Journal of Asia-Pacific Business

ISSN: 1059-9231 (Print) 1528-6940 (Online) Journal homepage: http://www.tandfonline.com/loi/wapb20

Dynamics of Islamic Financing in Malaysia:

Causality and Innovation Accounting

Mansor H. Ibrahim & Raditya Sukmana

To cite this article: Mansor H. Ibrahim & Raditya Sukmana (2011) Dynamics of Islamic
Financing in Malaysia: Causality and Innovation Accounting, Journal of Asia-Pacific Business,
12:1, 4-19, DOI: 10.1080/10599231.2011.539446

To link to this article: http://dx.doi.org/10.1080/10599231.2011.539446

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 Journal of Asia-Pacific Business, 12:4–19, 2011
Copyright © Taylor & Francis Group, LLC
ISSN: 1059-9231 print/1528-6940 online
DOI: 10.1080/10599231.2011.539446

ARTICLES

Dynamics of Islamic Financing in Malaysia:

Causality and Innovation Accounting

MANSOR H. IBRAHIM
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Universiti Putra Malaysia, Selangor, Malaysia

RADITYA SUKMANA
University Airlangga, Surabaya, Indonesia

The article evaluates dynamic interactions between Islamic financ-

ing and macroeconomic and financial variables for Malaysia
using the Toda-Yamamoto (1995) causality test and innovation
accounting approach. The results suggest strong causal influences
of interest rate on Islamic financing but insignificant causal rela-
tions from real stock prices or real production to Islamic financing.
Thus, while the results suggest that Islamic financing in Malaysia
is resilient to boom/bust cycles of the stock market or fluctuations
in real activity, Islamic banks under a dual-banking environ-
ment are not spared from fluctuations in interest rate or monetary
conditions of the country.

KEYWORDS Islamic financing, causality, innovation account-

ing, Malaysia

INTRODUCTION

The emergence of Islamic banking and finance in the global scene has
captured great attention in recent years. Although early focuses have been

We would like to thank two anonymous referees of the journal for the constructive
comments. We, however, are responsible for the remaining errors.
Address correspondence to Mansor H. Ibrahim, Department of Economics, Universiti
Putra Malaysia, 46400 Serdang UPM, Selangor, Malaysia. E-mail: mansorhi@econ.upm.edu.my

4
 Dynamics of Islamic Financing in Malaysia 5

predominantly on product innovations and compliances to Islamic princi-

ples, there seems to be an increasing number of studies attempting empirical
assessment of the Islamic banking and finance sector. Among the interests
include estimation of money demand functions for Islamic economic system
(Darrat, 1988, 2002; Kaleem & Isa, 2006; Yousefi, Abizadah, & Maccormick,
1997), efficiency and performance of Islamic banks and financial institutions
(Ahmad Mokhtar, Mohd Harif, & Adziz, 2006; Hasan, 2004; Sufian & Haron,
2008; Rosly & Bakar, 2003), and behavior of Islamic stock market indexes
(Rahim, Ahmad, & Ahmad, 2009; Yusof & Abd Majid, 2007). Although these
studies have shed some lights on various aspects of Islamic banking and
finance, we believe that the vast interest shown by the global community
necessitates further analyses. Indeed, the behavior of Islamic bank financing
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and how it is related to macroeconomic and financial variables deemed rel-

evant in conventional bank loan behavior seems to receive relatively little
attention.
This article seeks to contribute to the empirical literature on Islamic
banking and finance by examining Islamic financing dynamics and its rela-
tions to key macroeconomic and financial variables for the case of Malaysia.
In Malaysia, Islamic banking and finance industry has been in existence for
more than 30 years and has progressed in parallel with conventional banks.
With the government’s emphasis on developing Malaysia as an international
Islamic financial hub, Islamic banks in Malaysia have witnessed increasing
penetration in domestic lending or financing market. Over the period 1998
to 2008, total Islamic financing has grown at a monthly average rate of 2.1%.
As a comparison, the total bank loans have expanded by merely 0.4% over
the same period. With this relatively high growth of Islamic financing, the
ratio of total Islamic financing to total bank loans has increased from 1.7%
in 1998 to 14.8% in 2008. Interestingly, these have taken place under the
backdrops of recent economic and financial uncertainties.
In the analysis, we consider three macroeconomic and financial vari-
ables that have been the recent focus in the literature on bank loan behavior.
These are real production or output, interest rate, and stock prices. As Islamic
banks in Malaysia operate side by side and compete with well-established
and more sophisticated conventional banks, our main inquiries are: (a) Are
Islamic banks affected by the same factors identified for conventional bank
loan behavior? (b) Is Islamic bank financing driven more by a real factor?
(c) Has interest rate or monetary policy exerted any influences on Islamic
financing? And, finally, (d) Have Islamic banks succumbed to fluctuations
in financial variables such as interest rate and stock prices and, conse-
quently, susceptible to boom/bust cycles in financial markets? The answers
to these inquiries should be important for the development of the Islamic
financial system in Malaysia or other countries adopting a dual-banking
system.
 6 M. H. Ibrahim and R. Sukmana

The article is structured as follows. In the next section, we provide

background information. Then, we detail our empirical approach followed
by data and estimation results. Finally, we provide a summary of the main
findings and concluding remarks.

BACKGROUND INFORMATION

Islamic banking and finance has been in existence in Malaysia for more than
30 years. The first Islamic financial institution in Malaysia known as Tabung
Haji or Pilgrims and Management Fund Board was established in 1969 to
mobilize and manage savings of Muslims intending to perform pilgrimage.
The first Islamic bank, Bank Islam Malaysia Berhad (BIMB), came into exis-
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tence 14 years later with the passage of the Islamic Bank Act 1983. Over
the early years of Islamic banking, BIMB operated under a monopolistic sta-
tus in providing Islamic banking services. As noted by Hussin (2005), after
the initial stage of its monopolistic years, the Islamic financial landscape in
Malaysia went through developing years during 1990 to 1994 and take-off
years thereafter. A milestone during the developing years is the introduction
of Islamic Banking Scheme in March 1993 to allow conventional financial
institutions to widen their scope of operations to Islamic banking services.
Intending to make Malaysia as an international center of Islamic banking
and finance, Bank Negara Malaysia (i.e., Malaysia’s Central Bank) has imple-
mented various development and policy measures during the take-off years.
Among them include the establishment of Islamic money market in 1994,
requirement of separate disclosure of Islamic banking scheme operations in
1996 and opening of full-fledged Islamic banking scheme banking branches
to replace Islamic banking windows of conventional banks in 1996 (Hussin,
2005). In 1999, the second Islamic bank known as Bank Muamalat was
established. Since then, the Islamic financial scene in Malaysia can be stated
as being more vibrant and competitive especially with recent allowance for
domestic and foreign financial institutions to establish new Islamic banks in
Malaysia.
The main element distinguishing Islamic banks from the conventional
banks is the practice of profit-and-loss sharing instead of interest (or riba)
given or charges to deposits and loans or financing, which is viewed imper-
missible in Islam. On the Islamic banks’ liability side, Islamic banks are
viewed as managing partners or trustees of deposited funds, normally in
the form of investment deposits.1 The profits obtained from managing these
funds are then shared between banks and depositors. On the asset side,
Islamic banks have various financing instruments. These include muraba-
hah (cost-plus financing), mudharabah (profit sharing), and musharakah
(joint venture).2 Murabahah is a sale transaction between Islamic banks as
sellers and customers as buyers where product prices are based on mark-up
 Dynamics of Islamic Financing in Malaysia 7

or cost-plus pricing. On the request of buyers, Islamic banks will take pos-
session of the goods and sell to the buyers at mark-up prices normally
payable in installments. Mudharabah is the profit-and-loss sharing financing
contract offered by Islamic banks as capital provider to potential investors
or entrepreneurs. Under mudharabah, profits are shared between the two
parties based on a mutually agreed ratio while losses are borne solely by the
capital provider. Instead of mudharabah, the Islamic banks can also offer
joint venture financing or musharakah, under which all partners (banks and
entrepreneurs) provide funds, share profits, and bear losses.
Over recent years, Islamic banks in Malaysia have experienced rapid
progress. Table 1 presents total loans and deposits of Islamic banking system
in Malaysia. During the span of over 10 years from 1998 to 2008, Islamic
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financing has increased by more than 10-fold from only RM7, 317 million in
1998 to RM107, 739 million in 2008. Meanwhile, total deposits in the Islamic
banking system have increased by more than 14 times from 1998 to 2008.
The table also indicates increasing intermediation role of Islamic banks with
the financing-to-deposits ratio increases from 0.65 in 1998 to more than
1.00 by 2004. Thus, Islamic banks are also capable of offering financing in
excess of deposited funds in the banks, which is feasible under the fractional
reserve banking system. The financing-to-deposits ratio then subsided to
0.70 in 2008. Indeed, the growth of Islamic financing has outpaced the total
loan growth of Malaysian banking system as reflected by the increasing ratio
of total Islamic financing to total loans of the banking system. Although the
ratio was below 0.02 in 1998, it almost reached 0.15 by 2008. Based on
these, it is not an exaggeration to state that the Islamic banks have assumed
a more important role in Malaysia. Thus, with the policy direction to develop
further the Islamic banking system, there seems to be a great need to look
at the behavior of Islamic banking, especially its financing behavior and its
relation to the economy.

TABLE 1 Loans and Deposits of Islamic Banking in Malaysia

Financing-to-deposits Financing-to-total
Years Financing Deposits ratio loans ratio

1998 7,317.5 11,234.8 65.132 1.754

1999 13,843.0 22,950.7 60.316 3.504
2000 21,049.7 32,107.1 65.561 5.056
2001 28,467.2 41,770.2 68.152 6.584
2002 37,425.6 47,493.7 78.801 8.276
2003 49,406.2 49,863.3 99.083 10.428
2004 59,936.2 58,794.1 101.942 11.663
2005 69,941.4 65,369.4 106.994 12.533
2006 78,518.3 83,310.5 94.248 13.242
2007 89,865.1 103,149.4 87.121 13.949
2008 107,739.3 154,860.9 69.606 14.829
Source: Monthly Statistical Bulletin published by BNM (1998–2009). Total financing is from Table 1.21
while total deposits are from Table 1.18 of the bulletins.
 8 M. H. Ibrahim and R. Sukmana

Despite the fast progress of Islamic banking and finance, existing studies
on Malaysia have predominantly focused on bank-lending behavior in gen-
eral, and only few published studies have attempted empirical evaluation
of Islamic financing. Notable among them are recent studies by Abd Karim,
Mohd Harif, and Adziz (2006), Ibrahim (2005, 2006), and Kassim, Abd Majid,
& Yusof (2009). Among these studies, only Kassim et al. (2009) evaluated
the behavior of Islamic financing and deposits in Malaysia.
Ibrahim (2005) analyzed the role of bank lending in the propagation of
financial shocks and in accounting for macroeconomic fluctuations. Thus,
the analysis has a specific focus on the bank-lending channel of monetary
transmission mechanism. From the analysis, Ibrahim (2005) documented
robust evidence suggesting dynamic interactions between bank balance
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sheet variables (loans and deposits) and real output. He also demonstrated
the vulnerability of the Malaysian banking sector to financial shocks as cap-
tured by changes in the exchange rate and stock prices. In a subsequent
study, Ibrahim (2006) reaffirmed the importance of stock market fluctua-
tions in influencing bank lending behavior. Bank loans are also noted to
accommodate expansion in real activity. Looking at bank loans to various
sectors, Abd Karim et al. (2006) further noted the negative effect of monetary
tightening to bank loans. Moreover, they documented evidence for disparate
responses of various sectors to an increase in the interest rate with loans to
manufacturing, agriculture, and mining sectors to be most affected.
Most recently, Kassim et al. (2009) turned the analysis to the dynamic
behavior of Islamic bank financing and deposits. They demonstrated the
sensitivity of Islamic financing and deposits to interest rate changes, against
the argument that Islamic banking operations are shielded from interest rate
fluctuations (Khan, 1985). Interestingly, looking at their results as reported in
Table 1 and Table 2, real industrial production seems to have a very minimal
role in accounting for variations in Islamic financing and deposits. These

TABLE 2 Unit Root Tests

Level First difference

Variable ADF PP ADF PP

F −0.9554 −0.6884 −12.291 −12.274

Y −0.9601 −1.3218 −5.5634 −16.093
S −4.6619 −2.7897 −4.0407 −9.9105
R −3.3453 −2.2442 −4.1129 −8.1509
Note: ADF = augmented Dickey-Fuller test; PP = Phillips-Perron test; F = real Islamic
financing; Y = real industrial production; S = real stock prices; R = interest rate;
AIC = Akaike Information Criterion.
The AIC is used to select the lag order in the ADF test equation. The intercept and
trend terms are included in the test equations for the variables in levels while only the
intercept term is included for the variables in first difference. The 5% critical values
for testing unit root in level and first difference are –3.444 and –2.883, respectively
(MacKinnon, 1996).
 Dynamics of Islamic Financing in Malaysia 9

results mean that, their operational links to real assets notwithstanding, the
behavior of Islamic banks is not driven by the real factor and, worryingly, is
subject to interest rate risk. Still, an open question from their analysis is on
whether Islamic banking can be resilient in facing recurring financial crisis
or financial boom/bust cycles. Although predominant evidence suggests the
significant role of stock price fluctuations on bank lending behavior, stock
prices have not been evaluated in their studies. Accordingly, the current
study can be viewed as complementary or an extension to Kassim et al.
(2009).

EMPIRICAL APPROACH
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With the interest on dynamic interactions between Islamic bank financing

and its determinants, we form a four-variable system of equations. Three
macroeconomic and financial variables normally noted to have influences
on conventional bank loans are considered. These are real industrial pro-
duction (Y), real stock prices (S), and interest rate (R). The relevance of Y
in affecting loan demand and supply is well noted in the literature. Whether
the R affects Islamic financing, however, is contentious. On one hand, with
interest-free financial services, Islamic banking is seen to be more stable
and should be decoupled from R fluctuations (Khan, 1985). On the other
hand, Islamic banks operating under a dual banking system may be prone
to variations to R. More particularly, there may be a flight to and from
conventional banking following changes in the R. A rise in R, for exam-
ple, enables the conventional banks to reap the benefits from widening
lending—deposit spread and, as a consequence, make conventional banks
to have a competitive advantage in luring depositors away from Islamic
banks. As a consequence, this flight to conventional deposits may lessen the
capability of Islamic banks in their financing.
As mentioned in the previous section, the recurring boom/bust cycles
in the financial markets or heightened stock market volatility observed in
recent years are noted to affect bank loan behavior. To the extent that bank
financing and loans are collateralized by such assets as real property and
shares, increasing share prices improve firms’ balance sheet position while
decreasing share prices expose banks to default risk (Garlach & Peng, 2005;
Hoffman, 2004; Kim & Moreno, 1994). This can have implication on firms’
accessibility to finance as well as banks’ willingness to supply funds. In a
similar vein, reflecting expectations of favorable macroeconomic condition,
the increase in stock prices may also motivate the expansion of bank loans
to the private sector. Given these findings for bank loans, we add S in the
analysis to ascertain whether Islamic financing is subject to financial asset
price fluctuations.
As a basis for inferences, we first assess the causal patterns among
the variables using the Granger noncausality test advanced by Toda
 10 M. H. Ibrahim and R. Sukmana

and Yamamoto (1995). The Toda-Yamamoto approach is essentially the

modification of the traditional Granger (1969) causality test. The causality
between variables in Granger sense posits that, in explaining future value
of a particular variable (say Y ), we may rely on its lagged values. However,
if another variable (say X) can improve the prediction of Y beyond what
is contained in lagged Y , then X is said to Granger cause Y . Thus, the test
of Granger causality is essentially the test of predictability or precedence
(Gujarati, 2003). This means if future changes in Y are more likely to be
preceded by past values of X or past values of X contain information on
future values of Y , then X is said to Granger cause Y . In bivariate setting, the
statistical test of Granger causality from X to Y is implemented by regressing
Y on lagged values of Y and lagged values of X and evaluating the signif-
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icance of lagged X values in the regressions using the standard restricted

F statistic. The Granger causality test, however, requires the variables in the
regression to be stationary. In the case of nonstationary data, the test results
can be misleading as the F statistic has a nonstandard distribution.
Toda and Yamamoto (1995) have modified the Granger causality pro-
cedure by augmenting the lag order in the regression by the maximum
integration order of the variables in the system to circumvent the poten-
tial statistical problem of Granger causality test. We adopt this test due to
its simplicity without the need to impose long-run parameter restrictions.
Moreover, as long as the maximum order of integration suspected in the
included variables does not exceed the true autoregressive lag order, the
test can be used even if the stability and rank conditions are not fulfilled.
Finally, the test requires no knowledge of the variables’ cointegration prop-
erties. This is essential given the skeptical nature of pretest analyses such as
unit root and cointegration tests.
As an illustration, the causal influences of the three macroeconomic and
financial variables on real Islamic financing are assessed using the following
equation:


k+d max 
k+d max 
k+d max 
k+d max
Ft = a + bi Ft−i + ci Yt−i + di St−i + ei Rt−i + ut
i=1 i=1 i=1 i=1
(1)

where,
k is the optimal vector autoregressive (VAR) lag order and dmax is the
maximum integration order suspected in the system.

In the specification, we fix lag k such that the error terms in the VAR system
are serially uncorrelated. Meanwhile, dmax is set on the basis of augmented
Dickey-Fuller (ADF) and Phillips-Perron (PP) unit tests. The test for causality
 Dynamics of Islamic Financing in Malaysia 11

from, for example, Y to real Islamic financing is based on Wald F statistics

by restricting the coefficients of Y up to lag order k to 0. Thus, the null
hypothesis of the test isH0 : c1 = c2 = . . . = ck = 0. The causal relations from
other variables to real Islamic financing can be implemented in the same
manner. Needless to state, we can also test the causal influences on Y, S,
and R of other variables in the system.
We also cast the analysis in a traditional VAR setting to further assess
the variables’ dynamic interactions. Denote Z = [F, Y, S, R], the VAR model is
written as:


k
Zt = A0 + Ai Zt−i + εt (2)
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i=1

where,
A0 is a 4 × 1 vector of constant terms,
Ai is a 4 × 4 matrix of coefficients,
ε is the classical error terms, and
k is the autoregressive order specified such that the error terms are serially
uncorrelated.

It is worth mentioning that the VAR estimated coefficients are difficult to

interpret. The standard Granger F test based on (2) provides information
on whether a variable (e.g., Y or S) is causally linked to another variable
(e.g., real Islamic financing [F]), holding the remaining variables in the sys-
tem constant. This is surely a limitation because it only captures the direct
linkages between the variables, ignoring the possible indirect influences that
are propagated through other remaining variables.
Accordingly, following standard practices, we rely on an innovation
accounting of the variables’ dynamics, namely, variance decompositions and
impulse response functions. As the name implies, the variance decomposi-
tions attribute a variable’s forecast error variance to its own innovations
and innovations in other variables. They provide a natural measure for
the relative strength of the influences of various shocks on the variable
under consideration. Meanwhile, the impulse-response functions trace the
directional responses of a variable of interest to a one standard deviation
shock in other variables. They also delineate the magnitudes as well as
the persistence of the responses. By taking into consideration the full feed-
back mechanisms and direct and indirect influences of the shocks, variance
decompositions and impulse-response functions enable full evaluation of
the variables’ dynamic interactions.
A critical aspect in simulating variance decompositions and impulse
response functions is identification of structural shocks. In the current
analysis, we adopt Sims’ (1980) recursive scheme using Choleski factoriza-
tion for the purpose of shock identification. It should be pointed out that,
 12 M. H. Ibrahim and R. Sukmana

given its recursive nature, results from variance decompositions and impulse-
response functions can be sensitive to variables’ orderings. A solution
normally adopted to address this ordering problem is either by evaluating
the results based on alternative orderings of the variables or by imposing a
priori the recursive structure in the system. For the latter approach, which
we follow in our case, the recommendation is to place the most exogenous
variables first and the most endogenous variables last. Basically, the variable
ordered first is assumed to respond to other variables with lags whereas
the variables ordered higher are assumed to respond contemporaneously to
the variables placed before in the ordering. Based on this, we place Y first
and S last. This is sensible as production tends to be sluggish in respond-
ing to shocks whereas stock prices tend to absorb news more quickly as
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compared to other variables. In between these two variables, we place R

second and real F third. Although we have no a priori strong reasoning for
ordering R and F, it is pleased to note that switching the positions of R and
F does not materially affect the results and inferences. Thus, our ordering
is Y, R, F and S.

DATA AND RESULTS

Data Preliminaries
The data are monthly from January 1998 to June 2009, the span of which
is dictated by data availability. We use total financing of Islamic banking
system deflated by the consumer price index to represent F. We employ
real industrial production and 3-month treasury-bill rate to capture respec-
tively the level of production and monetary conditions of the country. Given
obvious seasonal patterns in the industrial production, we deseasonalize
the series using the census X12 procedure. Finally, the real share prices
are end-of-the-month closing prices of the Kuala Lumpur composite index
deflated by the consumer price index. The data are sourced from Monthly
Statistical Bulletin (various issues) published by Bank Negara Malaysia.
Except R, all data are expressed in natural logarithm. Figure 1 provides the
graphical plots of these series. As may be observed from the figure, F and Y
trend upward. Meanwhile, we may observe wide fluctuations in S over the
period under consideration. Finally, the R indicates monetary easing in the
aftermath of the 1997/1998 Asian financial crisis.
As a preliminary analysis of the variables’ stochastic properties, we first
subject each series to ADF and PP unit root tests. This is essential because
the test results can be used to gauge the maximum order of integration in the
system for the implementation of the Toda-Yamamoto causality test. Table 2
presents the ADF and PP test results. Although both tests tend to agree in
classifying F and Y as an I (1) process, they pointed to different stochastic
properties for S and R. Namely, S are noted to be stationary in level under
the ADF test. Meanwhile, the PP test renders the variable stationary in first
 Dynamics of Islamic Financing in Malaysia 13

11.5 5.8

11.0 5.6
10.5
5.4
10.0
5.2
9.5

9.0 5.0

8.5 4.8
1998 2000 2002 2004 2006 2008 1998 2000 2002 2004 2006 2008
(a) Islamic Financing (F) (b) Real Industrial Production (Y)
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7.2 12

10
6.8
8

6.4 6

4
6.0
2

5.6 0
1998 2000 2002 2004 2006 2008 1998 2000 2002 2004 2006 2008
(c) Real Stock Prices (S) (d) Interest Rate (R)

FIGURE 1 Graphical Plots of the Variables.

difference. Similarly, the null unit root hypothesis can be rejected for the R
in level at 10% significance level under the ADF test, signaling its stationarity
property. However, the PP test soundly suggests the integration order of 1
for R. This uncertainty in classifying some variables into I (0) or I (1) justifies
the Toda-Yamamoto causality test, which we now turn to.

Noncausality Tests
We conduct the Toda-Yamamoto causality test by setting the maximum order
of integration to 1. The optimal VAR lag order is set to 4 on the basis of
uncorrelated errors. Table 3 provides the causality test results. From the
table, it is noteworthy that S do exert significant influences on Y. Meanwhile,
real industrial production does not seem to cause F. However, it should be
noted that, despite its prohibition on the use of R, its behavior is still affected
by the R. Sensibly, this might be a feature of a dual-banking system where
Islamic banks operate side by side with the conventional banks. Fluctuations
in R may still affect F due to a flight to or from conventional banking. From
the demand side, an increase in R may shift demand from conventional
 14 M. H. Ibrahim and R. Sukmana

TABLE 3 Toda-Yamamoto Noncausality Tests

Lagged right-hand-side variables

Dependent
variables F Y S R

F — 0.7263 (0.538) 2.4574 (0.066) 3.5996 (0.016)

Y 0.7047 (0.551) — 4.3691 (0.006) 0.2330 (0.873)
S 1.1011 (0.352) 2.7783 (0.044) — 7.6051 (0.000)
R 1.6255 (0.187) 0.8862 (0.450) 4.4087 (0.006) —
Note: F = real Islamic financing; Y = real industrial production; S = real stock prices; R = interest rate.
Numbers in parentheses are p values. The optimal lag order of the VAR is 3 while the maximum order of
integration suspected in the variables is 1.

loans to F and vice versa. Alternatively, an increase in R makes conventional

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banks more attractive to depositors and accordingly lead to the rise in con-
ventional deposits and loans. Moreover, operating under the same monetary
environment, Islamic banks are also affected by the Central Bank’s monetary
policy directions or monetary liquidity. In short, the Islamic banks are not
spared from competitive pressures and monetary conditions of the country.
Apart from these central results, we also note the predictability of
S for Y, the finding that is in line with the notion that the stock market cap-
tures future expectations of real activity as embedded in the stock market
valuation model. Table 3 also suggests evidence that there exists feedback
effect from Y to S, which should be expected as S are fundamentally tied
to the real factor. We also may observe from the results the bidirectional
causal linkage between S and R. As expected, the R should affect the stock
market through mainly the discount factor in the stock valuation model. The
causality that runs from the stock market to R may be due to policy reaction
to stock market fluctuations. Additionally, it may be caused by the stock
market wealth effect that increases demands for loanable funds and accord-
ingly R. Finally, we may also note from Table 3 a unidirectional causality
from R to Y.

Innovation Accounting
As a further analysis, we estimate a level VAR model for the set of variables
under study. Prior to estimating the level VAR, we first implement the max-
imum likelihood cointegration test due to Johansen (1988) and Johansen
and Juselius (1990). Essentially, the Johansen-Juselius cointegration test is a
VAR-based test to discern whether there exists a long-run relation among
the variables in the system. In our context, the test is essential because
the presence of cointegration validates the use of levels VAR in innovation
accounting analysis. From the test, which is not reported to conserve space,
the null hypothesis of no cointegration is rejected in favor of a unique coin-
tegrating vector that ties the variables together in the long run. From the
estimated VAR, we simulate variance decompositions and impulse-response
 Dynamics of Islamic Financing in Malaysia 15

TABLE 4 Variance Decompositions

Explained by variations in

Horizons F Y S R

(a) Variance Decompositions of F

3 78.212 1.087 3.072 17.628
6 69.589 2.604 1.956 25.850
12 59.198 3.840 1.114 35.848
18 52.928 4.301 0.733 42.038
24 49.421 4.291 0.543 45.745
(b) Variance Decompositions of Y
3 0.697 92.453 6.294 0.556
6 0.563 77.985 14.556 6.896
12 0.365 64.899 17.380 17.356
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18 0.875 58.997 16.854 23.274

24 1.888 55.067 15.770 27.275
(c) Variance Decompositions of S
3 1.364 12.435 74.312 11.888
6 1.568 20.157 56.188 22.087
12 1.378 23.025 51.052 24.545
18 1.356 23.504 49.895 25.244
24 1.434 23.588 49.291 25.687
(d) Variance Decompositions of R
3 1.252 5.951 0.896 91.902
6 2.995 5.167 4.392 87.446
12 5.217 4.175 7.302 83.306
18 6.398 4.336 8.891 80.374
24 7.064 4.811 9.891 78.233
Note: F = real Islamic financing; Y = real industrial production; S = real stock prices; R = interest rate.
Variable ordering – Y, R, F, S.

functions to assess the dynamics of F and its causal relations to Y, S, and R.

Table 4 reports the variance decompositions whereas Figure 2 presents the
impulse-response functions.
Overall, the results generally support the noted causal patterns among
the variables. As may be observed from Table 4 panel (a), quite sizable
proportions of the F forecast error variance are attributed to variations in
R. Indeed, R shocks are most dominant in explaining variations in F. More
specifically, the R explains more than 45% after 2-year horizon. Reaffirming
these results, the impulse-response functions suggest negative responses of
F to one standard deviation shocks in R (Figure 2 panel a). This pattern
of responses conforms to our a priori expectations. Further, we find only
minimal role of S in explaining the error variance of F. Moreover, there seems
to be temporary significant responses of F to innovations in S. Finally, the R
does not seem to affect F. These results conform well to Kassim et al. (2009)
who documented significant R exposure of F and insignificant influence of
Y. However, unlike the aggregate loan behavior as documented by Ibrahim
(2005, 2006), the effects of stock market gyrations on F tend to be marginal.
 16 M. H. Ibrahim and R. Sukmana

(a) Real Islamic Financing (F)

.04 .04 .04
.02 .02 .02
.00 .00 .00
–.02 –.02 –.02
–.04 –.04 –.04
–.06 –.06 –.06
5 10 15 20 5 10 15 20 5 10 15 20
Response to Y Response to S Response to R
(b) Real Production (Y)
.03 .03 .03
.02 .02 .02
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.01 .01 .01

.00 .00 .00
–.01 –.01 –.01
–.02 –.02 –.02
5 10 15 20 5 10 15 20 5 10 15 20
Response to F Response to S Response to R
(c) Real Stock Prices (S)
.08 .08 .08

.04 .04 .04

.00 .00 .00

–.04 –.04 –.04

–.08 –.08 –.08

5 10 15 20 5 10 15 20 5 10 15 20
Response to F Response to Y Response to R
(d) Interest Rate (R)
.6 .6 .6

.4 .4 .4

.2 .2 .2

.0 .0 .0

–.2 –.2 –.2

–.4 –.4 –.4

5 10 15 20 5 10 15 20 5 10 15 20
Response to F Response to Y Response to S

FIGURE 2 Impulse-Response Functions.

Other interesting results that we observe are the bidirectional causality

between Y and S and between R and S. As should be expected, the Y
increases in response to positive shocks in S. Likewise, S increase following
a one standard deviation shock in Y. The variance decompositions of Y and
 Dynamics of Islamic Financing in Malaysia 17

S suggest more than 15% (23%) of the variations in Y (S) is accounted by

innovations in S (Y). The R shocks are also noted to explain significantly
the forecast error variance of Y and S. As expected, both variables respond
negatively and significantly to the increase in the R. Finally, we observe little
influences of S on R. We further observe that the R drops following the
increase in Y, which perhaps suggests the relative importance of the supply
side that links Y to loanable funds.

CONCLUSION

In light of the increasing importance of Islamic financing and policy direc-

tions to develop Malaysia as an international center of Islamic financial
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services, this article evaluates dynamic behavior of real Islamic financing

and its relations to macroeconomic and financial variables deemed relevant
for conventional bank loan behavior. These variables are real industrial pro-
duction, real stock prices, and interest rate. The article makes use of the
Toda and Yamamoto’s (1995) Granger noncausality test to identify causal
patterns among the variables. Then, it estimates a level VAR model and sim-
ulates variance decompositions and impulse response functions to further
discern their dynamic interactions. In general, the key findings related to
the relations between real Islamic financing and the three macroeconomic
and financial variables are robust across the Toda-Yamamoto causality test,
variance decompositions, and impulse-response functions. Adding credence
to the key findings as well as our empirical approaches are the documented
interactions among other variables that mostly conform to expectations.
We tend to conclude that Islamic financing in Malaysia is driven mainly
by interest rate variations, is minimally affected by stock market fluctuations
and not influenced real industrial production. This means that Islamic banks
tend to be resilient to recent volatility in the stock market and fluctuations
in economic activities. In other words, Islamic financing is not subject to the
boom/bust cycles frequently recurring in the financial markets. However,
the behavior of Islamic financing is still affected by the interest rate. Indeed,
as indicated by the variance decompositions, the interest rate seems to be
most dominant compared to other variables. Moreover, a rise in the interest
rate tends to depress Islamic financing. We contend that, being under a dual-
banking system, the Islamic banks are not spared from monetary conditions
of the country. In addition, having to compete with well-established and
more sophisticated conventional banks, Islamic banks may have to follow
the pricing strategy of conventional banks. The exposure to interest rate
changes is perhaps inherent in the dual-banking system, which calls for
further evaluation on how to reduce this risk or even to eliminate it from the
Islamic bank system. This is essential since the operation of Islamic banks
should be delinked from the interest rates.
 18 M. H. Ibrahim and R. Sukmana

NOTES

1. In line with conventional banks, Islamic banks also offer other form of deposits such as current
or checkable deposits. However, the Islamic banks do not offer a fixed interest payment on these
deposits.
2. This list of financing products is by no means exhaustive. They are provided to picture Islamic
banks’ principle of operations. For details of financing products of Islamic banks, please refer to Ayub
(2007).

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