A structural VAR analysis of Islamic financing in Malaysia

The purpose of this paper is evaluate the interrelations between Islamic financing and key economic and financial variables including real output, price level, interest rate and stock prices for the case of Malaysia.

The paper makes use of a structural vector autoregressive (SVAR) model to discern the influences of key economic and financial variables on the behavior of Islamic financing.

The basic results indicate that Islamic financing responds positively to innovations in real output. In addition, the price level shocks also tend to have significant but lagged effects on the financing provision of Islamic banks. Most interestingly, Islamic financing is impacted negatively and immediately by positive interest rate shocks, contradicting the argument that Islamic bank operations are shielded from interest rate fluctuations. Indeed, the excess sensitivity of Islamic banks to interest rate fluctuations and their lagged responses to price level shocks are found to be robust across alternative SVAR specifications.

Operating under a dual banking system, Islamic banks are not immune from monetary conditions of the country. Indeed, it seems to be exposed to the interest rate risk, an aspect that needs to be accounted for by Islamic banks in their risk management.

With the emergence of Islamic finance industry, understanding the implications of various macroeconomic factors on Islamic financing is essential. This study adds to this understanding, which has received limited attention.