The Impact of Interest Rate Changes on Islamic Bank Financing

Abstract

This study investigates the impact of interest rate changes on the demand for Islamic financing in a dual banking system. Theoretically, any change in the interest rate would lead customers who are guided by the profit motive to substitute Islamic financing for conventional bank loans and vice versa. Using monthly data from 1999 to 2007, the study found that any increase in the base lending rate would induce customers to obtain financing from Islamic banks and vice versa. The study concludes that because customers are profit motivated, Islamic banks in the dual system are exposed to interest rate risks despite operating on interest free principles.