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Review of Islamic Economics, Vol. 9, No. 1, 2005 31

An Econometric Analysis of
Conventional and Islamic Bank
Deposits in Malaysia
Remali Yusoff and Rodney Wilson

Abstract: The objective of this study is to determine the main factors influencing
Islamic and conventional deposits in Malaysia’s banking system. A structural model
consisting of five behavioural equations and three identities was applied to annual
data for the 1983–2001 period. Ordinary least squares analysis in the log linear form
was used to estimate the influences of various factors on the conventional demand
deposits, conventional time deposits, Islamic demand deposits, Islamic time deposits
and Islamic investment deposits. The results show that bank deposit growth was
influenced by changes in real gross domestic product, interest rates on conventional
deposits and the profit-share for savings and investments in Islamic banks. The Chow
test values show that demand deposits and time deposits in Islamic banks are more
stable than conventional demand and time deposits. Furthermore the findings
indicated a stronger relationship between the monetary base and conventional
deposits than between the monetary base and Islamic deposits, as shown by the t
statistics and the values of the adjusted R2.

I. Introduction
Large numbers of scholars writing on Islamic banking claim it is more
stable than conventional banking. However, almost all these studies
are theoretical. Our search of the literature shows that the studies by
Darrat (1988) and Hassan (1996) attempt to empirically verify the
superiority of Islamic banking in terms of deposit stability, using

DR REMALI YUSOFF is a Lecturer in Economics at the School of Business and

Economics, University Malaysia Sabah, Kota Kinabalu, Malaysia.

DR RODNEY WILSON is Professor of Economics in the School of Government and

International Affairs, Durham University.
© 2005, international association for islamic economics
Review of Islamic Economics, Vol. 9, No. 1, 2005, pp.31–52.
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32 Review of Islamic Economics, Vol. 9, No. 1, 2005

monetary aggregates (M1 and M2). In particular, Darrat (1988)

claims the superiority of Islamic banking in Tunisia, a country
without a real history of Islamic banking. Therefore, the purpose of
this study is to provide additional empirical analysis regarding the
determinants and volatility of Islamic bank deposits, using data on
demand and time deposits in Malaysia.
The emergence of strong Islamic movements over the last three
decades has generated a renewed interest in Islamic economics,
especially in Islamic interest-free banking. Iran and Sudan have
instituted Islamic banking systems, while many other countries have
established a mixed or dual banking system where Islamic banks
operate side by side with the conventional banks. Malaysia followed
the latter course, with its first Islamic bank, beginning operations in
July 1983, Bank Islam Malaysia Berhad (BIMB). The blueprint for the
modern Islamic banking system came in 1983, with the introduction
and enforcement of two new acts known as the Islamic Banking Act
and the Government Investment Act. However, in Malaysia the
demand for Islamic banking dates from the establishment of Lembaga
Tabung Haji Malaysia in 1969, now known as Tabung Haji. Tabung
Haji usually collects and invests the savings of those who want to
perform pilgrimage to Makkah in accordance to Islamic law
(SharϢah), and disburses the funds to pay for airfares and
accommodation.
Following a decade of the successful functioning and
performance of BIMB, the Malaysian government on March 4th
1993, introduced an interest-free banking scheme (Skim Perbankan
Tanpa Faedah). Under this scheme, all conventional banks were asked
to participate and offer Islamic finance by opening Islamic counters
that would exist side by side with conventional counters.
Islamic banks and conventional banks with Islamic counters or
branches in Malaysia, offer deposit facilities that rely on profit
sharing instead of interest. The bank offers demand and savings
deposits under the concept of guaranteed custody (Al-WadϢah) and
investment deposits under the concepts of profit sharing (Al-
Mu\¥rabah). Islamic banks are prohibited from issuing securities
such as long and short-term bonds that involve interest, debentures
and preference shares. At present, the Islamic banking financial
instruments are based on the four main sources of funds, namely
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demand, savings, investment deposits (accounts) and shareholder’s

funds.
(i) Demand deposits – this kind of deposit has similar functions
to its counterpart in a conventional bank. It usually comes under the
concept of guaranteed custody (Al-WadϢah). Under this type of
account the depositors have full right to withdraw their funds at any
time without prior notice. Here the reward depends upon the banks’
own discretion based on the profit that they declare.
(ii) Savings deposits – these are usually for those who want to
earn some income and at the same time avoid the risk of capital losses.
For this type of deposit the Islamic banks do not provide any fixed
return to their depositors, but instead share the profits with their
customers, since these savings deposits are also usually understood as
guaranteed custody (Al-WadϢah).
(iii) Investment deposits – equivalent to a fixed deposits or
investment account with a conventional bank. This account usually
comes under the concept of profit sharing (Al-Mu\¥rabah). However,
the differences between the investment deposits in Islamic banks and
fixed deposits in conventional banks is that these types of accounts
are not considered as liabilities or debt, but as participatory accounts.
Here the banks invest their client’s money, with their general or
specific consent, depending on the account contract, in different
projects. After that, shares in profit are distributed between the bank
and its customers according to a pre-agreed ratio.
(iv) Shareholders funds – the main source for Islamic banks to
raise equity by offering common shares to the general public. Islamic
banks and financial institutions are not allowed to issue preference
shares, as these involve a fixed dividend corresponding to interest,
which is prohibited by Islamic law.

Islamic banks also grant working capital financing that mainly

involves five financial instruments. These are:
(i) Al-Bai¢ bi-thaman ¥jil – usually a contract that refers to the
sale of goods on a deferred payment basis. Equipment or goods
requested by the client are bought by the bank, which subsequently
sells the goods to the client at an agreed price (the sale price) that
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34 Review of Islamic Economics, Vol. 9, No. 1, 2005

includes the bank mark-up (profit). The client may be allowed to

settle payments by instalments within a pre-agreed period or through
a lump sum payment.
(ii) Al-Mu\¥rabah a contract between the bank and its client for
the sale of goods at a price that includes a profit margin agreed by
both parties. As a financing technique, it involves the purchase of
goods by the bank as requested by its client. The goods are sold to the
client at cost – plus profit margin agreed between them at the time of
contract. Repayment terms, usually in instalments, are specified in the
contract.
(iii) Al-Ij¥rah (Leasing) – A customer who wishes to engage the
services or the rights to the services of an asset may seek financing
under on ij¥rah (leasing) arrangement, the bank will purchase the
asset and subsequently lease it for a fixed period. In return, the
customer (the lessee) is obliged to pay for the lease rental and fulfil
any other terms and conditions as agreed by both parties.
(iv) Al-Musharakah (profit and loss sharing) – this is usually for
project financing, which involves a partnership on a joint venture
basis between the contracting parties. The parties share profits on a
pre-agreed ratio, but losses are shared on the basis of equity
participation. The management of the project may be carried out by
all the parties or by just one party. This is a very flexible partnership
arrangement where the sharing of the profits and management can be
negotiated and pre-agreed by all parties.
(v) Al-Mu\¥rabah basically an agreement between two parties,
one providing 100 per cent of the capital for the project, and the other
(mu\¥rib) managing the project through entrepreneurial skills. Profits
arising from the project are distributed according to a predetermined
ratio. Any losses accruing are borne by the provider of capital
provided these are beyond the control of the entrepreneur.

As already indicated, this study uses the ordinary least square

(OLS) econometric method of regression to estimate the main factors
influencing Islamic and conventional bank deposits. Three types of
tests are used:
(i) The Chow test for the structural change;
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(ii) The t test where the value of t is the coefficient of the monetary
base and the value of R2 is used to measure the correlation of
the variables;
(iii) The statistic of variances to measure the velocity of deposits.

The paper is organized as follows: section 2 reviews briefly past

studies on the comparative stability of Islamic and conventional bank
deposits. Section 3 discusses the research methodology and model
framework used here. In section 4, the results of the OLS estimation
are reported and discussed. Section 5 provides a summary and
concluding remarks.

II. Literature Survey

Since the establishment of Islamic banking a considerable amount of
theoretical literature has been published on its operations and
methods pf financing (Khan, 1985; Haron, 1995). However, only a
few empirical studies have been undertaken of the modelling of
monetary stability under an Islamic financial system (Khan and Khan,
1990; Yousafi et al., 1997). All these studies have attempted to prove
that Islamic monetary instruments are as stable as interest-based
instruments.
The most comprehensive study of monetary stability under an
Islamic banking system was that undertaken by Hassan (1996);
already been referred to. He studied the behaviour of the demand for
money in 15 Islamic countries and concluded that interest-free money
demand deposits are more stable than interest-bearing deposits. The
only previous work in this field in Malaysia was a study by Kaleem
(2000), who developed a model to test the monetary stability under
the country’s dual banking system. However this used monetary
variables rather than bank deposit data, and the data run was more
limited than for this present study.
This empirical study is the first to analyse the relative stability of
the Islamic and conventional bank deposits in Malaysia. Previous
studies such as that by Kaleem have attempted to provide proof of the
relative stability of the banking systems, but this could not be
determined by a comparison between the performance of M1 and M2
definitions of money supply.
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36 Review of Islamic Economics, Vol. 9, No. 1, 2005

The model specification in this study follows the model used by

Darrat (1988) and Hassan (1996). As mentioned above Hassan
concluded that interest-free money [MNI (M1)] is more stable than
interest-bearing money [MI (M2)]. In addition, according to Darrat,
interest-free money (MNI) is stable; however, interest-based money
(MI) is not.
This model has been chosen because the relevant data are
available for both conventional and Islamic banks deposits in
Malaysia. Moreover, this model matches the objectives of this study,
and allows for the testing of the hypotheses. Some modification has
been made, however, so as to allow for and to conform to the
Malaysian economic situation.

III. Research Hypothesis

Islamic monetary instruments work side by side with conventional
monetary instruments in Malaysia. For this reason, it is important to
test whether the Islamic monetary instruments can produce more
stability than conventional monetary instruments. Therefore, this
study attempts to test the following hypotheses:
(i) That Islamic bank deposits (profit sharing) are more stable than
conventional deposits (interest-based);
(ii) That the correlation between Islamic bank deposits and the
monetary based demand function is stronger than that between
conventional deposits and the monetary based demand function;
and
(iii) That the velocity of the Islamic bank deposits is more stable than
the velocity of conventional deposits.

IV. Research Methodology

An econometric model is developed to explain the relationship between
the variables in the model. The equations include the Islamic bank profit
sharing deposits equation, the conventional interest-based deposits
equation, the equation to test the correlation between profit sharing and
interest-based deposits and monetary base, and the equation of the
velocity of the profit sharing and interest-based deposits.
The model consists of five behavioural equations and three
identities. The deposit model for the Islamic bank deposits explains
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Review of Islamic Economics, Vol. 9, No. 1, 2005 37

the behavioural and other important determinants of money deposits

in the Malaysian Islamic banking system, and the model for the
conventional deposits explains the behavioural and other important
determinants of the money deposits in the conventional Malaysian
banking system.
The correlation between the profit – shares and the monetary
base is used as well as the correlation between interest-based deposits
and the monetary base. The velocities of the profit sharing deposits
and the interest-based money deposits are used to test which money
deposits are more stable by a comparison of both velocities of money.
The framework that has been used for the study includes an
interest-based deposits model, a profit sharing deposits model,
correlation between interest-based deposits with the monetary base,
correlation between profit-sharing money deposits with monetary
base, a velocity of interest-based deposits model, and a velocity of
profit-sharing deposits model as endogenous variables. For the
interest-based and profit sharing money deposits the explanatory
variables used include the real gross domestic product, the nominal
interest rate on demand, and time deposits (RDt and RTt) for the
conventional banks and the profit sharing ratio (SPSDt, SPSTt and
IPSt) for the Islamic banks, the consumer price index, and the
dependent variables lagged by one year. For the estimations the
parameters include interest-based money deposits and profit sharing
(interest-free) money deposits, that are estimated using the ordinary
least square (OLS) econometric method.

V. Model Framework
This section develops the quantitative relationship for money demand
between different Islamic and conventional monetary instruments.
Like any other demand function, the typical money demand function
contains real income to represent a budget constraint, existing
inflation and the interest rates prevalent in the economy. The money
demand function may be defined as:
e
Mt=L(GDPt,Rt,Pt,P t) (1)

where
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38 Review of Islamic Economics, Vol. 9, No. 1, 2005

Mt denotes is the nominal money demand at time t.

L is a function relating money demand to real income, the nominal
interest rate and the general price level.
GDPt stands for is the gross domestic product at time t.
Rt denotes is the nominal interest rate at time t.
Pt is the general price level at time t.
Pet is the expected rate of inflation at time t.

5 .1
1 . The model structure for the conventional deposits model
From the above explanation and discussion, the model structures for
the conventional demand deposits and conventional time deposits of
the money demand model in this study are as follows:

a1 a2 a3 a4 u1t
DDCt = a0 GDRLt RDt CPIt DDC t-1 µ (2)

b1 b2 b3 b4 u2t
TDCt = b0 GDRLt RTt CPIt TDCt-1 µ (3)

The conventional identity equation:

MDCt=DDCt + TDCt (4)

5 .2
2 . The model structure for the Islamic deposits model
The model structures for the Islamic demand deposits, Islamic time
deposits, and Islamic investment deposits of money demand model in
this study are as follows:
c1 c2 c3 c4 u3t
DDIt = c0 GDRLt SPSDt CPIt DDIt-1 µ (5)

d1 d2 d3 d4 u4t
TDIt = d0 GDRLt SPSTt CPIt TDIt-1 µ (6)

e1 e2 e3 e4 u5t
IIDt = e0 GDRLt IPSt CPIt IIDt-1 µ (7)
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The Islamic identity equation:

MDIt = DDIt + TDIt + IIDt (8)

Closing identity, hence, is:

MDt = MDCt + MDIt (9)

Equation 9 is the closing identity equation, where the total

deposits of money (MDt) is equal to conventional deposits of money
(MDCt) plus Islamic deposits of money (MDIt). It should be noted
that u1t, u2t, u3t, u4t, u5t are the structural disturbance terms at time
t, and µ are the error terms.

VI. Empirical Results

The selection of the variables in the equation and the model
specification is based on the theory, statistical, and econometric
statistics that are the right cohesion marks, the significant informative
variables being R2, the F value and the Durbin h statistics. The results
of regression for the conventional deposits and Islamic deposits are
shown in Tables 1 and 2 (Appendix A).
The results show that the real gross domestic product, the
interest rate, the consumer price index, and the one-year lagged
conventional demand deposits and conventional time deposits can
explain the conventional demand deposits and the conventional time
deposits. The results also show that the real gross domestic product is
significant at the 10% and 1% levels for the conventional demand
deposits and conventional time deposits respectively. This means,
ceteris paribus, for every 1% increase in the real gross domestic
product the conventional demand deposits and conventional time
deposits will increase by 1.1753 and 1.7276 respectively. This result
also shows that the real gross domestic product plays an important
role in determining the increase in demand and time deposits in
conventional bank accounts. This also means that people have more
surplus money or income, which enables them to deposit their money
in banks.
The interest rate is significant at the 10% and 1% levels to
explain the conventional demand deposits and conventional time
deposits. The responsiveness of demand deposits and time deposits
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40 Review of Islamic Economics, Vol. 9, No. 1, 2005

with respect to interest rate is 0.2731 and 0.3498 respectively. This

means, ceteris paribus, that for every 1% increase in the interest rate,
conventional demand deposits and conventional time deposits will
increase by only 0.2731 and 0.3498% respectively.
Consequently, we can see that the real gross domestic product
and interest rates, also significant at the 1% level, explain the
conventional time deposits. The elasticity of the conventional time
deposits to the real gross domestic product and interest rate are
1.7276 and 0.3418 respectively. This result also shows that the real
gross domestic product plays an important role in determining the
increase of the time deposits in conventional banks. This is because
people have extra income enabling them to deposit their surplus in the
banking system.
The above results also show that the real gross domestic product,
the profit sharing rates, (SPSDt, SPSTt and IPSt), the consumer price
index, and the one-year lagged dependent variables are important in
explaining the Islamic demand deposits, Islamic time deposits, and
Islamic investment deposits. The profit sharing rates are significant in
explaining the Islamic demand deposits, Islamic time deposits and
Islamic investment deposits at the 1%, 10% and 5% levels
respectively, whereas, the one-year lagged dependent variables are
significant at the 5% level in explaining both the Islamic demand and
time deposits.
In addition, the results show that the estimated responsiveness of
Islamic demand deposits, Islamic time deposits and Islamic investment
deposits to real gross domestic product are 0.6895, 0.6885 and
0.2426 respectively, which means, ceteris paribus, that Islamic
demand deposits, Islamic time deposits and Islamic investment
deposits will increase by only 0.6895, 0.6885 and 0.2426% for every
1% increase in real gross domestic product. The weakness in the
responsiveness of Islamic demand deposits, Islamic time deposits and
Islamic investment deposits to real gross domestic product appears to
confirm the observation made by Wilson (1997) regarding Bank Islam
Malaysia’s deposit growth, namely that:
“Between 1987 and 1991, Malaysian gross domestic product
growth actually accelerated from 5.4 per cent to 9.7 per cent.
The years of economic stagnation had been the mid-1980s,
with GDP falling by 1 per cent in 1985 and growing by a mere
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1 per cent in 1986. Yet these were the years when Islamic Bank
deposits grew rapidly. It seems there is no correlation between
macroeconomic performance and that of the Islamic Bank”.

However, the results reveal that the profit share rate is an

important factor in explaining the Islamic demand deposits, Islamic
time deposits and Islamic investment deposits. Profit sharing rates for
the Islamic demand deposits, Islamic time deposits and Islamic
investment deposits are significant at the 5% level. The estimated
elasticity of the Islamic demand deposits, Islamic time deposits and
Islamic investment deposits with respect to profit sharing are 1.3905,
1.2526 and 1.7188 respectively. This means, ceteris paribus, that for
every 1% increase in the profit-share (rate of return) for demand
deposits, time deposits and investment deposits will increase by
1.3905, 1.2526 and 1.7188% respectively. The elasticity of Islamic
demand deposits, time deposits and investment deposits may be
caused by the ability of the depositors to respond in a positive manner
to profit sharing. Thus, in the case of Islamic demand deposits, time
deposits and investment deposits, especially for Muslims, growth
depends on the profit share rate that they can get for their deposits.
Furthermore the results also show that the adjustment level is
quite moderate for all equations in the model, the figures being 47.1%
and 85.1% for the conventional demand deposits and conventional
time deposits, whereas the figures were 25.1%, 22.4%, and 24.1%
respectively for Islamic demand, time and investment deposits.

VII. Hypothesis Tests

Islamic banks deposits (profit sharing) are more stable than
conventional deposits (interest-based)
In order to test the hypothesis that deposits with profit sharing are
more stable than deposits with interest, the stability of deposits
function is tested with the aid of the Chow test. One of the more
common applications of the F test is in tests of structural change. This
test is called a Chow test, after Chow (1973) who invented it. This test
is to see if there is a shift in the structural data for these equations.
The results of the Chow test for the Islamic deposits and conventional
deposits are shown in Table 3.
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42 Review of Islamic Economics, Vol. 9, No. 1, 2005

These results show that all the behavioural equations used in this
model are stable throughout the research period, both for the
conventional deposits and Islamic deposits. Therefore, all the
equations should accept the null hypothesis. This means that there is
no change in the parameter values at the significance level of 10%.
Although this study finds that both the conventional and the
Islamic deposits are stable, the Islamic demand deposit and Islamic
time deposit are more stable than the conventional demand deposit
and conventional time deposit. This is measured through the value of
the Chow test (Fc), which is smaller for the Islamic demand and
Islamic time deposits than for the conventional demand and time
deposits, as shown in Table 3. The values of the Chow test for the
Islamic demand and time deposits are 1.62 and 2.17, which is smaller
compared to the corresponding values for conventional deposits,
namely 3.23 and 2.88.
There may be several reasons for this:
(i) The Malaysian government is relying on conventional
monetary and fiscal policies in its efforts to achieve monetary and
price stability, economic growth and development in financial
markets rather than using Islamic financial instruments;
(ii) The excess liquidity in Bank Islam Malaysia Berhad and Bank
Muamalat Malaysia Berhad. This is happening for several reasons: (a)
the growth of deposits in Islamic banking far exceeded the demand
for Islamic financing, especially during the period from 1983 to 1992;
(b) there was an inadequate number of Islamically acceptable
investment outlets, especially before 1992; (c) Bank Islam Malaysia
Berhad and Bank Muamalat Malaysia Berhad remain profitable
because of their low level of risk exposure and their pursuit of a
conservative financing policy, despite excess liquidity;
(iii) The Islamic banks’ policy of conservatism, rooted in
underlying observations such as: (a) severe losses that signals the
failure of the philosophy and the implementation of Islamic banking
and financial instruments; and (b) the nature of Islamic contracts
undertaken are mostly based on fixed return trade financing rather
than on the profit and loss sharing system. This means that the banks
and the government in practice guarantee the deposits and
investments in the Islamic banking and financial instruments.
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This finding supports those of Hassan (1996) and Kaleem

(2000), but disagree with those of Darrat (1988) and Khan (1985),
who found that Islamic banking is stable and is more crisis-proof than
conventional banking. However, Yousefi et al., (1997), in their study
of monetary stability and interest-free banking, concluded that a case
for the superiority of Islamic banking has, certainly in the case of Iran,
not been made.

The correlation between Islamic banks’ deposits and the monetary

base demand function is stronger than that between conventional
deposits and the monetary base demand function
The objective here is to discuss and assess the relative effectiveness of
and differences between profit sharing and interest-bearing deposits in
the formation of monetary policy. Darrat (1998) suggests two
prerequisites for policy usefulness that may be used to check the
performance of both the Islamic and the conventional financial
instruments. The first is the effective control of the monetary
authorities over their financial instruments. Secondly, there should be
a strong and reliable relationship between the monetary instruments
and the main goal of the monetary authority. The regression results
are shown in Table 4 and reveal three major findings:
(i) The monetary authorities have a significantly higher level of
control over conventional banks’ deposits than over Islamic banks’
deposits. This can be seen from the value of t statistics for monetary
base (MBt). The values of t statistics for DDCt, and TDCt are 14.348
and 17.093 respectively, and are higher compared to the Islamic
deposits DDIt, TDIt, and IIDt, which are 6.826, 8.341, and 6.095
respectively.
(ii) The results also show that conventional deposits are highly
significant as compared to Islamic deposits, as their coefficients are
0.8286 and 0.4518 for DDCt and TDCt, whereas the coefficients for
Islamic deposits are 0.0505, 0.0293 and 0.1653 respectively.
(iii) Similarly, the regression results show that conventional
deposits exhibit a strong relationship between the dependent variables
and the independent variables compared to Islamic deposits. This can
be seen by the fact that the values of adjusted R2 for conventional
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44 Review of Islamic Economics, Vol. 9, No. 1, 2005

deposits are higher than for Islamic deposits (where adjusted R2 for
DDCt = 0.9234, TDCt = 0.9448; while adjusted R2 for DDIt =
0.7284, TDIt = 0.8013, and IIDt = 0.6801).
The regression results and findings show that there is a high level
of control over conventional monetary instruments compared to
Islamic monetary instruments. The above results and conclusion show
the strong relationship between interest-based deposits and the
monetary base, thus allowing the monetary authorities to have a more
direct control over the conventional deposits, which in turn will have
an impact on other macroeconomics variables. These results also
indicate that the conventional monetary instruments play a more
important role than Islamic monetary instruments in the Malaysian
economy, in conformity with the earlier observations by Wilson
(1998): “Although Islam may be a continuing factor influencing
politics, as far as Malaysian development is concerned, the influences
of conventional economics on Islam may be greater than the impact
of Islam on economy policy”.
In addition, this result is consistent with the studies by Hassan
(1996) and Yousefi et al., (1997), who found that the conventional
money demand has a strong relationship with, or more controllability
by monetary authorities, than Islamic money demand. This finding,
however, conflicts with those of previous studies by Darrat (1988)
and Kaleem (2000).
To conclude: the regression analyses suggest that the interest-
based deposits in Malaysia exhibit a stronger and more reliable
relationship with policy instruments. These results suggest that the
interest-based monetary system provides policy-makers in Malaysia
with an effective monetary control tool.

The velocity of the Islamic bank deposits (profit sharing) is more

stable than the velocity of conventional deposits (interest-based)
The velocity of money plays a crucial role in contemporary
macroeconomic analysis and the stability of velocity represents a
necessary requirement for effective monetary policy. A major
objective of monetary policy is to achieve price stability and low
unemployment in the economy. This can be achieved through the
stability of velocity over time, because an unstable velocity will
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Review of Islamic Economics, Vol. 9, No. 1, 2005 45

weaken the link between monetary policy and the rest of the
economy. In addition, an unstable velocity could affect overall
economic and financial stability adversely, as a result of the inability
accurately to predict the velocity of money, which may deepen the
cycles of high unemployment and high inflation. Therefore, having a
stable and smooth velocity of money is vital for prudent monetary
policy-making and for the good health of the economy.
The variance of a particular type of money velocity will indicate
the stability of the deposits for that type of money. The results of the
analysis of variance carried out to find out whether the velocity of
profit-sharing deposits is more stable than the velocity of interest-
bearing deposits is shown in Table 5.
The variances of the velocity for conventional deposits were
lower than the variances for the Islamic bank deposits. The variances
for the velocity of the conventional demand deposits and conventional
time deposits are 2.67 and 5.06 respectively; this is lower than the
variances of the velocity of the Islamic demand deposits, Islamic time
deposits and Islamic investment deposits, which have variance values
of 93.97, 122.04 and 35.55 respectively.
These results contradict the findings of Darrat (1988) and
Hassan (1996), who reported that it was the interest-free money that
was more stable than the interest-bearing money. However, these
results support the study by Yousefi, Abizadeh and McCormick
(1997), which found that the velocity of money in conventional
banking was much less volatile, the demand for money balance was
stable, and that price stability prevailed compared with a less stable
situation in Islamic banking in the case of Iran. Generally speaking,
according to this study, it was found that for Malaysian banking
deposits, the velocity of conventional deposits is more stable than that
of Islamic banks’ deposits.
In order to discuss these issues in more detail, we can compare
the velocity of the interest-based deposits with that of the interest-free
deposits, as illustrated in Figures 1 and 2 (Appendix C). From Figure
2, the velocity of the interest-free deposits for DDIt, TDIt and IIDt
fell from highs of 828.60, 563.55 and 277.34 respectively in 1983 to
lows of 28.34, 38.49 and 8.07 respectively in 2001. It is encouraging
to note however that the velocity of these three interest-free deposits
has fallen over the years, as the size of the Islamic deposit base has
grown.
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46 Review of Islamic Economics, Vol. 9, No. 1, 2005

Nevertheless, statistics for the velocity of the interest-based

deposits (DDCt and TDCt) reveal a smoother behaviour. In the case
of DDCt, velocity ranges from a peak of 7.95 in 1983 to a trough of
1.93 in 2001. Therefore, the velocity of interest-based deposits in
Malaysia also shows a smoother pattern than the velocity of the
interest-free deposits over the study period. In fact, the velocity of the
interest-based deposits for TDCt is better behaved, varying only
between 7.45 in 1983 at the peak, to 3.33 in 2001 at the trough. In
addition, the variability of the velocity of the interest-free deposits is
much higher than that of the velocity of the interest-based deposits in
Malaysia.
To conclude: the preceding analysis suggests that the velocity of
the interest-based deposits is less volatile than that of the interest-free
deposits in Malaysia. Therefore, we may say that an interest-based
banking system promotes and plays an important role in financial and
economic stability in Malaysia since it apparently reduces instability
in the underlying velocity of money, thus providing monetary
authorities in Malaysia with an environment more conducive to
conducting an effective macroeconomic policy.

VIII. Summary and Conclusions

The objective of this research was to examine the main variables, and
the stability and efficiency of the Islamic monetary instruments
pertaining to the Malaysian dual banking system. To achieve this
1983 – 2001 annual time series data on Malaysian banking
institutions was analysed using the ordinary least square (OLS)
econometric technique. An empirical methodology similar to that of
Darrat and Hassan was used, although Hassan’s result fails to
support the Darrat findings. The main aims of this study have been:
(i) To develop a conventional and Islamic bank deposits model
with the same explanatory variables, with regard to the
financial instruments used in the Islamic banks and
conventional banks in Malaysia’s dual banking system;
(ii) To analyse the demand for money with regard to the
conventional and Islamic bank deposits model instruments;
(iii) To compare the effectiveness and flexibility of both financial
instruments. For the analysis, we replicate and further
developed Hassan’s (1996) methodology.
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Review of Islamic Economics, Vol. 9, No. 1, 2005 47

Overall the equation for the model reflects the money deposits of
the Islamic and conventional banks in Malaysia. With regard to the
conventional money deposits (conventional demand and conventional
time deposits), the research results show that the real gross domestic
product, the interest rate, the consumer price index and the
conventional demand and conventional time deposits lagged for one
year are important factors in explaining the changes in the
conventional demand and conventional time deposits. This implies
that the total amount of conventional demand and conventional time
deposits are influenced quite significantly by the real gross domestic
product.
It also means people have more money to save. It seems that
there is a clear correlation between macroeconomic performance (real
gross domestic product growth) and the performance of the
conventional banks (conventional deposits). This can be seen from the
values of elasticity for the conventional demand deposits and
conventional time deposits against the real gross domestic product,
which were 1.1753 and 1.7267 respectively.
The research has also shown how real gross domestic product,
the profit share (rate of return to depositors), the consumer price
index and the dependent variables lagged for one year are important
factors in explaining the Islamic demand deposits, Islamic time
deposits and Islamic investment deposits. This can be seen from the
values of elasticity for Islamic demand deposits, Islamic time deposits
and Islamic investment deposits, which were 1.3905, 1.2525 and
1.7188 respectively in relation to the profit share (significant at the
1%, 10% and 5% level respectively).
The result of this research suggests a number of policy
implications. The conventional banking institutions contribute
significantly to the banking industry and help fund investment that
contributes to socio-economic development. In order to ensure the
survival and continued growth of the banking industry in Malaysia,
several measures should be taken. This research provides empirical
evidence that the real gross domestic product, the interest rate, and
the profit sharing rate play an important role in the Malaysian
banking industry. Therefore, sustainable development in the
economic sphere will, through its positive effect on income, increase
demand and time deposits from depositors in both conventional and
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48 Review of Islamic Economics, Vol. 9, No. 1, 2005

Islamic banks. The interest rate and the profit share rate need to be at
a level that can attract depositors to place their money either in the
conventional or Islamic banks. The market for each type of deposit is
segmented however, and therefore an increase in interest rates may
not adversely affect Islamic bank deposits even if profit sharing rates
are not increased. What matters most is real gross domestic product
developments and the behaviour of macroeconomic variables, not the
pricing of returns by the conventional banking sector.
Therefore, the practical measures to increase total Islamic
investment deposits, whether in the Islamic banking, or other
financial institutions which provided Islamic counters, are more
related to service quality than pricing. The optimal use of the current
Islamic counters can be improved by better management and
enhanced technology. In the final analysis however it is the Islamic
bank or conventional provider’s reputation for SharÏ¢ah compliance
that matters for Muslim customers, although this does not mean that
they wish to see their religious motivation for choosing SharϢah
compliant deposits taken for granted, by banks that provide a poor
return or poor service because of the limits to competition in a
segmented market.

REFERENCES

Chow, Gregory C. (1973). Econometric Methods. New York: McGraw-Hill.

Darrat, Ali F. (1988). “The Islamic Interest-Free Banking System: Some Empirical
Evidence”, Applied Economics, 20 (3), pp. 417-425.
Haron, S, (1995). “The Framework and Concept of Islamic Interest-free Banking”,
Journal of Asian Business, 11 (1), pp. 26-39.
Hassan, M. Kabir (1996). Stability of Money Demand under an Interest-Free versus
Interest-Based Banking System. University of New Orleans Occasional Paper in
Finance, New Orleans.
Kaleem, Ahmad (2000). “Modelling Monetary Stability Under a Dual Banking
System: The Case of Malaysia,” International Journal of Islamic Financial Services, 2
(1), pp. 3-11.
Khan, Mushtaq Ahmad and Khan, Ashfaque H. (1990). “A Re-examination of the
Stability of the Demand for Money in Pakistan,” Journal of Macroeconomics, 12 (2),
pp. 307-321.
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Review of Islamic Economics, Vol. 9, No. 1, 2005 49

Khan, Waqar M. (1985). Towards an Interest-free Islamic Economics System.

Leicester: The Islamic Foundation.
Wilson, Rodney (1997). Islamic Finance. London: FT Financial Publishing (Pearson
Professional Limited).
Wilson, Rodney (1998). “Islam and Malaysia’s Economic Development”, Journal of
Islamic Studies, 9 (2), pp. 259-276.
Yousafi Mahmood; Abizadeh, Sohrab and K. McCormick (1997). “Monetary
Stability and Interest-Free Banking: the Case of Iran”, Applied Economics, 29 (7)
July, pp. 869-876.
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50 Review of Islamic Economics, Vol. 9, No. 1, 2005

Appendix: Empirical Results

Appendix A
Table 1 : The Regression Analysis for the Conventional Demand Deposits
and Conventional Time Deposits
Dependent Independent variables
variables
Intercept lnGDRLt lnRDt lnCPIt lnDDCt-1 R2 Durbin h
Λ * *
Ln DDC -4.7240 1.1753 0.2731 -0.1245 0.5291 0.9861 0.63
(-1.442) (1.812) (1.865) (-0.620) (1.353)

Intercept lnRTt lnTDCt-1 lnCPIt lnDDCt-1 R2 Durbin h

Λ *** ***
Ln TDCt -2.9527 1.7276 0.3498 -0.1361 0.1494 0.9941 1.35
(-1.501) (4.349) (4.877) (-0.856) (0.478)

Table 2 : The Regression Analysis for the Islamic Demand Deposits, Islamic
Time Deposits, and Islamic Investment Deposits

Dependent Independent variables

variables
Intercept lnGDRLt lnSPSDt lnCPIt lnDDIt-1 R2 Durbin h
Λ *** ** ** **
Ln DDIt -3.5217 0.6895 1.3239 -0.6359 0.7495 0.9608 0.87
(-1.845) (0.705) (3.583) (-0.632) (2.382)

Intercept lnSPSTt lnTDIt-1 lnCPIt lnDDIt-1 R2 Durbin h

Λ * ** ** **
Ln TDIt -3.6729 0.6885 1.2526 -0.2623 0.7764 0.9289 0.46
(-1.975) (0.689) (1.856) (-0.246) (2.848)

Intercept lnIPSt lnIIDt-1 lnCPIt lnDDIt-1 R2 Durbin h

Λ * ** ** **
Ln IIDt -3.7435 0.2426 1.7188 -0.7198 0.7587 0.9436 0.67
(-1.422) (1.803) (2.772) (-0.661) (2.775)

Note 1: Figures in parentheses are t values.

Note 2: (*), (**), (***) denotes statistical significance at the 10%, 5%, and 1%
level, respectively.
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Review of Islamic Economics, Vol. 9, No. 1, 2005 51

Appendix B: Stability Test Results

Table 3 : The Structural Stability Test of Conventional Deposits and Islamic

Deposits

Model Fc Adjusted R2
Conventional demand deposits 3.23 0.9814
Conventional time deposits 2.88 0.9921
Islamic demand deposits 1.62 0.9477
Islamic time deposits 2.17 0.9052
Islamic investment deposits 3.54 0.9248

Note: Fc is the Chow test statistics. The value of the F-statistic at the 10%
significance level for the whole equation is 4.25.

Table 4 : The Relationship between Monetary Base and the Interest-Based

Deposits and Profit-Sharing Deposits Dependent Variables

Dependent Variables Constant t statistics Monetary Adjusted

base (MBt) R2
Conventional demand deposits 19.4783 14.348 0.8286 0.9234
Conventional time deposit 19.7129 17.093 0.4518 0.9448
Islamic demand deposit -77.2470 6.826 0.0505 0.7284
Islamic time deposit -76.6867 8.341 0.0293 0.8013
Islamic investment deposit -93.3807 6.095 0.1653 0.6801

Table 5 : Summary Statistics of Variances of the Velocity of Money

Variables Variances
Velocity of conventional demand deposits 2.67
Velocity of conventional time deposits 5.06
Velocity of Islamic demand deposits 93.97
Velocity of Islamic time deposits 122.04
Velocity of Islamic investment deposits 35.55
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52 Review of Islamic Economics, Vol. 9, No. 1, 2005

Appendix C: Velocity Ratios

Figure 1: Velocity of Interest-Based Deposits in Malaysia,

1983-2001

9
8
7
Velocity Ratio

6
5
4
3
2
1
0
1983

1985

1987

1989

1991

1993

1995

1997

1999

2001
Years

DDC TDC

Figure 2: Velocity of Profit-Sharing Deposits in Malaysia,

1983-2001

900
800
700
Velocity Ratio

600
500
400
300
200
100
0
1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

Years

DDI TDI IID