Dual market competition and deposit rate setting in Islamic and conventional banks

Abstract

This paper addresses the issue of competition in dual banking markets by analyzing the determinants of deposit rates in Islamic and conventional banks. Using a sample of 20 countries with dual banking systems over the 2000-2014 period, our results show significant differences in the drivers of Islamic and conventional banks' pricing behavior. Conventional banks with stronger market power set lower deposit rates but market power is not significant for Islamic banks. In predominantly Muslim environments, conventional banks set higher deposit rates and further higher when their market power is lower. Whereas conventional banks are influenced by the competitiveness of Islamic banks, Islamic banks are only affected by their peers in predominantly Muslim countries. Our findings have important implications regarding competition and bank stability in dual banking markets.

Competition in Dual Markets: Implications for Banking System Stability

“…Intensified dual market competition is not significant for Islamic banks where conventional banks are significantly impacted. This result is different from Kabir and Worthington (2017), who find a similar effect for two bank types but is in line with Meslier et al (2017), who find the missing effect of competition on Islamic banks' deposit rate setting. Islamic banks might benefit from captive clients, making them more stable even in a highly competitive market.…”

“…A higher value Lerner index indicates greater market power. We follow the previous work of Meslier et al (2017), Turk-Ariss (2010) and Weill (2011) to create the index. The index is computed by the following equation.…”

“…Since we focus on the market-level competition, following Leon (2015) and Meslier et al (2017), we use the weighted average value of the Lerner index to create a country-level…”

“…We focus on countries with both Islamic and conventional banks. Following prior work in Islamic banking (Abedifar et al, 2013;Cihak and Hesse, 2010;Meslier et al, 2017) We use the Z-score, which has been extensively applied in the banking literature to measure bank stability. The Z-score measures the standard deviation that the banks' return has to diminish to deplete equity.…”

“…Despite the fact that Islamic banks are relatively new to the market, conventional banks' behavior in the dual market has changed in reaction to this situation. A recent study by Meslier et al (2017) shows that conventional banks counter Islamic banks' competitive pressure by setting higher deposit rates when their market power is lower. The behavior of conventional banks, in this case, could jeopardize their financial stability.…”