The Islamic inter bank money market and a dual banking system: the Malaysian experience

Abstract

PurposeThis paper seeks to examine the operation of an Islamic inter‐bank money market (IIMM), within a dual banking system.Design/methodology/approachThe paper describes Malaysia's Islamic IIMM. It then examines some of the key risks associated with money market functions. An empirical examination of the extent to which yields in the IIMM are correlated with conventional money market yields is undertaken. The implication of this on interest‐rate exposure for the Islamic financial sector is discussed. Finally, the paper looks at some of the challenges and offers conclusions.FindingsThe paper argues that even though an Islamic money market operates in an interest‐free environment and trades Shariah‐compliant instruments, many of the risks associated with conventional money markets, including interest‐rate risks are relevant. The empirical evidence, based on Malaysian data, points to Islamic money market profit rates/yields that are highly correlated and move in tandem with conventional money market rates. Given the dynamics of fund flows and cross‐linkages, an IIMM operating within a dual banking system cannot sterilize itself from interest‐rate risks. In fact, the paper argues that such an IIMM may actually enhance interest‐rate risk transmission to the Islamic banking sector, by providing additional channels of transmission. Ironical as it may be, the operations of an IIMM in a dual banking system may serve to bring the Islamic banking sector into closer orbit with the conventional sector.Originality/valueThe paper offers insights into the IIMM, focusing on Malaysia.