The lead-lag relationship and the determinants of Islamic banks’ profit rates: Malaysian evidence

The purpose of the study was to investigate the causal relationship(s) and ascertain their degree and directional influence on each other amongst the variables that affect Islamic Profit Rates of the Islamic banks in Malaysia. These intuitive variables are constructed based on a literature review to establish the theoretical relationship(s) of the various Islamic Finance hypotheses to construct the plausible co-integrated vector(s) to test their causal relationships, if any, and/or the level of influences exerted by the variables amongst and on each other; may also provide insight to further research. Standard time series techniques were applied to test the empirical data for i) cointegration to establish if there is any long term theoretical relationship between the variables and if they exist; was not just a spurious coincidence; ii) Long Run Structural Modeling (LRSM) to test any significance of their theoretical cointegrating relationship(s); iii) Vector Error Correction Model (VECM)to identify any directional causality and which of those variables are leaders (exogenous) and/or followers (endogenous); iv) Variance Decomposition (VDC) to estimate their relative degree of exogeneity and endogeneity and through Impulse Response Function to graphically map out the dynamic response of each variable when another variable is shocked and finally using a Persistence Profile to affect a system wide shock to these variables to estimate the speed with which the variables get back to equilibrium. This assignment was motivated by the statement "The issue is not a choice between rigor and intuition, but rather how well-founded on rigor is your intuition" Jacob Frenkel (Harvard University). How may this be of relevance to Islamic Finance? Much of the intuitions of the latter subject hitherto are anecdotally postulated on qualitative and descriptive theories and this study attempts to scientifically test some of these intuitions through the application of these techniques to validate or negate; if not to gain more insight to the degree of influences or explanatory latitude of those intuitions induced from the various Islamic Finance theories.