, it is believed that the finding is valid. Islamic banks in Indonesia are not remote from the interest rate volatility in their presence under a dual banking system. It is the displaced commercial risk that threatens Islamic banking profitability in a changing market interest rate situation.Practical implicationsUnder a dual banking system, the stability of interest rates and the financial system is of great importance for the policy maker in developing the Islamic banking industry in Indonesia. As long as the BM is still a major source of income to the Islamic banks, it is necessary for Islamic banks to have prudent risk management to mitigate the negative effect of displaced commercial risk and maintain its profitability. Implementation of profit equalization reserves concept is a possible measure for Islamic banks to shield their operation.Originality/valueThis paper is believed to be the first study on Islamic BM behavior in Indonesia. It is expected to provide useful information for policy makers and Islamic bank management to develop a sound and profitable Islamic banking industry in Indonesia.