International Journal of Islamic and Middle Eastern Finance and Management

International Journal of Islamic and Middle Eastern Finance and
Management
Bank margin determination: a comparison between Islamic and conventional banks in
Indonesia
Erwin G. Hutapea Rahmatina A. Kasri
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Management, Vol. 3 Iss 1 pp. 65 - 82
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Bank margin
Bank margin determination: determination
a comparison between Islamic and
conventional banks in Indonesia
65
Erwin G. Hutapea
Central Bank of Indonesia, Jakarta, Indonesia, and
Rahmatina A. Kasri
Islamic Economics and Business Center (PEBS)/Department of Economics,
Faculty of Economics, University of Indonesia, Depok, Indonesia
Abstract
Purpose – The purpose of this paper is to examine the relationship between Islamic bank margin
(BM) and its determinants. It also compares the BM behavior of Islamic and conventional banks in the
Indonesian dual banking system.
Design/methodology/approach – The paper employs a time series approach under the dealership
framework of Ho and Saunders. The autoregressive distributed lag model is used to inspect
cointegration between BM and its determinants for the period of January 1996 to February 2006 of five
sample banks (two Islamic banks and three conventional banks).
Findings – The result confirms that there exists a long-running relationship between the Islamic BM
and its determinants. In particular, as interest rate volatility increases, Islamic BM responds
negatively while that of conventional banks responds positively. The findings differ from most of the
other studies as they found a positive relationship between BM and interest rate volatility. This paper
also shows that the margin behavior changes as the basis of bank operations changes from
conventional to Islamic principles.
Research limitations/implications – The paper uses a relatively small sample of three (out of 150)
conventional banks as a comparison to two sample Islamic banks. However, as they come from the
same peer with the Islamic banks, it is believed that the finding is valid. Islamic banks in Indonesia
are not remote from the interest rate volatility in their presence under a dual banking system. It is the
displaced commercial risk that threatens Islamic banking profitability in a changing market interest
rate situation.
Practical implications – Under a dual banking system, the stability of interest rates and the
financial system is of great importance for the policy maker in developing the Islamic banking
industry in Indonesia. As long as the BM is still a major source of income to the Islamic banks, it is
necessary for Islamic banks to have prudent risk management to mitigate the negative effect of
displaced commercial risk and maintain its profitability. Implementation of profit equalization
reserves concept is a possible measure for Islamic banks to shield their operation.
Originality/value – This paper is believed to be the first study on Islamic BM behavior in Indonesia.
It is expected to provide useful information for policy makers and Islamic bank management to
develop a sound and profitable Islamic banking industry in Indonesia.
Keywords Banks, Risk management, Islam, Indonesia
Paper type Research paper International Journal of Islamic and
Middle Eastern Finance and
Management
Vol. 3 No. 1, 2010
1. Introduction pp. 65-82
The importance of financial system stability for aggregate economic activity has been q Emerald Group Publishing Limited
1753-8394
increasingly emphasized (Kaminsky et al., 1999; Hoggarth and Saporta, 2001; Borio, 2003). DOI 10.1108/17538391011033870
IMEFM This is especially true for a developing economy like Indonesia, where banking sector acts
3,1 as a dominant source of business financing. Thus, it is important that the intermediary
function of banks be carried out at the lowest possible cost in order to achieve greater social
welfare. Obviously, lower bank margin (BM) will lead to lower social costs of financial
intermediation (Maudos and de Guevara, 2004, p. 2260).
The setting of Indonesian banking system, where Islamic banks operate alongside
66 and compete with their conventional counterparts, gives a direct motivation to study
Islamic BM. In fact, in the last five years the Islamic banks had been growing at 64
percent rate annually, surpassed their counterpart that grew around 30 percent
annually (Bank Indonesia, 2007). Thus, we are motivated to examine the determinants
of Islamic BM. In particular, we are interested to investigate the effect of interest rate
volatility on the Islamic BM. For comparative purpose, we also investigate the
determinants of conventional BM. Given that the Islamic banks have to follow the
Sharia rules, we expect that the Islamic BM will behave differently with that of their
counterpart.
In efforts to arrive at conclusive findings, we use the extended version of the
dealership approach developed by Ho and Saunders’ (1981) study and employ the
autoregressive distributed lag (ARDL) bounds testing approach to test the existence of
the relationship between BM and its determinants. The data cover monthly series from
1996:01 to 2006:02 of a sample of five Indonesian banks (two Islamic banks and three
conventional banks). As one of the conventional banks converted to an Islamic bank in
the reviewed period, we also inspect the existence of a break in the BM behavior. It is
expected that this study could give a better understanding on the behavior of the
Islamic BM in Indonesia as well as enrich Islamic banking literature.
This paper proceeds as follows. In the next section, existing literature and empirical
evidence on BM is discussed. Section 3 describes theoretical setting for Islamic BM and
empirical approach of the study, followed by Section 4 which discusses empirical
results of this study. Section 5 concludes the paper and highlights some relevant policy
implications.
2. Literature review
2.1 Definition and models of BM
BM is generally defined as the spread between interest revenue on bank assets and
interest expense on bank liabilities, which is presented as a proportion of average bank
assets or earning assets (Ho and Saunders, 1981; Angbazo, 1997; Saunders and
Schumacher, 2000). As a branch of study on bank behavior, prior to 1981, there was no
significant development in the literature on bank margins. In its early time, the
literature on BM determination might be traced back to Pyle (1971, as cited in
Baltensperger, 1980, pp. 25-9). Afterwards, the literature on bank margins can be
classified into two approaches:
(1) the dynamic intermediation or dealership approach (Ho and Saunders, 1981;
Angbazo, 1997; Saunders and Schumacher, 2000; Valverde and Fernandez,
2005, 2007); and
(2) the static micro-model of banking firm (Zarruck, 1989; Wong, 1997).
The dealership approach is developed by Ho and Saunders (1981) to study the

determinants of bank interest margin. According to them, in playing its role as a dealer
that sets the interest rate on loans and deposits, a bank faces uncertainties and costs Bank margin
since the demand for loans and the supply of deposits are stochastic in the sense that determination
they arrive at different times. Thus, it has to hold a long or short position in the
short-term money market to balance this uncertainty that make it exposed to interest
rate risk. This inevitably affects the BM. It is further suggested that greater degree of
risk aversion, larger size of bank transaction and greater variance of interest rate are
associated with larger bank spread. These imply that even if banking market is highly 67
competitive, as long as bank management is risk-averse and faces transaction
uncertainties a positive BM will exist as the price of providing deposit-loan
immediacy.
In contrast, the second approach analyzes banking firms in a static setting where
demand for loans and supply of deposits simultaneously clear both markets. It is
developed from the criticisms that the first approach fails to consider some relevant
aspects of the bank’s operation, such as the administrative cost to maintain loan/deposit
contracts and the institutional structures of the banking market (Lerner, 1981, p. 601).
Zarruck (1989) pioneered the study and found that the risk-averse bank operates with a
smaller spread than the risk-neutral bank. This finding was later challenged by Wong
(1997) who extended Zarruk’s work by incorporating credit risk and interest rate risk
into the model. In contrast to Zarruk’s finding, Wong suggested that the optimal bank
interest margin is larger in the case of risk-averse banks compared to that of
risk-neutral banks. That is, the spread widens as the bank’s risk aversion rises.
Therefore, as this model leads to different results, most empirical studies on BM use the
first approach.
2.2 Empirical research on BM determination

Besides developing the theoretical model, Ho and Saunders (1981) examined the
validity of their model in 53 sample banks in the USA using quarterly series for the
1976:04-1979:04 period. It is reported that the main determinants of the size of actual
BM were transaction uncertainty (pure spread) and implicit interest rate. The pure
spread was smaller in the case of large banks compared to that of the small banks,
mainly due to the differences in the US banking market structure rather than risk
aversion and transaction size of the banks.
A number of empirical works on BM have employed and extended the original
model of Ho and Saunders (1981). Angbazo (1997) incorporated other types of risk,
namely credit risk and liquidity risk, to study 286 US commercial banks in the year
1989-1993. He found that high BM is associated with high credit risk, interest rate risk,
and liquidity risk. Capital base, management quality and opportunity cost of reserves
are also significant and positively related to BM. This study is enlarged by Saunders
and Schumacher (2000) to cover 614 banks in six selected European countries (UK,
Germany, Switzerland, France, Italy, and Spain) and the USA from 1988 to 1995. They
found that BM appears to be equally sensitive to both the short-rate and long-rate
volatility[1]. These results are confirmed by Maudos and de Guevara (2004) who
extended the work of Saunders and Schumacher (2000) by introducing operating cost,
degree of market power, and bigger sample size in the period 1993-2000.
A study by Valverde and Fernandez (2005) enrich the BM literature by
investigating the determinants of BM in banking market of seven European countries
(Germany, Spain, France, The Netherlands, Italy, UK, and Sweden) from 1994 to 2001.
IMEFM Different from the previous studies, the authors incorporated a broader framework of
3,1 BM analysis. In particular, they estimated the determinants of the BM using the
traditional measure of interest margin (the loan to deposit rate spread), a wider
accounting margin (gross income) and a broader BM measure following the New
Empirical Industrial Organization perspective (the Lerner index). They also employed
two simultaneous equations, i.e. those with level and first-differenced variables. In the
68 interest margin regression, they reported that the index is not significant, but both
liquidity and interest rate risks are significant. Operating inefficiency and capital to
assets ratio are positive and significant. As a proxy to specialization, they found that
the ratio of loans to total assets is negatively and significantly related to the spread.
They suggested that the banks specialized in lending can offer a lower BM due to
higher efficiency (Valverde and Fernandez, 2005, pp. 8-9). A more recent study from the
same authors, Valverde and Fernandez (2007), extended the previous research and
further investigated the relationship between specialization and BM. Using the same
data set and adding the explanatory variables to include vectors of the pure spread’s
determinants (risk and market power), other bank-specific factors, bank specialization
factors and regulatory/macroeconomic control variables, they found that both market
power and risk parameters alter BMs when financial innovations are introduced.
“In particular, output diversifications permit the banks to increase their revenue and
obtain higher market power since revenue from non-traditional business (which
includes non-interest income) may ‘compensate’ for lower interest margins that result
from stronger competition in the traditional segments (deposits/loans).” These results
explain, at least in part, the paradoxical coexistence of decreasing interest margins and
increasing market power in European banking sectors which earlier studies have
discovered (Valverde and Fernandez, 2007, p. 15).
As far as study of bank’s margin is concerned, the literature on bank margins for
Islamic banks is hardly available. Although they are not directly related to the study of
BM, some works on Islamic bank performance and profitability are found to be helpful
in laying down the theoretical foundation for the Islamic BM. Haron and Shanmugam
(1995) pioneer the empirical study by investigating Bank Islam Malaysia over the year
1983-1993. Using autoregressive models to examine the relationship between the rates
of return and the level of deposit in the bank, the study finds that there is an inverse
relationship between the variables. This implies that the Islamic bank customers did
not consider returns from the Islamic bank deposit as an incentive to maintain their
funds with the bank. However, as this result is contrary to the “normal” behavior of
investors, Haron and Ahmad (2000) expand the study to include all funds deposited in
Islamic banks in Malaysia from January 1994 to December 1998. The results indicate
that the rates of return have strong positive relationship with the Islamic banks’
deposits, while the interest rates have strong negative relationship with it. Therefore, it
is suggested that the Islamic banks’ customers in Malaysia are attracted to higher
return and guided by the profit motive. A more recent study by Sukmana and Yusof
(2005) which employs a wider data set (January 1994 to October 2004) also confirm
conclusions of the previous studies. Accordingly, higher BM is required to attract such
customers.
In the case of Indonesia, using time series analysis for 1994-2002 data, Mangkuto
(2004) confirmed that the deposits outstanding of Bank Muamalat Indonesia were
negatively responsive to the market interest rate. That is, as interest rates increase,
depositors take their fund from the Islamic bank and move it to the conventional Bank margin
banks, thus reducing the Islamic banks’ deposit outstanding. He therefore suggested determination
that the Islamic bank’s depositors were mainly “rational” depositors who were driven
by profit motive in using the bank’s services. Scope of the study is later widened by
Kasri (2008) to cover data of all Islamic banks in Indonesia from March 2000 to August
2007. Using vector autoregressive model model, she revealed that the mudharaba[2]
investment deposit in the Islamic banks are cointegrated with return of the Islamic 69
deposit, interest rate of the conventional banks’ deposit, number of Islamic banks’
branches, and national income in the long-run. She also reported that rate of return and
interest rate move in tandem, indicating that Islamic banks in Indonesia are exposed to
benchmark risk and rate of return risk. Further, as the level of Islamic deposit
decreased when interest rate increased, she suggested that the banks are also exposed
to displaced commercial risk. In Islamic banking literature, the displaced commercial
risk occurs due to market pressure that Islamic bank pays a return that exceeds the
rate that has been earned on assets financed by investment account holders when
the return on assets is under-performing as compared with competitors’ rates[3]. This
result, hence, confirms the previous finding of Mangkuto (2004). Taken together, these
results suggest that the Islamic banks are exposed to various banking risks which will
inevitably affect the BM.
3. Empirical approach
3.1 Islamic BM: theoretical setting and empirical specification
The nature of Islamic BM is determined by the nature of its component. Islamic banks
never have a predetermined-commitment to pay the return or profit to depositors,
neither in nominal sum nor in rate, since this violates the Sharia rules regarding riba.
Thus, deposit or financing rates of Islamic banks’ debt-based products[4] are known
ex ante, while those of the equity-based products[5] are known ex post. Taken together,
as the deposit rate and financing rate of the equity-based products of Islamic banks
will be known at the end of period, it follows that the Islamic BM is ex post in nature[6].
Conversely, the deposit rate of conventional banks is a predetermined-commitment
by the name of interest rate. Since the deposit and lending rates are predetermined
as interest rate commitment, the net interest margin of conventional banks is known
ex ante.
As financial intermediaries, Islamic and conventional banks normally face the same
problems in their operation. Among others, they have to face asymmetrical arrival time
of financing demand and deposit supply, interest rate volatility, default risk on
financings, and liquidity risk. In light of the original model of the dealership approach
(Ho and Saunders, 1981) and its extended versions (Angbazo, 1997; Maudos and de
Guevara, 2004), the relationship between the Islamic BM and its determinants can be
stated as follow:
BMt ¼ FðS t ; X t ; 1t Þ ð1Þ
where BMt is the reported Islamic BM at time t, St is a vector of the determinants of the
pure spread (interest rate volatility and default risk on financings), Xt is a vector of
bank-specific control variables (liquidity risk, capital base, implicit return to
depositors, opportunity cost of bank reserves, and management quality), and 1t is
residual term.
IMEFM Following discussion in the previous sections, we argue that there are seven factors
3,1 critical in determining the BM, namely interest rate volatility, default risk, liquidity
risk, capital base, management quality, implicit return to depositors, and opportunity
cost of bank reserves. With respect to interest rate volatility, theories and empirical
evidences show that conventional banks would ask for a higher margin as
compensation when interest rate risk increases. In contrast, we argue that Islamic BM
70 reacts negatively to interest rate volatility. That is, as market interest rate volatility
increases, ceteris paribus, Islamic banks need to increase their deposit rate or to
decrease their financing rate. In the deposit market, as market interest rate increases, it
is possible that Islamic bank’s customer withdrawn their fund and transfer it to
the conventional counterpart, a risk known as displaced commercial risk[2]. In the
financing (credit market), however, demand for Islamic banks’ financing will also
increase when market interest rates increase, as their prices are normally lower as
compared to the credit interest rate of the conventional banks. Hence, as the market
interest rate swings, no matter whether it increases or decreases, Islamic banks are
exposed to a certain degree of risk, which possibly comes from the movement of either
their depositors or users of funds. Thus, the higher the volatility of market interest rate,
the bigger the displaced commercial risks faced by Islamic banks such that the banks
need to increase their deposit rate or to decrease their financing rate or operate at a
lower margin.
Default risk (of financing) is the risk of non-repayment on financing due to the
inability of the funds’ users to fulfill their obligations to banks. Both Islamic and
conventional banks have to face this risk in their operation. Since financing is the major
source of income for both banks, deterioration of financing quality will affect the banks’
profitability and subsequently the banks’ viability. As default risk increases, Islamic
banks will put a higher risk premium on financing, then the financing price will increase
and, ceteris paribus, the BM will increase. Thus, the BM relates positively to the default
risk. In a similar way, liquidity risk or the risk of not having sufficient cash or borrowing
capacity to meet deposit withdrawals or new financing demand could force banks to
resort to emergency funds at a higher cost. As liquidity risk of a bank increases, it will
ask for a higher risk premium, which might be done through increasing financing rate.
As a result, ceteris paribus, the Islamic BM will increase. Hence, the Islamic BM responds
positively to the liquidity risk.
In the cost of capital perspective, higher portion of equity in the capital structure
will lead to higher cost of capital as the cost of equity is higher than the cost of debt.
Following the earlier literature, an increase in the capital base may increase the
average cost of capital and, to compensate for the cost, the bank will ask for a higher
financing rate. As a result, ceteris paribus, the Islamic BM will increase or, in other
words, Islamic BM would respond positively to the capital ratio. Likewise, implicit
return to depositor that reflects extra payments to depositors through service charge
remission or other types of transfers is positively related to the Islamic BM, ceteris
paribus. As the implicit return to depositors is a component of the operation costs of the
banks, a higher financing rate will be asked to cover the higher costs.
Akin to conventional banks, Islamic banks have to fulfill reserve requirement
regulation which reduces the banks’ opportunity to give financing. Previous literatures
suggest that the banks will request a higher financing rate as the reserves increase in
compensation for opportunity forgone. Thus, ceteris paribus, we argue that the Islamic
BM responds positively to the opportunity cost of bank reserves. Finally, management Bank margin
quality – reflecting the ability of management to minimize costs at a given level of
income or to maximize income at a reasonable level of cost would – would react
determination
negatively to Islamic BM. That is, as efficiency of Islamic banks improves, the banks
would be able to reduce their costs and thus will ask for a relatively lower margin than
that of the inefficient banks.
In view of the above, in this paper, we directly estimate the relationship between the 71
Islamic BM and its determinants in the following model:
BM ¼ Fðdefault risk; interest rate volatility;
liquidity risk; capital ratio; implicit return; ð2Þ
bank reserve; management qualityÞ
This empirical model also serves as our hypothesis in studying the behavior of the
Islamic BM. The data and empirical variables as proxies to the theoretical variables are
discussed in the next section.
3.2 Data and empirical variables

In this paper, we use monthly data of banks publication reports covering 1996:01 to
2006:02 (122 observations) from the Bank Indonesia database. We use a sample of five
banks: two Islamic banks, namely Bank Muamalat and Bank Syariah Mandiri
(henceforth BM and BSM, respectively), and three conventional banks, namely Bank
Bumiputera, Bank Ekonomi Rahardja, and Bank Agroniaga (henceforth BB, BER, and
BA, respectively). In order to get a comparable picture of the margin behavior of
Islamic and conventional banks, we select the conventional banks of the same asset
size as the Islamic banks[7].
It is important to note that in this paper, we define Islamic BM as the ratio of
net-financing income to average earning assets. Net-financing income equals income of
financing minus income distributed to depositors. As our study compares the margin
behavior of Islamic banks with that of the conventional banks, the Islamic BM is a
comparable variable to the net interest margin of conventional banks. Meanwhile, net
interest margin is the ratio of net interest income to average earning assets. Definition
and measure for each determinant of the conventional bank (CB) and Islamic bank (IB)
margin as well as expected relationship between the variables are summarized in
Table I.
3.3 Econometric procedures

Based on the empirical specifications and variables discussed in the previous section,
the regression model is specified as follows:
BMt ¼ a þ b1 DEFt þ b2 MKTt þ b3 LIQt þ b4 SOLVt
ð3Þ
þ b5 IMPLt þ b6 OCBRt þ b7 QMt þ nt
where all variables are as previously defined, a is intercept and bi (for i ¼ 1, 2, . . . , 7)

are slope coefficients.
In testing the existence of the relationship between the Islamic BM and its
determinants (equation (3)), we apply the recently developed cointegration analysis
IMEFM
Expected
3,1 BM and its relationship
determinants Definition and measure CB IB
BM Ratio of net-financing income to average earning

72 assets
Default risk of financings Ratio of allowances for financing losses to total þ þ
(DEF) financing:
[(allowance for financing losses/
total financing) £ 100 percent]
Market interest rate Standard deviation of market interest rate: þ 2
volatility (MKT) qX ffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
ðr 2 rÞ2 =n 2 1
Liquidity risk (LIQ) Ratio of liquid assets to liabilities: þ þ

[(liquid assets/liabilities) £ 100 percent]
Capital base or solvency Ratio of core equity to assets: þ þ
ratio (SOLV) [(core equity/assets) £ 100 percent]
Implicit return to the Ratio of “non funding-related expenses minus þ þ
depositors (IMPL) non financing-related revenues” to average
earning assets:
[(net nonfunding related expenses/
average earning assets) £ 100 percent]
Opportunity cost of bank Ratio of cash and balance of the deposit with the þ þ
reserves (OCBR) central bank to total assets:
[(cash þ balance at CB/
total assets) £ 100 percent]
Table I. Management quality (QM) Ratio of operating cost to operating income: þ þ
BM [operating costs/
and its determinants operating incomes) £ 100 percent]
based on the ARDL framework, namely the bounds F-test[8]. The statistic used is the
familiar Wald or F-statistic, which is used to test the joint significance of lagged level
variables in a conditional unrestricted equilibrium correction model (UECM) presented
in the ARDL format[9]. If the computed Wald or F-statistic is bigger than the upper
bound, we reject the null of no cointegration between variables, vice versa. However, if
the Wald or F-statistic falls inside these bounds – , i.e. bigger than the lower bound but
smaller than the upper bound – inference about cointegration is inconclusive and
knowledge of the order of the integration of the underlying variables is required before
conclusive inferences can be drawn (Pesaran et al., 2001, p. 11). This approach has
advantages, as it does not involve pre-testing the integration property of the variables
under study[10] and can be applied to small samples.
Before conducting the F-test for cointegration, we need to form the UECM for
Islamic BM equation and select the optimal lag length[11]. Based on the dealership
model, the UECM of the Islamic BM equation is as follows:
X
n X
n X
n Bank margin
DBMt ¼ a0 þ lp DBMt2p þ gp DDEFt2p þ wp DMKTt2p
p¼1 p¼0 p¼0
determination
X
n X
n X
n
þ fp DLIQt2p þ up DSOLVt2p þ dp DIMPLt2p
p¼0 p¼0 p¼0
ð4Þ
X
n X
n 73
þ cp DOCBRt2p þ qp DQMt2p þ p1 BMt21 þ p2 DEFt21
p¼0 p¼0
þ p3 MKTt21 þ p4 LIQt21 þ p5 SOLVt21 þ p6 IMPLt21

þ p7 OCBRt21 þ p8 QMt21 þ 1t
where all variables are as previously defined, D is the first difference operator, n is the
order of UECM model [ARDL(n, n, . . . , n)], and p1 (for i ¼ 1, 2, . . . , 8) is the slope
coefficients of lagged levels variables.
The null hypothesis of the bounds testing for our model is that there exists no
cointegration between the Islamic BM and its determinants. Given that there exists a
cointegration between the Islamic BM and its determinants, for the sake of parsimony,
we adopt the general-to-specific approach of Hendry (1977) to select a parsimonious
specification for the dynamic of the Islamic BM[12], then we are able to establish the
long-run relationships of the Islamic BM through normalizing coefficients of
regressions of the UECM.
4. Empirical results and discussion

4.1 The bounds testing for cointegration
Table II presents the F-statistics for testing the existence of cointegration between BM
and its determinants. In general, the results suggest that there is evidence of
cointegration between the BM and its determinants for each sample bank. In particular,
for BM, we reject the null hypothesis of no cointegration between variables at lags 1-4
and 6 but we fail to reject the null at lags 5, 7, and 8. For BSM, we reject the null
hypothesis at all lag lengths. Meanwhile, for BB and BER, we find evidence of
Lag order BM BSM BB BER BA
1 4.516 * 12.447 * 6.994 * 4.833 * 3.730 * *

2 6.344 * 8.855 * 4.495 * 5.352 * 3.307 * * *
3 4.499 * 7.888 * 5.521 * 5.685 * 4.640 *
4 3.626 * * 4.965 * 3.695 * * 5.523 * 2.090
5 2.915 9.637 * 3.517 * * 4.834 * 3.705 * *
6 3.323 * * * 6.553 * 2.295 1.429 3.681 * *
7 1.957 3.158 * * * 1.804 1.763 3.602 * *
8 2.211 8.308 * 1.482 1.382 2.238
Notes: Statistic is significant at: *0.01, * *0.05, and * * *0.10 levels, respectively; critical values for the Table II.
F-test are taken from Narayan (2004) with number of observations T ¼ 80 and number of regressors F-statistic for testing the
k ¼ 7; lower and upper bounds for 0.01, 0.05, and 0.10 levels are 3.021-4.350, 2.336-3.458, and 2.017- existence of a levels bank
3.052, respectively margin equation
IMEFM cointegration at lags 1-5 but we do not find it at a higher lag. Lastly, for BA, we reject
3,1 the hypothesis of no cointegration except for lags 4 and 8.
4.2 The long-run equation for bank margin

4.2.1 Long-run equation of Islamic banks. The evidence of cointegration between
Islamic BM and its determinants for BM and BSM serves as an empirical ground for
74 existence of the Islamic BM equation and allow us to proceed and estimate the
coefficient of the Islamic BM equations. The long-run coefficients of the BM equation
for the respective sample bank are reported in Table III.
The relationship between the Islamic BM and its determinants for BM, as reflected
in the long-run equation, is generally as expected. The coefficients of various
determinants, namely default risk of financing, interest rate volatility, liquidity risk,
solvency ratio, implicit cost, and opportunity cost of bank reserves carry the expected
signs. In particular, the Islamic BM positively responds to the default risk, solvency
ratio, implicit costs, and opportunity cost of bank reserves. Conversely, it negatively
reacts to interest rate volatility and liquidity risk. However, the coefficient of
management quality carries a negative sign, which is not as expected. As described
earlier, the management quality is measured by efficiency ratio, whereby a higher ratio
reflects a lower efficiency, thus we expected that inefficient management would be
reflected in the higher margin. This finding suggests that the efficiency ratio might not
be the best proxy to the management quality; otherwise, it becomes a puzzle in the
margin behavior of Islamic banks.
Of special interest is the coefficient of interest rate volatility. The finding of negative
sign on interest rate volatility’s coefficient for BM reinforces the theoretical foundation
for the Islamic BM behavior described earlier. Moreover, with regard to the size of its
impact on the Islamic BM, the interest rate volatility stands in second place after the
implicit cost (with coefficient of 2 0.0195). This finding implies that as the volatility of
interest rates (measured by its standard deviation) increases by 1 percentage point,
ceteris paribus, the Islamic BM will decrease by 0.02 percentage point. Further
implication of this relationship is that the performance of Islamic banks will deteriorate
BSM
BM (1,0,0,0,0,0,0,5) BB BER BA
Variables (6,3,4,2,5,6,5,5) 96:01-99:10 99:12-06:02 (1,5,5,4,0,0,4,5) (2,5,1,4,0,2,0,0) (1,0,0,0,3,0,0,3)
DEFt 0.0040 2 0.0076 0.0034 0.0622 0.0021 20.0025

MKTt 2 0.0195 0.0021 2 0.0064 0.0110 0.0048 0.0385
LIQt 2 0.0003 2 0.0070 2 0.0036 20.0057 2 0.0018 20.0004
SOLVt 0.0153 0.0236 0.0109 0.0046 0.0048 0.0010
IMPLt 0.0371 0.2805 0.4499 0.4315 0.5374 0.7266
OCBRt 0.0149 2 0.0511 0.0362 0.0034 0.0022 20.0193
QMt 2 0.0143 2 0.0176 2 0.0080 20.0251 2 0.0040 20.0098
Notes: The regression is based on the conditional UECM[9], using an ARDL(n1, n2, . . ., n8)
Table III. specification, which is appropriate for each sample bank, with dependent variable BMt estimated over
A comparison of long-run 1996:01-2006:02; for BSM, it is estimated in 1996:01-1999:10 and 1999:12-2006:02 due to its conversion
equation of BM to be an Islamic bank in 1999:11
as the volatility of interest rates increases, given the fact that the BM is still the major Bank margin
source of income for the Indonesian Islamic banks. determination
As mentioned earlier, the second Islamic bank of our sample banks, BSM, had
operated under a conventional framework prior to its conversion into an Islamic bank.
In fact, this setting benefits us in observing the existence of switching behavior in the
BM of BSM in the period under consideration. Since BSM was converted into an
Islamic bank in November 1999, we perform the Chow Break test to check the existence 75
of switching behavior with 1999:11 as the break point. Having the F-statistic equal to
23.95, we reject the null hypothesis of no break in the model at the 0.01 level of
significance. This finding motivates us to break the observation into 1996:01-1999-10
as the conventional period and 1999:12-2006:02 as the Islamic period, and then estimate
the BM equation for each period.
In general, we find that the BM equation of BSM in the Islamic period is as expected
and thus strengthens the abovementioned empirical evidence of BM. All coefficients of
the Islamic BM determinants of BSM carry the expected signs. With respect to interest
rate volatility, however, the size of its coefficient is only 2 0.0064, which is far below that
of BM of 2 0.0195. Moreover, based on its effect on the Islamic BM, for BSM, interest rate
volatility stands in fifth position, following the implicit costs, opportunity cost of bank
reserve, solvency ratio and management quality.
Comparing the BM equation of BSM in its conventional and Islamic periods, we
observe some differences in the coefficient sign of some determinants. For instance, the
coefficient sign of default risk of financing changes from negative to positive and the
coefficient sign of opportunity cost of bank reserve changes in the same way.
Interestingly, the coefficient sign of interest rate volatility changes from previously
positive in the conventional period to be negative in the Islamic period. This reveals
that, as interest rate volatility increases, conventional banks will ask for a higher
margin to compensate for the interest rate risk (reinvestment or refinancing risks),
while Islamic banks have to increase their deposit rate or decrease their financing rate
(thus the margin decrease) to protect their operation from increasing magnitude of
displacement risk. With respect to the bank’s response to the interest rate movement,
this finding implies that the margin behavior changes as the basis of the bank’s
operation switches from conventional practices, where it faces interest rate risk, to the
Islamic principles where it faces the displaced commercial risk.
Having seen that the coefficient of interest rate volatility is negative in sign for both
BM and BSM, we further investigate the empirical justifications of the finding.
Specifically, we examine the behavior of the Islamic BM components, namely price of
financing products (financing rate) and rate of return to depositors (deposit rate), under
different trends of market interest rate. Indeed, with the purpose of properly analyzing
the behavior of the components under a different tendency of market interest rate, we
break the observation into increasing and decreasing periods of market interest
rate[13]. Afterwards, for the respective periods, we calculate the correlation coefficient
between market interest rate and financing rate, measured as a ratio of financing
income to financing outstanding. We also calculate the correlation coefficient between
market interest rate and deposit rate, measured as a ratio of profit
distributed-to-depositors to deposits outstanding. The results are reported in Table IV.
Some interesting findings could be highlighted from our investigation. In the
increasing interest rate period, we observe that the financing rates of Islamic banks
IMEFM
Increasing Decreasing Increasing Decreasing
3,1 regime regime regime regime
Correlation (96:01-98:08) (98:08-00:02)a (00:02-02:01) (02:01-05:03)
BM
Financing rate-market rate 2 0.6624 0.5521 – –
76 Deposit rate-market rate 0.6082 0.9118 – –
BSM
Financing rate-market rate 0.7006 0.2417 20.4334 0.5497
Deposit rate-market rate 0.5386 0.3101 0.2423 0.8062
Notes: Financing and deposit rates are measured as ratios of financing incomes (equivalent to interest
Table IV. incomes) to total financings outstanding and ratio of profit distributed-to-depositors (equivalent to
Correlation between interest costs) to total deposits outstanding, respectively; afor the BSM, this period is set to 1998:08-
financing and deposit 1999:10 in order to avoid the effect of conversion of its operation from conventional bank into Islamic
rate with market rate bank on 1999:11
(BM and after-conversion-BSM) move opposite to the market interest rate, as supported
by the correlation coefficient of 2 0.66 and 2 0.43. In contrast, the deposit rates change
in a similar direction to the market interest rate, as suggested by the correlation
coefficient of 0.61 and 0.24. These results imply that, as the market interest rate
increases, the Islamic banks are unable to adjust instantaneously their financing rate,
since upwardly adjusting the financing rate will violate the Sharia rule regarding
the alteration of selling price[14] once it was agreed up-front. On the other hand, as the
market interest rate increases, to dissuade their depositors from withdrawing their
funds (displaced commercial risk), the Islamic banks have to increase their deposit rate.
In fact, these two contrary effects will bring down the Islamic BM in periods of
increasing interest rates. This evidence restates our finding on the negative sign of the
interest rate volatility’s coefficient for BM and BSM.
In the period of decreasing market interest rates, we verify that both the financing
and deposit rates move in tandem with the market interest rate. For BM and BSM, the
correlation coefficients of financing rate-market interest rate are 0.55 and 0.55, while
the correlation coefficients of deposit rate-market interest rate are 0.91 and 0.81.
However, to this point we are unable to explain why the Islamic BM responds
negatively to the market interest rate in the decreasing period. Thus, we estimate the
effect of market interest rate on the financing and deposit rates of Islamic banks[15].
The result reveals that as the interest rate decreases by 1 percentage point, ceteris
paribus, the deposit rates of BM and BSM will decrease by 0.03 and 0.07 percentage
points, respectively, while the financing rate of the two banks will decrease by 0.008
and 0.04 percentage points, respectively. Thus, we can verify that the deposit and
financing rates respond disproportionately to the market interest rate. As the market
interest rate shrinks, the deposit rates decrease by a bigger percentage point compared
to that of the financing rate. This evidence is found in the regressions of both BM and
BSM, with the evidence of BM being more apparent. In fact, this is the reason why the
Islamic BM does not decrease in the period of decreasing market interest rates. Again,
this finding reinforces the negative sign of interest rate volatility’s coefficient in the
Islamic BM equation.
Another interesting finding in the decreasing rate period would be the fact that the
financing price is able to adjust to the market interest rate in the decreasing period,
but not in the increasing period. As argued earlier, any alteration of selling price in the Bank margin
fixed-price mode of financing will breach the contract as it violates the Sharia rule. determination
That is, in light of the Islamic principles, it is prohibited to make any increase to the
selling price, i.e. adding the mark-up as interest rate increases or for whatever reasons,
as this is unjust and will increase the burden of the customers. However, giving a
discount or rebate under the name of the bank’s kindness without altering the selling
price is permissible as long as the rebate is not contracted and should be at the bank’s 77
discretion[16]. In fact, to protect their operation from the displaced commercial risk of
financing in the decreasing period, in which the customers “re-finance” their financing
in the Islamic banks with that of conventional banks since now the market interest rate
is lower, it is a common practice for the Islamic banks to give a discount or rebate to
their customers.
It is also worth to note that when the financing rates of both of the banks decrease
only by 0.008 and 0.04 percent, their deposit rates decrease by a bigger magnitude,
i.e. 0.03 and 0.07 percent, respectively, while the deposit contract is based on the
profit-loss-sharing (PLS) contract. Recall that there are two factors working here in
reducing the deposit rates to a bigger extent as compared to the financing rates.
The first factor is the decrease in the financing rate itself as discussed previously, while
the other factor is the movement of depositors from conventional banks to Islamic
banks since now the return of the first is lower than that of the second, ceteris paribus.
This deposits movement will bring down further the rate of return to depositors as now
the denominator (amount of deposits) increases while the numerator (profit distributed
to depositors) is relatively slow to adjust[17]. The deposits movement will continue
until the difference of deposit rates between the Islamic and conventional banks is not
significant enough to invite arbitrage opportunity action.
Finally, should we look at the correlation coefficient of BSM in its conventional period,
some interesting findings are noticeable. We verify that, in the conventional period, the
financing rate behaves in a different manner relative to that in its Islamic period. Indeed,
the dissimilarity is found in the sign of correlation coefficient of the financing rate and
market interest rate. As discussed earlier, after it became an Islamic bank, this coefficient
is found to be negative in the period of increasing interest rates. However, the coefficient
is always positive in the conventional period irrespective of whether it is in the period of
increasing or decreasing interest rates. That is, as conventional banks have no
constraints in adjusting their credit rate to follow the market rate, the correlation
coefficient is always positive in the different tendency of market interest rate.
4.2.2 Long-run equation of conventional banks: a comparison. Some comparisons of
the long-run BM behavior of Islamic and conventional banks could be pointed out from
Table III results. In general, both banks share similar behavior in the relationship
between the BM and majority of its determinants, namely default risk of financing,
liquidity risk, solvency ratio, implicit cost, opportunity cost of bank reserves and
management quality. In particular, although the coefficients of those determinants
vary in size, they show similar signs for all sample banks, irrespective of whether they
are conventional or Islamic banks[18]. This evidence reinforces the validity of Ho and
Saunders’ (1981) dealership model and its extended versions. With respect to the
interest rate volatility, while its coefficient shows a negative sign for the Islamic banks,
it is positive for the conventional banks. These findings reveal that the conventional
banks have no constraint in adjusting their credit (financing) and deposit rates to
IMEFM follow the market interest rate movement, regardless of whether it is in the period of
3,1 increasing or decreasing interest rates. However, as discussed earlier, the Islamic
banks are unable to adjust their financing price in the period of increasing interest
rates, since this will violate the very central principle in their operations, namely the
Sharia rule.
78 5. Conclusion and policy recommendation

We have examined the behavior of the BM in Indonesia using monthly data over the
period of 1996:01-2006:02. Applying a relatively new cointegration technique, namely
the bounds testing approach within the ARDL framework, we specifically identify a
long-run relationship between the Islamic BM and its determinants, namely default
risk of financing, interest rate volatility, liquidity risk, solvency ratio, implicit cost,
opportunity cost of bank reserves, and management quality.

In particular, this paper confirms the Ho and Saunders dealership approach and its
extended versions in BM determination. In the theoretical setting, we argued that
Islamic banks in Indonesia are not remote from the interest rate volatility in their
presence under a dual banking system. It is the displaced commercial risk, rather than
reinvestment and refinancing risk, that threatens Islamic banking operations in a
changing market interest rate situation. For Islamic banks case, our finding differs
from Angbazo (1997) and Valverde and Fernandez (2005, 2007). Indeed we find a
negative relationship between Islamic BM and interest rate volatility. This is in line
with the finding of Kasri (2008) as well as our empirical evidence that the Islamic BM
behaves differently relative to that of conventional banks, i.e. with respect to their
response to the market interest rate movement. Moreover, we documented that BM
behavior switched as the underlying operational principles of the bank changed from
conventional to Islamic principles. It is an opportunity for future research to compare
our finding with BM behavior in other dual banking system such as Malaysia, Bahrain,
and Pakistan. As we make use of time series approach, it will also be interesting to
employ different methodology like two-step approach and a pool-data analysis to
investigate the issue.
Our finding has particular relevance to the formulation of banking policy in
developing Islamic banks in Indonesia. As far as the Islamic banks are concerned,
knowing that the Islamic BM responds negatively to the volatility of the market
interest rate implies that the stability of market interest rates becomes of great concern
in developing the Islamic banking industry. As long as the BM is still a major source of
income to the Islamic banks, the instability of the market interest rates will have a
negative impact on the profitability and thus sustainability of the Islamic banks,
regardless its share to the Indonesian banking system currently. In light of this
understanding, Bank Indonesia as the monetary authority as well as the banking
authority (at least at the present time) should take into consideration the impact of
market interest rate volatility on the Islamic banks, in designing its monetary policy. It
is also necessary for Islamic banks to have prudent risk management to mitigate the
negative effect of displaced commercial risk and maintain its profitability. As such, the
profit equalization reserve (PER) concept introduced by Islamic Financial Services
Board (IFSB) is a possible solution that could be adopted by Islamic banks in
Indonesia. The PER is the amount set aside by the Islamic financial institutions out of
their gross income in order to maintain a certain level of rate of return for their
depositors (IFSB, 2005). The concept is in line with the finding and suggestion of Bank margin
Valverde and Fernandez (2007) in which (Islamic) banks could enlarge their range of determination
products and services in attempts to increase the revenue from non-traditional
business (which includes non-financing income) which may compensate for lower BM
due to stronger competition in the traditional segment.
Notes 79
1. The short-run rate is defined as the annual standard deviation of weekly interest rate on
three-month securities while the long-rate volatility is defined as that of the one-year
securities. An 1 percent increase in the volatility of interest rates increased BM by about 0.2
percent.
2. Mudharaba is a type of time deposit based on profit-loss sharing contract offered by Islamic
banks in Indonesia.
3. Further, according to IFSB, displaced commercial risk is defined as an exposure when the
Islamic banks are under market pressure to pay a return that exceeds the rate that has been
earned on assets financed or when the return on assets is under-performing as compared
with competitors’ rates. As such, the Islamic banks may decide to waive their rights to part
or their entire mudarib share of profits in order to satisfy and retain their fund providers and
dissuade them from withdrawing their funds (IFSB, 2005, Guiding Principles of Risk
Management for Islamic Financial Institution, p. 23).
4. Products of Islamic banks can be classified into debt- and equity-based products. The
debt-based (fixed-return) products are commonly based on the sale (trading) and lease of
tangible assets with delayed payment, among others murabahah (mark-up sale), ijarah
(leasing), istisna’ (sale to manufacture transaction) and salam (sale with future delivery).
5. The variable-return products employ PLS contracts such as mudarabah (trust financing) and
musharakah ( joint financing).
6. Although in the extreme case, where all financing products are fixed-return (debt-based) and
thus the financing rate is known ex ante, notice that the Islamic BM remains ex post since the
deposit rate is unknown ex ante.
7. Please see the Appendix for the detailed comparison of the banks.
8. In empirical studies of time series, estimation of relationship in levels such as equation (3) is
justified as long as variables appearing in the equation are stationary. Should some variables
in the system or all of them be non-stationary, then they should be cointegrated. Otherwise,
we will face the problem of spurious regression. Notice that in the presence of non-stationary
variables, Granger and Newbold (1974) suggest that there might be a spurious regression
with high R 2 and t-statistics that appear to be significant, but the results has no economic
meaning (in Enders, 1995, p. 216). Thus, it is important in the first place to verify the
cointegration properties of the variables under study. In general, this analysis is based on
the use of two main approaches in the cointegration analysis have been widely used, namely
the two-step residual-based test as developed by Engle and Granger (1987) and the
maximum likelihood-based test as developed by Johansen (1988) and Johansen and Juselius
(1990). However, those approaches require a pre-testing integration order of the studied
variables. Otherwise, pre-testing bias problem could happen. In light of those problems,
Pesaran and Shin (1997) and Pesaran et al. (2001) developed a new technique based on
F-statistic in the autoregressive distributed lag specification (henceforth ARDL) framework.
9. There are two sets of critical values for the F-test, which assumes all the regressors are, on
the one hand, purely I(1) and these are referred to as the upper bound critical values, and, on
the other hand, purely I(0) and these are referred to as the lower bound critical values.
IMEFM 10. In particular, the cointegration test is directly applicable irrespective of whether the underlying
regressors are purely I(0), purely I(1) or mixture of I(0) and I(1) (Pesaran et al., 2001, p. 1).
3,1
11. We make use of the information criteria, namely, Akaike’s information criterion (AIC) or
Schwarz’s information criterion (SC). However, as emphasized by Pesaran et al. (2001), it is
important to note that the assumption of serially uncorrelated errors is essential for the
validity of the bounds tests. Therefore, this concern must be incorporated in determining the
80 appropriate lag length of the UECM. In this paper, we calculate the AIC, SC, and F-statistic
by imposing the same lag length for all first differenced variables in equation (4).
12. In particular, we start from the base model as suggested by AIC or SC, then sequentially
reduce the insignificant lag-length for each of the lagged first-differenced variables until the
last-lag is significant.
13. It seems easier for us to understand the response of the deposit rate and financing rate under
the increasing or decreasing interest rate era rather than under increasing or decreasing
interest volatility. In fact, the finding of coefficient correlation between the interest rate and
its volatility (standard deviation) equal to 0.66 serves as a basis for us to proceed.
14. This argument is reliable, as the dominant contract in financing product is murabahah
(fixed-price financing). Even if the contributions of mudarabah and musharakah (PLS
financing) in the assets portfolio of Islamic banks are significant, this argument is still
workable on the basis that the business sector generally performs poorer in an increasing
interest rate period. Hence, the financing income of the Islamic bank will remain constant or
might decrease as the profit of the business sector deteriorates.
15. Note that before we proceed, we have tested whether the market interest rate “causes” – in
the Granger sense – the deposit rate and financing rate or not to provide basis for the
investigation. From the Granger test, we find that the market interest rate Granger-causes
the deposit rate and financing rate of BM at 0.01 levels, respectively. For BSM, we find the
same result at 0.01 and 0.10 levels, respectively.
16. At least for the practice of Islamic banks in Indonesia as it is allowed by the Fatwa of
National Shari’a Council No. 46, February 22, 2005.
17. It has been known in the banking practices that there is a lag between the times the bank
receives deposits and the times the bank lend out the money. This happens to conventional
banks and Islamic banks as well.
18. An exception is given to BA since this bank shows a peculiar sign in the coefficients of
default risk of financing and opportunity cost of bank reserves. However, the other five
regressors have similar sign with those of remaining conventional banks.
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Appendix
Name of bank BM BSMa BB BER BA

b
Description
Assets 2,028 3,011 1,816 5,229 918
Financings 1,589 2,186 1,186 1,673 706
Earning assets 1,738 2,678 1,510 3,688 848
Deposits 1,523 2,354 1,394 4,074 666
Core equity 226 460 183 251 120
Variables c
BM 0.502 0.697 0.474 0.502 0.471
DEF 5.577 6.425 2.411 7.694 4.696
MKT 2.799 2.799 2.799 2.799 2.799
SOLV 14.264 32.865 12.849 4.656 18.409
LIQ 19.815 74.819 40.713 57.325 28.278
IMPL 0.675 0.551 0.375 0.322 0.264
OCBR 7.590 5.014 4.653 4.536 3.965
QM 100.41 87.08 93.78 89.39 91.95
Table AI. Number of observation 122 75 122 122 122
Description of sample
banks and variables Notes: aAll figures for BSM are after it converted to be an Islamic bank (1999:11 to 2006:02); ball
mean figures in this section are in billions of IDR; call variables are in percentage
Corresponding author
Rahmatina A. Kasri can be contacted at: rahmatina@ui.edu
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The dealership approach is developed by Ho and Saunders (1981) to study the

2.2 Empirical research on BM determination

3.2 Data and empirical variables

3.3 Econometric procedures

where all variables are as previously defined, a is intercept and bi (for i ¼ 1, 2, . . . , 7)

BM Ratio of net-financing income to average earning

Liquidity risk (LIQ) Ratio of liquid assets to liabilities: þ þ

þ p3 MKTt21 þ p4 LIQt21 þ p5 SOLVt21 þ p6 IMPLt21

4. Empirical results and discussion

Lag order BM BSM BB BER BA

1 4.516 * 12.447 * 6.994 * 4.833 * 3.730 * *

4.2 The long-run equation for bank margin

DEFt 0.0040 2 0.0076 0.0034 0.0622 0.0021 20.0025

78 5. Conclusion and policy recommendation

opportunity cost of bank reserves, and management quality.

Name of bank BM BSMa BB BER BA

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