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Relationship Between Deposit Rates of Islamic and Conventional

Banking

Literature Review

The rate of return has always an important role in explaining the saving behavior of an

individual. In fact that is considered as the basic of financial activities. Thats why

different financial institutions offering different return rates on their different depositoryschemes. Deposit having high maturity has high rate of return and those having low

maturity has low rate of return. For instance the current account has very shorter maturity

having offered no return, and saving deposits have high maturity offered high rate ofreturn.

The difference among the Islamic and conventional banking system can be judged on the

basis of risk involvement. The Islamic jurists (Ullama Keram) argued that the element of

risk should not be removed from the financial transaction, if that is removed from thefinancial transaction then that transaction is no more remained the business or trade but

involved in the category of Usury(Riba). Thats why the profit rates of Islamic banksshould be accrued form one year to another year, according to the performance of the

bank, not according to the change in interest rate (Gafoor, 2001).

Just like to conventional banking, Islamic banking too provide the facility to their

customers by offering different types of depository schemes. Islamic banking accept the

capital providers right to utilize the best possible opportunity that arises from the factors

such as the risk involvement, rate of profit and the period of investment.It found that Islamic banking system around the world use usually three main type of

deposits; current accounts, saving accounts and investment accounts. On current andsaving deposit the bank guaranty the depositor the nominal value that he has deposits butgives no guaranty on return; and the investment deposits are operated fully under the

concept of profit and loss sharing (PLS) model (Ariff, 1988).

In another study analyze the relationship between total Islamic deposits and rate of

interest that offered under Islamic and conventional banking depository schemes in

Malaysia. They reached to the result that there is negative relationship between interestrates and total interest free deposits. They argued that Islamic saving and investment

accounts holders are highly influenced by the profit motive. So if the Islamic banking has

to attract their customers then they must have to offered profit rate more than

conventional banks or has to offer some other incentives that attract customers (Haroonand Nor Affifa, 2000).

In Malaysia a study conducted on finding causal relationship between Islamic andconventional banking instruments. The procedures involved the Granger causality test

and unit root test. And the finding of the study shows that the conventional TDRs

Granger causes Islamic TDRs in all respects. And they conclude from their study that

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Islamic banking should consider interest rates before adjusting their profit rates (Kaleem

and Md Isa, 2003).

A study that conducted by Humayon and Presley(1998), have provide a bright way to the

islamic financial; implementing and research authority that it would not be good to act as

isolated part of literature from western literature, but islamic financial can perform morebetter if ;they adopted the supportive arguments that is found in the western literature. It

would too encourage the focus of west on the new modal of Islamic finance for research

(Humayon and Presley, 1998).A study which conducted in Malaysia by Obaidullah (2005) has produced his wording on

the Islamic banking as: that Islamic banking is facing very competitive environment due

to their strong competitor. And Islamic financial institutions could be exposed to the risk

of strong withdrawal by its customer because of the high rate they received fromconventional institutions as compare to the Islamic institutions. In such scenario the

Islamic financial institution should have to pay such market competitive rates with which

they could retain their customers (Obaidullah, 2005).

In order to find out that weather the islamic banking and conventional banking is similarin practice are different from each other, a study conducted on the Malaysian Islamic

banking system by Beng soon Chong and Ming-Hua Liu in 2007. They tried to find outthe Granger Causality between Islamic and conventional banking, and had found that

there is relationship between both banking systems. Although in theoretical base a unique

feature that differentiates both banking system is interest (Riba). But in practice they

found that both systems were not as much different from each other (Chong & Liu ,2007).